Greece, the EU and the Power of Fiat Currency

Greece is evidently going to hit the financial skids next week.  The EU appears to have stopped bargaining (as have the Greeks, who now want to put the issue of austerity in exchange for another EU bailout to their voters).  Without bargaining, there won't be a deal.

How did things end up this way?  One perspective is that, by entering the Euro Zone, Greece gave up a lot of power and put itself under the control of the EU.  When a country issues its own currency (i.e., fiat currency), it has considerable control over its currency's value in relation to other currencies.  If the country slides downhill economically speaking, it can devalue its currency and export its way out of trouble.  The Japanese have done this for decades, and the Chinese and other developing nations are endeavoring to emulate the Japanese. 

But what if the country, instead of issuing its own currency, uses another medium of exchange?  Historically, gold and silver, and sometimes copper, served such a role.  But a country that uses an independent medium of exchange can't devalue its way out of a recession.  It has to find another way; and sometimes it can't.  That's why the industrialized West moved off the gold standard in the 20th Century.  It prevented them from using central bank policies to recover from economic downturns.

Fiat currencies have a very bad image among many in the political right.  Gold standard conservatives fear that governments will inflate the wealth of citizens away for reasons of political expediency.  They rightly point to the morass of post-World War I Germany, when the Weimar Republic did that, resulting in widespread malaise and paving the way for fascism. 

But gold standard adherents forget a basic principle of economics:  goods become widespread in the market because people demand them.  Fiat currency is simply another good, and people demand a lot of it.  It serves as a medium of exchange, and no major economy can exist without a copious supply of the medium of exchange.  Gold was extremely scarce in Colonial America, and deer skins (i.e., buck skins, from whence came the term "buck"), tobacco and other goods served as an alternative to gold.  Various commercial promises to pay, such as drafts, promissory notes, banker's notes, and the like, also came to be used in lieu of gold.  Fiat currency was government's way of simplifying the problem of lack of gold and silver that could be used as media of exchange.

Fiat currency also conferred power. When the American Revolution began, the Continental Congress issued paper money in order to finance the rebellion.   This paper was subject to inflation, and considerable controversy eventually surrounded its use.  Nevertheless, the Continental Congress' ability to issue fiat currency helped to sustain the Revolution.

The U.S. government in the 19th Century outlawed the issuance of bank notes and other private currency and substituted the greenback in their stead.  Although the U.S. government clung to the gold standard, it devalued the dollar against gold once the Great Depression began, and took the dollar off the gold standard during the economic difficulties of the early 1970's.  In other words, gold wasn't really the standard.  The dollar was worth what the government said it was worth, not what the market price of gold happened to be.

The power of fiat currency became vividly clear during the Great Depression and World War II.  The U.S. government began to borrow in large amounts (i.e., engage in deficit spending) in order to alleviate the Depression.  Then, it borrowed enormous amounts to finance the war and defeat fascism.  After World War II, the U.S. government flooded the free world with dollars, so that there would be a currency to replace the British pound as the world's reserve currency.  The U.S. government derives enormous power from the fact that the dollar is the world's reserve currency.  People in other countries have to pay attention to America, because America's currency keeps the world's economy going.  Even in the Communist bloc, the dollar mattered.  As Communist economies flagged, the dollar became the underground, but de facto real, currency in many Communist nations.  Communism's legitimacy was in part undermined by the strength of America's fiat currency.

Greece is in a real fix, because its citizens don't want austerity, but they want to remain part of the EU.  Reality is that they are damned if they do and damned if they don't.  Staying in the EU will require agreement to the EU's demands for more austerity, which will probably worsen Greece's depression.  Leaving the EU will also likely mean that the Greek depression will worsen.  Who's at fault for this mess is a complicated question, but the answer, in short, is like Agatha Christy's novel, Murder on the Orient Express.  Everyone involved in and with the EU is responsible.  And there's no easy way out of the mess, for anyone.

But a larger point is that fiat currencies aren't good or evil.  They are a tool, one that can be used productively or counter-productively.  We need to watch what the Fed is doing--closely.  But let us recognize that much of America's strength comes from its fiat currency. 

Questions About Bitcoin

The hype about Bitcoins is reminiscent of some of the early hype about the Internet.  Long, long ago, in the Paleolithic times of 20 years ago, the Internet was seen as an idyllic world where all would be equal and a person could accomplish anything with a computer and just a little effort.  The wide open nature of the Net allowed anyone, however anonymous and humble, to speak out and be heard, create and be seen, reach out and touch untold millions, all with just a few keystrokes.  Wondrous things would happen; lead would be turned into gold; a veritable digital Eden would arise and everyone who entered would attain nirvana.

Well, it didn't quite work out that way.  Gigantic corporations now dominate the Internet, and powerful government agencies lurk in the background, spying high and low, leaving no server unmolested.  Bad people from around the world seek to victimize, defraud and destroy; and the wide open nature of the Net allows them to do so with just a few keystrokes.  The free-standing individual who was supposed to have been the pillar of the digital community has shrunk into an online sheep, waiting helplessly to be fleeced of all personal information, browsing habits, bank funds, and credit lines.

