A brief history of money and its breakdown- Part 2

January 10th, 2007

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In today?s topic, we will continue from the previous topic, A brief history of money and its breakdown- Part 1 by touching on the gradual breakdown of the monetary system from two centuries ago till now. Today, the world?s money is totally fiat (money that enjoys legal tender status through the authority of the government instead of through the choice of the free market). Again, the recommended reading for today is Murray Rothbard?s What Has Government Done to Our Money? As Rothbard said in that book:

To understand the current monetary chaos, it is necessary to trace briefly the international monetary developments of the twentieth century, and to see how each set of unsound inflationist interventions has collapsed of its own inherent problems, only to set the stage for another round of interventions. The twentieth century history of the world monetary order can be divided into nine phases.

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury. At this point, we must stress that gold was not any arbitrary choice by the government. Rather, it was the choice of the free market over the course of centuries as the best money. Thus, at that time, the world had a uniform money medium, which as Rothbard said, ?facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labour.? Furthermore, such an international gold standard put a rein on government inflating the money supply as well as helped kept the balance of payment of each nation in equilibrium. Though it was not perfect, it ?provided us with by far the best monetary order the world has ever known, an order which worked, which kept business cycles from getting out of hand, and which enabled the development of free international trade, exchange, and investment.?

Next, the First World War arrived. Under the confusion of a wide-scale war, each warring government (except the United States) came off the gold standard and printed money to fund the prohibitive cost of waging war, which would not be possible under the gold standard. Thus, national currencies were devalued and fell in relative value to gold and the US dollar.

After the First World War, the most logical step would be to return to the gold standard at a redefined weight of gold for each national currency. However, British insistence at maintaining the unrealistic pre-war definition (due to national pride) led to their economic malaise. Instead of rectifying the folly of their ways, they induced and coerced foreign governments into the same mistakes at the Genoa Conference of 1922. This resulted in a gold exchange standard whereby (1) the US remained in the gold standard, (2) the British remained in a pseudo-gold standard and ?US-dollar standard,? and (3) the rest on the ?pound standard.? The outcome was a ridiculous pyramid of US dollars on gold, pounds on dollars and the other European currencies on pound. By 1931, as expected, the absurd gold exchange standard collapsed.

At this point in time, it was back to the post-war chaos of fiat currencies again. The US went off the gold standard partially?US dollars were only redeemable to foreign governments and central banks at a re-defined rate of 1/35 of an ounce. International trade and investment were at a standstill and ensuing economic conflict was said to be one of the leading causes of World War Two.

After World War Two, the United States led the way to a new monetary system?the Bretton Woods system. In this system, the US remained in a partial gold standard?US dollars were redeemable for gold by foreign governments. Other countries pyramid their currencies on top of the US dollars. Initially, the US dollar was undervalued and European currencies were overvalued. However, as time went by, with the US inflating their supply of dollars, their gold was increasingly being redeemed by European governments. Soon, it became harder and harder for the US to maintain the free market value of gold at $35.

By 1968, there was a crisis in confidence in the US dollars. The US then decided to abandon maintaining the US dollar at $35 in the free market. From then on, the US decided to ignore the gold free market and maintain the inter-government gold peg at $35. As expected, the free market value of gold soared above $35.

In August 15 1971, the US severed the last link between gold and the dollar. As a result, from then on, the world?s monetary system became totally fiat.

In December 1971, the Smithsonian Agreement was introduced to create some order by maintaining fixed exchange rates among currencies and without any gold backing. With the US continuing to inflate their dollars, fixed exchange rates were untenable. Finally, the agreement collapsed in February 1973.

Finally, that is what we have today?freely fluctuating fiat currencies. As Rothbard said,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.

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