Is the FIAT CURRENCY System Doomed? | Where Does Money Come From?

Where Does Money Come From?

If there is a financial crisis, the government comes up with a stimulus plan to revive the economy. The latest is a $1.9 trillion package to help overcome the effects of the Covid pandemic. Have you ever wondered how it is possible to get that much money so quickly? One of the reasons is that no physical, finite comodity backs the US dollar.

The value of the US dollar is based only on the full faith and credit of the United States. This makes it much easier for the US to increase its debt and resort to expansionary policies. Critics consider this damaging and predict that another economic crisis is looming and inevitable. Defenders believe the economic damage would be bigger if nothing were done.

 

 

The Historic "Gold Standard" & Fiat Currency

Meanwhile, debts skyrocket and some people even advocate going back to the "gold standard". How did we get here? Let's take a look. Since officially abandoning the gold standard in 1973 by President Richard Nixon, the dollar became the standard (paper) currency by which most other world currencies are valued and is what economists call a fiat currency (money). The word "fiat" comes from Latin and is often translated as a decree, but in summary, the term means that the money is not backed by a physical asset, like gold or silver.

 

 

Pretty much every currency in the world is fiat money, and their value fluctuates in relation to each other. Having a currency with no physical backing makes it easier for governments to control the supply of money. For example, this is helpful in moments of crisis and recession when governments resort to measures to inject more money and revive the economy. Where there's an upside, there are also downsides: some economists see this as the main disadvantage of the system.

 

 

Government Bond Issues

To understand both sides of this concept, let's take a closer look at where the trillions of dollars that are part of corona relief packages come from. To afford this amount of money, the government needs to create more currency which increases its debts dramatically. One of the ways of doing that is by issuing bonds. Government Bonds are debt securities, instruments used to raise more money and support the government's spending obligations.

 

 

Bonds are basically a legal document in which a lender, like a bank, agrees to lend money to the government, and in return, the debt can be repaid at a later date with interest. Depending on the country the bonds are issued in, the interest rates vary as do the dates that that the Bonds need to be repaid. In the case of the United States, the Treasury Department sells the issued bonds through auctions held throughout the year. Issuing bonds is a standard procedure.

 

 

The US Federal Reserve

In normal circumstances, there is a market to absorb the bonds without a big fuss. However, when we are talking about sa udden injection of trillions of dollars, things are not that simple. The role played by the Federal Reserve, also known as the Fed, is what makes the process very controversial. In theory, the Fed is privately owned entity independent from the US Government, and its main goal is to promote maximum employment, stable prices, and manage long-term interest rates in the United States.

 

 

But in extraordinary cases, such as the economic relief packages, the Fed also functions as a buyer, buying up most of the government bonds issued. In the first Corona Virus Relief package during Donald Trump's presidency, the Fed signaled its willingness to essentially buy an unlimited amount of government debt. The Fed is not allowed to buy bonds directly from the government. It needs to buy on what is called open market operations.

 

 

Open Market Operations Bond Sales

Government Bonds can be bought from the so-called primary dealers. This includes the big banks and brokers, like J.P Morgan, Goldman Sachs, and others. For example, once the Fed buys the equivalent of one trillion dollars in bonds from these institutions, it injects the same amount of money into the bank reserves, facilitates lending and increases the fiat (paper) money supply in circulation. This is "conjured up" direct (fiat/paper) money being injected into the economy, money that didn't exist until the Fed bought the bonds. Moreover, the Fed is no ordinary bondholder. By law, it has to pay its profits to the Treasury.

 

 

At the end of the day the Treasury pays interest on bonds, this money generated by bonds then become a profit and goes back to the government. At the same time that the Fed acts on open market operations, it also cuts its benchmark interest rate, reducing the cost of borrowing. When businesses and people borrow more, it stimulates the economy also increases the amount of money in circulation. For the critics, these measures are illegal and developed to stimulate the economy. They are considered as just loopholes in the system, an unofficial way of creating an endless supply of money out of thin air, without actually printing it.

 

 

Inflation, Devaluation, Economic Collapse & The Fed

There is risk to long-term stability and can lead to inflation, devaluation of the dollar, and eventually, the collapse of the economy. The big question is… is the Fed over-stimulating the economy with open market operations?

