More than sixty episodes of hyperinflation have taken place in countries using fiat monetary systems in the past century.2 Moreover, avoiding regular catastrophic collapse is hardly enough to make a case for it as a positive technological, economic, and social development.
With bitcoin showing us how an advanced monetary system can function entirely independently of government control, we can see clearly the properties required for a monetary system to operate on the free market, and in the process, we can better understand fiat’s modes of operation and all-too-frequent modes of failure.
Fiat may have been a huge step backward in terms of its salability across time, but it was a substantial leap forward in terms of salability across space.
Fiat increasingly divorces economic reward from economic productivity, and instead bases it on political allegiance. This attempted suspension of the concept of opportunity cost makes fiat a revolt against the natural order of the world, in which humans, and all other animals, have to struggle against scarcity every day of their lives. Nature provides humans with rewards only when their toil is successful, and similarly, markets only reward humans when they can produce something that others subjectively value. After a century of economic value being assigned at gunpoint, these indisputable realities of life are unknown to, or denied by, huge swaths of the world’s population who look to their governments for their salvation and sustenance.
bitcoin’s salability across space is the mechanism that makes it a more serious threat to fiat than gold and other physical monies with low spatial salability.
In the immediate aftermath of the war, there seemed to be no downside to the world’s central bank and its currency diverging from the sound gold anchor. Over time, the costs of these monetary shenanigans became apparent, as governments would increasingly abuse these schemes, ultimately making them a permanent feature of the fiat century—surreptitiously trading long-term prosperity for the illusion of short-term stability. The economic consequences of the inflation would weigh on the British economy for decades.
By maintaining the pound sterling at the prewar gold rate, the Bank of England sowed the seeds of several problems that became common in later implementations of the fiat standard. The bank maintained the nominal exchange rate between notes and gold, but in reality, the prices of normal goods and services increased sharply.
Price increases made life difficult for the average Englishman, spurring the rise of organized labor and popular demands for price and wage controls. Inevitably, rationing and shortages followed, as well as mass unemployment.
Revaluing the pound to accommodate the inflation would have meant devaluing the population’s savings; however, prices of goods and labor would have readjusted on the market. By foregoing this revaluation, maintaining an overvalued exchange rate, and discouraging the redemption of paper into gold, the bank delayed the necessary economic adjustment and prolonged the dislocations brought about by inflation and price and wage controls. Pressure grew on the government to spend to support the unemployed and the poor. However, further spending and expansionary monetary policy caused even more price increases and put greater pressure on sterling in international markets.
While all European countries effectively went off the gold standard in 1914, the U.S. had only done so in 1917, attracting large quantities of gold fleeing Europe. With the credit it provided to the Bank of England, the U.S. Federal Reserve also secured a large part of the British supply of gold.
All major European economies engaged in large-scale inflation to finance the war, after which their currencies were devalued against gold and were no longer redeemable at the prewar rate. At this point, the prudent step would have been to acknowledge that the fiat standard had served its purpose as a temporary war-financing measure and return to the gold standard. Governments had repeatedly promised this, and Europe’s citizens had expected it. However, returning to the gold standard at the prewar parity would have meant an inevitable end to the inflationary boom started by the credit expansion that financed the war and, subsequently, a painful recession. The U.S. chose this path, resulting in a sharp but quick recession in 1920, after which the U.S. economy began one of its longest expansions in history. U.S. gold redemption resumed in 1922 after a five-year suspension.
However, returning to the gold standard was very difficult when the Bank of England, still the center of the financial universe, had yet to resume the redemption of its notes into gold. Instead, the U.S. and the U.K. attempted to introduce a gold-exchange standard
In essence, global central banks would deposit gold at the Bank of England and U.S. Federal Reserve and use their international settlement network to add salability across space to their gold. This gave the Bank of England and the Federal Reserve significant leeway to go off the gold standard, because other countries’ reliance on these institutions’ financial infrastructure for international trade settlement meant they would rarely attempt to take physical custody of the gold.
