A Brief Examination of Fiat Currency, It's Uses Throughout History and The Implications of Its Use Today

Copyright 2009 Antonio Goicochea. May Not Give Away, Sell or Share the Content Contained Herein.

A Brief Examination of Fiat Currency, It’s Uses Throughout History

and the Implications of Its Use Today

Antonio Goicochea

University of Maryland University College

Abstract

This paper briefly examines fiat currency and some of the more dangerous economic and political events in history brought about through loose monetary policy and the misuse of fiat currency. Fiat currency is dangerous when misused for an extended period of time. The paper also concisely discusses benefits and disadvantages of the use of fiat currency. Finally, there is a brief discussion of the implications of a soft money standard in use today in the United States.
A Brief Examination of Fiat Currency, It’s Uses Throughout History and the Implications of Its Use Today.

QUICK OVERVIEW.

The use of fiat currency today is widespread. All currencies today are fiat currencies. In discussions with others, some with degrees in economics, the author has heard the argument that fiat currency is more relevant for today’s global interconnected economy, although the specific mechanics as to why fiat money is more relevant in today’s society has not been explained. On rare occasion, the author has also heard some propose a return to a hard money standard such as gold or silver.

Upon research of the viability of fiat currency the author has come up with some intriguing historical examples as to the use of fiat currency. In some instances fiat currencies have promoted fantastical economical and financial upheavals in various parts of the world throughout history.

Today it appears that the use of fiat currency is “en vogue” compared to other times in history. Previously, many detested its use and the adoption of paper currency has been met with skepticism among various circles of power.

Here in the United States, many of the founding fathers were not keen on the idea of using fiat currencies (Ludwig von Mises Institute 1996). They were more interested in a hard money system as were other important historical figures. President Andrew Jackson, for example, along with many other die-hard “hard money” proponents theorized that paper currency encouraged speculation which led to banks to lend more money than was necessary, especially in the form of risky loans, which in turn created bank panics, and depressions (Samuelson 2008). In France, Napoleon Bonaparte, against the consent of his advisors, wanted to abandon a soft money standard and reinstitute a gold standard even though the country was in enormous debt. Fortunately for France, and Napoleon, this return to a hard money standard worked (Lewis 2007). Ludwig Earhard, who was Germany’s finance minister after the second world war, linked the deutschemark to gold via the dollar as part of the Bretton Woods standard after witnessing Germany struggle with inflation as a result of the combination of paper currency and loose monetary policy (Lewis 2007). Today, we are witnessing some of the effects of fiat currency coupled with loose monetary policy.

THE ADVANTAGES OF FIAT CURRENCY.

However, there are some advantages of fiat currency, in the sense that because it is a currency not backed by anything of intrinsic value a nation can easily switch over to fiat currency and cease to redeem bank notes for gold or silver which was usually the case when most nations employed a representative money system. This has been deemed as a viable solution when a country is experiencing difficulty paying their debts. Government based debts can be incurred due to increased military spending as a result of significant and usually drawn out military campaigns, and also other spending by the government, which can come about through increased government expenditures. These government expenditures can include commissioned public works of sizeable magnitude, welfare payments and / or transfer payments along with other purchases (Maloney 2008).

To sum it up in layman’s terms, a country switching over to a fiat currency system can now pay back debts with instruments worth less in value by increasing the number of bank notes available. In modern parlance we call this “increasing the money supply.” Newly printed currency initially acts as high-powered currency as the market has not adjusted to this influx of newly printed (Maloney 2008). For that reason, the first to use newly printed currency reap the most benefit. However, because the markets eventually adjust to the dilution of value, the new currency loses its purchasing power. It is for this reason that many critics chide that fiat currency is a form of government sanctioned legal counterfeiting (Schroeder 2008).

For clarification, a representative money system is a monetary system where gold and silver are represented by bank notes or bills. Instead of carrying gold and silver coins, commodity money, bank notes are a much more convenient to physically carry instead of having to pay in weights of gold or silver coin. Imagine having to buy something of significant of significant value with gold and silver coins.

