Tag Archives: Fiat monetary system

Follow-up on the CAD question – Value of a currency, gold reserves and FRB

In response to my previous article, Aditya Sood had asked the following question.

Sir, I have a question. From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past. The fractional reserve is a new thing. So who decided that value of a currency should be de-linked from an underlying commodity? Was it that all countries saw some flaws in that system and decided to shift to a new one ? Or is it that one particular country/group of people enforced it upon the rest ? If yes, how did they manage to convince all the countries about shifting to a new system?

Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

Aditya’s question contains so many clues to the kind of misunderstanding that exists among ordinary people and the extent to which education is required to enable ordinary people to understand the varying grotesqueries of the prevailing system of money and banking.

Misunderstanding No. 1

Aditya asks

From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

The important point to understand is that in the not too distant past, commodities like gold and silver were money. There was no such thing as a currency independent of coins of these precious metals and there was therefore no question of the value of a currency being linked to its gold (or silver) reserves.

The clue to understanding these lies in understanding how some of the important modern currencies got their name. Take the British Pound, for instance. Ever wondered why it is called the Pound, or more specifically the Pound Sterling? Simply because the unit of money in England in the 1600’s was 1 lb (by weight) of Sterling Silver. 1 lb being a large weight (453.592 gms to be precise), there were other smaller units such as the shilling and the pence that served as the unit of money in smaller value exchanges. Each of these units stood for a definite weight of the same money commodity – Sterling Silver.

The concept of monetary unit is important to understand while we understand money. The monetary unit is a conveniently chosen quantity of the underlying money commodity. Money is a good like any other good and is one of the commodities exchanged in any trade transaction, it being the generally accepted medium of exchange. Every good in every exchange is exchanged in a certain quantity and so is money. The concept of the monetary unit is a method to specify and identify the quantity of the money commodity involved in an exchange. When the price of a good is quoted as 10 shillings, it means the quantity of sterling silver contained in, say, 10 coins marked 1 shilling each. In this sense, the monetary unit is similar to the unit of measurements like the metre, the kilogram and the litre.

So, in response to Aditya’s question, it is not that the value of the Pound Sterling was fixed as 1 pound of sterling silver. It was simply that the Pound Sterling was defined as 1 pound (by weight) of sterling silver.

Misunderstanding No. 2

Taking the same part of Aditya’s question

From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

the second important misunderstanding that is visible is that there was no such thing as the currency of a country. There was money, which was largely coins of specific weight and purity of metals like gold and silver, and there were different such units, each of a specific weight and purity and minted at a particular mint. In any economy, multiple forms of money were simultaneously in circulation and there even existed exchange rates among the different currencies depending on their defined weight and purity, the age of the coins and their wear and tear, and, last but not the least, the reputation of the mint itself.

In America in the 1700’s, for instance, Spanish silver coins were the most popular form of money. The most popular coins of all were the thalers. The name thaler is a shortened form of the longer Joachimsthaler which in turn stood for coins minted at the mint of a Count Schlick from the Joachimsthal or Joachim’s Valley region of Bohemia (modern day Czechoslovakia). These coins flowed into America thanks to the robust trade with Spain, what with large tracts of America then being Spanish colonies (Does The Mask of Zorro remind you of something related?). The reliability of these coins soon made them the most popular coins in trade. Even the Joachimsthaler was later to be upstaged by the even more reliable Maria Teresa Thaler. At the time of American Independence, a choice had to be made as to the unit of money of the newly independent States of America. The unanimous choice was the already prevailing thaler renamed as the Dollar.

The thaler stood for 371 ¾ grains of pure silver and the dollar too was chosen to stand for the same quantity of the same metal. In effect, it was just a formal acknowledgement of what was already the market’s choice of the money commodity and the monetary unit.

In addressing Aditya’s question, what we therefore see is that different regions ended up using different monetary units of one or the other of precious metals like silver and gold and that in each region one of these monetary units ended up being predominant due to various market factors.

Misunderstanding No. 3

I apologise for quoting the same bit from Aditya again, but it is interesting to note how many misunderstandings are revealed by just 1 sentence. He asked

From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

The notion of gold reserves being linked to the amount of money in circulation is an outcome of certain banking practices that started becoming prevalent in the late 17th and early 18th centuries. I am referring primarily to the emergence of paper money and demand deposits a money substitutes. The point is simple – paper money as we know it is a relatively recent phenomenon. For a large part of history, gold and silver coins served as the money.

Paper money emerged in the form of receipts issued by warehouses that stored money proper (gold and silver coins). Over time, these receipts started circulating in lieu of the money proper, the coins in storage. This evolved further into the concept of savings banks which accepted deposits of coins against which they issued bank notes. Savings banks, like their predecessors, the warehouses, charged their clients for the storage of the coins.

By the 16th and 17th centuries, these bank notes had become widely accepted as money substitutes that could, on demand, be redeemed in the money proper. However, savings banks observed that only a small fraction of their bank notes actually returned for redemption at any point in time. This served as a great temptation for the savings banks to in a practice that is today known as Fractional Reserve Banking.

Banks started issuing bank notes of cumulative face value far greater than the actual number of units of money proper in storage. The actual reserves of money proper they held was a fraction of the total face value of their own bank notes that they had put into circulation. This is the concept of the fractional reserve underlying the concept of Fractional Reserve Banking.

