Wikinvest Wire

Three Sins, One Gift - The Gift

Tuesday, January 31, 2006

This is the last installment in a four part series about Federal Reserve Chairman Alan Greenspan who, today, steps down after more than 18 years as head of the world's most important and most powerful central bank.

The first three parts in the series can be found here:

Sin #1 - Ignoring Asset Prices
Sin #2 - Bending to the Will of Others
Sin #3 - Fostering a Culture of Debt

The Gift - Hastening the Demise of Fiat Money

Throughout history monetary systems have come and gone, though few people have understood what money is or how it works.

Through the ages, most people have been content to labor at their chosen craft in exchange for seashells, pieces of eight, or slips of printed paper, with the expectation that sometime in the future, these items could be traded for other goods such as food, clothing, or shelter.

Money is, and always has been, a medium of exchange - a way for people to trade their labor, or the fruits of their labor, for other goods that they want or need.

To most people, it's as simple as that.

A Store of Value

But, money is also a store of value. This characteristic is important because individuals may opt to save some of the money they earn in order to use it some time in the future. Workers have an expectation that money earned today will have a similar value in the future - that it will purchase similar goods in similar quantities.

How well a particular form of money serves as a store of value is related to the supply of money - how fast the supply of money increases.

Money maintains its purchasing power best when it is limited in supply.

This is basic economics - supply and demand. If, over time, money is created at an ever-increasing rate, there will be much more of it in circulation. Significantly more money competing for roughly the same amount of goods causes prices to rise and the money loses value.

But, forms of money that are limited in supply are often times impractical as a medium of exchange. One solution to this problem has been to use paper money "backed" by some item that is limited in supply. In this case, money consists of two parts - one that is easily exchanged and one that stores value.

For much of recent history, paper money has represented precious metal. The paper money could be exchanged with others to facilitate trade, and it could be redeemed on demand for the precious metal that backed it.

Paper money could be created only to the extent that precious metal existed and the amount of paper money in circulation was effectively limited.

Severing the Link

Since 1971 when Nixon closed the "gold window", there has been no link between paper money (or its electronic equivalent) and anything that is limited in supply.

The world now operates under a pure fiat money system where paper money is "backed" by nothing other than faith in the government that issues it. That is, faith in the government, the central bank, and regulatory agencies to limit the amount of money being created, lest it lose that very important quality as a store of value.

Throughout history, no system of fiat money has endured the test of time. There have been numerous examples, most notably in 18th century France leading up to the French Revolution.

The reason? It is too easy to create fiat money.

Governments create money to solve problems - wars, natural disasters, poverty, re-election. When money can be created "out of thin air" there is seemingly no limit to how much money can be created or how many problems can be solved.

Governments like to solve problems.

The world's money handlers profit by creating money to lend to businesses and individuals. When money, in the form of credit, can be created "out of thin air", there is seemingly no limit to the prosperity that can be fostered or the money that can be made.

Money handlers like to make money.

No one has benefited more from today's fiat money system than governments and the financial industry. Governments have borrowed and spent to please their constituents, and the world's money handlers have grown wealthy as few can imagine.

Not a Panacea

But, over time, fiat money proves it is not the great panacea that people at first think it is. In the broad sweep of history, its effects, though initially welcomed and embraced as hope for a new era of prosperity, prove fleeting.

Ultimately, despite what the government and the money handlers tell them, people come to realize that their money is losing its value at a quickening pace. It is losing value because too much of it has been created.

The words of the government issuing the money begin to ring hollow and the riches of the money handlers become far too egregious.

This realization comes to different people in different ways.

The poor usually suffer first and most, as they experience difficulty making ends meet. Their money no longer purchases what it once did. The poor have little understanding of history's broad sweeps, what money is, or what money once was. They know little of storing value.

Those in the middle may have prospered by participating in the speculative games offered up by the money handlers. Throughout history, rising asset prices fueled by the extraordinary creation of money and credit have provided the opportunity for ordinary individuals to obtain great wealth and notoriety.

Eventually, they too come to realize that their money has lost value and the lifestyle to which they have become accustomed can no longer be supported.

But, as in nearly all eras, the money handlers prosper more than all others. Those at the top - the business elite, the bankers, the peddlers of influence - they reap the benefits that fiat money provides, most of them knowing well its dark secrets and sordid past.

