history of monetary standard

Why traditional finance needs a full reset – Part 1 (Fiat currency)

Human race took some incredible strides in the past 200 years. It is obvious to anyone who looks around – from housing to mobility to communications to machines, there is progress everywhere. Much of this progress can be attributed to the creation of a financial infrastructure that encouraged people to take risks with uncertain deferred payouts, undertake specialized tasks & effectively collaborate with others.

We created institutions and systems such as governments, courts, central banks, international institutions (World Bank, IMF etc), taxation, fiat currency,  banks and financial products such as savings, debt, investment securities to propel this monetary system. All these stake holders, products and systems developed over the past century constitute the ‘traditional finance’ infrastructure.

This infrastructure is now cracking under its own weight & there are several vectors across which the current financial infrastructure is failing. Let’s explore a few aspects of traditional finance that have completely failed (or close to the point of failure) and hence need a complete reset.

The four points of failure of traditional finance are

  1. Fiat Currency creating unsustainable & ballooning debt
  2. Central Banks creating artificial boom & bust cycles
  3. Gate Keepers (Commercial Banks) who have created huge invisible risks shielded by opaque structures
  4. Reserve Currency that is abused for geo-political reasons

In this article I discuss the first point of failure: a fiat Currency based monetary system. There are some exceptional scholars who have discussed this subject at length. Two books I highly recommend to my readers are “Fiat Standard: The Debt slavery alternative to human civilization” by Saifedean Ammous and “The Death of Money. Coming collapse of international monetary system” by Jim Rickards.

What is fiat currency based monetary system?

Brief History

From 1870-1914, a full gold standard based monetary system was adopted by major economies in the world. What that meant was that each country’s currency was fully backed by gold and gold can be bought or sold for a fixed price in paper money – this in-turn meant that currency exchange rate between different countries was also fixed. By pegging the price of currency to the price of gold, economies made sure that paper currency was backed by real value (in this case, the cost of mining, production & storage of gold which is a scarce metal).
Here is a timeline of changes related to global monetary systems. By 1971, US government could not sustain deficit spending and still retain a peg. In what is now called Bretton Woods Agreement, US declared that it no longer pegs US dollar to gold & that US dollar is the default currency for the world. And that started a fiat currency standard that is currently 50 years old.

history of monetary standard
Timeline of monetary standard

Fiat standard

Current fiat currency based monetary system that we live in gives central banks (and governments) the power to:

  • Be the sole monopoly for printing currency that citizens can use as store of value & medium of exchange
  • Back this currency by legal tender (make it illegal to have any other forms of currency)
  • Pay taxes only in the currency issued by government
  • Control banks to only deal with government issued currency
  • Above all, print currency with no backing, ie. currency can be generated even without creating an underlying good/service

Fiat system solely runs on trust. Citizens need to trust the government to preserve the future value of currency .

What is the problem with fiat currency?

Let’s understand the problem by going through an example:

There are 100 able bodied men in Wakanda (a hypothetical island somewhere in the world). Wakanda governing council uses ‘glass beads’ as money to exchange food, coconuts, tools etc among its residents. Such beads are rare across the island and only the council has the power to authorize a bead as ‘valid money’.

Coconut cutting season comes along and the Wakanda council asks all able bodied men for help. 1 day of labor can be exchanged for 1 glass bead of money. 90 men get to work and work for 30 days to cut all coconuts in the island. Each of them is happy to collect 30 beads. They can exchange these beads for food, clothing and shelter for their families.

Remaining 10 mean are slackers who don’t contribute anything.  This group of slackers befriend a European traveler who hands them some beads. These beads were just collectibles for the traveler with no intrinsic value – they are abundant and not considered money in his home country. Slackers then strike a secret deal with the council & gets them to authorize the beads as ‘valid’. Council is happy because they get more money to spend on welfare and social activities.

Council issues 300 new beads and gives 30 to each slacker. Compared to the 2700 beads (90 men *30 days & 1 bead/day) that were backed by actual effort of climbing trees & cutting coconuts, these 300 beads have no value backing them. They just came into the system because the council has power to create them from thin air. The net result is that there are a total of  3000 beads in circulation.

