Fiat Currency. Global Reserve Currency. Gold Standard.
You might have heard terms like this, but what exactly do they mean? How is what’s happening in Greece related to what’s happening here and why should I care? We’re going to use some ink in the next several articles laying out the basics of the ongoing financial crisis – no, it never actually went away – and what it means to us.
But first, permit me to share a true story.
My father once bought a third car since my older sister was now driving. Because he had what I now recognize as a blossoming mid-life crisis, he pulled into the driveway in a sporty, low-slung, forest-green convertible thinking that he’d bagged a two-fer. This car was a Fiat Spyder and it looked fabulous, the best that he could do with the money available.
We soon learned that the joke that Fiat was really an acronym for “Fix It Again, Tony” and it was a car that demanded unrelenting vigilance and discipline, more than any car that we’d ever owned. It was a mechanically unforgiving vehicle and if it wasn’t assiduously maintained it would wind up at the shop. There were times it went in despite his best efforts. Because the engine didn’t like the Pennsylvania winters, he kept it in the garage and covered the engine with a canvas tarp to protect it. So the morning routine was to enter the garage, lift the lid and remove the tarp, recite a Hail Mary and turn the key.
This car remained in the family until one late winter morning when Mom needed to drive it. She was running late so she jumped in the Fiat for a quick run to the bank. She sat waiting in the drive-thru lane when she noticed the window teller banging on the glass and yelling at her while pointing furiously at the hood. Mom glanced ahead to see that smoke was billowing out from under the hood where the tarp – which hadn’t been removed – had caught fire. After the tarp went up, the engine soon followed and within minutes, there was a toasted Fiat blocking the bank’s window lane.
Fiat: A Currency As Well As a Car
Our dollar, as are all of the world’s currencies, is called a fiat currency. It isn’t an acronym, but actually the latin term for “faith.” Each currency is considered a fiat currency because it is backed only by the globe’s faith and confidence in the ability and will of that particular country to support it in terms of competitive ability, resources and capacity to service its debt. That faith is demonstrated in the daily global transactions involving the buying and selling of the various currencies. All manner of entities engage in currency transactions – companies, banks, hedge funds, individuals and central banks – and it’s the point at which what buyers are willing to pay versus what sellers are willing to accept that the valuation occurs. And with globally networked computers, valuation occurs quickly and widely. Because the Norwegian Krone is used by a country with solid governmental finances and an oil exporting economy, the world demonstrates its respect by valuing their currency higher than Argentina’s, whose government burned international investors by defaulting on its debt. It takes far more pesos to buy one krone now that it did ten years ago.
That’s the key to my father’s Fiat and today’s currencies. Fiat currency is based to a significant degree upon the perception and faith of others. Maintaining that faith and supporting that perception requires a large degree of self-discipline and vigilance on the part of the owner to assure that it continues to be deemed worthwhile by others. If a country gets a poor valuation, like the Italian car, then the global economies vote against it in valuation.
How Did We Get To a Fiat Currency?
For many years, the American currency – like all of its peers – was backed by gold and silver and its control was mandated in the Constitution. What that literally meant, after paper notes were issued during the Civil War, was that the holder of a dollar bill was able to go into any bank and trade that paper dollar for a fixed amount of gold or silver. People learned to accept the dollars because the amount of metal was fixed and also because it was simply easier to carry paper bills than deal in gold. Because the dollar was thus backed by the metal for which it could be exchanged, it had a steady store of value that buoyed the people’s confidence in it as a currency.
This gold standard was a staunch enforcer of discipline upon the international markets. If America purchased more from England in 1866 than vice-versa, England could take all of the dollar bills it had received and return them to the US Treasury for an equivalent amount of gold from the government’s vaults. Consequently, the US Government then had less gold than could support the number of its own dollars in circulation and ran the risk of default should enough citizens opt to trade paper for metal. Dollars would then have to drop out of circulation and the result was less money for the citizenry. Countries had to live within their means or find new ways to grow wealth.
We’re not finished with the gold standard yet, but we need to cover something else first that will make the final days of the gold standard make sense.
What’s a Global Reserve Currency?
People generally believe that simpler is better and that view even runs to the handling of international financial transactions. To keep from having to constantly recalculate the value of one currency to another in international transactions, banks and merchants long ago opted to assure that international transactions were usually handled in one currency only. This is referred to as the Global Reserve Currency (GRC) and it’s a role presently held by our dollar because it serves as the medium of exchange for almost all international business transactions.
The status of GRC is bestowed by the world upon that currency which, in its view, is the steadiest and best able to weather the various storms – political, economic, natural – that occur. The dollar became the GRC at the end of the Second World War after a meeting of allied financial leaders at Bretton Woods, which lent its name to the ensuing agreement that formalized it. At that time, the US was literally the last country standing after a second global world war which devastated dozens of nations and exhausted the country with the GRC, Great Britain. It was agreed that going forward, all international transactions would be handled in dollars.
Remember something. The dollar was now the GRC but it was still backed by gold. The dollar’s status as the “anointed one” was only peripherally related to its gold backing and it hadn’t yet become a fiat currency. At that time, the US had roughly 20,000 tons of gold in its vaults at Fort Knox and elsewhere.
This gold-backed GRC system lasted for almost thirty years. And in that time, the country began to persistently run trade and government deficits so that we were sending more dollars overseas than we were bringing in from elsewhere. Our standard of living rose dramatically and we dreamed big dreams and tackled big projects but that meant that periodically, our gold flowed out of Fort Knox. Financing the Vietnam War, the Great Society and the Space Program took huge sums, and those dollars were returned by foreigners for gold.
Gold to Fiat
Around 1969, the US Government started acknowledging that the US was going to eventually run out of gold if things weren’t brought under control. There was yet another meeting of international finance ministers and they hashed out what’s now referred to as Bretton Woods II. In this agreement, the dollar – still the biggest kid on the block – continued to be the GRC but it was agreed that all of the world’s currencies would “float” in valuation against one another and gold would no longer be used to back the store of value as it had. Those valuations would be set by tracking transactions within the global markets and updated by computer, which now made this possible. The dollar’s value now floated against other currencies, which was good because we’d lost over half of our gold reserves in the preceding thirty-odd years. If the US handled our economy and budget well, the dollar’s value rose against other currencies. The flip side was that if our country didn’t pay attention, exercise discipline and maintain our fiat, it would eventually become toast as others punished it in the global marketplace.
So What Do You Need To Remember Going Forward?
- The dollar is a fiat currency with a value based solely upon the willingness of countries worldwide to accept it. That means that their perceptions, beliefs and biases play a major role in how well it holds value – especially to pay for things like oil.
- The dollar is the Global Reserve Currency, which means that almost all of the world’s business transactions occur in the dollar. It also means the dollar’s value is determined not just by folks in this country, but again, by others throughout the world.
- Financial systems can change and if there’s a pressing enough reason, change quickly. We went through two massive changes – Bretton Woods I and II – within a thirty year period. It might seem like a long time personally, but in history’s timeframe, it’s the blink of an eye.
- Covering a Fiat with a tarp is ultimately bad for the Fiat.
Thanks to Jesse at Jesses Crossroads Cafe for reviewing this article. Any errors are mine only.
Next Article from Don Harrold: Markets and the Law – The Gov, the Fed and the Goldman
Image credit: Paul Sapiano