Standards Vs. Fiat

Sorry if this post has any spelling errors. This computer doesn't have a spellcheck on it and my skills are sometimes suspect at best. I'll run it through Word when I get home this evening.

Mike Northover has been filling in for Michael Williams over at Master of None, and he's been doing a pretty admirable job, I must say. One of his favorite topics to blog on seems to be economics, which of course causes me to stop and read.

In one of his posts last night he makes the statement "I'm a big fan of the federal reserve, and the fiat monetary system that we have in place..."

I'll agree that the Fed has performed it's job very well given the tools it has at its disposal. The Fed trying to steer the economy is like me trying to steer a car down a steep mountain road full of switchbacks, while blindfolded and having beat a sledgehammer against the tires to make the car turn. It's not an easy task, and Greenspan and the Fed deserve a lot of credit for not sending us through the economic woods.

But I have to disagree and say that the fiat monetary system is not a wonderful idea. The risks associated with it are enormous, and the benefits pale in comparison.

The fiat system is based on the "full faith and credit" of the government issuing the cash. This is wonderful if you have relatively responsible people in charge of the economy and the printing presses, as the US has since Bretton Woods. But what if you get someone irresponsible or ill-informed about how the economy works?

One of the biggest problems with the fiat system is that there is no restraint mechanism in place. With the gold standard there was always the requirement to acquire more gold to back the currency. With the fiat system, the presses can run 24/7 just printing, printing, printing and there is nothing immediate in the system to make it stop. In fact, it becomes a self-sustaining inflationary cycle.

In the immediate short term, printing more money has some outstanding benefits for the government. They can use that money, backed only by the government's faith that it's good, to pay for more social programs, to pay for more infrastructure, or any goofball measure they may come up with. Politicians get a short term boost, the economy gets a short term boost, and everyone is happy. Right?

Not exactly. In the intermediate to long term unless that money is taken back out of the economy, usually by cutting spending somewhere or by raising taxes, we enter a situation where we have too many dollars chasing too few goods and services. Prices begin to rise, which leads to higher wages, which leads to more money chasing the limited supply of goods and services, and so on and so on and so forth. Welcome to the vicious wealth-sapping inflationary cycle.

Think it can't happen to us? It happened to ancient Rome. It happened to Weimar Germany. It has happened to almost all of the South America nations at some point. What makes us so special as to be exempt from the effects of an inflationary economic implosion?

Nothing does. The only reason it hasn't happened already is because we have had people in office who upheld the faith portion of the fiat system. We have had people in office who acted responsibly. But what happens if the economy stays stagnant or even starts to regress again?

The lure of easy money might become too much for many politicians. We could very well end up with a "reformer" getting elected. If things are bad economically, many people who don't understand the basis for the fiat system may accept or even embrace the idea of simply printing more money to pay for economic stimulus. It would never occur to most people that an inflationary or hyper-inflationary cycle brought on by irresponible printing would destroy our fiat monetary system by destroying the faith portion of the backing.

How easy might it be to rapidly increase the money supply in clandestine ways? Try this on for size: we are now going onto our third variation of the $20 bill in the last, what, 10-15 years? Now, I believe that the Fed is taking the old $20s out of circulation and destroying them, just like they should. But if they didn't, this would effectively triple the amount of $20 bills availble. Add that to each denomination and that would be a massive influx of new, inflationary pressuring cash entering the system. And many people wouldn't notice right away, as it could be hidden under the guise of improving monetary security.

The fiat monetary system is very similar in a way to the concept of communism. They are both wonderful, utopian theories that ignore the realities of human nature. Just as you will eventually find a slacker leech in a communist society, you will eventually find an irresponsible economic leader in a fiat monetary system. Just as the slacker destroys the faith required to maintain a perfect communist system, the irresponsible economist destroys the faith needed to maintian the fiat monetary system.

The ideal, though unwieldy, solution would be to return to a system of gold and silver coinage. With that, we would have an ability to immediately determine, through specific gravity testing, the quality of the money being presented and can make valuation determinations based on the purity and quantity of the metal being offered. It also has the benefit of tying the government to an absolute fiscal responsibility as the only way to mint more money would be to obtain more metal.

Gold and silver certificates are a compromise solution. In theory they are backed by a specific quantity and fineness of metal, but in reality, the government can print more certificates than they have metal to back. This is again due to human nature. Even in the midst of a run on the metal, not everyone would attempt to redeem their certificates. The number of non-redeemers is a number that can be calculated and predicted, just like the number of no-shows for an airline flight. Using that information, the government can exceed the limitations set by the metal backing, to a point. But at some point, fiscal responsibility is still forced upon them by the backing requirement.

Since Bretton Woods, the US has really dodged a bullet. We have had responsible people in positions of power who did everything they could to protect the full faith and credit of the Federal government. But do we really want to base our future on making the right decision every single time? Or do we want to have a system in place that is resiliant and allows for correction of errors in judgment?

The fiat system requires perfection. Mistakes cannot be made or else the whole system collapses. And that is not a good situation for something being run by humans or politicians.