In Praise of Fiat Currencies

....I won't be making any friends here with the Gold Bugs....

The amount of cash required in a given economy is a function of activity. It doesn’t bear any relation to the amount of gold it has in its mountains. Suggesting we restrict the amount of cash we have available for transacting business based on a gold find is not reasonable.

Think of money supply as oil for the economy. Too little and the engine of activity grinds to a halt. Too much and we get inflation.

The US went through one depression/crash after another until the Fed was set up. It was brilliantly done so, too. Think of the impossibility of setting up a fluid and flexible bureaucratic administration that can instantly deal with inflation and deal with liquidity needs in a country as big and diverse as America and do so well for nearly 100 years. Sheer brilliance.

Unfortunately, Greenspan broke it. But, the US$ not being a gold backed currency was not the problem. Greenspan was/is an idiot. As are almost all people working in the upper echelons of Big Government now, in every country. His foolishness wrecked the economy and set in motion the 2008 banking debacle, and contributed to the COVID fake crisis.

I will quickly explain how the Fed works. Of course, this will be overly simple. But, it would take 100 pages to explain it properly:

1. Inflation is monitored. This is key. If there is too much liquidity then inflation takes off. Too little and activity decreases. It is necessary to keep Money Supply large enough to allow for business activity, but not so much it creates excess cash, which creates inflation.

2. A bank takes a deposit and pays interest on it. It must ‘rent’ it out or it would go broke. It does so by lending it to someone in the form of a loan or a mortgage.

3. A bank takes in $100 M, for example. It usually has to keep some on hand, although reserve requirements in Canada were reduced to Zero some years back. For the most part all that money has to be ‘used’, ie lent out.

4. If a potential borrower goes to a bank and the bank has lent its money out it can borrow from other banks on cash they might have that isn’t being used. This is the ‘overnight’ rate. In this way all cash is being used for what should be productive activity.

5. Banks have regulatory agencies that monitor their lending to ensure they are following standard lending protocols.

The Fed, or any Central Bank, organizes all of the above. It also can create money in various ways. Which it will do so if the economy is stagnant, ie non-inflationary. It has different methods of doing this, which are too complicated for this ‘Stack.

In short, if a lot of activity is occurring the banks can lend to it, and if its deposits have been lent out, it can instantly borrow more. Either from other banks, or the central bank. If the activity is merely inflationary the Central banks raise rates which cuts the activity down thereby decreasing inflationary pressures. If there is no inflation the activity is considered to be productive and the Central Banks can fund these activities through increasing Money Supply.

AS LONG AS THERE IS NO INFLATION THE CENTRAL BANKS DON’T SEE INCREASED ACTIVITY AS BAD. THEY WILL ALLOW MORE MONEY TO INHABIT THE ECONOMY.

When we were gold backed there was a finite amount of cash. Let’s use an iPhone as an example. Someone invents an iPhone! Everyone wants one. But….they can’t buy one as one can’t be produced. Why? Because all the cash was being used already. In order for an iPhone to be produced then other business activity would have to slow down to the point where there was excess cash around enough to start producing iPhones. Which is why metal backed currencies suffered constant depressions and liquidity crises. In a Fiat system if people want the iPhone, or a washing machine, the manufacturer can borrow money from a bank, and start producing. The new production is new activity. New activity actually has a slight deflationary aspect to it vis a vis other things in some ways, and not in others. But, it isn’t inflationary as something is being produced.

Very simply stated: If an economy produces 1 million items and it has $10 million in its money supply each item costs $10, on average. If it then produces 2 million items and only has $10 million still floating around, then what? Half the businesses go bankrupt as there isn’t enough cash to pay for the production of these 2 million items. Which is essentially what always happens in fixed supply currency economies. In a Fiat System you can produce the 2 million items as an extra $10 million can be added to the economy instantly. No inflation, no need to bankrupt half the nation, and everyone now has twice as many goods. That is, they are WEALTHIER.

There would not have been the growth of modern technology in a Gold backed system. It is only a Fiat system that can respond instantly and fully to NEW demand.

What went wrong were a number of things. First, Greenspan blew it big time. The Fed mis-monitored inflation. They did so because of trade with third world and emerging world nations. They monitored the price of a door, for example. (They monitor prices of a ‘basket of goods’). The prices of doors, one item in a basket of goods, was plummeting. So…..no inflation, right? Therefore increase money supply, and see what happens. What happened? Nothing! No inflation. Why? Because China etal were producing all the goods we used to, and doing it with discounted currencies and using near slave labour. What Greenspan failed to do was notice locally made doors were rapidly increasing in costs. The $200 door had dropped to $100, but the local door was now costing $400. Big inflation. The ‘basket of goods’ inflation monitoring concept didn’t work when we were importing all our hard goods.

Greenspan pumped trillions into the economy with no deleterious effects on inflation. We weren’t producing anything though. Where did this money go to? It has to go somewhere. Hard assets. Real estate prices went through the roof.

Various States then jumped in and passed ridiculous laws. If you borrow against a home and you lose the home the bank couldn’t go after you personally. It could take the house and leave you out of the equation even if they lost money repossessing the home and reselling it.

States also stopped requiring minimum down payments.

Think about that. I can buy a house with nothing down. Yippee! If I fail to make my payments what is the bank’s recourse against me. Nada. What is the reasonable rational thing to do under those rules? BUY EVERYTHING YOU CAN. RENT IT OUT. IF IT GOES UP 10% SELL AND MAKE MONEY. BUY 100 HOMES. BUY AS MANY AS YOU CAN GET YOUR HANDS ON. YOU GOT NOTHING TO LOSE!

And rationally that is what people did. They could do so because of Federal banking rule changes, State banking rule changes, and the Fed mis-reading inflation leading to massive increase in Money Supply.

Is this the fault of Fiat Currency? No. It was poor management. It worked well for nearly 100 years (since 1913). Starting with Clinton, and moving right through to Obama, every administration set up a set of rules that encouraged people profiting from being stupid financially.

Going back to gold. The amount of cash required in a society to keep business active has nothing to do with the amount of gold it has. The idea the currency is gold-backed is silly. It never was. Go to the bank and ask for $1 worth of Gold. You wouldn’t get it. Go to Fort Knox with $1000 and say I want 31 ounces of gold (approximate price when we were on the gold standard). You wouldn’t get it.

It was a polite fiction. And, it served no one. It restricted activity….productive activity.

The problems we face right now are all poor governance. It isn’t because we aren’t gold backed. Switch to gold right now and we would plummet into a depression that would last forever. Or, until we switched back.