I O U Part 2: Fiat Currencies
When you talk of money, there are essentially two kinds, barring the use of actual precious metals for trade: representative money, and fiat money.
By definition, representative money is asset-backed, and functions on the basis of carrying not a value of its own, but a value equal to the amount of precious metals it can buy. As long as you can go to a bank and redeem gold or silver or another commodity with actual value with either a coin that has less market value in its metallic composition than face value, or paper money, that coin or bill is representative money.
Representative money came into play in China after the introduction of paper money, and eventually in Europe after the 13th century. Similarly, seigniorage was implemented that coins were for the first time given two values – their market value as metals, and their face value, which they represented. Face value was determined as cost of production, distribution plus tax, to make coin production more profitable for governments. Coins would be produced at their market price and given a face value, and handed out. When the coins were bought back by the issuers at a lower face value, seigniorage occurs as the cost of production and transportation was covered.
At first, seigniorage was the profit made by the British Empire after utilizing less silver to make a more durable Sterling Pound while keeping the face value of the coin steady. The same was done with the American Gold Eagle, changing the alloy to ease the cost of production while still keeping the value of the coin equivalent to the melt value of its weight in gold.
Nowadays, seigniorage exists in the form of interest – whenever a central bank prints money, they loan the money out to demanding banks and corporations with an expected interest. Eventually, when the money is repaid, the interest is considered seigniorage – that way the central bank doesn’t have to buy its own currency at face value and always keeps a profit. The major drawback – the interest the central banks ask for is nonexistent, as it is the bank itself that prints currency, and thus, debts to the central bank, while paid, never disappear and just make their way through the market.
Fiat money is the other side of the coin, and is a historically unsuccessful one. Essentially, it has no intrinsic value and no asset-based value. Its value fluctuates, and it cannot be exchanged for gold or other precious metals in high quantities at banks. Its value is based solely on how much trust people put into it, and on the market in which it is used.
The first recorded attempt at producing a fiat currency was in Rome, 54 AD. Emperor Nero changed the composition of the Denarius from being a pure silver coin to being 94% silver, introducing seigniorage and making a profit off of the coin production versus its value as a monetary instrument. However, proceeding emperors took the idea a little too far, and by 244 AD, the coin’s silver content was at a staggeringly low 0.05% silver. Soon afterwards, when the Roman Empire collapsed, no one saw the Denarius as a valid currency, having virtually no backing, and no secure value of any sort.
I’m overlapping histories a bit here, but when China implemented jiaozi, it used paper money as a representative currency. However, when the Mongol Empire attacked and inflation began to take hold, there were no assets left to trade the paper money in for. After losing to the Mongolians, Ghengis Khan’s grandson, Kublai Khan ran into a shortage of metals for exchange, and Chao, the Mongolian equivalent of jiaozi, had no actual asset-backing and was essentially a fiat currency – one with quite some success. The Mongol Empire went into a financial and cultural boom – until the overproduction of paper money spurred out a control and ruined the Empire’s economy.
Later, fiat money continued its troubled history in France, when upon the execution of Louis XIV, his successor, Louis XV, ordered that all taxes be paid in paper money, as per advice of John Law. Sadly, the coinage for exchanging all that money was nonexistent, and John Law was forced to flee after being the most cursed man in all of France.
Then again in the 18th century, France tried its hand at a paper-based currency called assignats, which shortly before Napoleon, was at an inflation of 130 times its original value. Then, Napoleon introduced the gold franc, realizing that a stable currency was better than fiat-based currency.
Yet after Napoleon’s era came to an ending, the paper franc was introduced. It successively lost 99% of its value over 12 years.
The term “hyperinflation” was then coined in the dusk of World War I, when post-war Germany began utilizing the Weimar Mark – a currency that lost so much value so quickly that people simply used it to heat their furnaces and make wallpapers rather than use it to actually buy anything. In fact, its value went from originally being worth one twelfth of a dollar, to having an exchange rate of 4.2 trillion marks per dollar. 4.2 Trillion.
The ridiculousness continues into more recent history – but what’s truly interesting is the U.S. dollar’s change into becoming a fiat currency. After the issuance of Executive Order 6012 which dictates that, upon the President’s approval, the U.S. dollar ceases to be a representative currency, and in the midst of World War 2, allied countries from all over the world joined together to discuss and prepare for post-war economics in what is called the Bretton Woods agreement. Chiefly, the agreement made it an obligation for every country to maintain an exchange rate, while tying itself to the U.S. dollar, and gave power to the IMF (International Monetary Fund) to temporarily sort out any and all international imbalances of payment.
The system dictated that fixed exchange rates be developed depending on the dollar, which in turn had a value of $35 per ounce of gold, redeemable by the U.S. government. The dollar was pegged to gold, and the world’s currencies were pegged to the dollar. At first, things were fine – the American economy boomed with export and import, and foreigners bought dollars to pay for American technologies and goods. The U.S. owned over half of the world’s gold reserve, so the system seemed stable.
However, the boom ended in the 50s, when Germany and Japan recovered from the war and the U.S.’s global economic output fell drastically. Later, the Vietnam War saw the creation of debt and inflation within the dollar, and it began being overvalued. Abroad, foreign countries owned more dollars than the U.S. owned gold, and after a drastic drop in their reserves, the government feared a complete run for its remaining gold reserves.
At first, West Germany left the Bretton Woods system, after refusing to devalue the Deutsche Mark to help the dollar. In turn, the dollar dropped in value against the mark. Countries began exchanging their dollars for gold; at first Switzerland, then France and other countries. By 1971, Switzerland left the Bretton Woods system and the decision of leaving as well fell upon the US, after further devaluation was advised.
Subsequently, after meeting with Treasury Secretary John Connelly, President Nixon issued Executive Order 11615 on August 15, 1971, which imposed a 90-day minimum wage and price ceiling, a 10% import charge and cut the dollar off from gold, making it a fiat currency. At first, the dollar saw success: but a risk of inflation soon followed, and is still keeping the U.S. on its toes, threatening the dollar with every successive year.
Despite this, however, the dollar retained its status as a reserve currency, and kept its value at a relatively stable level through monopolization of the Middle Eastern oil market, pumping oil prices up in case of severe inflation.
By March 1973, the fixed exchange rate became the floating exchange rate it is today, and after fearing the instability, the European Union commissioned the creation of the Euro, which entered circulation in 2002, and has been suffering of further economic turmoil following a global recession of 2009. Today, China appears to be on the verge of releasing a gold-backed Yuan, with the intention of it becoming a global reserve currency and changing the current global monetary system.