A recap from the previous money talk: the word dollar comes from the German word thaler referring to silver. Thus, the original dollar itself was silver. Over a century later, the paper dollar emerged, although still backed by gold or silver for many years. Fast forward to The Great Depression, when FDR nationalized gold- this meant that individuals would not be able to exchange dollars for gold. It took the rest of the world 40 years to catch up, when the Bretton Woods Agreement of 1944 was terminated; no foreign governments could exchange dollars for gold either. Thus, fiat money became the norm everywhere. Fiat money is not backed by any particularly commodity, but rather a basket of goods. In other words, the value of the dollar is based on what it can buy.
Fiat is a Latin word meaning “let it be done,” from fieri meaning “be done or made.” This is essentially an order or decree. What is “being done” in this case? The community that uses the fiat agrees that it has value and purchasing power. In general, economists find fiat money to be better than commodity money, mainly because there is an infinite supply of fiat, which means there is can be more money within an economy, and thus more access. And when there’s more access, there’s greater social mobility.
According to economist Charles Wheelan the gold standard can provide predictable exchange rates because if the world’s currencies are backed by the same thing, then we know exactly what a particular currency is worth. This matters because some countries overvalue their currency, a major source of international disputes. The gold standard makes things relatively simple. If an ounce of gold costs $35 in the US and 350 francs in France, then 350 francs is equivalent to $35. That means I can buy a pair of pants in US for $35, and buy the same pair in France for 350 francs. Nice and simple. Without this standard, nations can essentially make up an exchange rate. North Korea is a perfect example: a Chinese-made basketball costs $6 in America but costs essentially $500 in Pyongyang based on the official exchange rate. This means that if a North Korean company earned $500 in the US, at home it would only be able to afford something that is worth $6- enough to buy a basketball. While economists determine exchange rates by calculating a currency’s purchasing power parity (PPP), rogue nations can exist outside of this bound because there is nothing officially backing the currency.
The gold standard can also protect against inflation. As a reminder, inflation is when the value of the dollar decreases, meaning it has less purchasing power, and prices raise. Inflation is the result of money creation: But with the gold standard, value of the dollar remains stable because the quantity of money available is constrained by gold. That means that the government is limited to issuing the amount of paper money that they have in gold. In theory, the gold standard maintains international financial stability. Zimbabwe couldn’t flood the country with currency to the point where a beer costs 100 billion dollars (a prime example of hyperinflation).
But the reality is much different. The problem with the gold standard is that you cannot manipulate policy that affects domestic affairs. Nations use fiscal policy to protect itself during bouts of inflation and deflation. The Federal Reserve can essentially cause the money supply to grow or shrink to create stable prices. This means more people are able to purchase goods, which creates jobs, which allows for purchasing, etc. In other words, having fiscal mobility allows for a society to thrive. The key to this is having people in place that make sound monetary decisions. For example, during deflation, the Fed is able to inject money into the economy by lowering bank reserve limits. In a fractional reserve system (such as our own in America), credit money is created from lending. The amount of credit money that can be created from the original deposit is based on the fractional reserve limit, set by the Fed; this is typically 10%. For example, if a bank receives a $100 deposit, it can lend out $90. And of that $90, it can lend $89; and so on and so forth until it creates $1000 of credit money. Why is this important? Because people borrowing that money spend it, which means more deposits in the bank, which then create more credit money, allowing for more spending. And all the spending creates jobs, which allows people to earn money, spend money, deposit money, etc. In other words, the economy moves and is sustained (and even grows) based on the creation of credit. This is easiest to do when the amount of the money supply is not pegged to the amount of gold available.
Still, fiat money is not without its problems. It lends itself to hyperinflation due to bad actors making bad financial decisions. Additionally, what if there was a run on the bank? If people lost confidence in the financial system and ran to the bank to withdraw all the money, unfortunately most people would be short because banks lend out most of people’s deposits. To me, that’s a scary thought. It makes fiat money feel unstable. Again, as the economist Charles Wheelan notes, fiat money is both best and worst form of currency. It only leaves me with one thought. Sheesh.