Special Report: Is Currency Really Money? Everything About Fiat Currencies

As war raged on between Venice and Genoa in the 13th century, the first tales of fiat currencies were told in Europe in a jail cell.

Marco Polo had returned to Italy after years abroad, only to be captured by the Genoans and imprisoned. Being a wealthy merchant from Venice wasn't exactly appreciated. The same went for his cellmate, Rustichello, who was from Pisa.

As months passed in captivity, Polo told stories of China and Asia that would become the first accounts of the Far East. His cellmate documented them in "The Travels of Marco Polo."

What Marco Polo had come across was the paper money issued by the Yuan Dynasty under the rule of the legendary Kublai Khan. His people had been making use of paper money for several hundred years, dating back to the Song Dynasty in the 8th century.

Investopedia has a perfectly succinct definition of fiat currency:

Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith.

yuan note
A Yuan dynasty printing plate and note, circa 1280 A.D.

The Yuan Dynasty notes were issued by the Chinese government at exchange rates for gold, silver, or silk. In practice, however, they could not be redeemed.

Therefore, people using the currency had to take the value of the printed papers at faith, since they had no intrinsic value on their own.

The initial plan was to pull the notes out of circulation after three years and replace them. But that never happened. And before long, they learned the pitfall of currencies: inflation.

The government issued a fiat, an official declaration, that the paper notes were worth a set amount. Increasing the supply of notes without backing them up with additional gold, silver, or silk led to a precarious scenario in which the notes slid in value as more entered circulation...

Movement in either direction can be controlled to an extent; however, a sharp or uncontrollable movement only serves to self-reinforce.

Once public sentiment erodes, the value of a fiat currency is no longer centralized. After all, faith in the currency is needed. Once that is gone, the government's rules are gone and the mob rules.

Moving Up to the 20th Century

Fiat currencies didn't take root in Europe for quite some time...

Outside of some emergency situations, the first real fiat currency didn't appear until 1661 in Sweden — and then only to a limited effect. Some were tied to gold and silver; some were not. At times, both existed in some countries, with the paper money trading at a discount to the "hard money."

In colonial America, individual states issues "bills of credit" and various types of currency over the years. Once again, some were backed by silver or gold, but some were not.

As time wore on, currencies became far more centralized and uniform. By the turn of the 20th century, most nations had made themselves the sole issuer of bank notes and legal tender.

The economic havoc and immense cost of World War I led to the end of conversion of currencies for specie across the board, leading to an infamous example of a pitfall of fiat currencies, which we'll cover below.

Between wars, currencies were extremely volatile. Hyperinflation led to severe deflation and depression. Too often, currencies bounced between sharp inflation and deflation through ham-fisted monetary policy.

World War II brought another period of intense government intervention in economic activity, price controls, and monetary policy.

As the world reemerged from the cataclysmic wars, there was broad consensus amongst the major powers that something had to be done to stabilize currencies, exchange rates, and economies, and to rebuild faith in government control of all of the above.

In July 1944 and in preparation of postwar rebuilding, 730 delegates from all 44 Allied Nations gathered in Bretton Woods, New Hampshire, for the United Nations Monetary and Financial Conference. What emerged was the Bretton Woods System, in which all of the nations tied their currencies to the U.S. dollar through fixed exchange rates. The U.S. dollar was fixed to $35 per troy ounce of gold.

Fast-forward to the large deficits in the United States during the Vietnam War, and opportunism trumped sound international consensus...

The U.S. dollar was still convertible to gold, but only for central banks. On August 15, 1971, President Nixon unilaterally ended it. It was now a pure fiat currency. The dollar plunged by a third during the stagflation of the 1970s, and currencies destabilized worldwide.

What emerged has been called Bretton Woods II, although it wasn't coordinated at all. An international system of interdependency between states with generally high savings in Asian lending and exporting to Western states with generally high spending emerged. This paradigm lasted until about five to ten years ago.

With the global recession and currency wars raging to this day, there are renewed calls for worldwide standards for currencies and banks. The renewed calls for global stability of currencies have been dubbed "Bretton Woods III," mostly by the press and advocates for a new agreement.

So far, there is a tentative agreement on bank capitalization rules and requirements, but few nations have ratified the proposal.

In a lesser form, banking regulations in the U.S. and in Europe have been used to address the credit crisis during the recession that resulted in unorthodox monetary easing policies from central banks, but there are no binding international standards for currencies.

As a result, we're still mired in the effects of the "Nixon Shock" through volatility in exchange rates and fiat currency standards. Inflation, hyperinflation, and deflation are all still on the table as individual currencies are completely independent.

Inflation is by far the most common scenario. High inflation tends to lead to many economic woes, but hyperinflation and deflation expose the greatest weaknesses of fiat currencies. Check out a couple examples of each...

Weimar Hyperinflation

Following defeat in World War I, the old Imperial German government was thrown out and a federal republic named after the host city of the constitutional assembly was formed.

The new government had too many problems to address: exports were nonexistent; resources were greatly reduced from lost colonies and territories...

