Thursday, October 23, 2008

That's not a knife

I promised that I would tell you about fiat currency and the damage it's done, not just to this country, but to the world. Some of my readers have pressed me to do so sooner rather than later, so today I will go into some detail about what fiat currency is, how it came to be, and why it's so dangerous. I'll think you'll find it illuminating.

Before any serious discussion on the importance of currency can begin, it's important to understand what money really is. Money exists as a symbolic representation of units of energy. In a barter and trade system, goods and services produced are traded between free people in exchange for goods and services needed. Unfortunately, what one person may produce may not be needed at all times by those people who produce what is needed. For instance, a dairy farmer produces milk. In exchange for the feed for the cows he milks, he could trade milk to the hay farmer. In exchange for chairs and tables, he could trade milk to the carpenter. As long as everyone is in need of milk, the dairy farmer can trade for his needs.

But what if the carpenter is lactose intolerant? What if the hay farmer needs goats milk instead of cows milk? Then suddenly the dairy farmer is unable to receive the goods and services he needs. This problem is referred to as the “coincidence of wants” problem. Now, perhaps the dairy farmer could trade his milk to the goat farmer in exchange for goats milk and then trade that to the hay farmer, but it is easy to see how this system quickly becomes overly complex and inefficient. Soon the labor required to perform a series of trades in order to acquire goods and services to exchange for those needed by the dairy farmer becomes cumbersome and exponentially increases the associated cost.

This is where money comes in. In order to facilitate the exchange of goods and services, societies create forms of currency which act as an intermediate, agreed upon basic unit of exchange, representative of the energy required to generate it. As long as this intermediate commodity is not perishable and is in relatively consistent demand year round, then it can be reliably traded between free people. So now, the dairy farmer converts his milk into gold coins, which are then converted into chairs and tables. Or feed for cattle. Or live chickens. Or whatever else the dairy farmer needs. This is the basic philosophy behind the concept of money.

Currency exists in several forms. The earliest forms of currency were commodity based, which means that they were actual items with recognizable value, such as gold, and silver, or in some cases spices, crafted goods, or animal hides. The value of these commodities was based on the labor required to originally acquire them, so for instance, gold's value is based on the amount of labor required to find, mine, and refine it into a valuable substance.

This system is still cumbersome however, and so people began to use representative currencies. Representative currencies are notes of exchange which can be reliably traded for the commodities by which they are backed. So the value of representative money is equal to having that commodity in hand. The benefits of such a system are obvious. Now the dairy farmer could carry a bill fold filled with notes of exchange instead of a bag full of gold coins. Additionally, while commodity based currencies are actually made of commodities, representative currencies are backed by them, and as such, can be backed by a variety of commodities which are unrealistic as forms of currency on their own. Representative currencies could be backed by gold or silver, but also oil, water, whiskey, or pizza. It is the public's faith in the redeemability of the note which lends it its value.

This brings us to fiat currency. Fiat currency is not backed by anything. Anything. It is called fiat currency because its value is based on a government's order that it be accepted as a form of payment. It has no intrinsic value, and it can not be reliably exchanged for anything. In the absence of faith in the government which issued it, this money loses all value and becomes worth less than the paper it's printed on. Supporters of fiat currency will argue that it is backed by every commodity because it can be reliably traded for anything within the confines of the society which exchanges it, but in reality, even when traded for real goods or services, it is still not ultimately backed by real asset, and can never be redeemed by the holder. Essentially, the last person holding the bill when faith in the issuing government collapses is empty handed.

This isn't the worst part. The worst part is that because this money is not based on real asset, governments are free to print it at will. You can't create commodity based currencies in greater numbers than the commodities themselves exist. Representative currencies are protected from excess printing by the constant possibility of redemption. Any issuer of representative commodities who was unable to physically convert his printed currency would be guilty of an actionable fraud. But fiat currency can be printed in ever increasing numbers because there is no physical asset limiting its redemptive value.

Real commodity backed currencies hold their value. They resist inflation, devaluation, and counterfeiting. Even a sudden influx of their backing commodities wouldn't affect their value, because those comoodities still required energy to generate. The problem for governments is that these types of currencies act as a check on their power. You can't invade a foreign country, where the further you move from your revenue source the greater your constant operating costs become, if you have to trade in real currency along the way. You would have to bring your bags of gold and spices with you, and when you ran out, you'd be stuck. Effectively, this acted to leash aggressive nations to their homeland, and limited foreign adventurism. Now, countries only need a printing press, and they can generate limitless amounts of money, which they then order people to accept as payment.

There are other issues as well. Fiat currency is issued by central banks to the government as debt, which must be repaid with interest. While some argue that this is incorrect, such an arguement can be found here, even the numbers represented there clearly show that the treasury is not fully reimbursed for the cost of borrowing the reserve notes from the central banks. Saying that the treasury is reimbursed for some of its costs does not equate to "Federal Reserve Notes do not cost the Treasury any net interest." Additionally, some fiat money, such as the United States Nickel actually have an intrinsic value far below that printed on their face. This means that people are actually being forced, by government fiat, to trade for more than the value of the currency. The net result of all of this is that there is inherent debt in a fiat currency system, which must be passed from person to person like a hot potato.

Fiat money is nothing new. There are articles on the internet, such as this one, which describe the history of fiat money over thousands of years. It always fails. It's always eventually replaced by commodity backed currencies. But it is scariest in its terminal stage.

The terminal stage of fiat money is hyper inflation. Throughout the life of any fiat currency, there is constant inflation as a result of unrestricted printing. As people begin to lose faith in the currency itself, the issuing authority begins to print at a much more rapid pace in order to take advantage of its assumed value before it is lost. It is during this time that people begin wheeling buckets of money into the bakers to buy a loaf of bread.

It's not a joke, or a conspiracy theory. You can find more information on fiat money here, and here. It's been done again and again throughout history, and always to the same results. The government's argument is that this time it'll be different.

Don't bet the house on it.