- Aug 17, 2011
The Real Thing
Adam Smith captured the essence of paper (or fiat) money—the promise that it can be exchanged into real goods and services:
- When the people of any particular country has such confidence in the fortune, probity, and prudence of a particular banker, as to believe he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them.14
Paper money is now the dominant currency, and the dollar is the dominant form of paper money. The word derives from a large silver coin worth three German Marks—taler. American economist John Kenneth Galbraith observed that: “If the history of commercial banking belongs to the Italians and of central banking to the British, that of paper money issued by a government belongs indubitably to the American.”15
The U.S. dollar is sometimes referred to as the greenback, a reference to the green-inked backs of one of the first currencies authorized by the Legal Tender Act of 1862 during the U.S. Civil War. Greenbacks were not convertible into anything but constituted legal tender, that is, a creditor could not legally refuse to accept them as payment for any debt.
The current dollar, introduced in 1914, is three-quarters cotton and one-quarter linen. Approximately half the bills are one dollar denominations. The average life span of a bill varies—a $1 note lasts a mere 18 months whereas a $100 bill can last several years. Each bill is designed to be folded 4,000 times before it tears. Four hundred and ninety $1 bills weigh 1 pound(454 grams). One million dollars in $1 bills would weigh more than one ton. One trillion dollars in $1 bills would weigh one million tons.
Less than 8 percent of all dollars are in the form of paper money or coins. The vast majority of dollars exists in the form of entries in the accounts of borrowers or lenders. Paper money is an abstraction or, as most of it does not exist physically, the abstraction of an abstraction. Its sole reason for existence is as a medium of exchange. There are no limits to the amountof money that can be created.
Paper money can be easily damaged or destroyed. There is counterfeit money—a fake imitation of real money passed off as the real article. The real problems with paper money are subtler. As Baron Rothschild once boasted: “Give me control over a nation’s currency and I care not who makes its laws.”
In 1716 John Law, a self-taught banker, inveterate gambler, and convicted murderer, established the Compagnie d’Occident (the Mississippi Company) to exploit the wealth of Louisiana, then a French colony. In his pamphlet Money and Trade Considered with a Proposal for Supplying the Nation with Money, Law advocated using paper money to create wealth.
Law’s Banque General printed money by lending large sums to investors to purchase shares of the Mississippi Company, so driving the price higher. The vast quantities of paper money were supposedly guaranteed by reserves of gold coin. Law, now the duc d’Arkansas, actually issued paper money equal to over twice the gold available in the country. He was using the two companies to create vast fictitious profits for both. The pyramid scheme, where investors in the Mississippi Company received profits from subsequent investors, eventually collapsed. Today, governments have a monopoly in printing money.
Fear of reduction in the value of paper money meant that it was backed by gold for much of its history. The strange thing is that gold has almost no value as a commodity and is not itself a great store of value.
In 2009, gold bugs excitedly speculated about gold prices reaching $2,300. Even at that price gold would merely match its January 1980 value, after adjusting for inflation. The holder had earned nothing on the investment over almost 30 years! The gold price in 2010 adjusted for inflation was the same as the price in 1265. Dylan Grice of Société Générale summed up the case for gold as a store of value:
- A fifteenth-century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 percent over the next 500 years.16