The initial solution to these early liquidity crises required a strong trade policy and often a mighty military. Governments knew that to maintain the growth of their gold-backed currencies required a growing supply of gold. For example, 16th-century England had few, if any, gold mines. And yet the British Empire boasted one of the world’s largest gold reserves. How was that possible? Through conquest. While trade restrictions, such as banning gold exports and export subsidies, were also common in this age of mercantilism, clever trade policies were rarely enough for the largest of nations. Military conquest of other nations in search of gold was virtually required to maintain a growing empire. Colonization efforts, often implemented under the auspices of Christian missionary activity, served at least two purposes: 1) to provide a fresh source of gold for the colonizing nation and 2) to create a new market for export purposes.
Empires, however, are notorious for having voracious spending appetites. Despite multiple conquests, the monetary constraints would soon become severe enough to force a new solution. The temptation for spendthrift governments was obvious: cut the commodity backing of currency and turn on the printing presses. (History is replete with warnings for those nations who dared to remove the commodity backing from their currency. For a history of national economies that have been severely damaged or completely destroyed through the overproduction of paper money, see chapter 3.)
Throughout history, all governments have come to the same conclusion: remove the commodity backing from its own national currency, thereby creating more flexibility. When a nation detaches its paper currency system from any and all commodity backing, its currency is then considered by economists to be a fiat currency. When a currency is issued by fiat, it is backed only by government guarantees, not a commodity. Fiat money has no intrinsic value. Its value is derived strictly by government law, and unlike the first two types of money (commodity and receipt) there is no natural limit to the quantity of fiat money that can be produced. The benefits of such a system to a government should be obvious. Without the economic constraints imposed by gold, the money creation process available to governments with fiat currencies is virtually unlimited.
How Is Money Measured?
Regardless of the type of money a nation uses, one important quality that it must possess is an ability to be measured. This is especially true in the case of fiat currency. In response to our modern fiat dollar system, U.S. economists have devised four categories to measure the nation’s money supply. These four measurements are known simply as M0, M1, M2, and M3.
M0 Money Supply: This measurement includes all coin and paper currency in circulation, as well as accounts at the central bank that can be exchanged for physical currency. This is the narrowest measure of the U.S. money supply and only measures the amount of liquid money in the hands of the public and certain deposits with the Federal Reserve.
M1 Money Supply: This measurement includes everything in M0 as well as currency held in demand deposits (such as checking accounts and NOW accounts) and traveler’s checks (which can be liquidated into physical currency.)
M2 Money Supply: This category includes everything in M1, plus all of the currency held in saving accounts, money market accounts, and certificates of deposit with balances of $100,000 or less.
M3 Money Supply: As the broadest measure of the U.S. money supply, this category combines all of M2 (which includes M1) plus all currency held in certificates of deposit with balances over $100,000, institutional money market funds, short-term repurchase agreements, and eurodollars (U.S. dollars held in foreign bank accounts).
What Gives Fiat Money Its Value?
If you have a U.S. dollar bill nearby, pick it up. Examine it closely. Notice its many symbols and its colors.
Now ask yourself: What exactly is it that gives the U.S. dollar its value? And why are so many people willing to exchange their valuable goods and services, or work long hours at jobs they may or may not enjoy, for these small pieces of green paper?
Answer: Faith in the scarcity of the dollar.
Allow me to elaborate on this answer.
Since fiat currencies are not physically backed up by a particular commodity such as gold, they have no intrinsic value. (By intrinsic value, I am referring to the actual value of the physical piece of paper itself.) Using this definition, fiat currencies are technically worthless. Governments and central banks are fully aware of this and some even understand the inherent danger of fiat monetary systems. To overcome the potential hurdles faced by an intrinsically worthless currency, the U.S. government required acceptance of the U.S. dollar in nearly all domestic financial transactions through the passage of legal tender laws. Due to this legal binding, Americans willingly accept the fiat U.S. dollar because they believe it has value. It is true that the dollar has value, but this value is not of an intrinsic nature. Instead, the dollar’s “value” is derived from a carefully managed perception by the nation’s monetary authorities. This belief, or faith, in the dollar’s value, despite having no real intrinsic value, is a common trait shared by all fiat currencies. Interestingly, if the public were ever to lose faith in the value of the currency, the entire house of cards would fall.
Through the use of constitutional contortion, the United States has created a national demand for a fiat currency. Maintaining the illusion of the dollar’s value requires that the monetary authorities avoid a reckless increase of the U.S. money supply. Historically speaking, such increases have had disastrous effects upon the purchasing power of the underlying currency. Avoiding a dollar collapse requires a perpetual faith among the American public in the Fed’s willingness and ability to keep the currency in a limited supply.
Understanding Intrinsic Value
Many different commodities have been used as money throughout history. Take silver, for example. In addition to being used as money for centuries, the shiny metal also has many industrial uses such as photography, dentistry, jewelry, mirrors, optics, and medicine. With so many varied uses, it is no wonder that silver was widely adopted as money throughout history. Silver, and other similar types of commodity money, has intrinsic value. That is, it has value outside of its role as money.
Compare this to the U.S. dollar. How many uses does a dollar have? Paper money is different from commodity money in that it has no intrinsic value, although some have argued that in enough quantities, the dollar bill could be used as firewood, thereby giving it some intrinsic value. In fact, that is exactly what happened to paper money in Germany during the 1920s! You can read more about that monetary nightmare in chapter 3.
Conclusion
Today, all global currencies are issued by fiat and are controlled by an arrangement between governments and their central banks. For the first time in history, no currency on the planet is backed up by a physical commodity. And why have individuals been willing to accept these fiat paper currencies in exchange for goods produced and services rendered? Ironically, the answer is rooted in the public’s faith and trust in their respective government. The reason that the American public, or any society for that matter, is willing to accept a fiat currency in exchange for goods produced and services rendered is due to the belief that the government will maintain the currency’s value by keeping it in limited supply.
At this point, some readers may wonder why governments should strive to keep their fiat currency in limited supply. After all, couldn’t we eradicate global poverty by printing excessive amounts of currency and giving it to the world’s poorest citizens? If it were only that easy!
While some readers may understand why this is impossible, it is nevertheless a very important question because we have several examples of economically ignorant leaders throughout recent history who have attempted this very thing. Other leaders have attempted to grow their economies out of tough situations by printing excessive amounts of currency.
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