Currency in Question

Fiat money is being questioned

All of the uses of fiat money are currently being called into question in one way or another.  For example, economists long since discarded the notion of currency as a reliable measuring stick for a great many purposes.  They have developed alternatives such as constant dollar value, trade adjusted value of the currency, and, of course, the ECONOMIST’s “big Mac index.”

The contradiction between enumerating “store of wealth” as a function of the currency, while using deflated or constant dollar values when measuring across time, does not seem to bother economists.  But it is not just the store of wealth role of money that is being questioned.  The alternative measures listed above imply that its role as a medium of exchange between countries is in question.

The ability to retain conflicting views on the same subject is not unusual.  Interestingly enough, it often surfaces in connection with efforts to defend a fiat money.    For example, an article in the WALL STREET JOURNAL entitled “A Golden Solution forEurope's Sovereign-Debt Crisis,” pointed out that many sovereigns in southern Europe could reduce their borrowing costs by securing the loans with their gold reserves.  The whole issue arises as a part of the effort to defend a fiat currency, the euro. 

So, essentially, the article points out, the euro could be defended by having it abandoned for some purposes of a currency: for borrowing costs to be lower for gold-backed debt versus debt backed by the sovereign government, buyers of the bonds have to believe the wealth preserving value of the gold is better than the wealth-preserving value of the sovereign backed fiat currency.  Part of this is a questioning of the trustworthiness of the sovereign, but there is undoubtedly also an element of distrust of fiat currency.

The issue was raised in connection with southern European countries with large amounts of debt and large gold reserves.  So, undoubtedly the focus was on the trustworthiness of the countries.  But it would be naïve to assume that the distrust does not reflect upon the currency.  Basically, it reflects a belief that there is some probability that no entity will step in and honor the value of the currency implied by the debt.  In that respect, it is the currency that is in question.  Further, while the article focuses on southern European countries, the same issue has been raised in connection with other countries not in the Euro Zone.  At its extreme, entities are forced to issue bonds in a foreign country’s currency. The issue has receded in the background now that the European Central Bank seems to be indicating that it will step in to honor the debt.

In the example of the southern European countries, the proposal would result in one currency being used to pay taxes within the sovereigns, and a second currency, gold, being used to secure debt.  Further, since a substantial portion of that debt is held by other sovereigns or their proxies, the banks, it would move the medium of exchange between sovereigns toward gold rather than the fiat currency.  Put differently, barter between sovereigns would be carried out in gold if it involves a transfer across time.

Europe is not alone in experiencing a questioning of the role of fiat currency.  The WALL STREET JOURNAL on August 29, 2012 had an opinion piece entitled “The Gold Standard Goes Mainstream.”  It pointed out that the major political party in the US was calling for a Gold Commission.  Now, as we all know, government commissions often are nothing more than a showcase for politicians who like to hear themselves talk.  But it is worth noting that the topic they are talking about is the abandonment of fiat currency.

The opinion piece tries to make some sense of this.  Those readers interested in their interpretation of this should review the opinion piece.  However, an obvious interpretation of the very existence of the opinion piece is that a substantial number of people in the US are fed up with the failings of fiat currencies and looking for alternatives.

More direct and broad-brush questioning of the medium of exchange currently in use was advanced by Stephanie Pomboy, founder of MacroMavens, in an interview in BARONS (July 21, 2012).  The article was entitled “Coming: The End of Fiat Money” which leaves little doubt about the major focus of her comments.

She also makes it quite explicit by stating: “I don't see it in the next 12 months. I think a five-year time horizon is very, very realistic. I envision a gold-backed currency system. We are going back to hard money, rather than a fiat system where debtors can silently default by inflating their debts away.”

One does not need to go so far as to depend on a forecast.  The first time the statement was made by Pomboy, gold was trading in the 1570's.  Subsequently, the price in terms of fiat money has gone up.  Since gold has very little value other than as a medium of exchange and store of wealth, that price change reflects a decrease in the role of fiat money as a medium of exchange and store of wealth.  Of those functions, Pomboy’s focus is on investing as is reflected in her statement, “I would own gold [and] companies tied to mining.”

