This two part article examines the origins of money, from commodity money, through representative money, to today’s money which is based on debt. It also reveals the origins of banking from the goldsmiths of medieval Europe to today’s global system of fractional reserve banking.
By understanding how our modern system of money and banking came about, we can begin to appreciate the serious problems inherent within it. Every trader and investor needs to understand the implications this has for the global economy and the financial markets.
The end of the gold standard
The British and Germans came off the Gold Standard in 1914 so as they could print money to pay for World War One. By 1944 the only major nations that had a currency backed by gold, were the United States and Switzerland. With the Bretton Woods agreement of 1944, which established monetary order between the major industrial powers at the end of World War Two, the dollar became the global reserve currency. The US dollar was pegged to gold at US$35 an ounce.
However, throughout the 1960’s, in order to finance the war in Vietnam and the expansion of the welfare programs of FDR, President Johnson, and then Nixon, issued many more dollars than they had gold to back them. The French recognized this and so Charles De Gaulle began demanding gold in exchange for their dollars at the agreed rate of $35 per ounce.
Initially, the US paid up, but eventually, in 1971, as the run on the dollar sped up and faced with the rising cost of the Vietnam War, President Nixon took the shocking step of removing the dollar from the gold standard altogether.
The Nixon Shock
Notes: In one of the most important decisions in modern financial, economic and monetary history President Richard Nixon ended the US dollar’s convertibility to gold. The US essentially defaulted on its promise to other countries to redeem dollars for gold and in doing so he ended the Bretton Woods international monetary system. He also imposed a temporary tax on all imports.
From that point on the Swiss Franc was the only currency in the world with any kind of gold backing, and in May 2000 the Swiss Franc also severed any link to gold. Now, for the first time in history, no currency in the world is backed by anything of value.
The chart below shows what happened to the US dollar after 1971.
Purchasing power of the US dollar between 1971 & 2008
Between January 1971 and December 2008 the purchasing power of the dollar fell by 81%
And it was a similar story with the British pound when it went off gold backing.
Purchasing power of the British pound between 1750 & 2002 (log scale)
Throughout the Nineteenth Century the value of the pound was quite stable – a period during which it was considered “as good as gold”. However, as soon as the pound was taken off the gold standard its purchasing power declined markedly.
“This new financial system has failed the test of the marketplace” Paul Volker, Federal Reserve Chairman 1979-1987
The fiat money system
Today we live in an era where money is money only by fiat, that is by government edict, by the law. The term fiat money (pronounced Fee-At) is derived from Latin, meaning “let it be done”, as the money is established by government decree.
In the past people had the choice of refusing privately created bank notes but today legal tender laws state that citizens must accept this government-edict money, or fiat currency, as payment. This is despite the fact that fiat money has no intrinsic value and is not backed by reserves.
Essentially all that backs our money today is confidence. I.e. the confidence that governments will show fiscal restraint when it comes to managing their economies.
Under a gold exchange standard, the amount of money in circulation was limited by the quantity of physical gold held by the issuer. In order to increase the total amount of money in circulation more gold would need to be produced, and the production of gold involves a great many steps including: getting permits, drilling, blasting, mining, milling, leaching etc. The finished product then has to be transported and stored in a secure facility.
These expensive, time consuming and labour intensive processes, coupled with its scarcity, give gold its inherent value. Contrast that to today’s fiat (paper) currencies that can be (and are), created at the touch of a button.
The relationship between fiat money & debt
Only around 5% of the money in circulation is money that is created by the government in the form of notes and coins. More than 95% of all the money in existence today was created in the form of debt by people taking out loans at a bank.
As a result the total amount of money in existence only has one real limitation, i.e., the total amount of debt.
“It is a staggering thought. We are completely dependent on the Commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Bank creates ample synthetic money we are prosperous; if not, we starve. We are absolutely, without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is.” Robert H. Hemphill, Credit Manager of the Federal Reserve Bank of Atlanta
Summary & conclusion
Historically money was tangible and had real value. The value of gold (and silver), for example, came from its scarcity.
Over time money has gone from being tangible objects of value to being paper money that represents debt. Today our money has no intrinsic value and is not backed by reserves; it is ‘fiat’ money that government has declared to be legal tender.
It is generally believed that if there were no debts, the economy would be in better shape, however, as absurd as it sounds, under a fiat money/ fractional reserve system, if there was no debt, there would be no money at all.
The entire world economy now runs on a system of credit provided by banks and we are heavily reliant on new bank credit for economic growth, and as we saw during The Great Depression, without this new credit, the money supply contracted dramatically. This kind of deflationary collapse is what so many bankers and politicians are afraid of.
History shows that over time the purchasing power of fiat currency eventually approaches its cost of production, which is zero. There have been no known exceptions – from Imperial China in the 8th century to Zimbabwe in the 21st.
Today, thanks to the fact that currency debasement has been chosen by western governments as a large part of the solution to their massive indebtedness, our money is once again under threat.
As Jeffrey Garten, who has been a prominent figure in US politics since the Ford and Carter administrations, points out, “Washington therefore will have little choice but to take the time-honoured course for big time debtors, print more dollars, devalue the currency and service debt in ever cheaper greenbacks. The United States will have to camouflage a slow motion default because politically it’s the easiest way out.”
It is our belief that as faith in today’s fiat currencies is lost, we will eventually return to a system of sound money. I.e. we will return to currencies backed by gold, or perhaps a basket of commodities which includes gold.
A gold backed currency would limit the amount of money and credit governments could create, and would enforce fiscal restraint. As a result is would prevent governments from robbing citizens of their wealth through inflation.
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens”. John Maynard Keynes
One early sign of the desire by some to return to a gold backed currency was seen at the July 2009 G8 meeting when Russian President, Medvedev, held up a gold coin and said “this is the united future world currency”.
United Future World Currency gold coin
Today, more and more people are talking about the need to return to sound money. One group, known simply as “The Group”, are apparently developing a new Nordic Euro currency that will be gold backed.
“More and more people are asking if a gold standard will end the financial crisis in which we find ourselves. The question is not so much if it will help or if we resort to gold, but when. All great inflations end with the acceptance of real money – gold – and the rejection of political money – paper.” Dr Ron Paul, member of the United States Congress.
In our opinion every investment portfolio should contain some percentage of gold, either as a hedge against inflation, or as a form of catastrophe insurance.
“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.” John Kenneth Galbraith, author of Money: Whence it came, where it went.