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Wednesday, June 27, 2007 9:00 AM

Why does fiat money seemingly work ?

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written by Trotsky, edited by Mish

This is part 2 of a 2 part series. Part 1 was Misconceptions about Gold.

Imagine that you live on a small island mining the local salt mine, together with Pete the fisherman and Tom the apple grower. You'd exchange your salt for Pete's fishes and Tom's apples, while they would exchange fishes and apples between them.

One day Pete says: "Instead of fish, from now on I will give you pieces of papyrus with numbers marked on them. (Papyrus grows in near unlimited quantities nearby, to the obvious benefit of Pete)." Pete continues "One papyrus mark will represent 1 fish or 5 apples or 2 bags of salt (equivalent to current barter exchange rates). This will make it easier for us to trade among ourselves . We won't have to lug fishes, apples and salt around all the time. Instead, we simply present the papyrus for exchange on demand."

In short, Pete wants to modernize your little island economy by introducing money - and he already has one of those $1 papyrus notes with him, which he's eager to exchange for salt.

You'd laugh him out of the room, since you would realize that the papyrus per se is not of any value. If you were all to agree on using the papyrus, its value would rest on a promise alone - Pete's promise that papyrus he issues is actually backed by fish. Since the stuff grows everywhere, he could easily issue it by the bucket load. In fact, it's unlikely that any of the islanders would ever come up with such an absurd idea.

More likely they would use another good for which there is an actual demand (for instance, a rare type of sea-shell that is prized as an ornament and only seldom found on the island) as their medium of exchange.

In short, a free market medium of exchange/store of value can only be something with an already established demand. No worthless object would ever emerge to function as money in a free market.

So how did it happen?

How did essentially worthless objects come into widespread acceptance as money? To answer that question, we need to take a brief look at history.

Flashback: Rome 27 BC

Rome’s history of inflation and money debasement actually began with Cesar’s successor Augustus, whereby his method was at least not a prima facie fraud. He simply ordered the mines to overproduce silver in an attempt to finance the empire that had grown greatly under Cesar and himself.

When this overproduction began to have inflationary effects, Augustus wisely decided to cut back on the issuance of coins. This was the last time that a Roman emperor attempted to honestly correct a monetary policy blunder, aside from a brief flashing up of monetary rectitude under Aurelius some 280 years later.

Under Augustus’ successors, things began to deteriorate fast. Claudius , Caligula and Nero embarked on enormous spending sprees that depleted Rome’s treasury. It was Nero who first came up with the idea to actually debase coins by reducing their silver content in AD 64 , and it all went downhill from there.

It should be mentioned that Mark Anthony of Hollywood fame financed the army he used in his fight against Octavian – then later Augustus – also with debased coinage. These coins remained in circulation for a long time, obeying Gresham’s Law – "bad money drives good money from circulation".

Left: An AD 275 specimen of Aurelian’s Antonianus, 1 part silver to 20 parts copper .

In AD 274 Aurelius entered the scene with a well-intentioned monetary reform, which fixed the silver-copper content of the then most widely used coin (the Antonianus)at 1:20 – however, just as soon as this reform was instituted, the silver content resumed its inexorable decline.

Left: Emperor Diocletian the price fixer

In AD 301 Emperor Diocletian tried his hand at reform, this time by instituting price controls, an idiocy repeated numerous times thereafter, in spite of the incontrovertible evidence that it never works (Richard Nixon’s ill-fated experiment being the most recent example) .

Naturally, those price controls accelerated Rome’s downfall as goods simply began to disappear from the market place. Merchants began to hide their goods rather than accept the edict to sell them at a loss. This is of course why price controls are always doomed to failure.

One recurring feature of Rome’s long history of debasing its money was a perennial trade deficit due to overconsumption. Does this sound vaguely familiar?

The leap from clipping coins to outright fiat money

How was the leap from debasing coinage to outright fiat money accomplished?

There are two distinct intertwined historical developments that led ultimately to the present system.

Goldsmiths become bankers

The idea of fractional reserve banking was first introduced by the forerunners of our modern day banking system, the goldsmiths.

Goldsmiths were used as depositories for gold and silver, and the receipts they issued for such deposits soon began to circulate as the first bank notes – especially once they hit upon the idea to make them out to the ‘bearer’ instead of tying them to a specific deposit.

Above: An early goldsmith bank receipt

The convenience of carrying these bank notes instead bags of gold and silver soon caught on, and it didn’t take long for the goldsmiths to realize that deposits were rarely claimed in great quantities. It followed that one could temporarily lend deposits out and collect interest on such loans. So far so good – this is the legitimate business of banks.

