Three Sins, One Gift - The Gift

This is the final installment in the series "Three Sins, One Gift" that first appeared here in early 2006 as Fed Chairman Alan Greenspan was about to retire and current Fed Chief Ben Bernanke began his first term - exactly four years ago today. This piece was It has always been my favorite in the series due to the "cultural transformation" aspects. It was originally published here on January 31st, 2006.

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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 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.