Fiat Money

Page 10-13: FIAT MONEY:

In 1837, the newly declared Republic of Texas issued its first banknotes. There are still a few preserved, crisp and clean, in the state's museums. Lacking a gold reserve, the new country promised to pay the bearer of these notes 10 per cent interest a year. By 1839, the value of a Texan dollar had fallen to 40 US cents. By 1842 the notes were so unpopular that the Texan government refused to let people pay their taxes with them. Shortly afterwards people began demanding the USA should annex Texas. By 1845, when this finally happened, the Texas dollar had recovered much of its value. The USA then wrote off $10 million of Texan public debt in 1850.

This episode is seen as a textbook case of what happens with 'fiat money' — that is, money not backed by gold. The Latin word 'fiat' means the same as it does in the biblical phrase fiat lux — let there be light; it means 'let there be money' created out of nowhere. In Texas, there was land, cattle and trade — but not enough to warrant printing $4 million and incurring a debt of $10 million. The paper money collapsed and ultimately the Texan Republic disappeared.

In August 1971, the USA itself decided to repeat the experiment — this time using yhe whole world as its laboratory. Richard Nixon literally scrapped an agreement that pegged all other currencies to the dollar and the dollar to gold. From then on, the global currency system was based on fiat money.

In the late 1960s the future Federal reserve boss Alan Greenspan had denounced the proposed move away from gold as a plot by 'welfare statists' to finance government spending by confiscating people's money. But then, like the rest of America's elite, it would allow the USA, effectively, to confiscate other countries' money — setting the scene for Washington to indulge in three decades of currency manipulation. The result enabled America to accumulate, at the time of writing, a $6 trillion debt with the rest of the world.

The move to pure paper currency was the precondition to every other phase of the neoliberal project. So it took the American right a long time to figure out they didn't like it. Today, however, right-wing economics has become one long howl of rage against fiat money. Its critics believe it is the ultimate source of boom and bust — and they are partly right.

The move away from gold and fixed exchange rates allowed three fundamental reflexes of the neoliberal era to kick in: the expanded creation of money by banks, the assumption that all crisis can be resolved, and the idea that profits generated out of speculation can go on rising for ever. These reflexes have become so ingrained in the thinking of millions that, when they no longer worked, it induced paralysis.

It is news to some people that banks 'create' money, but they always have done: they have always lent out more cash than there was in the safe. In the pre-1973 system, though, there were legal limits to such money creation. In the USA, for savings that could be withdrawn at any time, banks had to hold $20 in cash against every $100 of deposits. Even if one in every five people rushed to the bank to take all their money out, there would still be enough.

At every stage of its design, the neoliberal project removed those limits. The first Basel Accord, in 1988, set the reserves needed against $100 of loans to $8. By the time of Basel II in 2004, both deposits and loans had become too complex to balance with a single percentage figure.So they changed the rules: you had to 'weight' your capital according to its quality — and that equitywas to be decided by a ratings agency. You had to reveal the financial engineering used to calculate your risks. And you had to take account of 'market risk': in other words, what is going on outside the bank.

Basel II was an open invitation to game the system — and that's what the bankers and their lawyers did. The ratings agencies misvalued the assets; the law firms designed complex vehicles to get around the transparency rules. As for the market risk, even as America veered into recession in 2007, the Federal Reserve's Open Market Committee — the room where they're supposed to know everything — stank of complacency. Tim Geithner, then boss of the New York Fed, predicted: 'Consumer spending slows a bit, and businesses react by scaling back growth in hiring and investment, and this produces several quarters of growth modestly below trend.'

The total failure to measure market risk correctly was not blind optimism; it was supported by experience. When faced with a downturn, the Fed always would slash interest rates, enabling banks to lend even more money against fewer assets. This formed the second basic reflex of neoliberalism: the assumption that all crises were solvable.

From 1987 until 2000, under Greenspan's leadership, the Fed met every downturn with a rate cut. The effect was not only to make investing a one-way bet — since the Fed could always counteract a stock market crash. It was to reduce, over time, the risk of holding equities. The price of shares, which in theory represents a guess as to the future profitability of a firm, came increasingly to represent a guess as to the future policy of the Federal Reserve. The ratio of share prices to earnings (annual profits) for the top 500 companies in the USA which had been between 10x and 25x since the year 1870, now spiked to 35x and 45x earnings.

If money is a 'link to the future', then by 2000 it was signalling a future rosier than at any time in history. The trigger for he dotcom crash of 2001 was Greenspan's decision to raise interest rates in order to choke off what he called 'irrational exuberance'. But following 9/11 and the Enron bankruptcy in 2001, and with the onset of a brief recession, rates were slashed again. And now it was overtly political: irrational exuberance was OK once your country was simultaneously at war with Iraq and Afghanistan, and once confidence in the corporate system had been rocked by scandal after scandal.

This time, the Fed's move was backed with an explicit promise: the government would print money rather than allow prolonged recession and deflation. 'The U.S. government has a technology, called a printing press', said the Fed board member Ben Bernanke in 2002. 'Under a paper-money system, a determined government can always generate higher spending and hence positive inflation'.

When financial conditions are positive and predictable, the profits of banks themselves are always going to be high. Banking became an ever-changing tactical game focused on skimming money off your competitors, your customers and your business clients. This created the third basic reflex if neoliberalism: the widespread illusion that you can generate money out of money alone.

Though they had reduced the percentage of capital banks were required to keep on hand, the IS authorities had maintained the strict partition between Main Street lending banks and investment banks imposed in the 1930s by the Glass-Steagall Act. But by the late 1990s, in a rush of mergers and acquisitions, the investment bank sector was growing global, making a mockery of the rules. It was Treasury Secretary Larry Summers who, in 1999, through the repeal of Glass-Seagal, opened the banking system to attentions of those adept at exotic, opaque and offshore forms of finance.

Fiat money, then, contributed to the crisis by creating wave after wave of false signals from the future: the Fed will always save us, shares are not risky and the banks can make high profits out of low-risk business.

Nothing demonstrates the continuity between pre- and post-crisis policy better than quantitative easing (QE). In 2009 having wavered before the enormity of the task, Bernanke — together with his UK counterpart Mervyn King, governor of the Bank of England — started the presses rolling. In November 2008 China had already begun printing money in the more direct form of 'soft' bank loans from the state-owned banks to businesses (i.e. loans that nobody expected to be repaid). Now the Fed would print $4 trillion over the next four years — buying up the stressed debts of atate-backed mortgage lenders, then government bonds, then mortgage debts, to the tune of $80 billion a month. The combined impact was to flush money into the economy, via rising prices and revived house prices, which meant that it was first flushed into the pockets of those who were already rich.

Japan had pionered the money-printing solution after its own housing bubble collapsed in 1990. As its economy floundered, premier Shinzo Abe was forced to restart the printing presses in 2012. Europe — forbidden to print money by rules designed to stop the Euro being debased — waited until 2015, as deflation and stagnation took hold, before pledging to print €12 trillion — one sixth of global GDP.

It worked, in that it prevented a depression. But that was the disease used as a cure for the disease: cheap money being used to fix a crisis created by cheap money.