To briefly recap:
- Petrodollar Wars 101: What was the Gold Standard? – where I gave the briefest possible history of currency, and how the British Empire brought the world onto the Gold Standard.
- Petrodollar Wars 102: The US Dollar Gold Standard – where I talked about the various failures of the interwar period, Keynes’ grand idea that never was, and how the Americans got their way in the end.
- Petrodollar Wars 103: the Collapse of Bretton Woods – where I listed the various ways to arbitrage gold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon suddenly and unilaterally told the French (and everyone else) to sod off.
Nixon’s decision to take gold convertibility away from the US dollar was game-changing. Today, we’re 40 years on, and we’ve gotten used to a world of fiat currencies. But then – they were new. And terrifying, I’d say. Especially after everyone had had 30 odd years of the security of gold.
To put this into perspective, it’s almost like your government suddenly declaring that the right of privacy no longer applies, and that all information will now be public. Your bank records, medical records, private emails and phone conversations, online dating profiles… Everything. Prior to that, you’d been going along, glibly assuming that you could keep most things to yourself, and then suddenly: there’s your laundry in public, all steaming and soiled.
In the same way, you might have been quietly accumulating money for your future, saving and looking forward to that happy day when you’d be Scrooge McDuck in a mansion with a safe the size of a dungeon and a diving board. Then Mr Nixon announces that the cash in your mattress and your bank balance are now just pieces of paper and numerals in a creditors’ ledger next to your initials.
The White House Concern
If I was in the White House midnight emergency meetings at the time, I think I would have been properly panicked about public outcries, inflation, market crashes, bank runs, and losing the next election. And there’s some good evidence of that concern: the announcement of the Bretton Woods dissolution was accompanied by a 90 day wage and price freeze, and a blanket 10% tariff on imports.
Effectively, Nixon was saying to the American people: “For at least the next 90 days, we won’t guarantee that your dollars will be exchangeable for gold – but we will guarantee that they’ll be exchangeable for everything else. And we’re going to stop the outside world from interfering with that by making it unprofitable for them to export to America.”
Also, because it’s quite entertaining, here’s what Nixon actually said:
“Let me lay to rest the bugaboo of what is called devaluation. If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today. The effect of this action, in other words, will be to stabilize the dollar.”
“Bugaboo”?! Either Nixon was folksy, or he was attempting to infantilise the response of those who were panicking. Which must have worked – because the decision was generally seen as a political triumph!
Regardless of the politics, you could almost view that 90-day freeze as the creation of a Commodity-Basket Standard, rather than a Single-Commodity (ie. Gold) Standard. Which should give some indication of the direction that the currency was going…
How Fiat Currencies Work
Fiat Currency: a currency that is not linked or “backed” to any type of commodity (eg. gold).
Fiat currencies are “free-floating” in the sense that the currency no longer has its own fixed intrinsic value relative to some specified good/item. Rather, a fiat currency derives its value from a government regulation/law. So, for example, the American Government declares that the US dollar is the sole legal tender, and that the Federal Reserve has the sole authority to manage the supply of US dollars, and therefore, the US dollar is the US currency.
The term “fiat” derives from the latin word for “let it be done” – and a government is usually said to declare a currency as legal tender by fiat.
It’s usually at this point that people begin to feel a bit panicked – as though they’re Wil. E Coyote and they’ve just looked down to discover that they stopped walking on land three paces ago. Because how can money be money if it doesn’t have its own intrinsic value?
Which brings us to an even more existential question:
What is Money anyway?
In its simplest form, money allows us the freedom to trade our goods and services for other people’s goods and services. Before money, we had to barter: “Let me give you these eggs in exchange for that rather comely set of animal skins”.
But the barter system is wildly inefficient, because it means that:
- I have to have something to trade;
- You have to have something to trade;
- I have to want what you have to trade;
- You have to want what I have to trade; and
- We have to be able to agree that what I have is worth what you have.
Which is a lot of admin.
So money comes into play as something that all of us will accept in exchange for our goods and services (a generally-accepted medium of exchange), because it will allow us to buy something at a later date (a store of value). It’s also particularly useful if we can break it down and build it up relatively easily (a unit of account), because one egg is generally worth less than a set of new clothes.
Traditionally, whatever was the most widely used commodity became money. So you might have traded in bushels of wheat if you were a farming community; or you might have traded in dried fish if you lived on a river. But when you think about it, that’s really just being practical with whatever is close to hand.
The whole thing could just as easily have worked if we’d all been trading in IOU notes with each other – provided that we were all men of our word. And even then, if you suddenly became aware that one guy was being a bit liberal with his IOU notes, you’d stop accepting his word for it.
If you carried that process to its logical conclusion, you’d probably find that there’s one guy in the village whose word is particularly trustworthy; and if anyone tries to fake one of his IOU notes, he’ll find the culprit and quarter him publicly.
Pretty soon, his are the only IOU notes that everyone will accept. And presto: you have a currency.
And fiat currencies are exactly that:
- you have a Central Bank that is the only issuer of a currency;
- they are “men of their word” because they commit to a given certain set of policies around the printing and protection of their IOU notes;
- they have the backing and support of the governing authorities;
- so we all accept their notes as good-for-value.
Instead of being backed by one specific asset (like gold) by a commitment from the Central Bank, fiat currencies are backed by all assets because they are freely convertible into non-monetary assets in the market.
And it’s only when a Central Bank starts playing excessively with the printing press that the rest of us react by losing complete faith in the currency, which is the very definition of hyperinflation.
So as it turns out – fiat currencies aren’t really so different from a Gold Standard, provided that the Central Bank doesn’t give in to the temptation to play the fool.
But in the American Case
At the time of Nixon, the Federal Reserve wasn’t just the Central Bank of America, it was also the Central Bank of the world. And while Nixon may have been doing good things for his American voters, his decision to remove gold exchangeability was a complete violation for the voters from the rest of the world.
Because when you initiate a free market for your currency – suddenly, everyone that uses that money is a voter. And if they don’t like you and/or your policies, maybe they’ll try to stop using it.
In the next post, I’ll be talking about what it actually means to be the Global Currency of Reserve…
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.