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Banking on Failure: History of Money And Gold (Flat Money)

WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

The prior excerpt for Chapter 7 discussed “Role of Money” and “Gold and Silver through the Millennia”

Fiat Money

[su_dropcap style=”flat”]E[/su_dropcap]ARLIER WE STATED that the dominant requirement for money is the people’s certainty of “enduring value.” Yet we then expressed the view that there is nothing tangible on Earth with this certainty. Gold and silver are merely the best candidates.

Fiat money consists of tokens such as coins or paper certificates with little or no inherent value that a government decrees has stated value. The enduring value of such money, then, stems from the people’s confidence in the government to maintain the value and validity of the money. One critical aspect of maintaining value of the otherwise worthless money is that the government mandates that businesses and people accept the fiat money in all payments.

Like many ideas in life, fiat money can certainly work as intended in one’s imagination. If our employer pays us for our labor with colorful pieces of paper and we know we can exchange this paper for immediate or future purchases, then the money is functioning. An evident risk is counterfeiting of the colorful paper, so the government must take pains to produce the paper money in a form that is difficult Banking on Failureto emulate. The government will also create and enforce laws to forbid the counterfeiting.

A citizen living under the mandate to employ the fiat money must depend on government to uphold the same mandate on businesses and other citizens. All laws require expansion of the state for purposes of observing and implementing compliance. The citizen’s greater risk, though, is that merchants and others assign lower purchasing power to the fiat money over time. The synonymous terms “loss of value” or “devaluation” or “price inflation” all describe a common propensity of fiat currencies through history.

Since fiat money has no intrinsic value, the citizen implicitly relies on government to maintain the money’s value relative to goods and services in an economy. Yet the record of government is poor in this respect. A government that wishes to increase spending without commensurate taxation or borrowing or other visible seizures of citizen’s assets will simply print more money. We discuss inflation and monetary policy in later chapters. Suffice it to say for now that – all else equal – government printing of additional fiat money devalues the money and therefore harms the citizens.

Historical examples of fiat money and sustained devaluation include the U.S. “continental” during the Revolutionary War (circa 1780),[1] the assignat of the French Revolution (1789-96),[2] the U.S. “greenback” during and after the Civil War (1860’s),[3] the Confederate “grayback” during the same Civil War,[4] the respective currencies of Germany and Austria in the years following World War I (early 1920’s),[5] and the currency of Zimbabwe during 1981-2009.[6]

It would not be an exaggeration to estimate there are hundreds of past examples of “painful” devaluations of fiat money. An important example of fiat money is the experience of China beginning circa 820. History credits the Chinese ruler Hien Tsung with the invention of paper money at this time.[7] The innovation lasted for roughly six hundred years to the mid-fifteenth century.[8] Marco Polo traveled through China and wrote a favorable description of this country’s money in 1271.[9] The historical lesson is ambiguous. While this “paper money regime” spanned hundreds of years, copper coins and other valuable items backed the paper money initially and at other times.[10] The Chinese paper money failed and produced high inflation, however, when the dominant ruler deleted the collateral backing the currency:[11]

When the Mongols, under Kublai Khan, swept over China they saw the advantages of paper money and followed the Sung Dynasty practice. For the first twenty years it worked well, as they backed the notes system with silver. However, as their empire expanded, they found themselves unable to pay the soldiers and resorted to the printing press. By 1358 their paper money was virtually worthless.[su_spacer]

The simple explanation for devaluation of fiat money when it occurs is that governments like to spend money. One practical flaw of fiat money is the requirement of government fidelity to balanced budgets to avoid the temptation to print money to fund deficits. Governments of many countries with fiat money recognize this weakness and endow central banks with the control of the country’s money (“monetary policy”). The central bank is simply a branch or agency of government, but enabling legislation often applies the adjective “independent” to the central bank. The implied intent is that monetary policy should not be under the control of “the main part” of the current government.

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Figure 7‑2 Central Bank controls the money citizens use

Whether the goal is to explain, support, or criticize this independence of the central bank from “the main part” of the government, the task is challenging! For example, one is tempted to deduce that an “independent” central bank would not assist “the main part” of the government by buying this sovereign’s debt to facilitate a fiscal budget deficit. Yet this is a primary activity of modern central banks! We discuss central banks at length in chapter 8. It remains correct to say that citizens living in a system of fiat money depend on government to choose not to devalue the money. There is no protection from the will of the government.

Debasement of money is possible also with precious metal coins. In the period 1542-1551 in Great Britain, the Crown under King Henry VIII removed existing silver coins from circulation, melted them down, and recast new coins with less silver. The government required the citizens to accept the new coins as if they had equivalent value to the old coins. By the end of the period of this “Great Debasement,” the value of money had fallen by 75%. Thus, systems of fiat money are not the only venues for government-imposed devaluation.

The succeeding excerpts for Chapter 7 will discuss “History of the Gold Standard” and the “Modern World with Fiat Money


[1] See, for example, “Not Worth a Continental”

[2] See, for example, J. E. Sandrock, “Bank Notes of the French Revolution, Part II – The Assignats of the First Republic”

[3] See, for example, “Greenbacks and the Civil War”

[4] See, for example, M. Weidenmier, “Money and Finance in the Confederate States of America,” Claremont McKenna College, 2002.

[5] See, for example, A. Fergusson, When Money Dies: The Nightmare of the Weimar Collapse, Kimber, 1975.

[6] See, for example, “Which are the most devalued currencies?” and also “Zimbabwe moves devalue currency by 95%,” Financial Times, April 27, 2007.

[7] See chapter 11 of P. L. Bernstein, The Power of Gold: The History of an Obsession, Wiley, 2004.

[8] Id.

[9] Id.

[10] See “The Development of Paper Money,” Colin Narbeth & Son Ltd.

[11] Id.

Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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