At some point in time, with a populace accustomed to ever-increasing prosperity and hope, fiat money fails to deliver.

The seams begin to bulge and the system becomes increasingly strained as ever-increasing amounts of fiat money must be poured into the economy to maintain its momentum.

The public becomes disillusioned, realizing they have been duped into behaving in ways that their forefathers would ridicule. Their profligate ways - lifestyles which don't square with incomes - give way to the harsh, cold reality that there is no free lunch and there are no easy riches.

They realize the government has mismanaged the nation's affairs, that the money handlers have once again benefited handsomely, and then there is unrest.

One thing leads to another, and one more fiat money system comes to an end.

The Greenspan Era

As the most powerful central banker in the world for nearly two decades, Alan Greenspan has done more than any other individual to increase the supply of money and credit in a world full of fiat money.

He has done more than anyone else to perpetuate the belief that creating money "out of thin air" can solve problems and that enriching the money handlers can benefit society.

He is, today, regarded by some as the greatest central banker of all time. But, the history books for this era have not yet been written - time has not yet passed judgment on his deeds.

Through the ages, man's tools and devices have changed, but his basic desires and weaknesses have remained. He is easily misled to believe things that he wants to believe, and the same hard lessons are re-learned over and over as the memories of previous generations fade.

In recent years, Alan Greenspan has provided much for people to believe in and many reasons to forget the past.

Because fiat money twists and distorts, changing how needs and wants are perceived and satisfied, the common man's reasoning ability is easily overwhelmed by the illusion of prosperity.

Alan Greenspan has done much to alter perceptions and maintain illusions.

The Gift

Ultimately, all fiat money systems are doomed. After all, politicians and money handlers are human, and when provided access to easy money to solve problems or garner profits, they will use it in ever increasing amounts until crisis ensues.

The fiat money system that Alan Greenspan inherited from Paul Volcker in 1987 was, however, a strange anomaly. It held promise. Its life expectancy had been extended through a stern paternal instinct and the meting of "tough love" during a tumultuous transition after breaking free from its gold tether sixteen years prior.

After punishing interest rates and much anguish, the system had been righted.

It appeared that the fiat money of the late 1980s would endure for generations - such a good job had Mr. Volcker done in quelling animal spirits and lowering expectations.

But those who had studied history knew that this would be a cruel joke to play on Mankind. The world's strongest economy, about to vanquish the evil Red Menace and stand alone in the world, operating with paper money backed only by promises?

Had Alan Greenspan meted pain as his predecessor did, administered "tough love" instead of appeasement, things may have turned out differently.

But that was not his style.

Whether intentional or by happenstance, whether inspired by Ayn Rand and an Objectivist self interest, motivated by his early years as a gold bug, or driven by a simple desire to be popular, Alan Greenspan's actions have resulted in drawing nearer the end of another era of fiat money.

Alan Greenspan's gift to the world was to squash the hope that Paul Volcker's actions had augured - to bring nearer that eventuality that can not be avoided, and which should not be put off. For Man is Man - his tools have far outpaced his ability to reason and he is not suited for a world of pure fiat money.

No one knows what tomorrow will bring, but all signs indicate that the future of fiat money will not be one of enduring value. A generation of relative stability has begat instability.

Eventually, the current system of fiat money will give way to a new system, and this process has been by hastened by Alan Greenspan.

This was Alan Greenspan's gift.

18 comments:

dlp said...

Wow - a fitting send-off.

Aaron Krowne said...

The US dollar is now backed by only one thing: the promise that one can earn a mediocre (debatably, at or less than real inflation) return on a treasury bond purchasable by those dollars.

If anyone has proven that this is what the system boils down to, it is China.

Yet this situation has also highlighted the irresponsibility of government. If a US bond is all that one can expect from US currencies, then where is the money to pay the interest on those bonds coming from? Indeed, what is one to do with the yield, which is also in dollars? Buy more bonds? What if you want something "real" instead?

The history of the past thirty years has shown that the intrinsic incentives of government, combined with this fiat money system, inevitably produces what is plainly a pyramid scheme.

And like you said, the ones in power (be they priests of finance or politics) are the ones at the top of the pyramid.

Anonymous said...