Operationally, every Fractional Reserve Bank is fundamentally insolvent. It has made promises that it just does not have the ability to keep. If a bank has a reserve ratio of 10%, any number more than 10% of the total notes emitted coming in for redemption at a time means that the bank has to make public its insolvency and shut down.

But why did banks risk such insolvency? The reason was that the money could be loaned out at interest and the bank could earn an actual profit in money proper. Basically, banks were getting to earn easy money by lending out other people’s property that had been given to them for safekeeping.

This system of Fractional Reserve Banking, while temporarily profitable, is not without its consequences. Bank notes emitted thus were offered as loans to producers. Thus, they were injected into the production system as credit expanded beyond the actual pool of available real savings. This was, as is to be expected, accompanied by interest rate depression below the free-market level. In simple terms, as explained out here, this is precisely how the inflationary boom is created. However, as explained by ABCT, the seeds of the inevitable economic depression are sown during the inflationary boom. The economic depression would start with a spate of bank runs, leading to widespread closure pressures on highly inflationary fractional reserve banks.

Unfortunately, the Fractional Reserve Banking system was also a convenient way for governments to raise resources for their ever-burgeoning spending plans. Fractional reserve banks were therefore able to lobby governments to protect them from the effects of their own irresponsibility. This close, symbiotic relationship between governments and the banking system grew ever stronger through a series of boom-bust cycles throughout the 18th and 19th centuries eventually leading to a system of governments taking control of the system of money by instituting Central Banks and conferring on them a monopoly over the issue of the fiat money and control over the banking system.

The biggest step in this process was the setting up of the Federal Reserve Bank of the US in 1913 with a monopoly over the issue of US Dollars. The inflationary practices of the banking system under the Federal Reserve’s watch led to the Crash of 1929 and the Great Depression of 1929-1945. Under the pretext of the Great Depression, the US government moved the monetary system further from a linkage to real money such as gold through policies such as outright gold confiscation and devaluing the dollar from 1/20.6 oz of gold to 1/35 oz of gold. The argument cited was that the demand to hold gold was responsible for the Depression. The reality was that the government wanted to put an end to the commodity-based monetary system and free itself from the strict limits imposed on government spending by the laws of economics.

The US thus moved from a gold standard to a notional gold exchange standard where US citizens could not redeem dollars in gold but foreigners and their governments could. By 1971, however, the situation worsened on account of further inflationary fractional reserve banking and the US was about default on its obligation to redeem dollars in gold to foreigners. That was when the then President Nixon repudiated all obligations of the US government to redeem dollars in gold, thus putting the entire world on a pure fiat standard. The UK had already done so in 1931 leaving the Dollar as the sole global currency.

This, in short, is how the monetary system of the world transformed from a pure commodity-based monetary system to a pure fiat monetary system controlled by governments through Central Banks and the rest of the banking system. Basically, the banking system followed practices that landed them in trouble and created economic depressions. The blame was steadily and repeatedly placed on precious metals, especially their scarcity, eventually leading to a government takeover of the system of money and the banishment of silver and gold from their market anointed role as money proper.

What do we learn from this deviation into history?

It is incorrect to make statements like value of a currency being linked to the reserves held by the government or a monetary authority like a Central Bank. The monetary system of today is essentially the outcome of a systematic though protracted government takeover of a market determined system of money.

Addressing the rest of Aditya’s questions

Aditya then asks

The fractional reserve is a new thing.

It evolved basically as a way to earn money from nothing and grew by lobbying support from governments that benefited from FRB.

So who decided that value of a currency should be de-linked from an underlying commodity?

If one person or entity should be blamed, it is the US government. At a more general level, it is the banking system, Central Banks and governments that, through their machinations, moved the monetary system off a commodity base into a pure fiat system.

Was it that all countries saw some flaws in that system and decided to shift to a new one?

No. The commodity-based system of money had no major flaws. In fact, it is precisely the scarcity of precious metals that makes them good monetary materials. Rather, it was that governments and the banking system the world over saw a commodity-backed monetary system as a serious limitation on their inflationary and extravagant ways and foisted an FRB system on the markets. When their system failed (as it is expected to), they blamed the failure on the commodity and used it as an excuse to take control of the monetary system and change it to something that was more beneficial to them.

Or is it that one particular country/group of people enforced it upon the rest ?

Not exactly, various governments, in their own ways, encouraged, fostered and finally acted to enforce a pure fiat monetary system.

If yes, how did they manage to convince all the countries about shifting to a new system ?

No one had to convince any one. Every government and every fractional reserve bank wanted this system. Since governments were ready to use the power in their hands to make this happen, they did.

Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

There were economists of the Austrian School like Ludwig von Mises who cautioned against these moves but they were largely ignored.

What we can learn from this

Most of us carry a number of misconceptions that distort our view of the working of the world. A lot of what we hear from most common sources needs to be questioned if we are to make sense of what is happening in the world around us. History shows us that those who are in charge of the system of money and banking are themselves responsible for the key monetary and economic problems of the day. Unless we grasp this fundamental issue, we will find it very difficult to comprehend true and lasting solutions to serious economic challenges.