Thursday, April 26, 2012

Faith and Fiat Money

By Bert Whitehead M.B.A, J.D. © 2012

"Fiat Money" is commonly defined as money that has no intrinsic value and cannot be redeemed for specie or any commodity, but is made legal tender through government decree.

I have heard "Faith" defined as the belief in the experience of others.

This sums up our long-term economic dilemma. Since Nixon ended the convertibility of dollars to gold to combat inflation, the U.S. has given up any pretense of backing the dollar with gold or any commodity. So the currency we carry in our wallets and purses is essentially only slips of paper with pictures of dead white guys.

U.S. dollars are nonetheless respected and used globally as the world reserve currency. This only persists because everyone believes the dollar has value and can be used by people to buy things. Thus, we have faith that we can spend dollars to buy what we want. So far, so good.

But what happens if people around the world stop believing this? How could this scenario unfold? What can you do to protect yourself? This is the scare tactic that gold advertisements trumpet to entice people to protect themselves by buying gold as an investment.

There are over a hundred instances throughout the centuries during which governments issued paper money and backed it by a commodity, usually gold. "Fiat" paper money has never, however, lasted more than a few generations. Gradually these rulers or their successors could not resist printing more money to increase their spending to finance wars, or cover desirable social objectives. By decree they declared an increase to the legal currency even though they did not add enough gold to their reserves. This became known as Fiat Money.

Once merchants realized that they couldn't convert their money and receive the amount of gold they expected, they raised their prices. Inflation results when too much money chases fewer goods and services. In the 1970's this global issue was addressed by allowing currency values of each country to 'float' against other countries.

Government overspending is a hotly debated topic. Some economists (Keynesians) insist that there are times when it is appropriate for governments to run a deficit. They argue that, unless the government 'primes the pump' by increasing national debt, the country's economy could spiral into depression. The other side provides evidence that a government can't be trusted to ever pay off its debt. Running annual deficits will gradually debase the money and the economy will inevitably be ravaged by inflation.

Both sides of the debate can point to situations as proof that their theory is correct. Take the Great Depression, for instance. Did FDR's social economic stimulus bring our economy back to life in the 1930's, or was it really our entry into World War II that rescued the economy? Was the inflation in the 70's a result of the oil cartel raising prices, or did it arise from Nixon printing more money?

In reality, economics is not, strictly speaking, a 'science.' We can never apply the scientific method to economics since we can’t suspend a complicated global economy in time and study the effect of controlling selected variables.

Modern economists insist that the soundness of a country's 'hard' currency is not determined by how it is “backed”, but rather by whether it is easily converted into other assets. Historically, gold facilitated this convertibility, but that has been replaced by a nation's productive capacity, or gross domestic product (GDP). This seems reasonable, though it can be argued that this is a purely academic paradigm. Alas, austerity is the only known antidote to runaway inflation: we never know when our money ceases to be convertible (or 'spendable') until we can't spend it any more!

Today, for example, people would surely be hesitant to accept Greek drachmas at whatever rates their government decrees. As Argentina nationalizes private property to support their government spending programs, they should expect that the rest of the world will increasingly distrust the value of their peso. All countries that ignore economic realities are eventually exposed as their 'soft' currency starts trading on an internal 'black market.' The 'black market' sets the true value of their currency, irrespective of what the government decrees.

The take-away of this blog is simple: Currencies today do fluctuate in value. Trying to guess which one will go up next is not investing: it is gambling. Gold can be comforting if you can't sleep, but don't bet your retirement on it.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY

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