Today, the major currencies of the world are fiat currencies.

THE DISADVANTAGES OF FIAT CURRENCY.

The long-term disadvantages to using fiat currencies are that governments and central banks are too tempted to print extra currency. When the currency supply expands too much, purchasing power decreases. The argument has been that if the currency supply remained constant, in a similar manner to hard money standards, there would not be the same type of volatility that usually comes about through fiat currency. For example, U.S. Treasury Secretary and former New York Federal Reserve President Timothy Geithner went on the Charlie Rose Show and discussed that some of the variables that contributed to the current economical calamity we are dealing with: “… I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this [crisis]” (Rose 2009).

Mr. Geithner, in the above quote is telling us that central banks, in this case the Federal Reserve, had created too much currency and had sustained this practice for too long. He is telling us that fiat currency along with other factors have played a role in the current meltdown we are experiencing today. Students of history should not be surprised. Ever since fiat currencies were first implemented, each and every single fiat currency has failed, and some of these failures have been ominous. Let’s briefly examine some of the more memorable examples in history.

Selected Fiat Currency Failures Throughout History.

The Ancient Greeks.
Fiat currency was first thought to have been invented and used by the ancient Greeks (Maloney 2008). The ancient Greeks implemented fiat currency to finance an over-extended militaristic campaign. Instead of using commodity money as they used to, they started using fiat currency by debasing the precious metals content in their coins until the face value was worth far more than the intrinsic value of the debased metal to pay for their war expenses. Within a few years this currency became worthless and coupled with an overextended foreign military policy, the Greek Empire was crushed. The Greeks effectively accomplished what their enemies had failed to do; The Greeks destroyed themselves (Maloney 2008).

Rome under the rule of Diocletian.
The Roman Empire, similar to the Greeks, began to mix various metals into their coins. Eventually these coins no longer contained a gold or silver mixture and became “nothing more than tin-plated copper or bronze” and as a result inflation soared (Maloney 2008).
As inflation began to skyrocket, the famous Roman Emperor Diocletian issued his famous Edict or Price in 301 A.D. which mandated price controls and government wages. The Edict also mandated a “death penalty on anyone selling goods for more than the government mandated price and […] froze wages” (Lewis 2007; Maloney 2008; Weatherford 1997). However, to the surprise of government, these attempts to stem inflation and bring the economy under control backfired as prices continued to rise. Merchants were still finding a way to charge market prices and the threat of the death penalty failed as a deterrent (Lewis 2007).
As economic difficulties intensified, the Roman government became more involved in the central planning of the economy with the invention of welfare, and ample government funded public work projects. Deficit spending was taken to extremes. The new economic policies of the Roman government were failing.

To measure the increase of inflation over time, In 301 when the famous Edict of Prices was issued, 50,000 denari could purchase a single pound of gold. Halfway through the 4th century it took 2.12 billion denari to purchase a pound of gold. This was first known case of hyperinflation to occur in history (Maloney 2008). This level of inflation eventually destroyed the Roman Empire and the public reverted to bartering (Lewis 2007). Some historians state that the collapse of the Roman Empire led to the dark ages (Lewis 2007).

France and John Law.
John Law was considered something of a financial genius in his time and lead a turbulent life filled with great successes and severe failures. Without getting too much into his background, John Law eventually relocated to France after a few legal scrapes in England. By the time Law arrived in France, the well-loved “Sun King,” Louis XIV, was irresponsibly incurring large debts by funding extensive military campaigns and his lavish lifestyle, which included the construction of Versailles. Around this time John Law had written several treatises pertaining to “trade, money and banking,” one of which also discussed the benefits of paper currency (Weatherford 1997). When Louis XIV passed away, Le Duc of d’Orleans, who was a gambling buddy of John Law, was made Regent until Louis XV was old enough to rule France. At this time Le Duc d’Orleans discovered that tax revenue would be insufficient to meet the interest payments owed on France’s debts. John Law promptly seized this opportunity and presented the Regent with two treatises he had written expounding the benefits of paper currency (Lewis 2007; Maloney 2008).

