The Fiat Money System

Essay by sunmellieCollege, Undergraduate December 2009

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In a fiat money system money has value because of its relative scarcity and the faith placed in it by the people using it. In this system, there is no limit on the amount of money that can be created. Fiat monetary systems come into existence as a result of excessive public debt. When the government cannot repay its debt in gold or silver, the temptation to remove physical backing rather than to default becomes irresistible. This was the case in 18th century France during the Law scheme, [1] as well as in the 70s in the US, when Nixon removed the last link between the dollar and gold, which is still in effect today.

In a fiat monetary system, once the confidence of the value of money is gone, it becomes worthless, regardless of its quantity. The founding fathers were concerned about the unrestrained control of the money supply and they agreed the limitation on the issuance of money was necessary.

Thomas Jefferson warned of the dangers of assigning control to the banking sector, "I believe that banking institutions are more dangerous to our liberties than standing armies. Already they have raised up a money aristocracy that has set the government at defiance. This issuing power should be taken from the banks and restored to the people to whom it properly belongs. If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered. I hope we shall crush in its birth the aristocracy of the moneyed corporations which already dare to challenge our Government to a trial of strength and bid defiance to the laws of our country" [2]With the adoption of the Constitution in 1789, Congress instituted the First Bank of the United States authorizing it to issue paper bank notes to simplify trade and eliminate confusion. In the U.S. Constitution (Section 10) states are forbidden from making anything but gold or silver a legal tender. In 1792 the Federal Monetary System was established with the creation of the U.S. Mint in Philadelphia. The U.S. Coinage Act of 1792, consistent with the Constitution, provided for a U.S. Mint, which stamped silver and gold coins. Statute defined one dollar as a specific weight of gold.[6]The first use of fiat money in the United States was in 1862, as a tool to pay for the cost of the Civil War. They were circulated along with Gold certificates, backed by the government’s promise to pay in gold.

Later, in order to "pay" for WWI, countries had to print a lot of paper currency. When the depression began countries tried to cash in their pounds and dollars for gold. A run to convert pounds to gold collapsed the pound. That run on gold forced the end of the gold exchange standard. So began the end of the Bretton Woods Agreement. [5]In 1963 New Federal Reserve notes with no promise to pay in "lawful money" was released. No guarantees, no value.

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states.

Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which is now part of the World Bank Group. [5] These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments.

By 1947 the IMF and the IBRD themselves were admitting that they could not deal with the international monetary system's economic problems.[7] Thus, the much looser Marshall Plan—the European Recovery Program—was set up to provide U.S. finance to rebuild Europe largely through grants rather than loans. The Marshall Plan was the program of massive economic aid offered by the United States to many countries in Western and Eastern Europe (including countries belonging to the Soviet block, e.g. Poland) for the rebuilding of their economies.[7]John Law urged the establishment of a national bank to create and increase instruments of credit and the issue of banknotes backed by land, gold, or silver.[3] He had the idea of abolishing minor monopolies and private farming of taxes and creating a bank for national finance and a state company for commerce and ultimately exclude all private revenue. This would create a huge monopoly of finance and trade run by the state, and its profits would pay off the national debt. The French Conseil des Finances, merchants, and financiers objected to this plan.

The wars waged by Louis XIV left the country completely wasted, both economically and financially. And the resultant shortage of precious[3] metals led to a shortage of coins in circulation, which in turn limited the production of new coins. It was in this context that the regent, Philippe d'Orléans, appointed John Law, as Controller General of Finances. [3]As Controller General, Law instituted many beneficial reforms. He tried to break up large land-holdings to benefit the lower class, encouraging the building of new roads, the starting of new industries, and the revival of overseas commerce.Law proposed to stimulate industry by replacing gold with paper credit and then increasing the supply of credit, and to reduce the national debt by replacing it with shares in economic ventures. Though they ultimately failed, his theories were 300 years ahead of their time and "captured many key conceptual points which are very much a part of modern monetary theorizing".[3]By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit. This represented the point where holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade deficits. In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs.[7]In the first six months of 1971, assets for $22 billion fled the U.S. In response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price controls, a 10% import surcharge, and most importantly "closed the gold window", making the dollar inconvertible to gold directly, except on the open market.[7] Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed the "Nixon Shock".

The surcharge was dropped in December 1971 as part of a general revaluation of major currencies. But by March 1976, exchange rates were no longer the principal method used by governments to administer monetary policy.

Governments through history have often switched to forms of fiat money in times of need such as war, sometimes by suspending the service they provided of exchanging their money for gold, and other times by simply printing the money that they needed. When governments produce money more rapidly than economic growth, the money supply overtakes economic value. Therefore, the excess money eventually dilutes the market value of all money issued and you have inflation. Once the confidence of the value of money is gone, it becomes worthless, regardless of its quantity.

Metal based coins had the advantage of carrying their value within the coins themselves — on the other hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal. A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. English and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether — gold left Asia and silver left Europe in quantities European observers like Isaac Newton, Master of the Royal Mint observed with unease.[8]1. Will and Ariel Durant, The Age of Voltaire, Simon & Schuster(1965), page 132. "John Law by Antoin E Murphy, Oxford U. Press, 1997, page 1".

3. Condie, Richard (1978). "John Law and the Mississippi Bubble". National Film Board of Canada. Retrieved 2009-02-19.

4. The Collected Writings of John Maynard Keynes (London: Cambridge University Press, 1980), vol. 26, p. 101. This comment also can be found quoted online at [1]5. Mason, Edward S.; Asher, Robert E. (1973). The World Bank Since Bretton Woods. Washington, D.C.: The Brookings Institution. pp. 105–107, 124–135.

6. Columbia University Department of Economics Discussion Paper Series The Birth of Coinage Robert A. Mundell Discussion Paper #:0102-08 page 11/13 in the Pdf.

7. Why does money have value? Mike Moffatt, About.com "Sir Isaac Newton's state of the gold and silver coin (25 September 1717).". Pierre Marteau.