Fiat Currency

[dak4n6]

I recently watched a documentary about recinding the gold backing of the US dollar and its consequences. This was done by Nixon in 1971 and is called the 'Nixon Shock'. It was done because the US debt had mounted to such a point the Feds became aware that they did not have enough gold to cover if all the foreign lenders should call in their debts.

Currency that has no intrinsic value other than the word of the government is called 'fiat currency'. This documentary stated that all fiat currencies in the past have failed at some point. They also stated that fiat currencies are prone to hyper-inflation, they described the mounting deficit as a classic Ponzi scheme, and went on to speculate that our current economic crisis is the white water just before the falls, so to speak.

Were they being sensationalist, or accurate? Any economists out there? What do you think?

[MEfree]

I haven`t seen the documentary and have only taken a handful of Econ classes as part of my finance degree, but do think there is merit to their thought process.  While some government debt is probably ok for a while, how long can a country issue IOUs that they expect their kids to pay to make up for the fact that tax revenue is less than current spending??

[achorripsis]

Originally Posted by MEfree

I haven`t seen the documentary and have only taken a handful of Econ classes as part of my finance degree, but do think there is merit to their thought process.  While some government debt is probably ok for a while, how long can a country issue IOUs that they expect their kids to pay to make up for the fact that tax revenue is less than current spending??

I have a MS in Economics. Gold standard worked well except it didn't as evident in the bank panics in the 19th century and its impact on the Great Depression See Barry Eichengreen's Golden Fetters: The Gold Standard and the Great Depression. I have not seen the documentary, but commodity based currencies make little sense to me. Fiat money works fine as what money is supposed to be: a medium of exchange, unit of account and a standard of payment. You are wise to be skeptical of this documentary. Unfortunately there is a lot of misinformation and downright ignorance on economics matters.

The problem with MEfree's question is that he's assuming the only way that the federal government spends money is either through taxes and the issuing of bonds. It is important to keep in mind that the United States federal government is the issuer of its own currency, therefore has no limits on its spending. Congress can decide to spend money because it has the lawful ability to create money to finance that spending. The only real restraint of spending is inflation, which can happen when you have an excessive expansion in the monetary base. Its ok, because MEfree is repeating a common misconception.

[dak4n6]

Originally Posted by achorripsis

The problem with MEfree's question is that he's assuming the only way that the federal government spends money is either through taxes and the issuing of bonds. It is important to keep in mind that the United States federal government is the issuer of its own currency, therefore has no limits on its spending. Congress can decide to spend money because it has the lawful ability to create money to finance that spending. The only real restraint of spending is inflation, which can happen when you have an excessive expansion in the monetary base. Its ok, because MEfree is repeating a common misconception.

So wouldn't a gold standard curb excessive indiscriminate creation of currency? And, in the recent past, hasn't the Fed Reserve been doing exactly that - excessive printing of new currency to finance the bailouts and pay off foreign loans? And, aren't we now seeing the resulting dilution in the buying power of the dollar?

[achorripsis]

Originally Posted by dak4n6

So wouldn't a gold standard curb excessive indiscriminate creation of currency? And, in the recent past, hasn't the Fed Reserve been doing exactly that - excessive printing of new currency to finance the bailouts and pay off foreign loans? And, aren't we now seeing the resulting dilution in the buying power of the dollar?

Maybe, but keep in mind about the demand for money and the supply and uses of gold. It could curb excessive creation of currency but I have also read sophisticated arguments that it wouldn't guarantee it anymore than what we have now. Plus think about the practical ramifications to switching back. You're repeating a common misconception that somehow the Federal Reserve monetizes congressional spending. The Federal Reserve does not buy bonds directly from the Treasury to create money. What it doe is buy bonds on the open market. That's why its called "Open Market Operations". The buying power of the dollar is all relative. You have think about relative prices. What can the dollar buy in San Francisco versus what it can buy in Tulsa is obviously different. If we're talking about using the dollar in international currency exchanges, there are pros and cons for having a weak versus strong dollar.