Law was promptly gifted a bank at the behest of the Duke, which was called Banque Générale, and was also awarded the right to print paper currency (Maloney 2008). Thus, Le Banque Générale acted as a privately owned central bank. This occurred on May 15, 1716 (Maloney 2008).

Initially all went well. The French economy experienced an economic boom, which initially tends to happen when a nation’s monetary system switches over to a paper currency based system even though the notes were originally claimed to have been backed by gold specie. John Law became something of celebrity as a result of this artificial economic boom. In 1718 Le Banque Générale changed its name to Le Banque Royale, signifying that the regent would guarantee all bank notes. Unfortunately, after the creation of the central bank and the conversion to a paper currency system, Le Banque Royale began to issue more notes that in aggregate could not be fully redeemed as these notes were guaranteeing the redemption of more than twice the quantity of gold available in France. John Law’s involvement in the Mississippi Bubble and expansion of the currency supply precipitated significant inflation (Friedman 1994; Maloney 2008). French citizens and stock holders in the Mississippi Company, which Law controlled, began to worry and attempted to redeem their shares of stock and bank notes for various precious metals, primarily gold and silver, until French banks had exhausted their supply. Those redeeming their bank notes were now receiving payment in copper. John Law’s paper currency system collapsed shortly thereafter. The country was on the brink of severe social unrest and on May 10th 1720 John Law was terminated from his position as Controller General of Finances. John Law single handedly created a major international market crash and the demise of his paper currency system embroiled France and most of Europe into a depression that lasted decades. (Ferguson 2008; Maloney 2008). It only took four years.

Some authors and historians believe these events were a distal cause of the French Revolution (Ferguson 2008; Gonçalo 2001). However, one of the contributory proximal causes of the revolution came about when France attempted to reinstitute paper currency. This came about in 1776 when another Scotsman and a Swiss convinced the French government to employ fiat currency once again (Lewis 2007). This second attempt at fiat currency failed and the French Revolution soon followed. Perhaps this is the reason why Napoleon decided against his advisors recommendations to reinstitute a soft money standard and chose to readopt a hard money standard (Lewis 2007).

The Continental And The Greenback.
To finance the Revolutionary War, the founding father’s of the United States switched over to a fiat based currency called “the continental.” The continental quickly lost nearly all of its value (Friedman 1994). Fortunately, the United States government put in a great deal of effort to expediently pay off accrued war-time debts (Creadon 2008). As common sense would dictate, excessive debt can be dangerous when misused as we can see is the case with governments, myriad firms, and individuals over time.


The Civil War itself was financed by Greenbacks, another form of fiat currency (Friedman 1994). As we can see, because fiat currency allows the currency supply to expand with ease, governments find them popular in order to finance wars.

The Weimar Republic.
After World War I Germany was in severe debt. The Treaty of Versailles after World War I ordered Germany to pay reparations to several countries. However, Germany was experiencing difficulty paying their reparation and began to expand the supply of their paper currency to pay off these debts with weaker papiermarks (Maloney 2008). It was only a short amount of time before Germany excessively expanded their currency supply and experienced hyperinflation so severe that the economy was virtually reduced to barter in the 1920s (Lewis 2007). Before Hitler rose to power, the currency became so worthless that German citizens were burning papiermarks to heat their homes and also used it as wall paper. Many history students of high school and college age have heard the story of a man who went the shopping at the local grocery store and left his wheel barrow outside piled with papiermarks. When he came back the wheel barrow was gone but the currency was still present (Smith 2004).

