The Perils of Paper Money

Over at The Atlantic, David Wolman has written A Short History of American Money, From Fur to Fiat, which might better be called An Apologia for the Bernanke-Krugman Philosophy of Turning Paper into Gold. What was left out of this commercial for fiat money and the Federal Reserve is much more telling than what is included. Later columns will be devoted to the important parts of history that the article passed over, but in this essay we'll deal only with the most glaring of many problems I see: an inverted understanding of the purpose of money that ignores the fundamental purposes of money itself.

Money has three fundamental functions to perform: to act as a medium of exchange, a unit of account, and a store of value.

A lack of understanding of the importance of the third of these three functions is apparent in this statement, describing the Bretton Woods Agreement, which the author interestingly never mentions by name:

Bizarre as it may sound, a small group of men sitting around a table determined that a 1-ounce nugget of gold would be worth, not $34 or $36.75, but $35.

This is a total inversion of the concept of sound money. The decision was not that "a 1-ounce nugget of gold would be worth $35," but rather that the value of a dollar would be fixed at 1/35 of an ounce of gold. While that may seem to be an arcane difference, it really speaks to the heart of the matter. Since gold could be depended on to hold its value relative to other goods, and history has repeatedly shown that ink on paper cannot, this decision was intended to maintain relative stability in the value of the dollar against material goods -- what we speak of as "sound money."

This inversion of the understanding between the value of money and gold led, inevitably, to the action described in the next quote from the article.

[O]n August 15, 1971, President Richard Nixon severed the last remaining connective tissue between a material substance and national currencies. Nobody could exchange greenbacks for gold anymore. The number of dollars required to buy an ounce of gold would from here on out be determined by the markets, just like it is for oil, sod, dental equipment, and tulips.

We can easily determine how this decoupling of the dollar from any substance of value has worked out by examining the following chart.¹ Note that it was in 1913 that the Federal Reserve System was chartered and 1933 that President Franklin Roosevelt confiscated the gold owned by American citizens, ending convertibility between the dollar and gold domestically. Note when the value of the dollar against other goods and services began to decline, as the rising price levels in this chart illustrate. Also note the particularly steep upturn that began at approximately the same time as Nixon's action described above.

One critical lesson to be derived from that chart is that today's paper dollar will buy approximately the same goods that four cents (yes, $.04) would have bought in 1913, the year that the Federal Reserve System was created. Store of value? Hardly.

Tom Woods, a senior fellow of the Ludwig von Mises Institute, author and historian, underscored some of the additional lessons of that graph in a recent column.

The British achieved the most pronounced and sustained economic growth of any society in the history of the world while on the classical gold standard, which had been abandoned and replaced by the gold exchange standard by the 1920s. There have not been fewer and shallower recessions since gold was abandoned, and the panics of the 19th century were caused not by gold but by inflationary paper money. Banking crises have skyrocketed, with 124 of them from 1970 to 2007.

What we have had is a dollar that’s lost over 95 percent of its value, while it held or gained value before the transition to fiat money. Think about what that means for people’s ability to save for old age.

With the official inflation rate running about three percent, ShadowStats reporting an actual rate approaching 11%, and bank savings accounts paying less than one percent, it's immediately obvious that attempting to save money for any period of time is a fool's game. Even at the official rate, a dollar loses two percent of its purchasing power if placed in a savings account for a year, and if the ShadowStats figure is indeed accurate (as confirmed here and here), that saved dollar plus the penny paid in interest can be expected to buy ten percent less in a year's time than it does today.

As we stated above, money has three fundamental functions to perform: to act as a medium of exchange, a unit of account, and a store of value. It obviously has not fulfilled its third purpose since the creation of the Federal Reserve System, and it performs the other two roles less effectively every year.

If money continually loses a fraction of its value, as paper money does (see the above chart) the second of the three fundamental purposes of money, a unit of account, is impacted. Note how frequently data sources that cover more than a few years regularly state "adjusted for inflation" or "in constant year 19xx dollars." And if money loses value rapidly enough, it even loses the ability to fulfill its first stated purpose, that of a medium of exchange, a stage referred to as hyperinflation. In such cases, the purchasing value of the paper money falls precipitously. One well known case, although by no means the worst, was the hyperinflation experienced in Germany in the 1920s, when people spent money as soon as they got it, to avoid its rapid loss of value.

By late 1923, the Weimar Republic of Germany was issuing two-trillion Mark banknotes and postage stamps with a face value of fifty billion Mark. The highest value banknote issued by the Weimar government's Reichsbank had a face value of 100 trillion Mark (100,000,000,000,000; 100 million million). At the height of the inflation, one US dollar was worth 4 trillion German marks.

As for the dollar's usefulness as a store of value, I can buy two gallons of gas for the silver quarter that bought me a single gallon of gas in 1970. I can buy more goods with an ounce of gold today (nominal value $1750) than I could in the 1920s, when it had a nominal value of $20.

What'll a pot-metal quarter or a 20-dollar bill buy you today?

That's what "store of value" means to your pocketbook.

...and that's all I have to say about that.

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¹ The supplied chart ends in 2005; in a future column we'll look at the ever-increasing steepness of this chart since then. This Tireless Agorist feels it would be detrimental to the health of his readers to introduce too much shock to their system at once.