Next season comes along. Slackers get bolder – this time they make the council issue 1000 fake beads. Each slacker now appropriates 100 beads compared to the 30 beads earned by hard working men. With so many new beads flushing the system, each bead can now buy lesser food/clothing and shelter. Hardworking men can get lesser value in exchange for their work & slackers are getting more for doing nothing. This process goes on until honest people lose faith in the system & stop saving beads for their family. Inflation of beads destroys credibility of beads and leads to a society of ‘rent-seekers’ replacing a society of ‘hard-workers’

In the above example, replace the ‘beads’ with US dollars, ‘council’ with government, ‘slackers’ with bankers, and hardworking men with ‘middle class’ and you get the real story of current monetary systems.

When you give power to a person, (s)he will abuse it:

By giving enormous power to a person, you are increasing the likelihood of abuse. A powerful person can and will use his power. ‘Traditional Finance’ vests the most important power of ‘minting money’ with the government. To make matters worse, there are absolutely no checks and balances that prevent governments to mint unlimited money.

One look at the US federal debt and we’ll know the extent of this power abuse. There is not a single period in the last 100 years where the US society was debt free. Year after year, government spent more than it earned and the deficit (spending – earning) kept increasing (current debt levels are > $30 trillion). This level of deficit can only be sustained by relentlessly printing money out of thin air. Politicians love running deficits as they can get them re-elected to office.

Savers are suckers

More free money that comes into the system, more is the destruction to the value of existing money. Saifedean Ammous defines a term called ‘Time Preference’ – people with high time preference give sole value to the ‘present’ and assign negligible value to future. People with low time preference value the future more than the present – they tend to sacrifice the present for a better future for themselves and their families.

Typically, societies that save a lot have low time preference and societies that consume a lot have high time preference. Savers allow the capital invested over longer term projects and increase the productivity of the society. For a civilization to progress, we need savers and savers will only save if they have confidence that their savings will not erode over time. Unfortunately that is exactly what is happening – the purchasing power of dollar has continuously eroded over past 100 years.

Chart below shows that 1$ in 1913, the year when Central Bank was created, has lost its purchasing power by a factor of 30. A dollar in 1913 can buy 30 times more value than that in 2022 – and this has happened while the currency in circulation has continuously increased to the current level of 2.3 trillion USD. In a society where money printing chips away the value of a dollar, savers become suckers. There is absolutely no sense to save in dollar terms.

Source: World Gold Council

Another chart that illustrates the same idea of loss of dollar value is from Saifedean Ammous book, Bitcoin standard.

Major currencies priced in gold, from 1917-2017 (source: The Bitcoin Standard)

Above chart shows that almost every currency has lost more than 80% value against gold over 100 years. When this chart is combined with previous, we can easily see why Gold standard is the most sound form of monetary system. Savers who saved in gold could pass riches to their younger generations whereas savers who saved in currencies practically gave nothing to their future generations because governments have robbed that value.

Perception of fiat currency stability is perhaps the biggest fraud perpetrated by governments worldwide on their citizens

Artificial infusion works in the short term but creates long term imbalances

During my business school days, we were always made to believe the economy moves in boom & bust cycles. There is a period of  expansion followed by contraction of economy. We were told that this was because of cyclical nature of greed and fear among market participants (a classic case of distributing blame on the entire society).


Logic says that credit expansion leads to growth and that growth leads to higher leverage & poorer risk management. Organizations with poor credit history also get access to credit and low rates. Eventually something breaks and there is a contraction of credit in the system leading to recession or de-growth.

Economic textbooks somehow give a feel of inevitability to this boom-bust cycle.

Fundamental reason for the boom/bust cycle goes back to the fragility created by a fiat currency monetary system.

Boom bust cycle is an outcome of fragility created by fiat currencies
Deficit Financing by Governments


John Maynard Keynes gave the ultimate drug of ‘deficit financing’ to the powers that be. He proclaimed that the only path to growth is through ‘spending’.  His theory was that when governments spend, that spending creates demand in the society and increases money flow in the system. Keynes went on to claim that this spending will eventually get more people to work & increase economic productivity.

