Print 
PDF
BookmarkIn one of the most popular articles that appeared on this site, we explained how 600 different forms of paper based money have all disappeared. Recorded history shows not one case where a form of paper based money has continued its existence. At best, some have survived a bit longer than the others.
When talking about paper based money, we refer to forms of money that are not backed by any tangible assets like gold or silver. A promissory note or coin was once used to redeem a predefined amount of gold or silver. Since 1971, only the note or coin has left with a promise to fulfill the function of money (hence fiat money).
In their latest report, PIMCO, who oversees more than $ 2 trillion in assets with a focus on fixed income investments, points to the effects of creating unlimited amounts of money. While doing so, they loudly ask the question what money is (source).
What IS money? A medium of exchange and a store of value is a rather succinct definition, but we generally think of it as cash or perhaps checks that reflect some balance of “ready” cash at a friendly bank. Yet as technology and financial innovation have progressed over the past few decades, and as central banks have tenuously validated the liquidity and price of various forms of credit, it seems that the definition of money has been extended to some other rather liquid forms of near currency such as money market funds, institutional “repo” and short-term Treasuries “guaranteed” by the Fed to trade at par over the next few years.
The KEY word in this phrase is “guaranteed.” What all these forms of money have in common is the guarantee (or promise) to be functioning as money.
As we know, money has three functions: a medium of exchange, a unit of account, a store of value. Let’s look at a basic question: who guarantees that these new forms of credit (considered as near money) will still do so in 5 or 10 years? Yes indeed, that monetary power that is called central bank acting in the name of the government.
When it comes to paper based money (or near money), it seems like every once in awhile the wheel is being reinvented. Today’s situation has similarities with the first paper based money case that was recorded in Europe.
1702 - The first paper based form of money in Europe
An excellent article by Charleston Voice (source) describes how the French government, driven by the illusion for control combined with innovative power, destroyed the French public’s purchasing power at the beginning of the 18th century.
“The genealogy of paper currency can hardly be traced up further back than the beginning of the eighteenth century. For the first time, we believe, ill 1702, a paper money was created in France, which was to be withdrawn on the 1st of April, 1705, bearing in the meanwhile the enormous interest of 71 per cent. per annum. It was received by the public with great favor, and circulated at par. But on the 1st of April, 1705, the paper could not be redeemed, as promised, and in order to induce the holders to consent to its renewal without too importunate clamors of discontent, the Government added 2 per cent. to the original interest, making 91 per cent.
Notwithstanding this encouragement, this tempting bait-notwithstanding this sop thrown to the fears of the multitude, the currency lost in a few days as much as 75 per cent. In 1706, by a decree of the Government, it was made a legal tender, and thus became a forced currency, under the penalty of pillory, exile, and a fine of three thousand livres.
But, strange as it may appear to those among us who favor measures of this description, from that moment the currency became valueless, so much so, that the Government paid one-fourth of it in coin, on condition that the rest should be converted into treasury notes-which conversion was followed by other conversions, until at last the Government emitted notes bearing an interest of 20 per cent., but without succeeding in stopping the increasing depreciation of every paper currency that was issued in rapid succession.”
Sounds familiar?
Our global paper based monetary system
Fast forward to the beginning of the 21st century, we can see that our leaders and economic thinkers consider historic lessons as a fallacy when it comes to paper money. The whole world lives on a monetary system that has no tie whatsoever with anything tangible. Instead of bringing in some balance through a hard asset, the US monetary base keeps on growing (see latest data) at the same pace at which central banks invent monetary solutions. Pete Kofod writes in his excellent piece The Money Wars:
It is important to recognize that all modern official currencies are in fact fiat currencies. The standardization for this occurred in two steps. The first occurred at the Bretton Woods conference in 1944. The conference had many objectives, but the key decision made was that all sovereign currencies would use the United States dollar as the reserve currency, and the dollar would in turn be backed by gold.
Given the chosen arrangement to establish a global reserve currency, selecting the US dollar was hardly a controversial move. Nations in the Americas were the only countries whose soil was not being ravaged by World War II. Furthermore, the United States was rapidly growing as a manufacturing powerhouse, generating the economic activity that could justify the dollar’s ascension to the role of global reserve currency. By demanding that the dollar be backed by gold, other nations were granted comfort that some non-political restraints were placed on the dollar in the future.
As readers know by now, Bretton Woods was replaced unilaterally by the “dollar standard” on August 15th, 1970. US President Nixon promised to retain the value of the dollar. We all know what happened with the value of the dollar since then. Interestingly, Pete Kofod lays out two other trends since then:
Predictably, politicians embarked upon a virtually unrestrained multi-decade spending spree. The dumber the idea, it seemed, the more money was thrown at it. As America’s vaunted manufacturing base was slowly eviscerated, due in no small part to the cost of carrying the state, the country turned to “high finance” for funding its expenses. The only defining quality of federal expenditures was how they consistently and without fail exceeded the budget, resulting in serial deficits and a commensurate accumulation of debt. Since America is the steward of the world’s reserve currency and no viable alternative has yet emerged, she continues her spending spree unabated to this very day.
The second trend is the abuse of the power of the US reserve currency. From a political and economic point of view, a country simply cannot afford to be excluded from the global monetary system. It is no secret that the US has used that power to its own advantage. Unfortunately, past results are no guarantee for future results.
And so it is that every time America tries to impose her will on the world stage through dollar-based sanctions, the long-term viability of the dollar as the currency of reserve takes a hit. Even if America weren’t spending herself into oblivion and kept a tight balance sheet, repeatedly using the dollar to achieve global political objectives has, unsurprisingly, significant unintended consequences. For starters, if nations and people around the world start to believe that arbitrary edicts can restrict access and flow of dollars, alternatives will be sought.
As history has shown, the government can control the monetary system for a certain time but not endless. As time progresses, the market can take over control. The global monetary system is at risk levels never seen before and as interconnected as never before. Holders of paper money should ask themselves what exactly they are owning … and what would happen if history is about to repeat itself.