To understand the situation, it's possible to look into the Fed's balance sheet, which consists of assets (like bonds) and liabilities owned by the bank. The total amount went from 4.1 trillion dollars in the last week of February 2020 to 7.5 trillion in the first week of February 2021. Not all of these are government bonds, but this number gives us an idea of how much the Fed had been acting during this crisis. Since the dollar is fiat money, there are no limits to issue debt and also no limits for the Fed to act and buy the bonds to continuosly supply the government with more fiat money. The effect being that as more paper dollars are made available in distribution it eventually reduces its value.

 

If the United States had a currency backed by something tangible, the Fed would not be able to rapidly expand the money supply to such an excessive amount currently seen in the US economic balance sheet. For example, if the Fed tried to do that while on the gold standard, it would cause the dollar value to fall due to oversupply, compared to its gold parity, and compromise the foundation of the system.

Many economic experts warn that this model is putting us on a trajectory of crisis and the collapse of the "greenback" is inevitable. So again, in a nutshell: This is  how the cycle of collapse would work:   Everything starts with the currency backed by a  physical asset.

The Economic Function of Gold

In the cas of the US Dollar, until 1973,  it was backed by physical Gold. The precious mineral gave value to currency and created a level of confidence that led to the worldly expansion of commerce and credit.  But, with currency attached to gold, there is a limit on how much credit it is  possible to generate. Plus the system is affected by the amount of gold able to be mined in the world and it becomes very exposed to speculation as the country needs to always keep its currency value in parity with the gold reserves.

This limitation led to the idea that backing the dollar with gold (the gold standard) was restrictive. A country then leaves the "gold standard" system. Then the fiat model is introduced through a decree (remember what FIAT means?). What follows is euphoria.

The country's monetory system is then easily flooded with liquidity. Stimulus packages, increasing spending in many areas and increasing trade. This leads to frivolous monetary abuse. Governments start spending more "money" than they hold and monetizes even more of their debts to fund their obligations.

History shows us how, slowly at first, economic growth starts to decline and confidence starts to fade. Inflation begins rising. All monetary confidence is lost. Hyperinflation follows and the economy collapses.

A new government creates a new system with a new currency backed by a physical asset. The cycle begins anew.

The Future of The US Dollar

Critics believe we are currently at a stage where the US government, and the US dollar, is starting to lose the confidence of other countries. Inflation inevitably will continue to rise and be followed by hyperinflation and financial collapse.

But is there any truth behind this pessimist view? Well, there isn’t a consensus. But it’s fair to say that the majority of economists would disagree   with the forecast. One of the most critical of these views is Nobel Prize Laureate and New York Times columnist Paul Krugman. As proof that  pessimism is unfounded, he points to the aftermath of the 2008 financial crisis.

From the start of the economic crisis until 2014, the FED’s balance sheet also grew exponentially, more than 4 trillion dollars. And still, inflation stayed low. Krugman believes that the risks aren’t any greater now. He believes that for the most part, the funds that the Fed injected into the economy simply piled up either in the bank reserves or in cash held by individuals and are not harmful.

The Fed's latest bond-buying spree is an evolution of what began as finding acceptance, considered normal during the 2008 financial crisis. Ben  Bernanke, former chair of the Fed during that time, also hit back at the critics. For him, what the Fed was doing wasn't printing money to finance government borrowing, but a temporary measure that would be reversed. He advises that eventually, the FED sells the bonds it acquired and things go back to normal.

Although they both believe the practice isn’t harmful to the economy long term, it’s important to point out the growing level of debt in the United States. According to the Congressional Budget Office, 2020 was the first year since 1946 that the country’s debt exceeded the size of the entire economy. The US had a total debt held by the public of 21,019 trillion, the equivalent of 100.1 percent of GDP.

In 2021, the number was projected to exceed 22,4 trillion dollars,102.3 percent of GDP. They also projected that the debt would represent 107 percent of GDP by 2031 when it should surpass 35.3 trillion dollars.

Does that mean that there is no way out of the crisis and a collapse is about to happen?

We will have to wait and see… interesting times ahead!