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As concluded in chapter 2, between 1914 and 1971, the global monetary system gradually and messily moved from the gold standard to the fiat standard. Governments effectively took over the banking sector everywhere, or the banking sector took over governments, depending on who you ask. Details of who wore the pants in this relationship are of no concern to this book, which wants to instead analyze the spawn of this marriage: fiat. This is not a history book, and the historical details behind the development of fiat will not be dwelt upon extensively, in the same way The Bitcoin Standard did not dwell on the history of the development of the bitcoin software. Both books instead look at monetary systems as they are operating in practice, setting aside the complex politics and computer engineering that has given them their current shape.
A good functional study of fiat allows us to posit this definition: Fiat is a compulsory implementation of debt-based centralized ledger technology monopolizing financial and monetary services worldwide. As illustrated in the previous chapter, the fiat standard was born out of the need for governments to manage their de facto default on their gold obligations. It was not consciously designed to optimize the user experience of currency, transactions, and banking. With this in mind, this chapter takes a closer look under the hood of the monetary technology powering most of the world’s trade today.
Contrary to what the name suggests, modern fiat money is not conjured out of thin air through government fiat. Government does not just print currency and hand it out to a society that accepts it as good money. Modern fiat money is far more sophisticated and convoluted in its operation. The fundamental engineering feature of the fiat system is that it treats future promises of payment of money as if they were as good as present money, so long as they are issued by the government, or an entity guaranteed a lending license by the government.
In the bitcoin network, only coins that have already been mined can settle transactions. In a gold-based economy, only existing gold coins can be used to settle transactions. In both cases, it is possible for a seller to hand over their present goods in exchange for a promise of future bitcoin or gold, but it is a risk they take personally, and if the buyer fails to provide the coins, the buyer gets to keep the good and the bitcoin. With fiat, government credit allows nonexistent tokens from the future to be brought to life when the loan is made, allowing the borrower and lender to both have access to the same financial resources.
Having been born out of government default, the essential characteristic of the fiat standard is that it uses the decree of government as the token of value on its monetary and payment network. Unlike with a pure gold standard or with bitcoin, the supply is not a set objective number of units being traded between network members. The units are ephemeral, constantly being created and destroyed, and their quantity is dependent on a subjective choice of which imperfect definition of money one uses, making it virtually impossible to obtain an objective agreed upon measure of the supply of money, or to audit the supply, as is the case with bitcoin. Since the government can decree value on the network, it effectively makes its own credit money. As the government backs the entire banking system, this makes all credit issued by the banking system effectively the government’s credit, and so part of the money supply.
Blurring the line between money and credit makes measuring the supply practically impossible. In a payment system like gold or bitcoin, only mature money (or money of full maturity, meaning money that does not have a future period of maturity at which it acquires its full liquid value) can be used to settle payments and debts. Under a fiat system, money that has not matured, and will only do so in the future, can be accepted as a payment, so long as it is guaranteed by a commercial entity that has a lending license.
At any given point in time, any financial institution with a lending license is able to bring new fiat tokens into existence and use them for meeting its financial obligations, or those of the borrower. When a client takes out a $1,000,000 loan to buy a house, the bank does not take an already existing mature $1,000,000 from its existing cash reserves, or from the balance of a depositor at the bank. It will simply issue the loan and create the dollars that are used to pay the seller of the house. These very dollars had not existed the moment before the loan was issued, and their existence is predicated on the borrower fulfilling their end of the bargain and making regular payments in the future.
The house buyer’s promise to repay the bank the loan in the future allows the bank to issue fiat tokens which can be paid to the home seller in the present. No present goods are used in the home purchase; no saver had to set the tokens aside to give to the borrower to pay the house seller. The present good of the house is handed to the borrower without the borrower having to offer a present good in exchange. Nor is the house seller granting the credit to the borrower and taking the risk of default. The credit is granted by the bank, and the risk is ultimately borne by the central bank guaranteeing the bank, the loan, and the currency. Had the house seller granted the credit, he would be taking on the risk of default, and he would be giving up his present goods willingly, affecting nobody else. But by utilizing the fiat standard, the house seller receives his payment in full upfront, and the buyer receives the house in full upfront. Both parties walk away with present goods they can use in full, even though only one of these goods existed before the transaction takes place. New fiat tokens were created to allow this transaction, and to defer the risk of default onto all holders of the currency, and society at large.
If it were to be likened to bitcoin’s operation, we could say that the fiat network creates or destroys an amount of new tokens with each block equal to the amount of lending that has taken place, minus the amount of loans repaid and defaulted on. Rather than a set new number of coins being added with each block, as with bitcoin, the number that gets added in each fiat time period is the net result of debt creation, which can vary widely and could be positive or negative.
