Fiat paper money on the way to worthlessness

September 19th, 2007

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Yesterday, the Federal Reserve officially cut interest rate to 4.75% (and the discount rate to 5.25%). Stock prices reacted by soaring. Whatever words central bankers use to describe their action (e.g. ?cut interest rates,? ?provide monetary stimulus,? etc), it all boils down to printing money (see How does a central bank ?set? interest rates?).

Take for example the Bank of England. Yesterday, they said that they will ?guarantee all deposits? in the failed Northern Rock bank (see Inflating out of trouble- unprecedented move by the Bank of England). From where do they get the money from in order to achieve this? A couple of centuries ago, under the classical gold standard (see A brief history of money and its breakdown- Part 2), every piece of paper money had an underlying gold backing. Today’s money is fiat. That is, each piece of paper money is backed by nothing! Consequently, it is easy for central bankers to create money out of thin air by printing them (or in today’s electronic age, just flick an entry in a computer database). So, that’s where the Bank of England get its money from!

But what are the consequences? As we said before in Cause of inflation: Shanghai bubble case study, the end result will be price inflation. Do it long enough and you will get hyper-inflation, which is what is happening in Zimbabwe right now. Common sense tells us that as you print more and more money, the value of each unit of money will fall relative to goods and services (i.e. prices will rise). If this folly is not arrested, people will eventually completely lose confidence in fiat paper money. For example, during the great German hyper-inflation in the 1920s, it is cheaper to burn German Marks than firewood for warmth!

And not only that, it’s not just the United States who is doing the printing. Australia, UK, China and Russia (just about every major nation in the world) is also doing the same. That is why asset prices all over the world are sky-rocketing (see Epic, unprecedented inflation). So, when you see stock prices surging in response to intrest rate cuts, do not take it as sign of economic optimism. The Zimbabwean stock market is ‘booming’ right now, but the economy is facing total collapse (see Zimbabwe: Best Performing Stock Market in 2007?).

In the next article, we will provide you with the chart on how one of the central bankers is debasing the nation’s currency.