Why Paper Money (Fiat Currency) Not Backed By Gold and Silver Breeds Less Confidence
Price Inflation Graph '05 - '15
There was a time when United States currency would be exchanged for gold or silver. The United States treasury would make the exchange. Our system of money was referred to as a bimetallic standard. In 1964, our government stopped exchanging silver certificates (dollars) for silver ingots or silver dollars (note, Vietnam). In 1971, the United States went off the gold standard, thus creating a purely fiat currency, a currency backed only by faith in the government's ability to pay debts. In both cases because of inflationary fears the value of gold and silver was rising and the government feared losing a significant portion of its stockpile.
Understanding the basics of a fiat currency is important to all of us. The mismanagement of a fiat currency can lead to very serious problems for the average person, not the least of which is severe inflation. A discussion of how fiat money can affect your life follows.
When our currency was redeemable in gold or silver, a person who was worried about inflationary signs (too many dollars in circulation and rising prices) could take and then hold gold or silver. These commodities have been used for money for hundreds of years. Their value tends to rise as inflation spreads. In this way, a person's gold or silver is money that can keep up with or exceed the rate of inflation, thus preserving the purchasing power for the holder. Holding the currency might result in loss of purchasing power.
When inflation is moderated, the owner can then sell the gold or silver (sometimes in the form of gold coins or silver coins minted by governments) which would have maintained its purchasing power versus the inflation. He would get more currency for the gold or silver than currency given when exchanged. This characteristic enables the buyer to then use the currency to buy the same amount of goods and services (which now sell at a higher price) as before the exchange, or as stated above, to exceed that.
Gold and silver have special "trust characteristics"; gold especially so. Currency backed by gold and silver hasn't experienced the same severe swings in value. Swings in a fiat currency's value come from the ease in which governments can create money to pay for programs and other debts (most frequently wars) - money is essentially printed or created digitally with the average citizen at the bottom of the political heap witnessing his hard-earned money going less far. There needs to be a relationship between the amount of money created and the gross domestic production. When currency is created without regard to the disparity between the two, inflation ensues. But, I don't even understand that relationship. This article is for average people like me.
When money is created based on how much gold or silver is in the treasury, the disparities described above don't occur as severely. People are protected by the precious metal. When Wellington contemplated the Battle of Waterloo, he had to make sure he had a supply of gold coins to pay his soldiers to fight Napoleon. Men were more likely to fight and die for gold than for fiat currency. Experiences with fiat currency, especially in Europe, and France in particular, had taught people to be leery of fiat. Today there is no alternative. All of the world's nations have adopted fiat currencies.
At one time our currency had United States Note or Silver Certificate written at the top. This indicated that something tangible was backing the currency. Now we have Federal Reserve Note printed. This indicates that no tangible asset is associated with the currency.
The trust one must have in fiat currency is based on what is referred to as the "full faith and credit" of the United States of America. To attempt to protect one's wealth, a knowledge of misuse of fiat currency can be very helpful. The Yuan Dynasty of China ended the use of fiat money in 1455 to end hyper-inflation. The "Continental" was a fiat currency issued by the continental congress before the constitution, but it didn't explain how a person was to collect the backed money as there was no gold or silver in the treasury. It eventually traded from 300-1000 Continentals to one unit of backed money! From 1790-1799, the French used Assignats. Assignats were backed by mortgages, but there was no control over printing them. In 1799, they were worthless. Other examples include Germany from 1914 to 1923, Hungary from 1945 to 1946, Zimbabwe from 1980 to April of 2008. For 32 examples of hyper-inflation contributing to or caused by fiat money, google "hyper-inflation examples" and read Wikipedia.
To give you another idea of why gold seems to be the standard for money, one can look at financial transactions. Gold is the only metal central banks accept as payments of debts between government central banks. Gold has a pedigree no other metal has. So lacking some sort of backing of gold or silver, fiat currency raises issues of trust. All fiat currencies (no metallic backing) have ended up hyper-inflated in the past.
Preparing for the Future
In preparing for the future, an individual must think about the behavior of his government and factor it in before making financial decisions. Even with regard to something as simple as a checking account or a simple savings account, inflation needs to be factored in, and an appraisal of the fiat currency's current situation made. For instance, if inflation is running at 5% and government influenced interest-bearing checking account rates are .01%, one can see that to protect purchasing power, a different course may have to be taken. One may opt to keep more money in a savings account and transfer when necessary to checking rather than holding a high balance in the latter. If savings account rates are low, one might consider I bonds (inflation protected savings bonds), or the purchase of gold and silver! These are not exotic investment choices.
I have bought some gold and silver from Ebay, but only from sellers with a sizeable number of transactions, and 100% satisfaction rating. The markup in price is probably the lowest available. It isn't hard to find sellers who fit those criteria. However, I would never recommend any investment. You need to learn more about fiat currency and inflation to make your own decisions, as sleep at night is important. If you are someone with small savings, you are the one who can least tolerate irresponsible government policy.
If the government considers issuing a new currency, you can be pretty sure it is an acknowledgment that the government is concerned about inflation. Unless a scheme for backing currency number two with gold or silver is discussed, you can take that as a warning your savings are at risk.
It may be that a penny saved is a penny earned, but that penny earned may be entirely insufficient. Delving into the financial news (as boring as it may seem to you) and understanding the pitfalls of a fiat currency may be very helpful to your wealth health.
© 2011 John R Wilsdon