But the goldsmiths decided to go one step further, issuing additional receipts for gold, even if they were not actually backed by a deposit. This is what came to be known as ‘fractional reserves banking’ - lending out far more ‘money’ than one actually has in the form of deposits.

Obviously this is fraud. Nonetheless, it’s perfectly legal today, but in essence it remains the same fraud it has always been, with the main difference being that today it's a more sophisticated as well as officially sanctioned fraud.

When bank notes were backed (at least partially) by gold and silver on deposit, fraud of this nature was frequently held in check by bank runs (or from a banker's perspective, fear of bank runs). Nowadays, no such fear exists. The ‘lender of last resort’ – the central bank – can (at least in theory) prevent such bank runs by conjuring new ‘money’ out of thin air. In essence, a de facto insolvent banking system is supported by this trick.

Tally sticks and Charles II

The other historical development that can be seen as an ancestor of the modern day fiat money system is England’s application of the medieval ‘tally stick’ method of recording debt payments.

Taxes in the largely agricultural economy of the Middle Ages were usually paid in the form of goods, and these payments were recorded with notches on wooden sticks that were then split length-wise (one half remained with the tax payer serf, as proof of payment). This was an ingenious method of avoiding counterfeiting.

In AD 1100, King Henry the First ascended the English throne, and adopted the tally stick method of recording tax payments. By the time of Henry II, taxes were paid twice a year, and the tally sticks recording the partial tax payment made at Easter soon began to circulate in a secondary discount market – i.e., they began to be accepted as payment for goods and services at a discount , since they could be later presented to the treasury as proof of taxes paid.

It didn’t take long for the King and his treasurer to realize that they could actually issue tally sticks in advance, in order to finance ‘emergency spending’ (not surprisingly, such emergencies often involved war – after the extortion of tax money the second big hobby of governments).

The selling of these claims to future tax revenue created the market for government debt – an essential part of today’s fiat money system as well.

A wooden stick, masquerading as ‘money’.

By 1660, the English monarchy , after a brief hiatus of experimentation with a pseudo-republican government under Cromwell, was reinstated and Charles II began his reign but with vastly reduced powers, especially in the realm of taxation.

Since Charles had to beg for tax money from the parliament, he struggled mightily with paying his vast pile of bills. Whenever Charles wrangled permission to raise taxes from parliament, he immediately went to cash in the future tax receipts by selling tally sticks to the goldsmiths at a discount. This necessitated the introduction of previously referred to method of making such debt payable to the bearer, which allowed the goldsmiths to sell it in the secondary market to raise funds for more lending to the King.

They also began to pay interest to depositors, in order to attract still more funds. At that stage of the game, the goldsmiths had a good thing going for them, since the King was the equivalent of a triple A rated sovereign borrower, who could always be relied upon to cover his debt with future tax receipts. No one thought it problematic that the vaults soon contained more wooden sticks than gold . There was an active market in this government debt, and the goldsmiths profited handsomely.

The King meanwhile decided to circumvent parliament and began to issue tally sticks as he pleased (as an aside, one half of such a stick, which originally remained with the treasury had a handle and was called the ‘stock’ - the term that has evolved to describe shares in publicly listed corporations today) .

Naturally, Charles was more than happy to exchange wooden sticks for gold, and not surprisingly, soon kicked off a veritable credit boom by upping his wooden sticks production.

Left: Charles II, the "Merry Monarch", in all his splendor, eyes focused on the loot.

Why was he nicknamed the "Merry Monarch"? Well, you would be merry too if you could kick off an enormous credit boom by exchanging sticks for gold.

So what does a king do with all that gold he received for sticks? During his 25 year reign, he waged 3 losing wars (2 against the Dutch, one against France); he survived 4 different parliaments (only the first of which wasn’t hostile to him); he helped to establish the East India Company, made shady deals with Louis XIV of France (his cousin), sired a horde of illegitimate children of which he acknowledged 14, and was renown for his hedonistic court. That's a lot of "merry".

Of course, there was a natural limit to this debt expansion. Once all the money attracted from depositors had been transferred to the King, additional deposits could only be acquired by means of offering higher interest rates than previously.

By 1671 the annual discount on the King’s debt had reached 10% and due to redemptions nearly overwhelming funds raised by new debt issues, things clearly had ceased to work for him. Charles suddenly and conveniently remembered that there was a law against usury on the books, and lo and behold, interest rates in excess of 6% were not permissible.