All three parties involved in this transaction are happy, so can such a system survive on the free market? This system appears favorable for the buyer, who is able to buy a home without having to pay the full price upfront. It appears favorable to the seller because it finances more potential buyers and bids up the price of their home. It also appears favorable to the bank, which can mine new fiat tokens at roughly zero cost every time a new lender wants to buy a house. But it only works by externalizing the risk to society at large, protecting the buyer, seller, and bank from default by having the government currency holders effectively take the loss through the inflation of the money supply. The sacrifice of the present good that allows both to spend can only come at the expense of the currency being devalued. The development of the fiat monetary system without free market choice, restricting the supply of goods, appears to be the only way such a system could survive for a long time.
Should a fiat system coexist with a hard money system in a free market, one would expect the rational investor would prefer to hold their wealth in the harder money which cannot be debased to finance credit. But even without the rational self-interest of the investor; the dynamics of inflation make it that a currency that is easily devalued will lose value over time next to the harder currency, and so, inevitably, in the long term, the majority of economic value will collect in the harder currency. But by monopolizing the payment networks necessary for the modern division of labor, governments can make currency holders take that risk for significant periods.
The fiat network is composed of around 190 central bank members of the International Monetary Fund, as well as tens of thousands of private banks, with many physical branches. At the time of writing, the fiat network has achieved almost universal adoption, and almost everyone on earth is either dealing with a fiat node, or handling fiat paper notes issued by such nodes. The Fiat Network is not voluntary and not optional; it can be best likened to mandatory malware. With the exception of a few primitive and isolated tribes yet to have fiat enforced upon them, every human on earth is assigned to a regional node where he or she must pay his or her taxes in their local fiatcoin. Failure to pay with the local fiatcoin can result in physical arrest, imprisonment, and even murder. This is an important driver for adoption which Bitcoin and gold lack.
The fiat network is based on a layered settlement system for payment clearance. Individual banks handle transfers between their clients on their own balance sheets. National central banks oversee clearance and settlement between banks in their jurisdiction. Central banks, and a few hundred international correspondence banks oversee clearance across international borders on the SWIFT payments network. The Fiat Network utilizes a highly-efficient centralized ledger technology with only one full node required to validate and decide the full record of transactions and balances. The entity is the United States Federal Reserve, under the influence and supervision of the United States Government. “The Fed,” as it is known to fiat enthusiasts, is the focal and central point of the fiat network topology. It is the only entity that can invalidate any transaction and confiscate any balance from any other fiat node. The Fed controls the SWIFT payment network and can prevent entire nations from joining this payments system and settling trades with other nations.
The fiat network’s base layer operates using a native token of debt denominated in United States Dollars. While it is common for fiat enthusiasts to think and talk of the network as having a variety of tokens, each belonging to a different country or region, the reality is that all secondary layer tokens are merely derivatives of the US dollar whose value depends on their backing in the US Dollar, and can best be approximated as the value of the US dollar with a discount equivalent to the country risk. For a variety of historical, monetary, fiscal, and geopolitical reasons, it has not been possible for any of the tokens to appreciate significantly against the US dollar in the long term. For all practical intents and purposes, national central banks managing their currency can either maintain its exchange rate with the dollar, or devalue it faster than the dollar.
The network’s native token, fiatcoin, is mined through an arcane, centralized, manual, risky, and haphazard process called lending. Obtaining a lending license from a central bank allows a miner (a financial institution) to issue debt, which results in the creation of new fiat tokens on the miner’s balance sheet. The difficulty of obtaining these lending licenses, and the difficulty of issuing new loans are determined through the complex web of rules and regulations generated by national governments, national central banks, the Bank of International Settlement, and the International Monetary Fund.
Unlike with bitcoin, there is no algorithmic adjustment to ensure the supply remains within known and clearly auditable parameters. With such primitive mechanism and without the digital and energy assurances of Proof of Work mining, the supply of fiatcoins continues to expand and contract globally at haphazard rates, with disastrous consequences. While the total supply of fiatcoins is unknown and unknowable, Chapter 6 discusses the process of fiat mining in more detail.
As a centrally-planned system, the fiat standard does not allow for the emergence of a free market in capital and money, where the interest rate, the price of capital, is determined based on supply and demand. The supply is ultimately determined by the extent of lending, which is in turn shaped by the interest rate and lending policy set by the federal reserve. The Federal Reserve System’s full fiat node holds periodic meetings for its central planning committee to decide the interest rate it charges the nodes it deals with, and all other interest rates derive from this and rise as they get further away from the central node.