[dak4n6]

The dollar doesn't by sh!t in San Fransisco. I know, I lived in the Bay Area 5 yrs.

This stuff is really complicated, but I would like to understand what's going on as it does have real impact on how we act and plan our futures. Sheesh, I'm just a dumb chemist.

Thanks for playing!

[clubchamp]

I have an undergrad in econ but I went the MBA route...

The simplest way to explain it is the "fiat currency" theory doesn't really apply to how we plan for the future because as achorripsis said there is solid counters for that theory. Now with that said we still need to lower our debt because it is vulnerability for our country and it could have a huge impact on future generations. As was said earlier every time we make tax changes to raise revenues the government always seems to turn around and find a way to spend it. I don't mean this in any sort of political way but if you get a chance read Ron Pauls book it's actually very insightful on some of our crazy spending.

[achorripsis]

Originally Posted by clubchamp

I have an undergrad in econ but I went the MBA route...

The simplest way to explain it is the "fiat currency" theory doesn't really apply to how we plan for the future because as achorripsis said there is solid counters for that theory. Now with that said we still need to lower our debt because it is vulnerability for our country and it could have a huge impact on future generations. As was said earlier every time we make tax changes to raise revenues the government always seems to turn around and find a way to spend it. I don't mean this in any sort of political way but if you get a chance read Ron Pauls book it's actually very insightful on some of our crazy spending.

I'm not so sure that debt really is much of a problem. There are very few instances of governments actually paying down their overall stock of debt. Really our public debt is just a lot of private wealth. Imagine telling investors that we won't issue treasuries anymore, they wouldn't like that because they're very safe assets. Why are they so safe? Because we really won't ever have to default on our debt, since we issue our own currency. Although we do have this artificial, arbitrary "debt limit" here in the US. Our debt is just basically budget deficits that just keep getting carried over and those deficits generate income for the private sector in the terms of interest payments. Now there might be philosophical objections to the growth of government, one that I don't share but I'm just telling you how it works since even some intelligent economists get this wrong.  What are some legit issues with national debt? Look at the equity and distribution of private wealth that this debt creates.

Read Ron Paul because he gives you the libertarian viewpoint and is an intelligent person but he's just plain wrong on the economics.

[rustyredcab]

The USA controls its currency and has many options available to influence inflation and stimulate the economy through monetary policy. On a gold standard, much of that monetary policy is eliminated. The USA is the main driver of the world economy. The more control as we can have over our currency the better IMHO.

And why gold? I've never understood the argument that gold will remain valuable -- even after the collapse of civilization. Maybe the few chemists will want gold, but its value to most of us is communally created -- just like the $20 bill in my pocket. If the world needs to be rebuilt tomorrow, I'd take a computer chip factory over a gold mine. Perhaps an even better example of communal value are diamonds. They too have some magic qualities but their value is created because of group-think more than industrial application. Today, the world values dollars. And because we are not on a gold standard, we are somewhat in control of the value of those dollars.

[MEfree]

Originally Posted by achorripsis

Gold standard worked well except it didn't

Quote:

Originally Posted by achorripsis

The problem with MEfree's question is that he's assuming the only way that the federal government spends money is either through taxes and the issuing of bonds. It is important to keep in mind that the United States federal government is the issuer of its own currency, therefore has no limits on its spending. Congress can decide to spend money because it has the lawful ability to create money to finance that spending. The only real restraint of spending is inflation, which can happen when you have an excessive expansion in the monetary base. Its ok, because MEfree is repeating a common misconception.

That is not what I am assuming at all.  Sure taxes and issuing bonds are two ways the government gets money to spend, but I am aware that the US issues its own currency, isn`t that what this whole thread is about?  What is the common misconception that I am repeating?