Great Post Tim
You have captured the essence of the relationship between govt and central banking; the inevitablity of its coalesence and eventual demise. I strongly recommend a book on this subject written by David Fischer entitled "The Great Wave". He documents how this has occured thoughtout the centuries.

Predicting the end of the Fiat Currency era is NOT an End-of-the-world type rant.

http://piggington.com said...

Great post - you have successfully crammed an enormous and complex subject into a very small space, and made sense doing so.

Since you did such a good job describing the problem, if I may recommend a followup post, you might be interested in debunking some of the standard arguments that fiat money is A-OK.

For example, the "bond vigilantes" that were supposed to keep the system in check. (Their influence has been overtaken by foreign central banks... but on the other hand, there are still plenty of Americans buying bonds, so can we really blame the foreign CBs for everything?)

Also, more money has been created, but thanks to the price-reducing effects of globalization, the money has gone into assets instead of consumer goods. (This still represents a decrease in purchasing power, imho, but you must admit that it is not affecting the poor in the "classic" way that you describe.)

I'd love to hear your thoughts on these and other topics relating to the viability of the current monetary regime... this is certainly THE most important financial question of our age.

Rich

Anonymous said...

Yeah, "Bond Vigilanties"...
I can remember back in the late 70's and early 80's when Friday's market action would be dominated by the Thurs afternoon release of the all important money supply figures. Too much growth and bond prices would fall. Today...
"no one seems to care; they carry on as if nothing were there."

iron56 said...

I will second the kudos to this piece, Tim. Well and pithily put.

I will also second the recommendation of Fischer's "The Great Wave," but note that it is describing something a bit different. The "waves" are defined by rising costs of food and energy coupled with decreasing labor costs, and hence decreasing costs of labor-intensive items. The result is a growing wealth disparity in society, as those on the bottom become poorer while those on top become richer. So it's neither "inflation" nor "deflation"--primary commodity costs keep rising even as labor becomes cheaper. (Sound familiar, sports fans?) He attributes the cause ultimately to population pressure, but dwindling energy sources will certainly work, too.

Fiat Citizen said...

About 1971...my only gripe is that you seem to say that it was Nixon who got the ball rolling on Fiat money. While yes he did close the gold window, the question is, did he really have any choice?

FDR 'adjusted' the peg from $25 to $35/oz, but between his day and the time that Nixon took over the economy went right on creating money. Whether it was the printing press or the evolution of credit (increasing money velocity), there was more effective money supply. The government did not adjust the peg, and instead turned to command & control tactics like forbidding private gold ownership controlling FX rates to prevent cross-currency gold arbitrage to prevent the depletion of Fort Knox. Hence, when Nixon took office, was there a real gold backing? And if so, $35 was way too low.

Nixon really only had 2 choices, dramatically adjust the gold 'peg' to something closer to where the market really was in gold, or abondon it. Both were hard choices.

However, if papey money is back by a scarce commodity 'on deposit' with central bank, how can a nation ever have ANY credit system without the resulting money velocity upping the effective supply of the paper version. Hence, unless you ban money lending and banking, how can you ever prevent money supply from outgrowing the scarce commodity on deposit. What i'm saying is that sure there are a lot of reason to hate a fiat system, but how do we know that a system backed by a hard, scarce substances doesn't effectively just result in the same thing? Government DO need to borrow during war, diaster, times of economic strife. And the private sector DOES need to borrow to invest and form capital. So how can the money supply demon ever be stopped? Gold backing or not?

--
Fiat Citizen

Anonymous said...

and here's a parting gift for
Greenie on his last day;
Google's DOWN $70 /share in after hours! Thanks for the memories Al
Dot Com Bust part two about to unfold.

Arioch said...

I heard he did his last speech in Norwegian just to make it even more confusing for everyone.

Anonymous said...

Fiat citizen,

A hard currency does not preclude borrowing, lending or any other banking activities. It is simply a check on imbalances before they become large enough to do significant damage. Interest rates would be market driven and quite likely to be moderately higher. So, the venture(s) to be funded had better be truly worthwhile.

Best regards.

Anonymous said...

Fiat money will NEVER die. The USD may fall, but it will be replaced by a new fiat currency.

Governments are too enamored of the ability to manipulate the money supply to ever permit a return to the gold standard. Only the very biggest economic actors could make this happen, and since they are inevitably allied with government (or vice versa) they will instinctively know not to even try. Smaller interests attempting this will be suborned, crushed, or simply ignored.