Interestingly enough some claim that these economic events set the stage for the rise of Adolf Hitler (Paul 2007). The connection is not apparent to the author but has heard this mentioned and has read this enough times to warrant further investigation. Either way, Germany returned to fiat currency in the 1930’s and after Hitler’s death monetary and fiscal policy had again virtually reduced the monetary system to trading hard goods such as “cigarettes and chocolate” as a form of money (Lewis 2007). A few decades later in the early 1970s, Germany’s fear of re-experiencing hyperinflation led them to have their currency float against the dollar as opposed to maintaining a previously determined fixed foreign exchange rate against the dollar which they agreed to under the Bretton Woods Standard (Hubbard & O’Brien 2009). This created pressure on the US economy as the deutschemark increased in purchasing power relative to the dollar and the U.S. began to hemorrhage gold to Germany. Under these circumstances Richard Nixon decided to break with the Bretton Woods Standard and the dollar was no longer pegged to gold (Landis 2003)

Fiat Currency and Hyperinflation in Perú: A Personal Example.
As a personal example, the family of the author is from Perú and discussed with family members their experiences with hyperinflation during the 1980s. During this time the Peruvian sol experienced significant devaluation and the economy was in shambles. The results of this severe inflation led to a multitude of problems. Hyperinflation in Perú wiped out the middle class; salaries barely increased in nominal terms, thus losing noticeable real purchasing power almost on daily basis. The moment paychecks were received, they were spent to purchase and hoard goods. There were lines in stores to purchase food but there was little food available to purchase. The government imposed price controls, forcing most producers and retailers to sell goods at a loss. These price controls incentivized the formation of black markets, which in turn charged market prices that were much higher than most could afford. Bankruptcies and foreclosures soared and in a country of less than 20 million inhabitants, over 3 million fled, most of whom were well educated professionals.

What happened to Perú may very well happen again today if loose monetary policy persists in fiat currency based economies.

Fiat Currency Today, The United States and Inflation.
Today all currencies are fiat and by their nature are inflationary. As previously stated fiat currencies tend to be inflationary because governments and central banks are tempted to increase the currency supply in times of crisis and keep the supply expanded. As a result of this we have to worry about inflation. The statistics and opinions of other economists that the author has read pertaining to the United States has led him to very worrisome conclusions. Some economists speculate a sharp increase in inflation of the US dollar over the next few years. For example, Economist Marc Faber in an interview with Bloomberg TV in May of 2009 predicted that the United States will experience hyperinflation (Tae-gyu 2009). Today, we are already witnessing the negative effects of hyperinflation on Zimbabwe.

This should worry many policy makers as well as the public. The dollar, which enjoyed an 11% increase in value 1776 to 1913 and has lost over 95% of its value since 1913, may no longer be considered the reserve currency of choice by the end of the next decade (Voorhees 2009).
Inflation would not be a problem if wages keep pace with rising asset prices and the cost of living. But this has not been the case. Using alternative CPI data gathered by John Williams and in conjunction with BLS data the author has estimated that the purchasing power of the average salary has decreased roughly by a factor of 2 since 1975 (www.shadowstats.com). In other words the average salary – both individual and household income - in 1975 purchased a little more than twice what the average salary can purchase today. As the dollar is now derived from debt and the government begins to encumber more and more debt we need to examine history and look for solutions. The author’s own conclusions using data available from the BLS and other economists has shown that the cost of living has increased disproportionately to incomes as stated above.

Today we are in a precarious situation with the Federal Reserve having to both raise interest rates and lower interest rates at the same time. The increase in the currency supply is necessary to increase liquidity in the banking sector however critics point out that the Fed is printing out currency at unprecedented levels. John Williams has recently published an articled that reports that the increase in the money supply is running at an annualized rate of 9% as of June this year (www.shadowstats.com). If hyperinflation were to occur in the United States there could be significant problems with respect to the scale, scope and size of the effects. What happens to a country when many of its 300 million citizens become restless and discontent due to poor fiscal and monetary policy? Finally, the author will leave you with a quote from Irving Fischer written in 1911 “Irredeemable paper money has almost invariably proved a curse to the country employing it” (Friedman 1994).

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Copyright 2009 Antonio Goicochea. May Not Give Away, Sell or Share the Content Contained Herein.