Originally Posted by achorripsis

I'm not so sure that debt really is much of a problem. There are very few instances of governments actually paying down their overall stock of debt. Really our public debt is just a lot of private wealth. Imagine telling investors that we won't issue treasuries anymore, they wouldn't like that because they're very safe assets. Why are they so safe? Because we really won't ever have to default on our debt, since we issue our own currency. Although we do have this artificial, arbitrary "debt limit" here in the US. Our debt is just basically budget deficits that just keep getting carried over and those deficits generate income for the private sector in the terms of interest payments. Now there might be philosophical objections to the growth of government, one that I don't share but I'm just telling you how it works since even some intelligent economists get this wrong.  What are some legit issues with national debt? Look at the equity and distribution of private wealth that this debt creates.

Read Ron Paul because he gives you the libertarian viewpoint and is an intelligent person but he's just plain wrong on the economics.

Sure you can say debt isn`t really much of a  problem the same way you can say hyper-inflation isn`t much of a problem.  It really depends who you are and what your financial circumstances are.  If you are in debt with zero savings and have a job where your pay check is likely to increase at or above the inflation rate, then hyper inflation could be a good thing for you.  OTOH, If you are close to retirement and have saved a lot of money that is invested in a way that is going to have an average return of 6% that does not go up significantly with inflation, then the thought of hyper inflation is much more concerning.

I also disagree with you about the "safety" of US debt.  Sure the fed can always prevent a default by printing money (aka, going out on the open market and purchasing the debt via an electronic transfer to the debt holder, thus expanding the fed balance sheet), but as you have said, this can cause inflation (although there are other factors including productivity gains and anything else that affects the supply and demand curves for the various items we consume.  If we were to experience hyper-inflation due to the excessive printing of money, then an investment in regular long term US bonds may have a lot less buying power than an investment in something more likely to keep up with inflation (i.e. TIPS, rental property, farmland, commodities or stocks of companies that may see profits increase in an inflationary environment).

Originally Posted by rustyredcab

The USA controls its currency and has many options available to influence inflation and stimulate the economy through monetary policy. On a gold standard, much of that monetary policy is eliminated. The USA is the main driver of the world economy. The more control as we can have over our currency the better IMHO.

And why gold? I've never understood the argument that gold will remain valuable -- even after the collapse of civilization. Maybe the few chemists will want gold, but its value to most of us is communally created -- just like the $20 bill in my pocket. If the world needs to be rebuilt tomorrow, I'd take a computer chip factory over a gold mine. Perhaps an even better example of communal value are diamonds. They too have some magic qualities but their value is created because of group-think more than industrial application. Today, the world values dollars. And because we are not on a gold standard, we are somewhat in control of the value of those dollars.

I agree that there would be problems trying to go back to the gold standard and agree that we have gotten and continue to get many benefits by being able to print money and have some control over our own currency.  This is one of the reasons that we have such a high standard of living.

Being able to issue debt in your own currency is a huge luxury.  Imagine how much golf you could play if Rusty Red Cab dollars were of equal value to US$ and that you could issue unlimited IOUs in this currency.  The trick to being able to do this is the other parties having enough confidence in RRC$ and their ability to hold value relative to the cost of goods and other currencies. As other parties lose confidence in RRC$ or the US$, then these currencies become less and less valuable and anything that you want to buy that is denominated in another currency becomes more and more expensive.

Confidence is key!  Among other things, we need to keep our debt at manageable levels so that the rest of the world has the confidence in the US$ and its ability to hold value.

Originally Posted by clubchamp

I have an undergrad in econ but I went the MBA route...

The simplest way to explain it is the "fiat currency" theory doesn't really apply to how we plan for the future because as achorripsis said there is solid counters for that theory. Now with that said we still need to lower our debt because it is vulnerability for our country and it could have a huge impact on future generations. As was said earlier every time we make tax changes to raise revenues the government always seems to turn around and find a way to spend it. I don't mean this in any sort of political way but if you get a chance read Ron Pauls book it's actually very insightful on some of our crazy spending.

I don`t know exactly what the "fiat currency" theory is, but I do know that a dozen years ago the $US was about 15% stronger than the Euro and is now about 20% weaker.  Put another way, if I ask my German brother in law for 100 Euro, I have to give him about $125, but in 2000 I only had to give him about $85.  Since Feb 1985, the US Dollar index has gone down from 148 to about 81 today.  Our paper money may not become worthless any time soon, but it sure takes more of it to buy things from abroad like oil, etc.

