Fiat Money Gets A Bad Rap

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The Gold Standard Sucks

For sometime, I’ve been wrestling for a good argument in favor of fiat money. A lot of people think the Gold Standard was something great and that the subsequent devaluation of the US dollar has somehow contributed to the current crises. Clearly the issues of ratings agencies and complicated derivatives and cross-collateralisation of debt has contributed directly to the GFC.

But it’s really hard to explain it in context. The Gold Standard itself has become some kind of long-lost El Dorado of monetary policy.

Here’s a really cool article by Ross Gittins about the difference between the current recession and the Great Depression.

The second cause of our Depression was our adherence to the ”gold standard”. (Actually, many Depression scholars have concluded that the decision of most countries to return to the gold standard after World War I was the primary cause of the Depression around the world. So much for Wall Street’s crash in October 1929.)

The value of the Australian pound was fixed to a certain amount of gold (the same amount as for the British pound) and anyone could demand that their pound note be exchanged for gold.

Without the gold standard, countries have ”fiat money”, where the value of a $5 note comes simply from the issuing government’s command that it be accepted as legal tender in payment of five dollars of debt.

For a long time people disapproved of fiat money, fearing that governments could erode the value of money by permitting inflation or by deciding to ”devalue” their currency against other countries’ currencies.

The hyperinflation in Germany’s Weimar Republic in the early 1920s convinced central bankers of the need to return to the gold standard. (In those days, the Commonwealth Bank was a government-owned trading bank and the central bank.)

Trouble is, a country that suffers a major fall in the value of its exports – a deterioration in its terms of trade – needs to respond by devaluing its currency. So sticking with the gold standard ensured the avoidance of inflation, but did so by crunching the economy.

Despite pressure from our deteriorating balance of payments to devalue our currency, we held the line until March 1931, when we left the gold standard and devalued by 25 per cent against the British pound. By then, however, our foreign exchange reserves were run down.

Subsequent research has shown that the sooner a country left the gold standard, the sooner it recovered from the Depression.

So the next time a somebody tells you that fiat money is bad, and the world is somehow crazy because Nixon abandoned the Gold Standard, the answer is the inflexibility of the Gold Standard is enough to give us the Great Depression itself. The floating currency actually acts as a shock absorber, and in this instance has probably saved us from the outright ravages of the GFC. It’s nice to know.

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