While a small percentage of fiatcoin is printed into paper bearer instruments with local insignia, the vast majority of fiatcoin is digital, stored on the central node’s ledger, or on the ledgers of the peripheral nodes. The digital fiat network offers limited possibility for final settlement, as all balances are tentative at all times and partial nodes, or the full node itself can revoke or confiscate any balance on any ledger at any point in time. Withdrawing fiat in paper notes is one way to increase the finality of settlement, but that is also not final because the notes can be easily devalued by local fiat nodes, or the Fed’s full node, and because individual paper notes can always be revoked by the central bank.
The core functionality of the fiat standard lies in the functions of the network’s nodes. Under the fiat protocol, each central bank has these four important functions:
To perform these functions, each central bank has a cash balance, commonly referred to as the International Cash Reserve Account. This is the base-layer fiat token, which has the highest spatial salability, as it can be used to perform settlement between national central banks. In what is arguably the most catastrophic engineering decision in all of human history, this cash balance is used to perform four simultaneous functions, the intermingling of which is at the root of all financial and monetary crises of the past century. These functions are:
Each of these tasks is discussed in more detail below, before the implications of their co-mingling are examined.
There has never in history been an example of a form of money that emerged purely through government fiat. While statist economists like to speak of the state’s ability to decree what money is, central bank reserves’ existence strictly debunks that. No government is able to decree its own debt or its own paper as money without holding other assets it cannot print in reserve, and using them to make a market in its paper and debt obligations. Even if a government were to force its people to accept its paper at an artificial value, it would not be able to force foreigners to accept it, and so if its citizens want to trade with the world, the government must create a market in its currency in other currencies. Unless the government accepts foreign currencies in exchange for its own, then that market cannot emerge and its own currency is rendered worthless since nobody would want to hold it when they could hold other, harder currencies which have more salability across space.
Even through the century of fiat and supposed gold demonetization, central banks have massively increased their gold holdings, and they continue to add to them at an increasing pace. The fiat standard’s main reserve currencies are used to settle trade between central banks, but evidently central banks themselves don’t believe they have demonetized gold, and don’t trust in their ability to hold value into the future, and so they continue to include increasing quantities of gold in their reserves. All monies that exist today are issued by central banks that hold gold in reserve, or central banks that hold in reserve currencies issued by central banks that hold gold. This not only illustrates the absurdity of the state theory of money, it also illustrates the fundamentally unworkable nature of political money at an international level. If every government issues its own money, how can they trade next to one another, and at what value? Why would anyone accept the money of a foreign country?
All central banks back their currencies with international reserve currencies they cannot print. For most countries, this is the US dollar, and for the US, it is gold. At the end of the third financial quarter of 2020, the dollar constituted around 51% of global reserves, the Euro 17%, gold 16%, the British pound 4.8%, the Japanese Yen 3.8%, and the Chinese Yuan 1.7%, and other currencies had smaller shares. These currencies are used predominantly in international trade transactions, where the dominance of the dollar is even more pronounced. On the foreign exchange markets, the dollar is a part of 88.3% of all foreign exchange market daily trades.
The dollar is the base layer token of the world fiat network, and national currencies are derivatives of it. There are in total 180 national currencies in the world today, and the market value of each can best be approximated as the value of the US dollar plus country risk. No country has had its currency appreciate next to the US dollar for any appreciable period of time. Other than the dollar and euro, all other national currencies are used mainly domestically, on the secondary national fiat banking layers.
Central bank reserves also settle the international current account (which includes international trade transactions) and the international capital account (which settles international movements of capital). All international payments to and from a country have to go through its central bank, allowing it a strong degree of control over all international trade and investment. Central bank reserves are enriched when foreign investment flows into the country or exports increase, but reserves are depleted when foreign investment leaves the country or imports increase. As individuals across national borders seek to transact with one another, they must necessarily resort to a system of partial barter, as Hoppe termed it, wherein they need to buy a foreign currency before buying the foreign goods. This has led to the emergence of the enormous foreign exchange industry, which only exists as an artificial middleman to profit from the arbitrage opportunities generated by the ever-shifting values of national currencies. This also effectively makes the government and central bank a third party in every international transaction involving the citizens of the country with foreigners.
By having the national reserves of the country also used for the settlement of international trade, international trade is held hostage to the central bank’s successful management of its currency. Should the creation of debt increase quickly, the value of the national currency declines next to international currencies. If it tries to stabilize the value of its currency, the central bank would have to start losing its international reserves, compromising its ability to settle trade for its citizens. The problems of foreign exchange management have been the underlying cause of the drive to totalitarian governments.
