The Never-Ending Fiasco Of Fiat Money by Thorsten Polleit, Foundation For Economic Education
There are seven points I’d like to speak to tonight.
[This speech was delivered to the Commodity Club, Zurich, June 15, 2016]
#1: Gold is Perfect Money.
People want and need gold for all kinds of reasons—industrial applications, jewelry, investments, and, yes, even for monetary purposes.
As malleable as this precious metal may be, the bottom line is that gold really is money. In fact, it’s the ultimate means of payment.
Former Federal Reserve chairman Alan Greenspan summed it best when he said in 2014: “Gold is a currency. It is still, by all evidence, a premier currency. No fiat currency, including the dollar, can match it.”
History bears this out. Money has taken on many guises over the centuries, but precious metals have always been the preferred format, and gold and silver especially.
And for very good reason: A medium of exchange has to have certain physical properties. It must be scarce, homogeneous, durable, mintable, portable, and it has be intrinsically valuable. That’s why we still say that something immensely valuable is worth its weight in gold.
Pardon the pun, but gold and silver fit the bill. Their high value per unit of weight is undeniable, and they are supremely money-like in all other respects. It’s no wonder that they have been market players’ go-to choice of money.
#2: Gold was replaced by fiat money for political rather than for economic reasons.
What, you may ask, is fiat money then? Well, the US dollar, the euro, the Chinese renminbi, the Japanese yen and the Swiss franc are all fiat monies.
Fiat money is simply paper that has been made legal tender by government decree. All fiat monies have three things in common:
For one, the state (or its agent, the central bank) has the monopoly on its production.
For the other, it is produced by way of bank credit expansion; in other words, it’s literally created out of thin air.
And finally, it has no inherent use value. Fiat money is just brightly colored paper and intangible bits and bytes that can be produced at any time, and in any amount deemed politically expedient.
Governments want to exert total control over the quantity of money so they can manipulate its buying power to suit their political ends.
Gold stands in the way of such machinations, so it had to go.
Austrian economist Ludwig von Mises had something interesting to say about this, and I quote: “The gold standard makes the determination of money’s purchasing power independent of the changing ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard; it is its main excellence.”
As you can gather, gold was indeed replaced by fiat money for political rather than for economic reasons.
#3: Fiat money causes trouble on a grand scale.
Fiat money is inflationary. Its buying power dwindles over time, and history has shown that this entropy is almost as irreversible as gravity.
Fiat money enriches a select few at the expense of many others. The first to get new money benefit to the detriment of latecomers.
What’s more, fiat money fosters speculative bubbles and capital misallocations that culminate in crises. This is why economies boom and bust.
Fiat money lures states, banks, consumers and firms into the pitfall trap of excessive debt. Sooner or later borrowers find themselves in a deep hole with no way out.
Fiat money is easy to come by so the state can finance its adventures and misadventures. Easy money; easy come, easy go. And the government keeps growing as it keeps spending.
As the state expands and flourishes like weeds in an untended garden, this outgrowth strangles the free market economy, causing production and employment to decline.
Now that we know what the problem is, let’s see what this bodes for our financial future.
#4: Low interest rates are here to stay.
Interest rates in many currency areas are at record lows.
Central banks have slashed short-term rates to zero and even lower, thereby dragging down longer-term bond yields.
They did this for a reason, and it is why low interest rates are probably here to stay.
Fiat money is to blame for this. Central banks have no choice but to keep pushing down interest rates if they want to pump up fiat money to keep the whole system afloat.
Otherwise, the phony boom contrived by credit expansion and borrowing at unnatural low interest rates will come crashing down.
Central banks certainly mean business when it comes to propping up the fiat money system, as the most recent financial and economic crisis of 2008/2009 goes to show.
The Fed bailed out the banking industry by knocking interest rates down to record lows and printing up vast quantities of money, a policy they call quantitative easing.
Most importantly, though, the Fed succeeded in mitigating market players’ concerns about loan defaults. The floodgates opened, credit started flowing again, and the flat-lining fiat money system was reanimated.
Hammering down interest rates until they hit rock bottom is easy, but economic and political constraints make it rather difficult to haul them back up again.
#5: Hunting for yield will inflate asset prices.
Things start getting messy when interest rates hit rock bottom or burrow deeper to go subterranean.
That is when investors start saying goodbye to bond markets and hello to other assets such as stocks, real estate and commodities. And when more buyers start shovelling money into any of these markets, prices go up, up, up.
As the prices of, say, stocks inflate, their future returns go down, down, down. Take, for example, a scenario where the fair value of the stock market is 100 $, while it currently trades at, say, $80.
If a zero rate policy drives stock prices up from $80 to $90, the future return drops from 25 to around 11 percent.
If stock prices rise further to, say, $99, the future return plummets all the way down to 1 percent.
If stock prices rise above $100, future returns will be negative! In other words, shareholders will pay for the privilege of owning equity! This sort of overvaluation may well occur if yields in bond markets spiral into negative territory.
Once all asset prices are inflated to a similar extent, the precarious fiat money system will be poised at the tipping point between inflation and deflation.
Deflation – a regime of falling prices – would unveil the unsound nature of the fiat money system for all to see. And the edifice of production and employment built on fiat money would come crashing down, toppled by deflation.
#6: Central banks will take harsh measures to prevent the fiat money system from collapsing.
Central banks can be expected to go all-out in their rescue efforts to keep the fiat money system afloat.
Take, for instance, the European Central Bank (ECB). It suppresses market interest rates and prints up new money to prevent overstretched banks and states from defaulting on their payments.
In fact, the ECB’s recent practice of buying bonds could actually be tantamount to starting up an enormous money printing machine. Here’s why:
The overnight deposits held in euro banks currently amount to around 5.6 trillion euros. Banks’ cash reserves, however, are just 844 billion euros. This tells us that they have a largish funding gap of around 4.8 trillion euros.
If the ECB is determined to close the funding