If you believe that the US$ is going to continue to weaken, then I think it does affect how you plan for the future.  This is why some people make foreign investments (currencies, stocks, bonds, real estate), buy stocks of US companies that benefit from a falling US$, etc.

As was alluded to, a weaker currency isn`t bad for everyone.  If I worked at a Detroit auto plant, I might see a weaker currency as a good thing in that it would help to make foreign cars more expensive and US cars more affordable for foreigners to buy.  OTOH, countries which have seen a constant devaluation of their currency don`t seem like the role models we should be looking to follow.  If the US$ was worth 1/10th of what it is today, what do you think gas would cost?

[achorripsis]

Sorry that the quotes got out of order. Still learning how to use this.

Originally Posted by MEfree

I also disagree with you about the "safety" of US debt.  Sure the fed can always prevent a default by printing money (aka, going out on the open market and purchasing the debt via an electronic transfer to the debt holder, thus expanding the fed balance sheet), but as you have said, this can cause inflation (although there are other factors including productivity gains and anything else that affects the supply and demand curves for the various items we consume.  If we were to experience hyper-inflation due to the excessive printing of money, then an investment in regular long term US bonds may have a lot less buying power than an investment in something more likely to keep up with inflation (i.e. TIPS, rental property, farmland, commodities or stocks of companies that may see profits increase in an inflationary environment).

We don't need to issue IOUs. When we say that we have too much debt, in essence we are saying that the private financial sector can't get enough of our bonds. Australia is one of the rare examples of a country paying down its debt stock. This occurred in the late 90s to the middle 00s. What happened? Banks started protest that the bond market was too think and they wanted a safe asset to invest in. Not only did they need those bonds as a safe asset, but they used it as a baseline for all their other risk.

Congress doesn't need the FED to prevent the default by printing money, they can create money themselves. The whole essence of this discussion, fiat money is money by decree. Congress can just decide to spend any amount of money they want to and the Treasury will pay those IOUs. This is the beauty of having a floating-exchange rate currency. Philip Cagen defined hyperinflation as the inflation rate as being 50% or more per month. Any instances of hyperinflation are very unique. If hyperinflation just happened because we keep printing money "out of thin air" then we would see a lot more with developing countries. While the threat of small to moderate inflation could be possible for countries like the US, hyperinflation is a more more complex phenomenon.

That is not what I am assuming at all.  Sure taxes and issuing bonds are two ways the government gets money to spend, but I am aware that the US issues its own currency, isn`t that what this whole thread is about?  What is the common misconception that I am repeating?

Look what you wrote in your post. You wrote that "how long can a country issue IOUs that they expect their kids to pay to make up for the fact that tax revenue is less than current spending??" Unless I misinterpreted you, you seemed to imply that the US can only pay its own debt through the tax increases like some sort of Ricardian Equivalence nonsense. When that is not the case at all. In fact all the US Treasury has to do is roll over their debt into their account at the FED because they are able to issue their own currency. We roll over trillions of dollars in debt all the time without hyperinflation, the dollar collapsing, and interest rates didn't go up.

[MEfree]

So if creating money has no potential negative consequences, why have laws against counterfeiting?  I`ll concede that there are a lot of factors at work, but ignoring everything except money supply, shouldn`t prices tend to go up as the amount money that is out there increases?

If a producer of goods see an increase in demand, does it matter if this increased demand comes from the fed/congress buying with money they created or you/me buying with money that we printed in our basement?  In either case, isn`t the price of a good going to rise if the demand for it increases.

Why do you think real estate prices are higher in San Francisco vs Tulsa?  It boils down to supply and demand with higher demand being caused by more people with $ wanting to spend it to buy land in SF rather than Tulsa.  Give the people in SF more money, like happened during the tech boom, and viola, real estate prices go up.  Take money away from this same group and, all ese being equal, expect to see a fall in real estate prices.