With all his recent loans carrying a far bigger discount, he simply declared the debt illegal, and stopped payments on it (with a few judiciously selected exceptions). Overnight, the King’s tally sticks reverted back to what they had really always been – worthless sticks of wood.

The King’s creditors, chiefly the goldsmiths and their customers, had, quite literally, "drawn the short end of the stick" (if you ever wondered where this expression came from, this is it).

Left: Charles II as he is apparently remembered today – a knight in shining armor, not the tyrannical thief that he really was.

Although tally sticks were still used until the early 19th century, and even formed part of the capital of the Bank of England when it was founded in 1694, the secondary market never truly recovered from this blow. Charles had, with the stroke of a pen, killed the better part of London’s budding banking system, and transformed countless of his creditors into destitute involuntary tax payers.

To add insult to injury, he even gained a propaganda victory, as the public tended to blame the goldsmiths for the mess (they were of course not entirely innocent, and above all had been quite gullible).

What the tally stick system and its application by Charles II however did achieve, was to plant the idea of how a fiat money system might actually be made to ‘work’.

John Law’s fiat money experiment in France

It was a Scotsman – John Law – ironically born in the very year (1671) when Charles defaulted on his debt, who tried the first great fiat money experiment inspired by these ideas. Living in exile in France, he found a willing partner in Philppe II Duke of Orleans' near bankrupt state for putting his ideas into practice.

Left: Philippe II, Duc d’Orelans, the Regent of France. When Louis XIV of France died in 1715, Philippe d'Orleans became Regent to the five-year-old King. Together with John Law, they combined to economically wreck France.

John Law's basic idea was that the more money in circulation the greater the prosperity of a country. His ideas can be found in a treatise he published in 1705 entitled Money and Trade Considered.

Right: John Law - World's first Keynesian economist

In his words, "Domestic trade depends upon money. A greater quantity [of money] employs more people than a lesser quantity. An addition to the money adds to the value of the country."

With the above logic, John Law arguably became the world's first Keynesian economist.

John Law became the comptroller general of finances and set up the Banque Generale Privee (later the ‘Banque Royale’), which used French government debt as the bulk of its reserves and began to emit paper money ‘backed’ by this debt – with a promise attached that the notes could be converted to gold coin on demand.

In an effort to make the new paper money more palatable to a distrustful public, it was decided to make it acceptable for payment of taxes (this idea is key and we will get back to it). A credit and asset boom of vast proportions ensued, especially after Law decided to float the shares of the Mississippi company, which enjoyed a trade monopoly with the New World and the West Indies.

Between 1719 and 1720 shares in the company rose from 500 to 18,000 livres. Then, predictably, the bubble burst, and it lost 97% of its market capitalization in the subsequent bust. Enraged and nervous financiers tried to reconvert their bank notes into specie in the ensuing massive economic crisis, but naturally, the central bank’s promise of convertibility could not be put into practice – it had inflated the supply of bank notes too much (the notes traded at discounts of up to 99% in the end).

The government at first tried to stem the tide with edicts forbidding the private ownership of gold , but in the end, the enraged mob drove Law into exile, and the fiat money experiment ended with the Banque Royale closing its doors forever .

Above: 1720: Investors in Law’s Mississippi Company scam want their money back

The crisis following the collapse of Law’s Mississippi enterprise gripped all of Europe – the eloquent master of fiat disaster had seduced investors from all over the continent, many of whom were suddenly penniless. Confidence in other European corporations eroded as well, and a great many bankruptcies took place.

Failures Everywhere

The history of the world is filled with examples like the above. Unfortunately time and space considerations will not let us detail the backdoor coup that enabled the establishment of the Federal Reserve, FDR’s sinister gold confiscation, Nixon’s dropping of the last remnant of the dollar’s gold convertibility, or China’s earlier experiment with paper money which ended in a disastrous hyper-inflation.

The brief monetary history of Rome is intended to establish the fact that the State has sought to engage in theft from the citizenry via monetary debasement from the very dawn of Western civilization. The focus on the 17th century application of the tally stick system in the UK as well as the focus of the transformation of London’s goldsmiths to bankers is meant to establish from whence the idea of putting together a workable fiat money system stems. This is an extremely important part of monetary history but is generally a less well known one.

The above historical recap was written to fill in some additional as well as essential information if one wants to understand how we arrived where we are today. With that history lesson out of the way, let's now address the question we asked at the top. How did worthless objects come into widespread acceptance as money?

