superior aspects of gold and silver meant that they soon became the money of choice for many people. But as people began to accumulate large sums of gold or silver coins in their homes, concerns over keeping them safe from theft or loss became a major concern. This demand for safety led to the creation of one of the earliest forms of modern banking, known as goldsmith banking.
Under the goldsmith banking system, which became popular in 17th-century England, a person would simply deposit his gold with his local goldsmith. Much like modern banking, the goldsmith would provide the depositor with a paper receipt stating the amount of gold on deposit. If the person wanted to redeem his gold, he simply returned his paper receipt to the goldsmith. (In exchange for this convenience of keeping the gold in a safe place, the town’s goldsmith would charge a small monthly maintenance fee.) Because these paper receipts were viewed as “good as gold” they became extremely valuable. As communities grew and trade activity increased, these paper receipts began to be accepted as payment for simple financial transactions.
Eventually, traders and merchants in need of capital began seeking out loans from the goldsmiths. Most goldsmiths embraced the new income opportunity and were willing lenders. Despite the novelty of this financial system, the lending process was fairly simple. The goldsmith created and issued a paper receipt to the borrower which gave the appearance that the borrower had gold in the goldsmith’s vaults. But in reality, no new gold reserves were backing this loaned paper receipt. The goldsmith knew that the only way this scheme would be discovered was if many of his depositors were to demand all of their gold at the same time. Because the goldsmith considered this highly unlikely, he could continue to profit from his newfound lending power with little fear of a default risk. (This idea of lending money not currently on deposit has become a highly profitable venture for bankers. It is known as fractional-reserve banking and is discussed at length in chapter 7, “Modern Money Mechanics: What the Banksters Do Not Want You to Know.”)
As the Industrial Revolution began, the demand for loans grew dramatically. The large profit potential through this new sleight-of-hand lending process led to a rise in competition. Small regional banks began issuing their own forms of paper currency, similar to the paper receipts created by goldsmiths, in order to compete. As nations grew in population and in commercial activity, the various forms of issued currency became overwhelming, often stifling the flow of commerce. When nations faced such pressures, the largest banks would seek a monopoly on national lending by recommending a unified paper currency system to the governing authorities. These new paper currency systems were often backed by some form of commodity, usually gold or silver. Of course, implementing and regulating a national paper currency system was a monumental task requiring vigilant oversight. Western governments, in particular, often capitulated to the banking interests by permitting the creation of one national central bank. The central bank’s role often included issuing the national currency of choice (almost exclusively paper money), regulating the money supply, and controlling interest rates. In addition, the central bank would often be responsible for monitoring the nation’s banking activity, and serving as the lender of last resort, due to its unique capability of creating the national currency.
Despite the sophistication of the new central banking arrangement, discrepancies between the government’s fiscal policies and the central bank’s monetary policies often led to economic upheaval. The result of these conflicting policies, coupled with the unpredictable economic growth patterns of an emerging nation, often led to financial imbalances. These imbalances proved extremely difficult for central banks. Maintaining a commodity backing for every piece of paper money in circulation soon became a laborious process and served to limit the growth potential of the economy. After all, if the government required the nation’s money supply to be restricted to the available amount of a particular commodity, such as gold, then economic growth would suffer.
The initial solution to these early liquidity crises required a strong trade policy and often a mighty military. Governments knew that to maintain the growth of their gold-backed currencies required a growing supply of gold. For example, 16th-century England had few, if any, gold mines. And yet the British Empire boasted one of the world’s largest gold reserves. How was that possible? Through conquest. While trade restrictions, such as banning gold exports and export subsidies, were also common in this age of mercantilism, clever trade policies were rarely enough for the largest of nations. Military conquest of other nations in search of gold was virtually required to maintain a growing empire. Colonization efforts, often implemented under the auspices of Christian missionary activity, served at least two purposes: 1) to provide a fresh source of gold for the colonizing nation and 2) to create a new market for export purposes.
Empires, however, are notorious for having voracious spending appetites. Despite multiple conquests, the monetary constraints would soon become severe enough to force a new solution. The temptation for spendthrift governments was obvious: cut the commodity backing of currency and turn on the printing presses. (History is replete with warnings for those nations who dared to remove the commodity backing from their currency. For a history of national economies that have been severely damaged or completely destroyed through the overproduction of paper money, see chapter 3.)
Throughout history, all governments have come to the same conclusion: remove the commodity backing from its own national currency, thereby creating more flexibility. When a nation detaches its paper currency system from any and all commodity backing, its currency is then considered by economists to be a fiat currency. When a currency is issued by fiat, it is backed only by government guarantees, not a commodity. Fiat money has no intrinsic value. Its value is derived strictly by government law, and unlike the first two types of money (commodity and receipt) there is no natural limit to the quantity of fiat money that can be produced. The benefits of such a system to a government should be obvious. Without the economic constraints imposed by gold, the money creation process available to governments with fiat currencies is virtually unlimited.
How Is Money Measured?
Regardless of the type of money a nation uses, one important quality that it must possess is an ability to be measured. This is especially true in the case of fiat currency. In response to our modern fiat dollar system, U.S. economists have devised four categories to measure the nation’s money supply. These four measurements are known simply as M0, M1, M2, and M3.
M0 Money Supply: This measurement includes all coin and paper currency in circulation, as well as accounts at the central bank that can be exchanged for physical currency. This is the narrowest measure of the U.S. money supply and only measures the amount of liquid money in the hands of the public and certain deposits with the Federal Reserve.
M1 Money Supply: This measurement includes everything in M0 as well as currency held in demand deposits (such as checking accounts and NOW accounts) and traveler’s checks (which can be liquidated into physical currency.)
M2 Money Supply: This category includes everything in M1, plus all of the currency held in saving accounts, money market accounts, and certificates of deposit with balances of $100,000 or less.
M3 Money Supply: As the broadest measure of the U.S. money supply, this category combines all of M2 (which includes M1) plus all currency held in certificates of deposit with balances over $100,000, institutional money market funds, short-term repurchase agreements, and eurodollars (U.S. dollars held in foreign bank accounts).
What Gives Fiat Money Its Value?
If you have a U.S. dollar bill nearby, pick it up. Examine it closely. Notice its many symbols and its colors.
Now ask yourself: What exactly is it that gives the U.S. dollar its value? And why are so many people willing to exchange their valuable goods and services, or work long hours at jobs they may or may not enjoy, for these small pieces of green paper?
Answer: Faith in the scarcity of the dollar.
Allow me to elaborate on this answer.