Central bank reserves are what ultimately back the reserves of the banking system. The essence of central banks was to be the entity where individual commercial banks would hold part of their reserves in order to settle with each other without having to move physical cash between their headquarters. With a fractional reserve banking system, the central bank also uses its reserves to provide liquidity to individual banks facing liquidity problems. This means that credit expansion by the banking system that leads to a boom and then an inevitable credit contraction will be remedied by the central bank using its reserves to support illiquid financial institutions, in effect increasing the money supply. Although the banking system in each country primarily deals with the local currency, the central bank nonetheless makes a market in its currency and foreign currencies, and when its own currency’s supply increases from credit expansion while the foreign reserves remain unchanged, the currency would be expected to depreciate compared to foreign currencies.
The modern central bank and government song-and-dance routine adopted over the world involves the central bank using its reserves to purchase government bonds, thus financing the government. Central banks are the main market maker in government bonds, and the extent of a central bank’s purchase of government bonds is an important determinant of the value of that national currency. As a central bank buys larger quantities of its government’s bonds the value of the currency declines, since it funds this purchase by inflating the money supply. As time has gone by and monetary continence has continued to erode, central banks today do not just buy government bonds but are also engaged in the monetization of all kinds of assets, from stocks to bonds to defaulted debt to housing and much more.
The intermingling of these four functions in the hands of one monopoly entity protected from all market competition is ultimately the root cause of the majority of economic crises afflicting the world. It is easy to see how these four functions can conflict with one another, and how a monopolist will have the perverse incentives to look out for their own interest at the expense of the long-term value of the currency and thus the wealth of the citizens.
Maintaining the value of the currency would arguably best be served by using hard assets as reserves, in particular gold. But the second goal, settling payments abroad, is only doable with the US Dollar and a handful of government currencies used for international settlements. So central banks’ first conflict is between choosing a monetary standard for future needs vs one for present needs. This dilemma of course would not exist in a global homogeneous monetary system such as a true gold standard, since gold would offer liquidity across the world today, as well as into the future.
As governments ultimately control central banks, in spite of the constant protestations to the contrary, it is quite possible for them to lean on the central banks to purchase bonds, allowing for more government spending. As a result, the local currency’s money supply is inflated, and selling pressure for it increases compared to international currencies. Governments are also likely to lean on their central banks to engage in expansionary monetary policy to “stimulate the economy”, which similarly inflates the money supply and brings its value down compared to international currencies. As governments centrally-plan their economies using inflation, they do so while endangering their foreign reserves: individuals start looking to sell the local currency for harder currencies, which creates more selling pressure on the local currency compared to the international currency; this forces the central bank to sell some of its international reserves. These individuals will also seek to send their newly purchased international currencies abroad to be invested in foreign countries, which could then lead their government to impose capital controls to stop that flow in order to maintain its foreign reserves.
Similarly, as these individuals expect the value of their national currency to decline, they are also more likely to purchase durable goods rather than hold on to cash balances. This can mean a lot of imports of expensive foreign goods, which also depletes the central bank’s foreign reserves. The government is then likely to retaliate with trade barriers, tariffs, and subsidies. The rationale for trade barriers is to discourage the local population from converting their local currency to international currency and sending it abroad. The rationale for tariffs is to reduce the flow of foreign exchange abroad, and to force importers to hand over part of their foreign exchange to the government as they import. And the rationale for export subsidies is to promote local exporters to increase the inflow of foreign reserves. We can now understand how the collapse of the global inflationary bubble of the 1920’s, and the presence of a global system of national reserves used along with gold, was ultimately one of the main drivers of protectionism in the 1930’s, which worsened the depression, and fueled nationalism.
The last two points are extremely important for the developing world because they are enormously significant to the only three drivers of economic growth and transformation: capital accumulation, trade, and technological advancement. As governments restrict the ability of individuals to accumulate or move capital and goods, it becomes harder and harder for individuals to engage in capital accumulation, trade and specialization, and to import advanced technologies.
The global monetary system built around government monopoly central banks effectively puts the entirety of the local capital markets and all imports and exports under government control. It is able to dictate what can enter and exit the country through its control over the banking sector. The fact that it can always squeeze import/exports and capital markets for foreign exchange revenue makes the government a very attractive borrower for international lending institutions. The entirety of the private economy can now be used as collateral for the government to borrow from the global capital markets.
At its essence, the Fiat Standard destroys savings and planning for the future in order to operate a payments network. As a thought experiment, imagine what would happen to a country that adopted a fiat standard before accumulating significant industrial capital. This is the developing world of today.
I hope you enjoyed this preview chapter from The Fiat Standard. If you would like to order the book, click here.