This was music to politicians who exploited the fiat based monetary system to print new currency and pump it into the system. Freshly minted money was used to spend on everything from education to social welfare to healthcare etc. Governments expanded their power by controlling every institution with their ultimate weapon: currency printing. All this monetary expansion was done in the the name of increasing productivity of society.

Even after all the technological breakthroughs in mobility, communication, space technology, engineering, no wonder each living person is paying higher prices & higher taxes. The efficiencies of technology & innovation are more than compensated by the costs of indiscriminate money printing leading to an ever increasing spiral of prices & taxes. As they say, the only 2 things certain in life are death and taxes.

By artificially pumping in unsound money into the system, Central Banks encourage commercial banks to lend aggressively (more on this in my next article on Central Banks). While this money definitely spurs growth in the short term, nobody cares whether that money is being optimally utilized or not.

When money is not earned by underlying goods/services, it becomes loose money with loose controls and poor risk management. This becomes a breeding ground for ‘rent seekers’, ‘gamblers’ and ‘con-artists’ to manipulate flow of money and profit from it.  Eventually, too much credit expansion leads to failures, bankruptcies and loss of value. This causes contraction in markets and the cycle persists.  Central bank poses itself as a savior by artificially altering the money supply and tinkering with interest rates whereas in reality it is the root cause for these boom/bust cycles.

Why money backed by gold was different?

Until governments had fiat currency backed by a gold standard, institutions were careful in the way they deployed money. Since money was not created out of thin air and lent out at low interest rates, the opportunity costs of deploying money at the wrong place was high in the gold standard. Mistakes were decentralized – inefficient companies died quickly much before they became ‘too big to fail’. Risk was properly priced in – projects with huge upside could raise capital (railroads, cars, steam engine etc) and people were fiscally responsible with their financial resources.

Until the classical gold standard was shattered in 1914, countries spent their money carefully on projects that led to maximum community gain. In fact the unlimited printing of currency can be argued as a main reason for World Wars 1/2 to persist for years instead of days or months. Had countries been on gold standard, one country would have exhausted its resources quickly & war would have ended soon. More recent Russia-Ukraine crisis clearly illustrates the indiscriminate use of power by one person who can print unlimited amounts of currency to fund a war.

Inflation, the invisible tax on savers

Chart below shows personal savings rate in US and barring the bump of 2020, personal savings rate has dropped from 15% in 1975 to 6% in 2022. This reduction is no coincidence – people realize that holding currency is a losing trade. Each year, holding dollars loses the purchasing power of its citizens.

Source: St Louis Fed (FRED Personal Saving Rate)

High inflation, which is a direct result of high money supply, reduces the real value of dollars. Although nominal dollars in your bank account remain the same, real dollar value continues to drop over time. Inflation along with taxes destroy people’s incentive to save money for future use. Everyone turns into a ‘value guzzler’ – spend as much as you can, who knows or cares about the long term. When a society adopts this attitude, it stops investing in long term, value generation projects.

Friedman On Inflation, Hanke on Hyperinflation
Hyperinflation in Weimar Republic 1919-1933

In the last 100 years, there have been over 60 cases of hyper inflation (inflation rate of higher than 50%) where people lost their life savings in just a few months. Hyperinflation is exclusive to fiat based currencies & can never happen if a currency is backed by value (eg. gold, oil, food etc). Countless lives are driven into poverty as witnessed in Weimar Republic, Venezuela, Zimbabwe etc – just this one reason is enough to lose faith in the fiat standard as it stands today.

Conclusion

Current financial infrastructure is unsustainable because it gives the power to a few individuals to control money supply. A fiat standard that does not peg the currency to any underlying value is bound to be exploited by governments and central banks. Indiscriminate printing of currency has robbed value for savers & all currencies have consistently lost value over past 100 years. Excess money supply that is not backed by underlying economic value creates inflation (and sometimes hyperinflation), ballooning debt and painful boom & bust cycles. Unless governments are stripped of power to indiscriminately print money, such episodes will continue looting millions of hard working individuals.

A system where an individual has a sovereign right to store his money and no power on earth can pilfer value from that stored money is essential for a fair world. Thanks to Satoshi Nakamoto (founder of bitcoin), we have a realistic chance to live in that world.