The Magic Of Money

Published in Investing on 1 July 2011

Can our current system of fiat money survive in the long term?

As we watch the birth pangs -- or the death throes -- of the Euro, the most ambitious monetary project in recent history, now is as good a time as any to enquire about the nature of money itself, and to ask whether this has something to do with the current financial crisis.

"Money" is anything which can be used as a store of value, a medium of exchange and a unit of account. 

There are three types of "money": 

  • "commodity money" (where the "thing" that is money has an intrinsic value equal to its value as money, like beads, livestock, silver bars); 

  • "representative money", which has no intrinsic value but which can be redeemed against something that does, like a piece of paper which can be exchanged for a fixed amount of gold; and 

  • "fiat money", which has no intrinsic value and cannot be redeemed against anything else. Unlike the first two types of money, there is no natural limit to the quantity of "fiat" money which can be created.

Money is one of the greatest inventions in human history; and "fiat" money, depending on your point of view, is either the ultimate example of human ingenuity or the spawn of the devil.

The rise of fiat money

Even though "fiat" money dates back to 11th century China, "commodity" and "representative" money have generally been preferred, despite the fact that they are less flexible, and often harder to manage, than "fiat" money. This is because nobody has yet found a way to harness and manage "fiat" money for any meaningful length of time without it eventually losing all of its value (or, if you prefer, reverting to its intrinsic value).

And yet today all advanced economies use "fiat" money.

The current dominance of pure "fiat" money is actually very recent, dating back to 1971, and any inflation chart will tell you all you need to know about the success of the system since then. Yet few people seem to want to put the genie of "fiat" money back into its bottle; most try instead to find a way of controlling it while it roams free. 

The latest strategy, at least in the West, consists of transferring power over "fiat" money away from politicians and into the hands of a class of independent experts -- central bankers -- with strict instructions not to yield to the temptation to print more, even when times are hard. And what we are seeing now -- on the streets of Greece, in western parliaments and in worldwide equity, bond and commodity markets -- is that strategy put to the test.

Credibility is key

Credibility is everything for "fiat" money: the credibility of central banks, of the politicians who set the rules for central banks, of the legal systems in which they operate, of the statistics they publish. My ten pound note displays the words: "I promise to pay the bearer on demand the sum of ten pounds" (in itself an elegant definition of the concept of "fiat" currency). It should in fact say "I promise to maintain the value of this piece of paper"; and the value of my ten pound notes depends largely on how much everyone believes this promise.

As I have argued recently, the rising price of gold is simply a visible measure of the falling credibility of "fiat" currencies, which itself is driven largely by the astronomical deficits of western countries and the growing fear that governments (and central bankers) will be tempted to use inflation to reduce them. 

Even the credibility of inflation figures themselves is now being questioned. It is no surprise that the European Central Bank has been the first to start raising interest rates, despite a lower rate of inflation than in the US or the UK, and despite the fact that Greece, Portugal, Ireland and Spain will all suffer greatly from increased interest rates. The ECB simply has the shortest history amongst central banks, therefore the least institutional credibility, and the most to prove.

If the ECB raises rates again in July, which still seems likely, this will essentially be done to prove its credibility as an independent guardian of the value of the Euro. But the ECB is wedded to the Euro and will do anything it can to protect it. Others may not be so single-minded, particularly central bankers who fear depression and unemployment, and politicians who see more votes in default or inflation rather than in slow, grinding repayment.

The current global financial crisis is essentially about whether "fiat" money can in fact be made to work or not, and the lessons of history are not good.

More from Vincent Scheurer:

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richjfool 01 Jul 2011 , 8:25am

But what's the alternative? If one believes that certain currencies are in difficulty or doomed, where can you put your money to protect against the situation, - other currencies, or gold, or pork bellies!? Gold, now very high, pays no interest and could suffer from setbacks or falls. Pork bellies and the like are not easily tradeable and are perishable. What's the answer? Even the Swiss franc (yet another currency) which historically has done very well, could fall back.

diddyda 01 Jul 2011 , 9:13am

The Bank of England is charged with maintaining the inflation rate at around 2%. Supposedly, taking difficult decisions to achieve this as the government cannot be trusted to administer this task.

With inflation nearly 3 times this benchmark and still rising. Interest rates are still stuck on 0.5% and no indication that they will rise in the near future. The man in charge gets a knighthood for falling asleep on the job .

Hate to think what he would have received if the B of E was successful in controlling inflation.

I'm no economist, but too little saving and too much spending got us into this mess. How do they think that increased spending will get us our of the sticky-stuff?

catandfiddle 01 Jul 2011 , 9:17am

Very good article!

To reply to an earlier comment - gold now very high - or is it? While people do not have confidence gold will continue to rise - don't know about you but I am far from thinking all the problems with Greece / PIIGS are solved - so gold could still be a good bet.

supasap 01 Jul 2011 , 9:24am

agree catandfiddle, gold and silver were main currencies for ages but the state couldn't rob the people through inflation swindles so fiat currency was invented but gold and silver has remained in background as alternatives, I can't see any fiat currency holding value hence gold in my view still has some way to go

F958B 01 Jul 2011 , 9:39am

Today, the cash demands of "big government" are very high in relation to the past.
This means a lot of tax, which people dislike paying.
Alternatively, the government prints the shortfall, causing inflation.

Inflation is a stealth tax which is not well understood by the average person, so the average person tends to react less to inflation than when they have to pay higher taxes or receive less benefits.

The average person also likes to see the price of their house, shares or gold increase in price (much of which is due to inflation) - not realising that they will be taxed on inflation-induced gains (income and capital) and actually lose buying power.

I doubt that we'll change from our fiat currency system because people think that they're getting rich when, in fact, they simply end up being devalued or taxed on the inflationary gains.

Mari11ion 01 Jul 2011 , 10:18am

And then there is "virtual" money, which exists only as a number in a database. My company pays me in numbers, I store the numbers in my online bank, and I transfer the numbers to my credit card provider, mortgage company, utility bills etc. That money never exists in any physical form.

BarrenFluffit 01 Jul 2011 , 10:40am

Stricly its not fiat in the sense of being harnessed to the goods and services that can be bought with it. And long term representative money is too narrowly linked to the actual uses of money and poses very difficult issues in determining its "real" value.

actiondan 04 Jul 2011 , 6:26pm

@diddyda - totally agreed. That knighthood for Mervyn King was nothing more than a political stunt to make it look like he was achieving something by doing nothing, and completely ignoring the BoE's original mandate.

I was sickened when I heard about it. Perversely I suspect that if Mervyn had acted wisely and applied the fiscal brakes well ahead of the current turmoil to avoid an outright crash, I suspect he'd not have been rewarded with the knighthood, because he'd have been despised by the bankers for ruining their party.

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