What is Money? A look at the US Dollar

Any discussion of economics and finance necessarily involves reference to money – usually in the form of currency and usually the US dollar. Thus we must establish a framework for what this is. Though this may seem overly-simplistic, it is crucial to understanding some of the looming threats to our economic wellbeing. Please bear with me.

For centuries trade was undertaken by way of commodity trading. No, not the exotic Chicago futures market, but rather a simple concept of I’ll buy your chickens and give you a pig as payment. Perhaps the seller would demand a mule instead and a trade was consummated. Of course this was not a very efficient means of exchange. So over many many years, trading evolved such that a standard medium of exchange was used – generally precious stones or metals. Eventually gold came to be the favorite and most recognized standard of value, recognized by Pharaohs of Egypt as a standard of wealth.

The beginnings of currency

 

Given the popularity of gold as a medium of exchange, it was just a matter of time before political rulers facilitated the trading concept by minting gold (or silver) into coins – thereby creating a standard of measure and acceptability. Coins appeared on the scene about 1,000 BC and became the accepted medium of exchange for almost three thousand years. The central concept that allowed this efficiency and acceptability was that the coin itself was actually a store of value – the value of the metal itself roughly approximated the value assigned to the coin. Occasionally governments would dilute the precious metal content by introducing other “base” metals, but this “debasement” of their coinage could cause it to lose acceptability and its value as a trading medium.

Paper Money

 

Though coins worked fairly well for centuries, they tend to be heavy and somewhat cumbersome. Sometime after 1,000 AD a Chinese emperor introduced the concept of paper money. The government would guarantee that the paper notes were convertible back to gold (or certain other valued commodities). The paper money system or “fiat currency” would be far more efficient than using heavy, bulky coins.  Unfortunately, the emperor was tempted to and eventually did print more of the paper money than he had gold to support and inflation overtook the economy and the paper money fell out of favor.[1]  It seemed it would take a very strong government entity, one with enough discipline to avoid the temptation of printing excessive amounts of paper money, before this concept would really work.

As years passed, numerous government entities continued the experiment with paper currency – sometimes in the form of “bills of credit” or other instruments backed by governments. But over and over these paper currency attempts failed whether they were US “Continentals”, the Confederate dollar or others. Germany introduced the Goldmark in 1871 which was backed by gold and convertible into an equivalent amount of silver coins. This worked well until World War I when the government dropped the convertibility and it became known as the Papiermark. This immediately lost value and Germany went into hyperinflation.

The lessons of history are numerous and obvious. Paper currency cannot sustain without convertibility into a real value store such as gold. A government guarantee of this is essential.

Bretton Woods

 

The world changed as World War II was coming to an end and the victors met to discuss global financial stability after a devastating war. In July 1944 John Maynard Keynes (UK), Harry Dexter White (US) and others hammered out an international concept of money for the first time in history. Though attempts were made to create a new international currency, it was deemed too challenging and instead the US dollar was elevated to a special status as a world-wide trading currency – to be accepted by all. Of course this would hold no weight, all realized, unless the dollar was supported by convertibility to gold – and so this was done. U.S dollars were convertible into gold at a rate of $35 per ounce. With international support, the dollar was now as good as gold and the first true international currency was born. The dollar did not supplant local currencies in their home markets, but their currencies would be fixed (via exchange rates) against the dollar and international trading could proceed. It was a golden age.

The Beginning of a Breakdown

 

This concept worked well and international trade and expansion flourished for 25 years. However, like the Chinese emperor, the requirement for the US to exercise sufficient discipline to maintain the gold convertibility proved too challenging. Heavy US expenditures during the Vietnam War lead to excessive currency (relative to gold to back it) and the world began to lose faith. In 1971, in what has been referred to as the “Nixon Shock”, the president took the dollar off the “gold standard” and the concept of stable international paper money ended. Other governments began to float their currencies against the dollar and the oil exporting countries (OPEC), worried about the value of the dollar and spurred by other political developments, even embarked upon an oil embargo.

But life goes on. The world still needs to trade and have a medium for exchange. Even though the US dollar was no longer backed by a convertible store of value, it was still backed by the full faith and credit of the United States of America – the most powerful economy in the world and one with a stable government and judicial system. Absent anything better, it seemed the U.S dollar would remain in its special place of privilege as the world’s international trading currency. This could remain indefinitely as long as the US exercised a reasonable amount of economic discipline and did not abuse its special privilege by simply printing money.

From 1971 through sometime in the first decade of the 21^st century, the US enjoyed its special privilege as the unquestioned owner of the world’s reserve currency.  Ever so slowly it succumbed to the temptation to print money, but like the anecdote of the frog in water which is slowly heated to the boiling point, no panic ensued. The US standard of living soared, not due to productivity or typical measures of economic health, but simply by use of the purchasing power of its paper money. The US imported cars, TV sets, fine leather clothing – whatever the world would supply and accept US dollars in return.

The world was becoming somewhat uncomfortable with this situation. Murmurs were heard at international meetings. The Euro had been created in 1999 as a possible alternative to the US dollar, but the political diversity of the underlying economies still proved less attractive than the dollar.

For three thousand years of currency trading, the basic concept of stored value or convertibility thereto had been a requirement for stability. Numerous attempts (probably hundreds) to float a paper currency without meeting this fundamental condition had failed. For almost 40 years of this three thousand, we have managed to conduct trade based on a pure paper system supported only by government guarantee. The question now is whether this system is sustainable.

The US Dollar

 

The only thing that could possibly dislodge the US dollar from its privileged role as the world’s reserve currency would be rampant spending (printing of money) by the US government. The increase in money supply would cause a direct inflationary response seen so many times before. So let’s look at the US money supply over the relevant period.

 

Monetary Base 1917 - 2009

An Unfortunate Coincidence

 

Much has been written about the financial crises of 2008 which is focused on the breakdown of the mortgage industry and the financial derivatives marketplace that ballooned along with it. The threats posed to the financial system world-wide were substantial and great minds converged on a Keynesian concept of fiscal spending to counteract what could have been a devastating contraction of markets worldwide. Perhaps this was the proper response.

Unfortunately, we are not acting in a vacuum on this isolated issue of the financial crises. In the chart above, one can see the significant effect this “save the world” plan has had on the US monetary base. Given that the world has been uncomfortably trusting the US dollar for almost 40 years, with that discomfort growing daily, it is unfortunate that such a significant historical event has occurred at this time. One has to wonder what this will mean for the long-term stability of a paper currency unsupported by a store of value the world has demanded for 99% of its trading history.

So, what is money? The question remains.

 

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[1]  Ramsden, Dave (2004). “A Very Short History of Chinese Paper Money”. James J. Puplava Financial Sense.