Public Demand for Fiat Money

For a long time, States were forced to accept gold's role as money. The absurdity of introducing unbacked paper money wasn't considered a viable avenue of robbing the citizenry. Rather, heads of State resorted to 'clipping' their coins or diluting their precious metals content if they wished to inflate. These early instances of inflation via reduction of the precious metals content of coins were intimately connected to the downfall of entire empires – most famously, the Roman empire. But along came Charles II, followed by John Law who had a brilliant idea for gaining public demand for fiat currency.

Demand for fiat money was created by its acceptance for payment of taxes.

What we have here, is really no less than the explanation for why pieces of paper with some ink slapped on them are not a priori laughed out of the room, as we proposed would happen with Pete’s papyrus promises in paragraph one. The demand for this paper is established by its acceptance for the payment of taxes.

The two major pillars of the system are based on coercion: directly via the legal tender laws (which decree that fiat currency must be used/accepted for all payments of debt, public or private) and indirectly via the value imputed to government debt which rests on the faith in the government’s ability to extort enough future tax revenue to be able to repay its debt.

This latter point is extremely important for the system to function. Government bonds are the tally sticks of our age, and serve as the main ‘backing’ of bank notes and their digital counterparts in circulation. They are what is tying the government and the banking system together, via the central bank.

The central bank has the power to ‘monetize’ such debt by creating money out of thin air, however, this roundabout way of going about it is an essential part of the confidence game, the creation of the illusion of value.

Theft of Purchasing Power

Left: Fiat currencies in the 20th century - monetary catastrophes unfolding at varying speed since the birth of the Federal Reserve.

Image thanks to the Gold Eagle editorial Fiat Money Systems. (click on image for a better view)

Since the central bank’s balance sheet is largely composed of government debt, it has an incentive to manage the public’s ‘inflation expectations’ and inflate the currency as inconspicuously as possible.

This does of course not mean that the inflation racket is inhibited per se. The theft has merely been organized in such a way that the people don’t complain too much.

If the government had to actually raise taxes instead of borrowing the staggering sums of money it uses to keep its welfare/warfare programs running (and keeping the vote buying mechanisms well oiled) it would have to raise taxes by so much that it would face a rebellion.

Instead government resorts to inflation.

Inflation is nothing but a cleverly disguised tax and that is the real meaning of that last chart.

The fox guards the hen house

Richard Russell, in a recent missive, reminisced about the $125 his first job after college earned him per month and the then high $22.50 he had to pay every month for his $10,000 GI life insurance policy. A new car cost $450. Those were princely sums in the 1940’s, but have become what he now calls ‘chump change’.

Obviously this hasn’t happened overnight although it can, as witnessed by Zimbabwe. Rather the public has become used to and injured by the ‘inflation tax’ proceeding at what appears to be a snail’s pace (at least according to the government’s official ‘inflation data’, which is like the fox guarding the hen house). It is of course not possible to measure an ‘average price’ of disparate goods , so this is just another part of an elaborate scam.

With the legal tender legislation in place, fiat money has also successfully put gold out of circulation. After all, no one is going to use ‘good money’ for transactions when he has the choice of using ‘bad money’ instead. Indeed, what has happened is that gold has increasingly shifted from the world’s monetary bureaucracies into private hands, as a store of value.

On a global basis, only about 2.5% of all official central bank reserves are in gold nowadays (obviously, some countries have far larger percentages of their reserves in gold, most notably the US and many European countries – even so, these reserves pale in comparison to the amount of fiat money and credit they have issued).

Everyone is Happy

It is also important to note that although they are being subjected to a hidden tax, most citizens actually are quite happy with things as they are. As Gary North has observed in a recent essay, everybody involved appears to be happy, the robbers as well as the robbed.

The banks are happy to be part of a cartel led by the central bank, which gives them immense latitude in indulging in consistent and flagrant over trading of their capital – spurred on by the moral hazard created by having a ‘lender of last resort’ at their disposal, with no restrictions on how much ‘money’ it can conjure up out of thin air;

The politicians and the bureaucrats are happy because there is no restriction on their spending and there is nothing stopping them from buying votes or indulging in whatever ‘pet projects’ they happen to dream up.

And lastly, among the people who should actually rise in protest, there are large sub-groups that are either wards of the State and dependent on its largesse (the shameful secret of the welfare state is that it makes irresponsible slaves out of previously free and responsible people), or have been seduced by the banking cartel’s propaganda and amassed so much debt in the pursuit of consumption that they are quite happy to see money being devalued at a steady pace.

Wealth Producers Have No Say

In a nation of debtors, inflation is the politically most palatable form of monetary policy – after all, everybody is focused on the short term (politicians and bureaucrats on their terms of office, consumers on their debt and their desire to buy more things they don’t need with money they don’t have, and so forth).