Further, one doesn't have to adopt Pomboy’s conclusion that gold will become the substitute for fiat money.  She could be totally wrong regarding gold.  Her comments reflect the growing trend toward questioning fiat currencies regardless of whether gold is a viable substitute.

Pomboy could well turn out to be partially right.  Fiat money may cease to function as a store of wealth and be replaced by gold or some other mechanism.  However, as discussed in a previous posting, “When a Currency Is Working, It Isn't Questioned,” the “store of wealth” role of a currency may be the least important of the three functions that economists often cited.  Further, it should be clear that the Hedged Economist believes that the only true store of wealth is the acquisition of something that produces wealth in the future.  No money in existence or ever conceived fills that role.

The examples above harken back to a past time when gold served as a currency.  One doesn't have to be a gold bug to question fiat currencies.  In fact, one can just question how fiat currencies are being managed without advocating an alternative to fiat currencies.  That is exactly what was reported in the WALL STREET JOURNAL on December 23, 2012.  The article was entitled “Global CurrencyTensions Rise: Japan's Abe Calls on Central Bank to Resist Easing Moves by U.S.and Europe.”

Although the title makes reference to Japan’s complaint about how fiat currencies are being managed, it references a number of other similar complaints and actions.  In fact, the general theme of the article is best summarized by a quote. It is from a presentation by Mr. King, a UK official.  He commented:  “I do think 2013 could be a challenging year in which we will, in fact, see a number of countries trying to push down their exchange rates. That does lead to concerns.”  He went on to say: “The policies pursued by countries for domestic purposes are leading to tension collectively.”

Such complaints are not new to international relations.  However, what does seem to be new is that a significant number of countries are acting upon their concern.  Further, their actions sometimes involve the use of a non-fiat asset as an alternative to fiat money for reserves.  US citizens, because it became a political issue, are well aware that China manages its exchange rate.  It has been an object of global criticism for its efforts to hold down the value of its currency.  China's purchases of reserves of commodities have become an important determinant of world prices and are closely followed by commodity investors.

But now a number of countries long committed to allowing the value of their currency to be determined by the market feel it is necessary to intervene.  They include Switzerland, Israel and South Korea, along with others like Brazil that do not have as long history of commitment to fiat money for actual trade. Policy makers in Australia also are under increasing pressure to fight the rise of the Australian dollar.  An article published on January 8, 2013 highlighted how unusual the current situation is by the very title of the article: “Button-Down Central Bank Bets It All.”  It went to some lengths to describe how unusual the behavior of the Central Bank of Switzerland has been. 

One should also note that governments’ use of gold as a part of its reserves has been rising.  In fact, there are observers who attribute a substantial portion of the rise in the price of gold to the efforts of governments to expand their gold reserves.  In a curious twist, if that is true, the governments' efforts are probably contributing to the demise of fiat currency.  It is highly likely that the rise in the price of gold calls attention to the failures of fiat currencies.

These currency disputes are currently within the bounds of just being tension.  One is free to attach their own level of significance to the fact that the tension is surfacing in the form of disputes about fiat money.  But it is hard not to believe that if enough countries are dissatisfied with the existing fiat currency system, an alternative will be found.  That alternative may be another fiat money, but that is not guaranteed.

On a totally different front, Barron's cover on December 31, 2012 highlighted an article entitled “The End of Cash?” In this article, it is the use of fiat currency as a medium of exchange that is questioned.  The article points out that “fewer and fewer Americans use cash to make purchases large and small…” The article explains that “while cash in circulation is growing, it is becoming increasingly marginalized for retail transactions. This year, greenbacks will account for an estimated 29% of U.S. retail payments, according to McKinsey & Co., down from 36% a decade ago.”

