It’s exactly 50 years since the US dollar became a “fiat” currency. Investors, economists and cryptocurrency supporters want to know whether it’ll see 50 more.
Fiat currency is money issued by a government or central bank where you have no right for it to be converted into gold or any other asset. Our New Zealand dollar is a fiat currency.
This means if you hold a $20 note you are trusting that everyone will respect the $20 value. You, and everyone else, accepts you have $20 of purchasing power.
For this reason, fiat currency is built on trust in the financial system. When this confidence evaporates the currency collapses, like in Venezuela or Zimbabwe.
Until August 1971, the US dollar was backed by gold, a system called the “gold standard”. The value of gold was fixed at US$35 per ounce, and every US dollar on issue had a US dollar of gold reserves.
Under a fully functioning gold standard, you can convert your paper money to gold at any time. This gives confidence that the value of the paper note is more than a promise, it’s backed by precious metal.
The gold standard, which required central banks to build gold reserves, wasn’t perfect. In the Great Depression many wanted to convert banknotes to gold, undermining the financial system.
Britain was forced to abandon the gold standard in 1931 and the US started restricting it in 1933.
If a government can only issue currency backed by gold, the ability to print money is limited by its ability to buy more gold. Many like this handbrake on money creation.
Fiat currency has many critics. The main question is whether you can trust a currency’s value when the central bank can just print more (note that banks can also effectively increase money supply through our “fractional banking” system, but that’s a separate discussion). Critics also worry that increasing the money supply fuels inflation, in turn eroding the value of money. Both are legitimate concerns.
The global financial crisis (GFC) tested the international financial system to its limits. With huge global debt, for some time it looked like the system could fold in on itself.
However, central bankers were creative and drastically increased the money supply (through quantitative easing) papering over cracks. From 2007 to now balance sheets of the world’s largest central banks increased an astonishing US$25 trillion to US$30t.
Interest rates fell without creating inflation. A magic combination, although not sustainable forever.
Questions around our economic system have grown support for cryptocurrencies, but not all the world is ready to switch. Central banks and governments aren’t hurrying to relinquish money supply oversight, but they will experiment with cryptocurrencies they can control.
Money printing saw debt soar through the GFC and last year’s Covid uncertainty. But that also saved the economic system in a way that neither bitcoin not the gold standard could have. That’s because without money printing we would probably have faced uncontrolled asset price deflation, like back in 1921 under the gold standard when US prices plummeted 11 per cent.
Essentially money printing saved us from one disaster but may end up creating a different one.
So muted celebrations for 50 years of the US dollar as a fiat currency. Question is, will it still be here in its same form in another 50 years? Given advances in fintech, cryptocurrency, the rise of China and imbalances in the current economic system, it is a very sensible question to ask.
(This article was originally published by Stuff August 23, 2021)