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.
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