It is important to understand why nations switched from representative money to fiat money, as this is where the story begins to explain why we are in a financial mess today.
Financial Globalization and the Gold Standard (1821−1913)
Before financial globalization there were regional powers, which dominated trade; hence, their currencies were most commonly used and accepted. Before the Roman Empire reached its height of power, the Persian Empire was the dominant force and its currency, the daric, was the most widely used currency. This was succeeded by the Roman currency, the denarius, and then the gold dinar of the Islamic empire. During the age of Imperialism (sixteenth to twentieth centuries), the currencies of European colonial powers dominated foreign trade, beginning with the Spanish dollar, followed by the Dutch guilder, then the French franc, and ending with the British pound in the late nineteenth century. With Europe in ruins following World War I, the U.S. dollar became the dominant trading currency and is the basis for the current international monetary system.
Until the nineteenth century, the global monetary system was not very well integrated. The system was regional in focus, with colonial powers wielding influence over their former colonies in Africa, Asia, the Middle East, and South America. The influence of the former Spanish empire led to the integration of American and European economies and monetary systems. European influence in Asia led to the dominance of European currencies, most notably the British pound.
In the eighteenth century, much of the world was on a bimetallic standard, meaning more than one precious metal was legal tender. The main metals used were gold and silver, and copper to some extent. This created problems, as mentioned earlier. During the Napoleonic Wars (1803 to 1815), the United Kingdom suffered a silver shortage and was forced drop this standard and go on a fiat standard. The main change to this system began in 1821 when the United Kingdom returned to a convertibility system and established the classical gold standard.28 This new system allowed banknotes to be redeemed for gold bullion at the Bank of England. The redemption rate was set at 4.24 pounds for one ounce of gold. So anyone holding pounds at the time could go to the Bank of England and redeem their pounds for gold at this fixed rate. The main objective of this was to bring trust and stability to the system. Over the next decades, more and more countries embraced this new standard and dropped silver. By 1880, most of the countries around the world were on some form of gold standard.29
With currencies stabilized, world trade began to grow at a faster pace than it had in prior decades. World leaders began to promote free trade, which led to a huge expansion in communications, railway transportation, and transatlantic shipping. This period also witnessed record levels of migration.
Once the globalization wave started to take hold, protectionism began to rise, beginning in Germany in 1879. German Chancellor Otto von Bismarck introduced tariffs on agricultural and manufacturing goods, making Germany the first country to institute protectionist trade policies. France and the United States followed shortly with their own protectionist policies. Despite these measures, global trade continued to flourish, leading to an increase in foreign investment and capital flows.
As a result of the rise in capital flows between Europe and the Americas, new financial centers developed. Before 1870, London and Paris were the main financial centers. However, Berlin and New York soon began to compete on par with London and Paris. Other financial centers grew in importance as well, such as Amsterdam, Brussels, Geneva, and Zurich. London remained the leading international financial center in the four decades leading up to World War I.30
At the end of this period, another major event occurred. The U.S. Congress passed the Federal Reserve Act on December 23, 1913, giving rise to the Federal Reserve System, which acts as the country's central bank. The authority of the Federal Reserve System is derived from statutes enacted by the U.S. Congress and is subject to congressional oversight. There is, however, some controversy surrounding the establishment of this system, as it removed the right of Congress to issue and control the currency, as stated in Article 1, Section 8, of the U.S. Constitution.31
The Federal Reserve Bank (the Fed), contrary to popular belief, is not a government entity. It is independent from the government and owned by member banks. The specific shareholding of the bank is not disclosed, but the bank's website states that more than one-third of U.S. commercial banks are members.32 Member banks receive an annual statutory dividend of 6 percent of their capital investment in the Fed, and the U.S. government receives the remaining profits.33
The main objective of the Fed was to become the sole lender of last resort and to resolve the inelasticity of the money supply in times of crisis. However, this liberated banks from the need to maintain their own reserves, and they began taking on greater risks. The system that was set up to safeguard the country from financial crises actually made the economy more prone to crises, as we shall see in the following chapters.
The Two World Wars and the Great Depression (1914−1945)
On June 28, 1914, Austrian Archduke Franz Ferdinand was assassinated while on a visit to the Bosnian capital, Sarajevo. This event led to Austria's invasion of Serbia one month later. Germany sided with its Austro-Hungarian ally, and Russia sided with its allies in the Balkans. Soon, Belgium, Luxembourg, and France were invaded by Germany, and the United Kingdom declared war, sparking the first world war of the century.34
Over the next four years, there would be 16 million deaths and 20 million wounded, making it among the deadliest conflicts in human history.35 Economically speaking, Europe was in shambles, with the exception of four allies – Britain, Canada, Italy, and the United States, which saw their gross domestic product (GDP) increase during the war. The decline in the GDP in Austria, France, Russia, and the Ottoman Empire reached 30 to 40 percent. In Germany, the GDP declined by 27 percent.36
In addition to the cost of war, high inflation and food shortages can be blamed for sparking the Russian Revolution in 1917. The tsar was overthrown, and a civil war began, bringing the Communist Party to power. The Union of Soviet Socialist Republics (U.S.S.R.) was established in 1922.
The war officially ended in November 1918, but the Treaty of Versailles was not signed until six months later, in June 1919. The treaty forced Germany to disarm and imposed harsh reparations to pay for war damages. Notable economist of the time John Maynard Keynes voiced his concerns about excessive reparations, saying it was too hard a punishment and counterproductive.37 Most of Germany's reparations payments were funded by loans from U.S. banks. Between 1919 and 1932, Germany paid out 19 billion gold marks in reparations and received 27 billion gold marks in loans from New York bankers and others. These loans were later paid back by West Germany after World War II.38
During the war, countries enacted trade embargoes on gold exports, leading many countries to abandon gold redemptions, thus dropping the gold standard altogether. This allowed their currency exchange rates to float freely. After the war, some countries deliberately weakened their currencies, hoping to boost exports and help their economies. In the 1920s, Austria, Hungary, Germany, Russia, and Poland began experiencing hyperinflation. Seeing the negative effects of this, the United States tried to persuade countries to go back to the gold standard and was fairly successful. By 1927, many countries had returned to the gold standard,39 but this wouldn't last long, as the world was again headed toward protectionist policies, which eventually made their way to the United States.
The Stock Market Crash of 1929 and the onset of the Great Depression raised protectionist fears in the United States, leading President Herbert Hoover to sign the Smoot–Hawley Tariff Act in 1930. The act raised import