No one considers for a moment, that in the long run, this policy means ruin. Over time, the middle and lower classes will see their real incomes and living standards shrink ever more, while the true beneficiaries of inflation – those who get first dibs on every dollop of newly created fiat money – amass more and more of the wealth that is stolen from its producers by inflation.

Not surprisingly, the small elite that actually profits from the fiat money system is quite content to take the long term view for itself.

The actual producers of wealth are a very small group, too small to have a decisive voice in how things should be run. They would have to pull a John Galt type stunt and all go on strike if they wanted to exercise some pressure. Unfortunately, big business is usually in bed with the State and also happy with the status quo.

One must always keep in mind that big corporations are generally not in favor of truly free, competitive markets. They give lip service to the idea, but concurrently lobby for anti-competitive regulations all the time.

Decades of successful propaganda

The propagandistic effort in support of the fiat money system has been enormous over the decades, and has been extremely successful.

Left: Greenspan unlocks the secret of making fiat money "as good as gold".

When Alan Greenspan told Ron Paul on occasion of his semi-annual testimony in Congress that he believed "we have had extraordinary success in replicating the features of a gold standard" he knew quite well that this was a bald-faced lie.

And yet, no one outside of Ron Paul would have even thought of questioning this absurd assertion.

As to why it is obviously a lie, consult the chart above. The dollar has lost 96% of its purchasing power since the Fed has been in business.

Let us also not forget that there still is a remnant of a market economy operating alongside the huge swathes of economic activity that have been appropriated by parasitic entities such as the State and its dependents.

It is this remnant that produces all of our wealth, in spite of the fiat money system. It involuntarily supports the system’s continued viability by doing what it does best – enhancing productivity, and thereby exerting downward pressure on the prices of goods and services (which works against the upside pressure on prices created by monetary inflation).

This in a nutshell shows why the system ‘seems’ to work – and actually does work on a short term basis.

Economic Interventionism vs. the Free Market

Apologists of the current system tend to laud its "flexibility". In reality this argument is nothing more than an argument for economic interventionism which history proves time and time again can't work in the long haul.

Another commonly heard argument is: "If the economy is to grow, so must the supply of money", as if that were immediately obvious. In fact, most people who hear this sentence do believe it to be a truism. In reality, increasing the supply of money confers no benefit whatsoever on society at large. It is not important how much money one has in terms of number entries in one’s bank account, it is important what this money can buy. Didn't John Law's experiment prove this beyond a shadow of a doubt?

It is not 100% certain that a modern free market economy would settle on gold as its money. In fact, it is not important what would emerge as money. What is important is that the decision on what should be used as money would be arrived at voluntarily by the collective actions of market participants.

That said, it seems highly likely that the previous historical period of trial and error that has led to the establishment of precious metals as money would still be accepted as having produced a satisfactory outcome by a modern free market economy. After all, we know that gold trades in the marketplace as if it were money. See Trotsky on Gold - Misconceptions about Gold for proof.

In a free market with a relatively stable supply of money, the supply and demand for money would still be subject to fluctuations similar to that for other goods, depending on time preferences. The free market interest rate would at all times correctly signal to entrepreneurs what the state of time preferences was at a given point in time, allowing them to allocate capital in the most efficient manner.

A fiat money system with interest rates administered by a bureaucratic central economic planning agency meanwhile constantly sends wrong signals to entrepreneurs about expected future demand and the true cost of capital and thereby encourages malinvestment.

The phases during which credit expands and malinvestments proliferate are known as "economic booms", and everybody loves them. When the liquidation phase occurs, otherwise known as "busts" few people are aware that it is the preceding booms that are at fault. And so the cry for more monetary and fiscal intervention arises, which lengthens and deepens the malaise by putting malinvested capital on artificial life support.

On the other hand, the free market tends to consistently lower the prices of goods and services over time. That is the logical result of increasing productivity. This is why the widely accepted tenet that we "need some inflation of the money supply to enable the economy to grow" is a complete lie.

Government mandated fiat currency simply does not work in the long run. We have empirical evidence galore – every fiat currency in history has failed, except the present one, which has not failed yet.

Nonetheless, the current fiat system is more ingeniously designed than its predecessors and has a far greater amount of accumulated real wealth to draw sustenance from, so it will likely be relatively long lived at least as far as fiat money systems go.

How long can this one last?

Bernanke shows us...

"It will work this long."

In a truly free market, fiat money would never come into existence. And that is why Greenspan is wrong. Governments can not create something "as good as gold". History clearly shows that that only the real thing will do.


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