I didn`t say that the only way the US can pay its debt is through tax increases.  When I said " While some government debt is probably ok for a while, how long can a country issue IOUs that they expect their kids to pay to make up for the fact that tax revenue is less than current spending??" I meant to imply that there are negative consequences to constantly running a high government deficit.

What I am saying is that an increased supply of $ is one factor that tends to push prices higher and make the $ weaker.  True, we have printed money in the past and haven`t seen hyperinflation or a complete collapse of the dollar, but it is hard to argue that we haven`t seen some inflation and a weakening of the dollar.

I`ll agree that there are likely other factors at work when you get the 50% monthly hyperinflation you are talking about which is why I mentioned confidence.

In the most simplistic terms and ignoring many factors, if you are a creditor, you would like to see deflation and get paid back in $ that can buy you more while debtors would like to see inflation to be able to pay back in $ that are less valuable (and likely easier to come by).  The US Gov is currently a net debtor, so all else being equal, the gov may benefit from inflation and a weaker dollar,but as I said earlier, high inflation and a weaker dollar don`t benefit everyone.

Your Australia example is an interesting one.  Many factors at play, but it took about 130 $Aus to get $100 in 1995, now it only takes about A$95.  Why has the Aussi $ doubled in value against the US dollar since 2001?  I`d guess that the fall of the US$ relative to the price of gold has been a big factor.  Another factor may be that an economy grows more when people are investing their money into businesses that create jobs, etc rather than helping finance government deficits.  I haven`t studied this, but by offering less government debt, Australia may have pushed more people into investing into private enterprises.

With some exceptions, we have enjoyed a long prosperous period here in the US since WWII, but still have a lot of debt.  Common sense tells me that you should spend less than you earn during good times so that you can spend more than you earn in bad periods.  The interest rates on our debt are very low currently, but what happens if they go up.  Sure the fed can manipulate the short term rate, but they haven`t always been so successful with the longer end of the curve.  In 1981, we saw the 10 year rate over 15% and didn`t see it back below 10% until 1985.  A rate even half this high will substantially increase our borrowing costs.

To me, this means higher taxes and/or less money to spend on defense, medicare, etc.  Is your position that it doesn`t matter as the gov can simply print/create all the money we want to spend?  If you are right, why are we having all the budget/tax battles?  If printing money to cover deficits only causes minor inflation, wouldn`t everyone be happier if we just stopped collecting taxes, increased gov spending, gave every citizen welfare checks of 10 K/month and printed/created money to pay for it all?

[golferchick]

Fiat is interesting. It's a tax on savers. It's a handout to people with debt.

[x129]

Countries manipulate their currencies to meet economic goals. Cheap dollars make it easier to export. Expensive dollars make it easier to import. Having a high currency by itself isn't a good or bad thing. Government borrow could crowd out private investment but so far that hasn't been an issue.

Governments are not business (or families) despite the analogies that politicians like to use. They have different rules to live buy. Borrowing billions of dollars to enhance the life of future generations (i.e. you build them a school, roads, bridges, internet access) has a chance to be a big win since they should then be more productive and able to to pay back the money easier.  The problem is that most of the money we borrow is used to pay for day to day stuff not long term investments.  The problem is that it is too easy to rob from future. There is a huge incentive in government to push pain out to the future (i.e. lets spend the SS dollars today and give out huge public pensions) and let the future generations bail them out. No one wants to tell seniors that they are only getting .75 on the dollar of the SS they expected because they got the other .25s from the deficit spending and SS raiding that happened when they were working in the 80s,90s, and 00.

Quote:

That is not what I am assuming at all.  Sure taxes and issuing bonds are two ways the government gets money to spend, but I am aware that the US issues its own currency, isn`t that what this whole thread is about?  What is the common misconception that I am repeating?

Sure you can say debt isn`t really much of a  problem the same way you can say hyper-inflation isn`t much of a problem.  It really depends who you are and what your financial circumstances are.  If you are in debt with zero savings and have a job where your pay check is likely to increase at or above the inflation rate, then hyper inflation could be a good thing for you.  OTOH, If you are close to retirement and have saved a lot of money that is invested in a way that is going to have an average return of 6% that does not go up significantly with inflation, then the thought of hyper inflation is much more concerning.