During the crisis of the 1930s, the U.S. government engaged in fiscal and monetary expansionism to ward off the collapse of its banking system and economy. These policies would not have been sustainable had the dollar continued to be redeemable for gold at $20.67 per troy ounce. In 1934, President Franklin D. Roosevelt ordered the confiscation of Americans’ gold, buying it from the public at $35.00, effectively devaluing the dollar by 43%. Less than two decades after Britain had set the fiat standard by taking hard money from the hands of its citizens and giving them fiat tokens, the U.S. followed suit. Both events were sovereign defaults, though history books rarely call them that. This was the fiat standard protocol installation, and the whole world copied it: run unsustainable deficits, default by confiscating and restricting the movement of gold, suspend redemption, increase the supply of paper notes, and if you can, try to get other countries to hold your currency as reserve. The U.S. did it best.
The new global monetary system was built around the U.S. dollar, which only other central banks could redeem for gold. The U.S. federal government still prohibited Americans from owning gold, and most other countries imposed restrictions on the metal’s ownership and trade. With all its extra gold, and its ability to export dollars to the rest of the world, there was very little restraint on the capacity of the U.S. government to spend in the postwar years.
The world still bought dollars because they needed them, and there was no reason for Americans to suspect a liquidity problem. But just like England in 1914, the late 1960s placed the U.S. in a gold crunch, as European central banks moved to redeem their increasingly devaluing hoard of U.S. dollars for hard gold.
The fiat standard was not the design of an engineer. It was instead the central banks’ desperate solution to their looming insolvency, the inevitable geopolitical outcome of a sixty-year-long marriage of politics and money. The history of fiat is the history of government-run financial institutions managing defaults. It was not a technology consciously designed to provide sound money or payment transfers. Central banks the world over would closely follow the prototype set by Britain and the U.S., as they too would default on gold and force the use of their fiat.
Fiat can be defined as a compulsory implementation of debt-based, centralized ledger technology monopolizing financial and monetary services worldwide. The fiat standard was born out of the need for governments to manage their de facto default on their gold obligations. It was not designed to optimize the user experience of currency, transactions, and banking.
Having been born out of government default, the essential characteristic of the fiat standard is that it uses government decree as the token of value on its monetary and payment network. Since the government can decree value on the network, it effectively makes its own credit money. As the government backs the entire banking system, this makes all credit issued by the banking system effectively the government’s credit, and so part of the money supply. In other words, the U.S. Congress and Federal Reserve are not the only institutions capable of conjuring money from thin air; any lending organization also has the capacity to increase the money supply through lending.
When a client takes out a $1 million loan to buy a house, the lending bank does not take a preexisting mature $1 million present in its cash reserves, or from a depositor’s balance at the bank. It will simply issue the loan and create the dollars that are used to pay the seller of the house. These dollars did not exist before the loan was issued. Their existence is predicated on the borrower fulfilling their end of the bargain and making regular payments in the future.
by monopolizing the payment networks necessary for the modern division of labor, governments can make currency holders take that risk for significant periods.
While fiat enthusiasts portray the network as having a variety of tokens, each belonging to a different country or region, the reality is that every currency but the U.S. dollar is merely a second-layer token, a derivative of the dollar. The value of non-U.S. fiat money depends on its backing in the U.S. dollar and can best be approximated as the value of the dollar with a discount equivalent to the country risk. For a variety of historical, monetary, fiscal, and geopolitical reasons, these tokens have not appreciated significantly against the U.S. dollar over the long term.
No form of money has ever emerged purely through government fiat. Statist economists like to speak of the state’s ability to decree what money is, but the existence of central bank reserves illustrates the limits of that view. No government can decree its own debt or its own paper as money without holding other assets it cannot print in reserve, using them to make a market in its paper and debt obligations. Even if a government were to force its people to accept its paper at an artificial value, it could not force foreigners to do so. If its citizens want to trade with the rest of the world, the government must create a market in its currency that is denominated in other currencies. Unless the government accepts foreign currencies in exchange for its own, its own currency would devalue very quickly, as happens to any fiat currency when its central bank stops offering dollars at the market price. Everyone will prepare to hold harder currencies with more salability across space.
All fiat currencies that exist today are issued by central banks that hold gold in reserve or by central banks that hold currencies in their reserves issued by central banks that hold gold.
