The Age of the Fiat Currency: A 38-year experiment in inflation

When the United States closed the gold window in 1971, the world entered a new era in which nearly all money was supported by nothing more than the full faith and credit of the governments issuing it. If one looks back to the history of paper money, no government has had the discipline to maintain its currency without resorting to the printing presses.

All of these paper money experiments have ended in disaster. This is one reason ‘gold bugs’ are so keen on the Gold Standard – because a currency tied to a real asset is better than a currency backed only by the promise of its government not to inflate (a return to Gold is nearly impossible, for reasons I outlined in my post "A New World Order").

But, the era since 1971 is unique in history in that ALL major currencies are fiat currencies. This is truly the Age of the Fiat Currency – unprecedented in human history.

As for how this will all pan out for the United States and elsewhere, Hayman Advisors of Dallas, has a few choice words to say:

As a nation and a world, we are coming to an important crossroad with the belief (whether it be forced or simply accepted) in "fiat" currency. The Old English Dictionary defines “fiat” as:

fiat. [a. Latin ‘let it be done’; ‘let there be made’]

In short, fiat currency is money that exists because an authority, government or custom simply declares or forces it to be as such. The American Heritage dictionary defines fiat currency as "paper money declared legal tender, not backed by gold or silver." I think of fiat currency as being paper money with no intrinsic value which has been simply declared to be legal tender. Up to this point, it has been widely accepted that currency or money is worth the goods and services for which it is routinely exchanged. I hope this remains the case, but think that the odds are against it. In the past, I have stated my belief that there is not enough money in the world to soak up the tens of trillions of dollars of deleveraging that must occur over the next few years. This could not be truer than it is today. While I do not have a solution (and maybe it does not exist) to the problems facing us today, what I do know is that attempting to re-lever a massively over-leveraged system is clearly NOT the answer. The disintermediation of risk is one of the primary causes of the current problem and it is NOT the solution.

Alan Greenspan said it best when he wrote Gold and Economic Freedom in 1966 (before he entered the Federal Reserve System; since then, he has been silent on the subject):

The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which – through a complex series of steps – the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy’s books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.

– Alan Greenspan, Gold and Economic Freedom, 1966

Edward here. But, that was the Alan Greenspan of the mid-1960s.  The Alan Greenspan of the mid-1990s was the "Bubble Blower-in-Chief" as Federal Reserve Chairman.  He was a man who believed in the necessity of printing money to avoid the necessary the pain of recession, a economic re-balancing process that is a necessary part of capitalism and a crucial feature of the business cycle.  It is like trying to stay awake at the expense of any sleep.

The problem with this is that the world is awash in fiat money.  Hayman Advisors continues (emphasis added).

To the best of our knowledge, there has only been 160,000 metric tons of gold EVER mined in the world. At $950 per ounce, all of the gold in the world would be worth $4.887 trillion dollars. On the other hand, we estimate that there is roughly $60 trillion of fiat money (including currencies, deposits, savings, money markets and CDs) in the world. Given the fact that world governments are caught with so much credit market leverage and losses, we believe that they will – in true Keynesian color – attempt to print their way out of this mess. If this occurs, you have to ask yourself: How many of people do you think it will take to begin to question the value of paper currency when it is being debased in an attempt to save world governments? If a small fraction of them stop believing, where will they go to preserve their wealth? My guess is the U.S. dollar and precious metals.

Edward again. Wait a minute, U.S. Dollars? Yes, the Greenback. Why? Because as bad as things in the U.S. are, things outside of the U.S. are as bad or worse. Think about some of the countries outside the U.S. like Japan, with their exports imploding. Germany is looking at -6% GDP this year. Hungary,Latvia, and Ukraine are in depression. Spain and Ireland are in Depression. Singapore and Taiwan have entered depression as well. It is not a pretty picture. So, the U.S. Dollar will serve as a safe haven as this deleveraging takes hold.

Here’s how Hayman sees it:

If the Federal Reserve begins to purchase large quantities of newly-issued Treasury bonds – the electronic equivalent of the printing press – we better hold on to our wallets! The good news for the United States is the fact that, as a percent of GDP, it will not have to print nearly as much as many parts of the rest of the world.

What worries me the most about our analysis is the fact that the U.S. will have to issue $2.35 trillion new Treasuries this year, and collectively, Europe will have to issue even more. Today, China and Japan own 65% of the foreign ownership of U.S. Treasuries. Have you seen what is happening to China and Japan lately? It does not seem possible that there is anywhere near enough money in the world to buy that many Treasuries.

To be clear, we believe that the U.S. (and in fact, the world) is in an ongoing debt deflationary spiral that will likely continue for some time (possibly years). The rampant printing of currencies around the globe is not, in our opinion, likely to be immediately “inflationary” (in the common understanding of the term) as leverage comes out of the private sector and asset values continue to decline. The greater concern is the potential inflationary time bomb that grows as governments continue to borrow, print and “stimulate.” What happens to inflation when the velocity of money goes from zero to 100?

Given all of the above, we are very confident in two predictions:

  1. The U.S. is in relatively better shape than the rest of the world, and the dollar will be a safer currency than virtually any other (and yes, that includes the Yen).
  2. Uncertainty and fear are rampant. Confidence in governmental and central bank leadership (are the two really that separate?) is plummeting worldwide. As a result, we believe people will look to “old-fashioned” stores of value – those which represented money long before green pieces of paper backed by a promise existed. Indeed, investors have already begun moving into precious metals. We expect this will continue.

Basically, these guys are more bearish than Nouriel Roubini, Peter Schiff and Michael Panzner combined.

As a result they say:

  1. It’s way too early to take a flyer in bank debt.
  2. It’s not even time to take a flyer in mortgage debt.
  3. Suspending mark-to-market in favour of mark-to-model is a sham. Writedowns will continue.
  4. Interestingly, they do not think Credit Default Swaps are that evil at all.

My thoughts here:  Their analysis is directionally right if extremely bearish.  I happen to think we could see a cyclical rebound as early as Q4 or Q1 of next year.

Nevertheless, we are witnessing the implosion of the Age of the Fiat Currency and its attendant deleveraging.  This is a major event – the most significant economic event n three-quarters of a century.  It would be naive to think it could end in two years as a result of central banks printing money. And then we’d be back to business as normal.  There are many more changes to come.


March 2009 Hayman Advisors Newsletter


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.