Brief Summary
This video explains the history and evolution of money, from commodity-based systems like rice to the modern fiat currency system dominated by the US dollar. It covers key events such as Nixon's decision to end the gold standard, the Bretton Woods agreement, and the implications of debt-based money. The video also discusses concepts like inflation, deflation, and the role of central banks in maintaining financial stability.
- The US became the global banker after Nixon ended the convertibility of the dollar into gold in 1971.
- Modern money is debt-based, created through loans and fractional reserve banking.
- The US dollar's status as the world's reserve currency gives the US unique advantages and responsibilities.
Intro
On August 15, 1971, President Richard Nixon declared the suspension of the dollar's convertibility into gold, marking a significant shift in global finance. This decision allowed the U.S. to operate as the world's banker in a global game of monopoly, with the ability to create money at will. Despite having over $36 trillion in debt, the U.S. can create the money to manage it, leading to debates about the implications of this power.
The US becomes the Monopoly banker
After Nixon's decision, the U.S. gained the unique ability to create money, similar to a banker in a Monopoly game who can print more money when needed. This power means the U.S. government can address its $36 trillion debt by creating more money, sparking debate about the consequences of this ability. The core question is why a government with the power to create money needs to borrow it in the first place.
The $36 trillion debt paradox
To understand the complexities of modern finance, it's essential to look back at the origins of money when it was based on commodities like rice. In early economies, rice served as both food and currency, with the value of goods determined by the labor required to produce rice. This concept forms the basis of the labor theory of value, where the value of an item is directly linked to the labor needed to produce it.
Money origins: Rice as the first currency
The labor theory of value suggests that the worth of something is tied to the labor required to produce it. In early economies, rice was used as money, and those with surplus rice had the power to trade it for others' time. However, rice as a commodity money had limitations due to spoilage, bulkiness, and transportation issues.
Labor theory of value and food wealth
Rice as a form of money had significant drawbacks, including spoilage and difficulty in transportation, which led to the need for a more durable and portable form of wealth. This need drove the adoption of token money, where rarity creates value. Gold emerged as a universally valued solution for trade beyond local regions, becoming the first truly global money.
Problems with rice money and rise of gold
With gold becoming a dominant form of money, the question arose of how to determine the price of goods like rice in terms of gold. Prices emerge naturally as the balance between the amount of gold people are willing to spend and the availability of rice. This balance can be affected by factors like droughts or bumper harvests, leading to supply-side inflation or deflation.
How natural prices emerge (two-tank analogy)
Price changes, whether due to supply or demand, affect people differently. Deflation, where the value of money increases, benefits savers but harms debtors, as they must sell more goods to repay their debts. Inflation, where the value of money decreases, helps debtors but punishes savers. Stable prices are the fairest, but modern societies tend to produce more over time, leading to deflationary pressure.
Inflation/deflation: winners and losers
To combat deflationary pressure, the Austrian town of Wörgl experimented with money that lost value over time. This money required monthly stamps to remain valid, encouraging spending rather than saving. The experiment resulted in a high velocity of money, boosting economic activity. The equation M * V = P * Q illustrates that economic output (GDP) can grow by increasing the money supply (M) or the velocity of money (V).
Wörgl's experiment and MV=PQ
Governments also play a role in expanding the money supply, often through taxation and spending cycles. Venice faced a crisis in 1171 and responded by issuing forced loans, where wealthy citizens lent gold to the state in exchange for paper certificates promising interest. These certificates circulated as money, effectively doubling Venice's money supply and introducing debt money with a floating value based on trust in the government.
Venice's crisis and forced loans
The concept of debt money was further developed by goldsmiths, who realized they could lend out deposited gold and issue paper receipts. This led to fractional reserve banking, where banks hold only a fraction of deposits in reserve and lend out the rest. Borrowers would deposit the gold back into the vault, creating a multiplier effect and expanding the money supply.
Birth of debt-based money
Goldsmiths began lending out paper banknotes without any gold backing, creating money from promises. This shift marked a profound change in monetary history, as the power to create money from promises became the foundation of the modern financial system. Banks also used IOUs from borrowers as collateral to borrow from other banks, creating chains of credit.
Goldsmiths and fractional reserve banking
The reliance on chains of credit led to instability, as seen when King Charles II stopped payments on his debts. This event mirrors the 2008 financial crisis, revealing how the monetary system rests on trust. Central banks, like the Bank of England, were created to provide a new layer above the banks, acting as a bank for the banks and providing emergency funds to prevent crises from spreading.
Credit collapse and chains of debt
Central banks stabilize the financial system by acting as a lender of last resort and managing the money supply. During times of crisis, governments can issue bonds, and central banks can create new money to buy these bonds, effectively printing money. The U.S. Federal Reserve used this power extensively during World War I and II to finance the war effort.
Central banking and financial stability
During World War II, the U.S. significantly increased its money supply, which was absorbed by the expansion in production. However, countries that printed money to buy U.S. dollars faced hyperinflation, as seen in Hungary. By the end of the war, the U.S. held a large portion of the world's gold reserves, leading to the Bretton Woods agreement in 1944.
Wartime monetary expansion
At Bretton Woods, the U.S. dollar was established as the only currency convertible to gold at $35 an ounce, with other currencies pegged to the dollar. This system created a hierarchy in the global monetary system. However, massive U.S. spending during the Vietnam War and Great Society programs strained the system, as the world needed more dollars, but creating them undermined their gold backing.
Bretton Woods and dollar dominance
By 1971, foreign governments held more dollars than the U.S. had gold to redeem them, leading countries like France to convert dollars to gold. The market price of gold rose above the official $35 an ounce, signaling that America's promise was unsustainable. Nixon responded by cutting the dollar's link to gold, creating a fiat currency system.
Nixon's decision and the fiat era
Nixon's decision established a global fiat currency system, where the U.S. dollar's value is based on the authority requiring its use. The Federal Reserve became the apex of the global banking system, with its ledger serving as the ultimate source of dollar creation. This resulted in a three-tier monetary world: the U.S. at the top, countries with their own currency in the middle, and those relying on dollars at the bottom.
The three-tier monetary world
Countries that don't create their own currency must balance their budgets or risk failure, similar to families. Countries with their own currency can create money through debt monetization, but excessive money creation can lead to inflation. Bond yields reflect expected GDP growth and inflation, serving as a market signal of confidence in the government.
Modern implications: debt vs. growth
The U.S. benefits from the dollar's status as the world's reserve currency, allowing it to issue bonds beyond what other nations could attempt. Treasury yields form the base of global finance, influencing interest rates worldwide. The sustainability of this system depends on economic growth exceeding Treasury yields. Risks include excessive dollar creation leading to inflation and coordinated selling of Treasury bonds by foreign countries.
Conclusion: The future of money
Despite the risks, the U.S. system endures because when the U.S. government runs a deficit, that money becomes private sector wealth. The U.S. faces a constraint in global productive capacity, as too many dollars globally can lead to global inflation. Nixon's decision detached money from physical reality, with today's dollars backed by the strength of the economy and collective faith in the future.