Maintaining the value of a currency is arguably best served by using hard assets as reserves, gold in particular. However, the second function, settling payments abroad, is only doable with the U.S. dollar and a handful of other national currencies used for international settlements. The first conflict central banks face is between choosing a monetary standard for future needs or present needs. This dilemma would not, of course, exist in a globally homogeneous monetary system, such as a true gold standard, since gold would offer salability across time and space.
By engaging in inflationary monetary policy, governments endanger their foreign reserves. Individuals start looking to sell the local currency for harder currencies, which creates more selling pressure on the local currency against other currencies. This forces the local central bank to sell some of its international reserves to attempt to stabilize the exchange rate. These individuals will also seek to send their newly purchased international currencies abroad to be invested in other countries. This could lead the government to impose capital controls to stop that flow in order to maintain its foreign reserves.
Note: Argentina in a nutshell
Capital consists of economic goods that can be used to produce other economic goods. Money can be traded for capital goods, but it cannot substitute for or supplement them. The stock of capital that exists in any society at any point in time can only be increased by deferring the consumption of existing resources. It cannot be increased by producing more claims on it.
All that can be achieved from credit expansion is an increase in the perception of wealth in the minds of entrepreneurs, whose ability to acquire financing drives them to think they can secure the capital resources they need. However, since more credit is being produced without savers deferring consumption, the capitalists are in fact beginning a bidding war for fewer capital resources. As the bidding war escalates, the profitability of many of the capitalists’ projects evaporates, and their projects declare bankruptcy, defaulting on the credit they received from the banks.
The fact that everyone is forced to use the same inflationary monetary asset leaves everyone vulnerable to its failure and makes the financial system as strong as its weakest link.
The harder a monetary medium, the less its supply will be inflated, and the more its owner can expect it to maintain its value, or even have it appreciate over time. The more the money can be expected to hold its value over time, the more reliably an individual can use it to provide for their future self. The more reliably one can provide for their future self, the more they can reduce their uncertainty about the future. The less their uncertainty about the future, the less a person discounts the future, and the more they are likely to plan and provide for it.
The introduction of fiat money stopped and reversed this seemingly inexorable progress toward ever harder money. The best money available in the world now increases in supply by around 7% per year. The ability to save value for the future is diminished, and the uncertainty of the future rises significantly. Greater future uncertainty and insecurity inevitably lead to a greater discounting of the future and a higher time preference.
Market prices result from purchasing decisions, but purchasing decisions are, in turn, influenced by prices. The price of a basket of goods is not determined by some magical “price level” force but by the spending decisions of individuals who can only spend the income they have. Purchasing decisions themselves are price-responsive and will adjust to changes in prices. The main and fatal flaw of the CPI, therefore, is that it is, to a large degree, a mathematical tautology and an infinite referential loop.
One of the most important ways in which the measurement of the CPI has been manipulated is through the removal of house prices from the basket of market goods, under the pretense that a house is in an investment good, an absurd redefinition. Investments produce cash flows, but a person’s own home cannot produce an income. On the contrary, it is consumed and it depreciates and requires continuous expenditure to maintain it. The fiat standard first destroyed the ability of individuals to save, then forced them to treat their home as their savings account. With low salability and divisibility, houses constitute terrible savings vehicles, but by excluding it from CPI, and teaching people to treat it as a savings account, inflation magically appears beneficial.
Anything that commands some scarcity premium becomes an attractive store of value under fiat, attracting increasing demand. Whereas industrial goods can easily respond to increased demand with increased supply, scarce goods, luxury goods, and status goods cannot increase in supply and end up continuously rising in price. The price inflation rate for scarce and highly desirable assets is around 7% per year.
inflation shows up in the cost of purchasing financial assets that yield income for the future. Returns on bonds have declined along with interest rates, reducing the ability of individuals to afford retirement. The market is effectively heavily discounting today’s money in terms of tomorrow’s real purchasing power as yields disappear. As the future becomes more uncertain, it is no wonder we witness a palpable rise in time preference.
Rather than a nefarious conspiracy to impoverish the majority to benefit the few, there was an undeniable economic and technological rationale for fiat money, given the technological possibilities of the world in the early twentieth century.