Did the failed French experience eliminate fiat money? No. Did the German hyperinflation stop it? No. Did any of the other hyperinflations even slow it down? No. The genie is out of the bottle now. Only a fall to a true Dark Age would reset the clocks back to where fiat money would not be used, and unless all knowledge of history were erased it would reappear as soon as the government rebuilt the printing presses.

Do you really think the fall of the USD has not been foreseen? While the seeds of the problem are due to central bank incompetence and political folly, once the result was inevitable it became an opportunity to be seized, not a crisis to be feared. When the people get hungry, they will demand action. They will demand what the media tells them to demand. So we will get a new fiat money system to put things back on track. Of course, you will have to check your freedom at the door.

Nilesh Chandra said...

It is absurd to even think of going back to any system other than fiat money.

We cannot go back to the Gold standard or the diamond or platinum standards, simply because there isn't enough quantities of any standard. To go back to the gold standard, gold's prices would have to be raised hundred fold, which would unleash a phenomenal crime wave as everyone starts ripping away gold jewellery from grand mothers to convert into dollars and euros.

Sure, we are all human and sure, we have the tendency to print money to solve problems. And every time someone does that, there are consequences (think Russia in the early 90's). It doesn't mean we get rid of fiat money systems because of their problems - it simply means we need better mechanisms to regulate money supply. Because of integration, the world is really moving in this direction. If Mexico tries to print too much money today thereby raising the prospect of inflation, you see the immediate outflow of billions of dollars and a crash on their stock exchange - both of which grab the attention of their politicians and central bankers who immediately stop the printing of money. Sure, this system still leads to shocks - but it is a pretty good system none-the-less.

This argument is similar to one probably made tens of thousands of years ago when our ancestors discovered fire - "we are after all humans, and our curiosity gets the better of us. Inevitably, many of us end up burning ourselves, so we should get rid of this dangerous way to cook our food and keep those lions away." Fortunately for us, they didn't ban fire but simply invented fire departments.

We don't need to predict the demise of fiat money systems - there are no alternatives. Instead, we simply need better market mechanisms to regulate this stuff.

chubbyray said...

I have to disagree. Currency by fiat does not represent any form of social or technological advancement, nor is a hard currency system unviable. A government is not required for money to exist. Money arises simply as a natural consequence of free commerce. Instead, currency by fiat is statism's primary instrument of influence and coercion.

To cast this argument in its simplest and purest form, there are governments and there are markets. You must decide on which side you stand. It isn't a question of means. It is a question of will.

"Whoever wants peace among nations must seek to limit the state and its influence most strictly"
- Ludwig von Mises

Jason John said...

Thank you for writing this article. I found this to be an effective summation of the status quo of our US government-bank, or perhaps the lack thereof. I'm a first time reader, and I have to say it really meant a lot to me to here things that reinforced what I suspected to be true about our spending trends with fiat currency, and also to read about the bigger picture.

In the next few years my best friend and I are looking to start our own business, with goals of significant expansion afterwards. It's a little nerve-racking because as we sit and lay it all out on paper, simultaneously we are trying to get a reading on consumer trends, is the bubble going to pop? Things like that. I suppose that puts us in the 'middle', in which we might prosper from speculative games, or make money while the market is eating itself. For me it's hard to say.

Anyway this article was extremely thoughtful and I appreciate your writings. It gives me a lot of food for thought on future endeavors. Cheers!

Anonymous said...

Greenspan obviously understands the consequences of his actions, therefore he must be deliberately hastening the destruction of the dollar.

My question is: Why? To what end?

The US does hold the largest gold reserves, so a new currency could be based out of the US.

70% home ownership tied to debt denominated in FRNs. Kill the banks and the public owns the houses free and clear?

Greenspan isn't dumb. I don't think he's evil either. He has an end in mind.

RJB said...

Literally, money comes from trees and so does the air the world and Mr. Greenspan needs to survive. I for one; believe in the "Land of Milk and Honey" and respect the ingenuity and know how that made such rivers flow free. The thought of someone cutting off the air we breathe and diverting the chances for a pore man like myself to have taste, really chaps my hide.

Anonymous said...

Hey Mr. Greenspan, I need to borrow $9.99 for a subscription to "Kiss my $%$^"

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