Fiat Standards

In the previous discussion regarding the creation of central banks, the issue of money being equated to the value of gold was touched upon and why the gold standardwas generally abandoned during the 20th century. However, little was actually said about the system of currency valuations that replaced it, which we shall described as the ‘fiat currency system’.

Note: Fiat currency system is one where a currency derives its value from government regulation and enforced by law. As such, it differs from systems that underpin the value of a currency by a promise to exchange an agreed amount of precious metals, e.g. gold, with what amounts to an IOU. The term ‘fiat’ is derived from the Latin meaning ‘let it be done’ or ‘it shall be’ such that fiat money is a ‘promissory note’ issued by a nation-state.

We might use the US dollar ($) as an example of a fiat currency, which is back by the federal government of America. As such, the US Federal Reserve, i.e. the US central bank can, in principle, simply print dollars and inject them into the economy. We might immediately recognise that this system could therefore become unstable in terms of inflation should short-term political priorities override long-term economic goals. Today, most nation-states issue their own ‘fiat money’, e.g. Japanese yen and British pound, even though we might recognise that none of these examples has any intrinsic value. However, it might be said that the monetary policy of the central bank of a given nation-states helps determines the value of its currency via the mechanism of foreign exchange rates. As such, the value of a currency within a global monetary system is determined by changing or floating exchange rates, which reflect the wider perception of the economic health of a particular nation-state. 

So why might the value of a fiat currency collapse?

In part, the value of any fiat currency depends on the confidence that the wider global market has in the ability of a central bank to meet its ‘promissory’ obligations. If the market loses  confidence, people and institution will start to exchange their currency holdings for other more secure assets. Of course, this loss of confidence will be reflected in the global exchange rate, which then has a knock-on effect, i.e. increasing the costs of imports and reducing the value of its export to the nation-state in question. However, these effects are ultimately seen by the central bank through an effective fall in its taxation revenues extracted from the people and businesses it governs. In simple terms, a loss of confidence in a currency leaves a political government with a stark choice, i.e. increase its rate of taxation on the people and businesses that may already be impoverished by an economic downturn or reduce the level of government spending by axing public services. However, axing public services may cause unemployment to rise, which may then lead to a further fall in tax revenue plus increased claims for unemployment benefits. Of course, in a democracy where the government's hold on power might be reversed at the next election, there is a temptation to find alternative short-term ‘solutions’.

So what other 'solutions' might be up for consideration?

Based on falling tax revenues and unpopular public service cutbacks, one obvious option that may present itself is to borrow more to increase the flow of money in circulation, i.e. basic Keynesian economics. However, the management of its fiat currency by the central bank also opens up the possibility to simply print more money, although modern economics appears to have devised a more sophisticated scheme called Quantitative Easing (QE), which possibly needs to be understood in a little more detail, even within this general overview discussion.

Quantitative Easing (QE)

While the goal is not to overload these discussions with too much detail, the issue of quantitative easing (QE) is possibly a good example as to why so many debates within economics continue. First, the accusation often levelled against QE is that is essentially amounts to the central bank printing money and while most economists probably agree that this not the case, the benefits of QE are far from clear. However, it is possibly useful to step back and explain a few things that might then help us better understand the argument for and against QE.

What is quantitative easing?

While the diagram right may be a somewhat crude summation, it may not be that far from the truth. For, as already outlined, the Keynesian approach to a downturn in the economy is to try to increase the amount of money in circulation. One of the option available to the central bank is to reduce interest rates, such that it becomes cheaper to borrow money, which in-turn simulates a return to growth. However, following a major depression or banking crisis, this mechanism alone is often not enough, even when interest rates effectively fall towards zero. Therefore, the central bank is forced to consider other options in order to inject money into the economy and while it might just ‘print money’ this is generally considered to be a bad idea. So what alternative might the central bank adopt to inject investment into their own local economy at a time of low investment confidence.

Might they sell the family silver?

While it is not necessarily a good analogy, individuals often have to liquidated their assets, e.g. selling the family silver, in order to raise cash to meet immediate cash-flow problems. However, in the case of QE, this take a somewhat inverted form with the central bank buying up bonds and other financial assets from the private banks. The money ‘created’ to buy these assets is said to be reconciled by removing an equivalent value of the assets from the nations balance sheet. So, using QE, central banks ‘create’ money and then buy securities, e.g. government bonds, from private banks with electronic ‘fait’ money that did not previously exist. This new money effectively increases the bank reserves in the economy by the quantity of assets purchased and in a similar way to lowering the interest rates, QE is supposed to stimulate the economy by providing the private banks additional money to make more loans. Of course, you might question that if zero interest rates were not enough to make people and business borrow more then:

How does a private bank having more money help?

Apparently, the idea is that the private banks then take the ‘new money’ and buy assets to replace the ones they have sold to the central bank, which then causes stock prices to rise and lowers interest rates, which in-turn boosts investment. As such, it is argued that interest rates on everything from government bonds to mortgages to corporate debt are probably lower than they would have been without QE. Equally, if QE helps to convince the market that the central bank is serious about fighting deflation and unemployment, it will also raise market confidence and further boost economic growth.

So are there any perceived downsides to QE?

One overall concern is that the financial markets may eventually come to see QE as simply a way of financing budget deficits due to short-term political priorities, which ends up only helping the rich - see CNBC News inset right. As such, it may only be buying some more time rather than providing a long-term economic solution. There is also concern that the effects of QE will have to be eventually reversed, such that the central banks will have to remove all the new money created and pumped into the bank system, if it is to return its balance sheet to a status-quo position. However, if all this new money increases asset prices, the opposite may occur as this new money liquidity is withdrawn from the system.

The Dollar Fiat Standard?

Since the early 1970’s, the US economy has enjoyed a unique position in the global marketplace with its fiat currency, the dollar ($), being held as a preferred currency in a trouble world. However, this unique position has also given the US government, and its consumers who elect it, access to almost  unlimited credit. As result, the US is now the world’s biggest debtor nation, whose trade deficit is being financed by other countries around the world in the order of nearly a $trillion/year. In effect, America uses its ‘fiat dollars’ to buy Japanese Toyotas cars, French wine and Chinese electronics, which these countries then use to buy US bonds and other financial assets. In total, the US debt is now estimated to be in the order of some  $18 trillion, leading some to speculate that the historic confidence in US fiat dollar might collapse at some point in the future.

What effect would this collapse have on global economics?

Without wishing to sound too dramatic, the collapse of the most dominate global economy could make the 2008 financial crisis appear as a minor downturn in the markets and lead to a new world order, potentially in terms of both economic and political power. Of course, even a partial loss of confidence in the dollar might cause interest rates to rise, affecting both mortgage and credit card rates with the knock-on effect of pushing the US economy back into recession. However, even a moderate US downturn would also affect other global economies dependent on the current level of spending by US consumers. While you may well feel that this outlook is far too pessimistic, the diagram below may suggest that problems in the global economy are but just one factor in the potential for a ‘Perfect Storm in an ‘imperfect’ world. The implications of this 'storm' will be discussed further under the headings: 'The Growing Storm', 'The Limits to Growth' and 'The Future of Eco-nomics'.