Tack on horribly punitive reparations demanded by other European nations, and there was no way to avoid hyperinflation.

The total payout from 1920 to 1931 — when payments were suspended indefinitely — came out to 20 billion German gold marks. It was the equivalent of $5 billion dollars, or one billion British pounds.

weimar hyperinflation$12.5 billion was paid with loans taken mostly from bankers in New York. The rest came in the form of commodities and goods, such as coal, chemicals, and railway equipment.

The total amount due according to the peace treaty was 132 billion marks. Even with a fraction of the amount paid, Germany did not finish paying off loan interest to U.S.-based banks until 2010.

Other nations will see payments through 2020, more than 100 years after the war.

Yet, reparations only accounted for a third of the German deficit between 1920 and 1923. The government simply had too much debt and spending.

In order to meet previous obligations, reparation payments, and debts, the Weimar Republic started printing paper marks as quickly as possible...

The repercussions were severe. In 1919, one loaf of bread cost 1 mark. By the time the government declared it couldn't possibly meet reparation payments in 1923, the same loaf of bread cost 100 billion marks.

The value of the paper mark had declined from 4.2/USD at the outbreak of World War I to 1 million/USD by August 1923.

Germany was stripped bare. Its dysfunctional economy produced little to nothing of value, and there was nothing left to prop up the fiat currency. The financial collapse led to further instability...

Eventually, the Nazis were considered a good way to counter communists while dismantling the Weimar Republic.

German industrial leaders and politicians thought Hitler could be controlled. History would prove otherwise.

The Latest Example

To see how hyperinflation behaves in the 21st century, we need only look at the Zimbabwean dollar.

Introduced in 1980 at par with the previously used Rhodesian dollar, it was once among the highest-valued currency. By the time it was pulled from circulation in 2009, it was one of the least-valued.

Despite attempts to control inflation by legislation and three redenominations in 2006, 2008, and 2009, the currency could not be saved due to a complete lack of faith in the government and economy.

When Zimbabwe gained independence, the country was going strong. Growth and economic development were steady. Wheat and tobacco production, both major products and exports, were better than before political autonomy was gained. Everything was looking good for the new nation.

Unfortunately, it wouldn't last. After droughts, massive government deficits, and credit crunches, reforms were needed...

An Economic Structural Adjustment Program (ESAP) from the IMF and the World Bank created a drag on Zimbabwe's economy. Austerity was imposed, public holdings were privatized, and the Zimbabwean dollar was intentionally depreciated by 40%. But not even that was enough to stop uncontrollable inflation.

In the late 1990s, the government instituted land reforms to redistribute land from white landowners to black farmers in an effort to reverse the effects of colonialism. These new farmers had no experience or training. Food production dropped sharply over the next decade. Virtually all other sectors, such as manufacturing, mineral extraction, and services faltered as well.

The banking sector completely collapsed. The ensuing credit crunch guaranteed no one had access to loans for capital development. Food output fell 45%, manufacturing output dropped 29% in 2005, 26% in 2006, and 28% in 2007.

Unemployment rose to 80%.

With out-of-control war expenditures, self-serving corruption, and a collapse of all forms of economic activity, there was no faith in the fiat currency issued by the government.

Just like in the Weimar Republic, the combination of economic collapse and loss of faith led to inconceivably exponential hyperinflation.

Other currencies from foreign nations were preferred for all transactions and bartering. However unwieldy, this was a far better alternative to the Zimbabwean dollar.

The Zimbabwean government accepted reality and functionally killed its currency on April 12, 2009.

By making the use of fiat currencies from foreign nations legal tender, there was no longer any reason for anyone to hold or convert to Zimbabwean dollars.

Zimbabwe hyperinflation chartThe Other Side of the Coin

Fiat currencies only work when inflation is low or moderate.

With the value of paper money slowly declining, economic activity is spurred. Businesses will invest profits in capital development to build profits that outpace depreciation. Consumers have no reason to hoard money and buy property, cars, and goods.

When inflation rates turn negative, there is a risk of a deflationary spiral. Currencies become more valuable over time.

In the short-term, this seems like a good thing. A person's wages become relatively greater, and any savings they have gain in value as well.

In the long term, this creates behavior that leads to recession or full-blown depression.

Businesses and citizens have no reason to purchase something today that will be worth relatively less tomorrow. Thus, money stops flowing through the economy. Demand drops, and previous reasonable supply levels become unsustainably high. Production and economic activity slump as businesses react to the new demand level. Wages then drop and unemployment rises as businesses pare down their bottom line.

The money everyone has is worth more — but with greatly reduced or nonexistent income and revenue, that hardly matters. In the end, everyone is worse off than before the deflation started. In particular, anyone or anything holding debt has to effectively pay more for prior obligations.

This is especially true for governments, the very same institutions that control the fiat currencies in the first place. As such, governments do everything they can to avoid deflation.

One of the few examples we can see of this effect is in the United States (as well as in many other countries) during the Great Depression...

The deflation partly occurred because of an enormous contraction of credit. Bankruptcies ensued, creating an environment where demand for cash in any transaction was rampant.