I also disagree with you about the "safety" of US debt.  Sure the fed can always prevent a default by printing money (aka, going out on the open market and purchasing the debt via an electronic transfer to the debt holder, thus expanding the fed balance sheet), but as you have said, this can cause inflation (although there are other factors including productivity gains and anything else that affects the supply and demand curves for the various items we consume.  If we were to experience hyper-inflation due to the excessive printing of money, then an investment in regular long term US bonds may have a lot less buying power than an investment in something more likely to keep up with inflation (i.e. TIPS, rental property, farmland, commodities or stocks of companies that may see profits increase in an inflationary environment).

I agree that there would be problems trying to go back to the gold standard and agree that we have gotten and continue to get many benefits by being able to print money and have some control over our own currency.  This is one of the reasons that we have such a high standard of living.

Being able to issue debt in your own currency is a huge luxury.  Imagine how much golf you could play if Rusty Red Cab dollars were of equal value to US$ and that you could issue unlimited IOUs in this currency.  The trick to being able to do this is the other parties having enough confidence in RRC$ and their ability to hold value relative to the cost of goods and other currencies. As other parties lose confidence in RRC$ or the US$, then these currencies become less and less valuable and anything that you want to buy that is denominated in another currency becomes more and more expensive.

Confidence is key!  Among other things, we need to keep our debt at manageable levels so that the rest of the world has the confidence in the US$ and its ability to hold value.

I don`t know exactly what the "fiat currency" theory is, but I do know that a dozen years ago the $US was about 15% stronger than the Euro and is now about 20% weaker.  Put another way, if I ask my German brother in law for 100 Euro, I have to give him about $125, but in 2000 I only had to give him about $85.  Since Feb 1985, the US Dollar index has gone down from 148 to about 81 today.  Our paper money may not become worthless any time soon, but it sure takes more of it to buy things from abroad like oil, etc.

If you believe that the US$ is going to continue to weaken, then I think it does affect how you plan for the future.  This is why some people make foreign investments (currencies, stocks, bonds, real estate), buy stocks of US companies that benefit from a falling US$, etc.

As was alluded to, a weaker currency isn`t bad for everyone.  If I worked at a Detroit auto plant, I might see a weaker currency as a good thing in that it would help to make foreign cars more expensive and US cars more affordable for foreigners to buy.  OTOH, countries which have seen a constant devaluation of their currency don`t seem like the role models we should be looking to follow.  If the US$ was worth 1/10th of what it is today, what do you think gas would cost?

[golferchick]

Originally Posted by x129

Countries manipulate their currencies to meet economic goals. Cheap dollars make it easier to export. Expensive dollars make it easier to import. Having a high currency by itself isn't a good or bad thing. Government borrow could crowd out private investment but so far that hasn't been an issue.

Also cheap dollars means a country doesn't have to pay as much money back on it's loans.

And it means citizens have less savings(tax)

[dak4n6]

Closely related to this issue is our local governments' (here in NJ) habit of covering budget gaps or increased costs (almost always for schools and education), by issuing municipal bonds. This is simply kicking the can down the road. To pay off bonds reaching maturity from 10 yrs ago and other debt, let's issue more bonds. Isn't this really just a Ponzi scheme? Does our government just keep doing this ad infinitum? Where does it end?

[MEfree]

Originally Posted by dak4n6

Closely related to this issue is our local governments' (here in NJ) habit of covering budget gaps or increased costs (almost always for schools and education), by issuing municipal bonds. This is simply kicking the can down the road. To pay off bonds reaching maturity from 10 yrs ago and other debt, let's issue more bonds. Isn't this really just a Ponzi scheme? Does our government just keep doing this ad infinitum? Where does it end?

Local Governments can`t print their own $, so in some ways it is more of an issue...investors will become reluctant sooner to lend to a local government for this reason..

[MEfree]

this is an interesting video about the US budget