In my last post on this subject I gave something of a history of my personal involvement in a local money scheme. What I wanted to establish is that I have something of a personal bona fides when it comes to talking about money in general. After all, how many people do you know who’ve actually created your own money from scratch, convinced a bunch of people to use it, and, then managed the results for several years?
I learned a lot from the experience, including the undeniable fact that money is ultimately psychological. That is to say, money has value for no other reason than people collectively decide that it has value. I’d suggest that readers read that last sentence over again and let it sink in.
People will talk about the ‘gold standard’ and mention that historically currency was based on the value of rare metals—like and gold and silver. Indeed, in my short historical description of the local bank issued currencies in 19th century America, I mentioned that people deposited their hordes of Mexical silver pesos in the local bank’s safe and that was supposed to be backing-up the local money.
The thing is, even silver and gold only have value because people think that it should have value. We know this because even those two metals can create inflation if too much of it gets made into money. And I’m not talking about debasing coinage by mixing in other metals—like the late Roman Empire. What I’m talking about is the so-called “Price Revolution” that occurred in Europe that lasted about 150 years, starting in the early 16th century. What this boiled down to was the Spanish Empire dumped huge amounts of gold and silver—looted from the Americas—into the European economy. This jacked-up the cost of living about 600% in those 150 years—which was an astounding amount in the historical context.
The only reason why people believe gold and silver are safe bets to base a currency on is primarily because most people, for most of human history, have agreed with this assertion. Which in fact means it probably is. Dump enough gold and silver into the market, though, and they would become just as worthless as Confederate money or Imperial Russian bonds.
What I’m trying to introduce readers to is the idea of ‘fiat money’. This is the idea that the value of money doesn’t come from some sort of ‘back-up’ like gold or silver, but merely from the prestige of the government or other institution that produces it. Fiat money is old—the Chinese (who else?) invented it in about the 12th century.
All the major governments in the world now issue fiat money, but that hasn’t always been the case. In 1944 most of the governments in the world agreed to something called the Bretton Woods Agreement. Among other things, this system ensured that all the currencies of the world would be linked to the US dollar, which made it—in effect—a universal currency or the world’s ‘reserve currency’. This is where we get the idea that we can compare every different type of money in the world is worth so much, compared to the US dollar.
Up until 1971 it was possible to redeem US currency in gold, which meant that the US dollars were remarkably stable. This ended under President Nixon, however. Even though this meant that American dollars suffered a lot more inflation, it continued to be the world’s reserve currency. This mean that to a very large extent whenever the American dollar became debased, so did every other currency in the world. This means that the US economy—along with a few others, like the Euro, Yen, and Canadian dollar (to some extent)—can ‘export’ its inflation to everyone else. To understand this point, consider the following graph that plots the value of gold versus the US dollar.
If the value of gold is constant, then the US dollar fluctuated wildly after Nixon decoupled the two. If gold is just another fiat currency, which the European Price Revolution would suggest, then the dollar and gold changed from dancing a waltz to doing the frug in 1971. Either way, they support the point of this article, money is psychology.
That’s because even though the value of US dollar (and a small number of others—to some extent) has collapsed vis-a-vis gold, people still accept it all over the world. Moreover, because people use it everywhere, that also means that American industry can still buy machine tools and raw materials from other countries—and those countries have dollars that they can use to buy stuff from the US. That’s hardly what happens to a currency that’s in the sort of free-fall the above graph would suggest.
What I’m talking about is that reserve currencies have become—in effect—the new precious metals of international finance. And what this means is that—at least to some extent—any nation with a national currency that is considered a ‘reserve’, is able to inflate itself without suffering any ill effects—because all the other ‘non-reserve’ currencies will just automatically inflate in lock-step. Economists describe this as the process where countries with reserve currencies can “export inflation” to other nations.
Part of this is again, because people believe that the reserve currencies are worth something. (Money is psychology.) Another part is the fact that our international financial markets are so interlinked that both governments and large corporations simply need some sort of common currency to value goods, services, and, commodities. Which means that if there were no existing reserve currencies, it would be necessary to invent them. (Money is sociology?)
I think this is a good place to stop in this second part of my series. In the next one, I’m going to move onto the rise of crypto currencies: why people want them, what role they serve in the economy, and, what has made them so popular.