The Federal Reserve was tasked with managing demand for cash through the monetary base. Instead, it contracted the amount of U.S. dollars in circulation by 30%.

Banks were forced out of business because they were unable to meet the sudden demand for cash with the heavily contracted money supply. Liquidation was forced upon them, but no one was buying assets and prices were at a steep discount.

Another less dramatic example is the Swiss franc, which functionally experienced deflation due to external reasons.

With the Greek debt crisis hitting a peak in 2011, along with broad European and U.S. debt issues, many investors were frantically looking for a safe store of wealth...

Switzerland had remained relatively unscathed by the problems. International money poured into the country. Between June 2010 and August 2011, the franc gained over 52% in value compared to the U.S. dollar, and over 28% compared to the euro.

Swiss Franc- USD and EUR

Businesses were threatening to pack up and leave the country due to how uncompetitive the price of their goods and services became. And citizens were taking international trips to buy everything from cars to groceries.

In September, the Swiss National Bank was forced to intervene by setting a minimum exchange rate of 1.20 francs to the euro. It also pledged to buy foreign currencies in unlimited quantities to enforce their new edict.

The franc fell 8% against the euro and 9% against the U.S. dollar in a mere fifteen minutes. By the end of the next day, it was down at least 8.2% as compared to all 16 of the most active currencies.

The Swiss National Bank intervened to control the Swiss franc exchange rate until it could no longer afford to in January 2015, sending a shock through currency markets.

“We have said goodbye to the minimum exchange rate,” Mr. Jordan said in the interview published Saturday. “But we will continue to consider the exchange-rate situation in our decisions and intervene in the foreign-exchange market if necessary.”

As the mismatch between the Swiss franc and other currencies gets worse, the Swiss National Bank will have no choice but to sporadically intervene.

Positives of Fiat Currency

So far, we've covered the pitfalls of fiat currencies.

Without a commodity or good used as a peg for value, there is a point of no return in the collapse of a government, national economy, or both that marks a point of no return for its currency...

However, there are large advantages to using fiat currencies.

Take a return to the gold standard in the United States, for example: If the U.S. government couldn't buy enough gold to issue new bills, it could not expand the monetary base at all. Businesses and banks would be limited in their ability to take loans and finance new capital investments, and growth would be hampered by a credit squeeze.

If the economy really heated up, there wouldn't be enough money for what would be considered safe loans and capital development. A period of strong growth would be severely undermined.

Along with more extreme business and economic cycles, there would be no way to address inflation, deflation, and/or unemployment.

Gold would also have to be under massively restrictive price controls worldwide. Otherwise, currency value could wildly swing without any basis on the national economy.

Just look at gold prices in 2013...

If the dollar had been pegged to the yellow metal, it would have lost 28% of its value as well:

2013 gold chart

A currency based on faith alone is hardly ideal, but it avoids excessive external manipulation and gives central banks greater control.

Responsible management by central banks can keep the possibility of high inflation and deflation in check through interest rates and monetary supply. Dropping interest rates and increasing the monetary supply tend to increase lending and reduce the risk of loan defaults in weak economic climates.

Raising interest rates tends to have an inverse effect of cooling down overheated economies and reigning in inflationary pressures.

Through these tools, market activity can be influenced with centralized policies that help businesses and citizens alike.

Weighing the Risk vs. the Reward

By now, I'm sure you can see how fiat currencies can act like a seesaw.

Shifting them back and forth can be beneficial, to an extent...

However, if balancing factors are absent — or if a government irresponsibly spends or alters interest rates for their benefit — the system breaks down and there can be no return to normalcy. At that point, they forcibly catapult anyone using the currency into poverty.

We'll let you make the conclusion as to how the Fed and other central banks are doing, but here are some things to consider...

With the Fed's unprecedented expansion of the monetary base, and with interest rates at virtually zero percent, it has no ability to further stimulate the economy without dumping more dollars into circulation.

We haven't seen the inflation and depreciation of the U.S. dollar that would be expected so far. Don't be fooled, though: There is no guarantee that inflation won't ramp up in the near- or long-term future.

The Fed determined the risk was worth the reward. So far, it has been right.

But many worry about a delayed effect of the Fed's actions. Only time will tell...

You should have a good grasp of the roots of fiat currencies, the risks we take by using them, and the rewards we reap when they are responsibly managed.

Through careful evaluation, you can interpret the signs and move wealth into equities when the currencies they trade in are healthy.

When a currency is weak, or a central bank is using risky policies that create a loss of faith and an ailing economy, you'll see it develop — and can shift your money into traditional stores of wealth like gold or silver.

Here at the Outsider Club, we'll continue to keep a close eye on economic and monetary policy for the U.S. dollar and other major currencies.

We'll also help you determine how they will affect you and your portfolio.

Thanks for subscribing to the Outsider Club. We'll continue to find ways to boost your portfolio with flexible and safe investments that will help you break free of the traditional trading advantages, traps, and pitfalls financial institutions use to siphon off your wealth...

The Outsider Club Research Team

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