Editor’s note: This is the second installment of the series in which we are looking at how money evolved, with the aim of helping people understand why cryptocurrencies are the next in line. You can read — you should actually — the first installment here.
The move to Fiat money finds its root in the huge need of improved trust and transparency
The first installment talked about how governments started issuing promissory notes called IOU in order to ease the trade process for travelers who needed to earn the trust of foreigners.
But, like every medium of exchange before it, IOU had its own limitations too. For instance, IOUs weren’t designed to inherently imply the time, date, interest and payment type when they were issued. As international trade grew, standardized currencies started surfacing around the world to solve this problem. Still, precious metals (mostly gold) remained the backbones of the newly standardized currencies, with the precious metals usually kept in state-owned vaults. This system of money issuance was called gold standard.
Let’s make it clear at this point that the Fiat currencies we use today resulted from various events — wars for instance — that simply meant that governments around the world needed to take measures to grow their economies. Since we’re taking a simplistic look at the evolution of money, we’ll leave the politics aside and focus on the fundamental issues that brought about the Fiat currency.
At its core, pegging the value of a currency to gold or any other precious metal meant that there’s a limit to the quantity of the currency you can have in circulation, at least in theory. It also meant that the value of a nation’s economy was proportional to the amount of gold it held. One problem with this system is that the value of a nation’s money goes beyond gold since gold production isn’t the only (and possibly not the largest) economic activity that happens in the country.
Because the supply of gold and other precious metals is limited and human want is insatiable, it was never completely possible for governments to back the entire quantity of the money in circulation up with gold, which always posed the risk of inflation, overvaluation and the government being in perpetual debt.
Here’s a real-life example of the limitation that gold-currencies had.
In 1944, 44 nations gathered in Bretton Woods, New Hampshire, for the United Nations Monetary and Financial Conference with the aim of rebuilding the international economic system that the then-ongoing World War II had shattered. One of the resolutions from the conference was the Bretton Woods system, which instituted a fixed exchange rate system and the U.S. dollar becoming the reserve currency.
The U.S. dollar was chosen as the reserve currency because the U.S. controlled about two-thirds of the global gold supply. In addition, the United States accounted for about 35 percent of the global economic output. Being the reserve currency meant foreign currencies were tied to the U.S. dollar and the U.S. dollar tied to gold. Countries could exchange their dollar holdings for gold at the rate of $35 per ounce. At its core, the system was supposed to establish a transparent and single exchange rate system to discourage anticompetitive practices amongst nations.
However, as other economies recover, notably Japan and Germany between 1950 and 1969, the contribution of the U.S. to the global economic output dropped to about 27 percent. This meant that foreign nations needed fewer dollars and more of the yen, Deutsche marks and francs. The drop in the dominance of the U.S. on the global economy plus its spending on the Vietnam War meant that foreign nations had huge reserves of the U.S. dollar that they are not spending back to the U.S. because they were buying goods from other places.
By 1966, foreign central banks had about $14 billion in their reserves, while the United States held only $13.2 billion worth of gold. Interestingly, only $3.2 billion of that reserve could cover foreign holdings. The remaining $10 billion holding was meant for the domestic holding. The U.S. deficit would grow to about $7 billion and the U.S. had to deal with serious inflation. To help stabilize the U.S. economy and the dollar, the Undersecretary for Monetary Affairs, who was charged with the monitoring of gold and other international exchanges, pressed European countries to revalue their currencies. This started a series of events that ultimately led countries to start trading their dollar holdings for gold and ultimately abandoning the Bretton Woods system. Seeing the shortcomings of the Bretton Woods system, the U.S. led by President Nixon abandoned the dollar-gold link in 1971.
The value of major world currencies would now be tied to the strength of the issuing economy, which is how we came about Fiat currencies. If you look closely, you’ll find that the need for improved trust and transparency is at the core of the movement from the gold currencies to Fiat currencies.