Wednesday, 7 January 2015

Money, Fiat Money and The U.S. Dollar

Money is nothing other than a “generally accepted medium of exchange”, a means of payment that we all accept in an exchange. The benefits of the use of money in an economy are tremendous and there can be little doubt that it is perhaps the biggest “invention” of all time (to be accurate, it came about spontaneously on the market, just like a trodden path in the woods comes about). With money, I don’t have to exchange my carrots for your potatoes. This greatly facilitates not only the exchange of goods, but also the exchange of services such as labour (employees would quickly get tired of receiving only potatoes). 

Money is also necessary in a society based on the division of labour, a structure which greatly increases productivity. As alluded to above, money came about on the market. Due to the great inefficiencies of direct exchange (potatoes for carrots) the market discovered, through a gradual process, that some goods where more sought after than others and exchanged much more frequently than others. An example of such spontaneity could be seen in the movie “The Shawshank Redemption” where cigarettes were used as money (which allegedly is common in prisons). Other examples of money through the centuries are cattle, shells, cotton and copper and I’ve even read somewhere that in certain ancient cultures even wives were used as money (terrible, I know). But through the ages, going back centuries, the precious metals such as gold and silver have always come out as the winners. Why? The answer is simple, because they possess the qualities of a “good money”, namely
·       Naturally scarce
·       Portable
·       Homogeneous
·       Divisible
·       Durable
·       Recognizable
Gold and silver, and other commodities are what we refer to as commodity money – they were in demand as commodities before they became generally accepted as a medium of exchange, i.e. money.

A big jump forward in time, some discovered that they could issue certificates redeemable in gold to people that deposited their gold for safe keeping. These were the goldsmiths, and it did not take them long to discover that they could issue gold certificates with a total face value that was higher than the gold kept in their vaults as it was a rare occurrence that all depositors came back claiming their gold at once. The goldsmiths hence made more money. Those certificates which were fully backed by gold are referred to as money substitutes. Those certificates not backed by gold, i.e. those that were issued though there was no gold deposited against them, are referred to as fiduciary media. They are not money proper, but are used as such. Time passed, the pure gold standard disappeared, then the gold exchange standard ended, and that is, in very crude terms, how most economies ended up with fiat money – money not backed by anything declared to be legal tender by government “fiat” (law). The crucial thing to keep in mind is that the different versions of the gold standards were ended by government decrees, not by the actions of the markets.

Fiat money, combined with central- and fractional reserve banking, makes it a walk-in-the-park for governments to take on debt. A current case in hand is what has been taking place in the U.S. for many years, especially since the U.S. banking crisis in 2008/9. Since September 2008, the federal debt has increased more than USD 8 trillion, or 80% plus change. And it’s still increasing today and likely will continue to do so for the foreseeable future as long as money can be created by the touch of a few buttons. Since July 1971, the money supply in the U.S. as measured by the M2 money supply has increased 1598% (it’s almost 17 times higher today than back then). Under a classic gold standard, this simply would not have been possible as the growth in the quantity of money wholly depends on the digging out of new gold deposits which do not grow at nearly that rate.

Meanwhile, the U.S. dollar is losing ever more of its purchasing power compared to gold. This is the real inflation inflicted upon the average U.S. citizen.