As the article explains.  “Having already vanquished checks, the two big payment networks, Visa (V) and MasterCard (MA), are even more focused on displacing cash.”  The article also points out that there are: “A wave of relative upstarts … beginning to garner attention, particularly as so-called digital wallets take hold. The eBay (EBAY) unit PayPal, Google (GOOG) Wallet, and Square are all plays on the digital wallet, essentially a locker of personal-payment data stored either in the cloud or on smartphones. The wireless carriers are also fighting to get into the game by controlling the secure chips that are becoming common in smartphones.”  Discover and American Express also compete to replace currency as the medium of exchange.

However, all of these competitors use currency as the measure of value.  The Hedged Economist would contend that as long as the fiat currency is used to measure value, these substitutes do not constitute a challenge to the fiat currency.  Thus, since the role of currency as a measure of value is not questioned, the article’s implications are indirect. 

A logical question is: How this differs from checks as a substitute for dollar bills, or for that matter, how is it different from the decision to issue a dollar coin rather than a paper dollar?  If one wants to understand how this relates to currency, it is necessary to go beyond just the methods being used to pay for transactions.  One has to look at the ways the transactions are being financed.

Keep in mind that many brokerage firms, including Fidelity and Schwab, offer credit cards linked to brokerage accounts.  In essence, the transaction is financed, not off of future income, but off of capital in the form of income-earning assets.  While still denominated in dollars, the transaction is secured not by gold or the government's guarantee, but by an income-producing capital investment.  Further, remember that the accounts the credit cards are linked to may allow margin borrowing.  This certainly represents something very close to the equivalent of the banking system’s fractional reserves.

Granted, the relationship between currency and these new forms of paying for transactions is indirect, but, basically, people are issuing their own currencies through the use of their brokerage account linked credit cards.  It bears a striking resemblance to the development of fractional reserves currency by individuals.  Fractional reserve banking was the original source for fiat currencies.  One should never forget that the first dollar bills, pound sterling, etc. were issued not by governments but by individual banks. 

A more direct challenge to fiat currency is appearing on the Internet.  The Hedged Economist recently received an inquiry about a clear effort to develop a new fiat currency.  The inquiry related to Coinbase.  Coinbase issues Bitcoin which is a new digital currency that is being used all over the world. 

It is interesting, although it has some of the markings of an affinity-based Ponzi scheme.  Despite that, it is worth close observation because it makes for very easy barter. As the ECONOMIST article referenced in the previous postings points out, "The origin of money is a response to barter costs, in which the best money is that which minimizes the costs of trade."  The person who forwarded the inquiry was told that about $25M USD is traded a day, and personally knows of several business that accept it.  So, to the tune of $25M USD, Bitcoin is serving as money.

Interestingly, Bitcoin's challenge to currency also includes an element focused on the role of currency as a store of wealth.  That challenge as a store of wealth is introduced by the fact that they have pre-announced how much additional currency will be issued.  To those familiar with the relationship between the value of money and the supply of money, that represents a definite challenge.  Coinbase will be issuing a pre-announced dollar value of the Bitcoins.  If their rate of issuance is less than the Central Bank’s rate of issuance, the dollar value of each Bitcoin could increase.  If that is done without impeding its role as a medium of exchange, it could become a very appealing currency.

Nothing in this posting or the previous two (“When a Currency Is Working, It Isn't Questioned” and “Currency and the Role of Government”) represent an endorsement of the positions noted.  Regarding gold, The Hedged Economist’s perspective has been the subject of a number of postings.  Hopefully, this posting is clear regarding other substitutes for fiat currency that it references.

Any discussion of the future role of fiat currency contains a forecast.  As has been discussed in The Hedged Economist, forecasts are always scenario-based.  What is significant about the questioning of fiat currency discussed in this posting is that it reflects the fact that a large number of people can see a variety of scenarios under which fiat currency will lose its luster.  The sheer fact that so many observers can see so many different scenarios under which fiat currency is called into question is in-and-of itself significant.  Thus, even without a full scenario it is possible to determine some characteristics of how our fiat currency system will change.  That will be the subject of the next posting.