The Norman Rockwellian narrative of Bitcoins would have us believe that they are a pure form of value, unmarred by the pock marks of central bank policy.  "Mined" by solving mathematical problems, transacted anonymously on a peer-to-peer basis, Bitcoins would be finite in amount and invulnerable to inflation since no one, supposedly, would control them.  Those who held Bitcoins would be liberated from the oppression of governments and the highway robbery of fee-charging financial institutions that handle transactions in fiat currencies.  A brave new monetary system would supersede the corrupt, degenerative fiat currencies of yore, the clouds would part and the sun would shine forever.

But reality is turning out to be blemished.  It seems that the use of Bitcoins for payment made an online market for illegal drugs called Silk Road attractive to denizens of dark corners of the Net.  The anonymity of Bitcoin transactions is a godsend for scoundrels and knaves of every variety, with government crime fighters largely unable to figure out who to put on the Ten Most Wanted List.  It's now clear that Bitcoins will attract criminals, organized criminals, terrorists, tax evaders, and other miscreants with something to hide.

But, are there bigger monsters lurking in the shadows?  Rogue nations, which may be facing sanctions in financial systems denominated in fiat currencies, might find Bitcoins a convenient way to get back in business.  And business could be nefarious indeed, with weapons, equipment for processing radioactive materials, drugs, and other suspect cargo changing hands.  Intelligence services--foreign and domestic--would have many reasons to use Bitcoins.  Undercover operatives need to be funded.  Bribes need to be paid.  Deniability would be enhanced.  Detectability--and accountability--would be reduced. 

Then, there's the market for Bitcoins.  Unregulated and opaque, it's ideal for manipulators and fraudsters.  The mining process is getting harder and harder, as the mathematical problems that need to be solved become increasingly difficult.  More and more computing power is needed to solve them.  That means bigger, more complex and more expensive computers must be used. The advantage goes to those that are well-capitalized.  Yet the price of Bitcoins is notoriously volatile.  Who can afford to invest in the massive computing power that it now takes to operate a successful mining operation while withstanding the wild price swings in Bitcoin prices?  Wealthy speculators, rogue nations, organized crime, and financiers operating from secrecy jurisdictions might all see an opportunity to make a fast Bitcoin or two--or maybe a lot more--off of the naive true believers who buy and transact at the retail level.  Trading anonymously, these big boys could bid prices up using multiple accounts they control to trade back and forth with themselves.  They could pay for online ads hyping Bitcoins as they walk the price up, provoking an investment frenzy among the sheep.  Then, as the price reaches meteoric levels, they dump the coins that they've mined, and then walk away, leaving the price to move whichever way it will (which is likely to be down). 

The biggest potential problem for Bitcoins may well be that the big players will move in.  And, as with the Internet, the little people will suffer.  Invest at your peril.

Have the Federal Reserve's Monetary Policies Failed?

Now that bank profits and bonuses abound, green shoots are alleged, and stock market investors are opening their 401(k) statements again, it would be worth asking whether the Federal Reserve's monetary policies have failed. At first glance, considering that the economy seems to have taken a step back from the abyss, that might seem absurd. But let's consider where things are.

Unemployment continues to rise. Wages stagnate and shrink. Consumers are pulling back on spending. Consumer confidence is falling. Home prices are mostly falling, except in the most moribund of markets where they've already dropped more than 50%. Housing starts and home sales have more or less stabilized, but at extremely tepid levels. Consumer debt is shrinking as Americans struggle with the unfamiliar experience of saving.

The Fed has partially succeeded--its policies helped the regulated banking system to survive, for the most part (Bear Stearns, Lehman, R.I.P.). But the unregulated multi-trillion dollar shadow banking system--mortgage and other asset backed securities, and credit default swaps--has largely collapsed. The collapse of a sizeable portion of the banking system leads to economic stagnation. It happened when a number of trust companies failed in the Panic of 1907, and again when thousands of banks failed in the late 1920s and early 1930s. What we're starting to see now--a jobless recovery where growth will probably be slower than molasses--is reminiscent of the stagnation that followed earlier banking collapses.

Monetary policy is heavily entwined in how we got here. We've experienced a series of asset bubbles facilitated by the central bank. There was the tech stock bubble of 1999, the real estate and credit bubble of the mid-2000s, and the oil bubble of 2008. Each bubble caused a lot of damage. Adjusted for inflation, the stock market reached its all time high in March and April of 2000, and has never regained those levels. Thus, some losses from the tech stock debacle remain. After that, stocks lost their luster and many investors headed for the real estate markets, while others sought refuge in "conservative" mortgage-backed securities backed by the hasn't ever fallen real estate market. The ensuing morass bogs us down even today, as losses continue to mount. The oil bubble, spurred by the lowest fed funds rate ever, wrecked every business plan the auto companies might have had, forcing GM and Chrysler to seek federal help while permanently laying off tens of thousands of workers. No wonder consumers have hit the mattresses. In the last 10 years, the Fed has administered one smack down after another to the economy.

Bug-eyed, audibly breathing advocates of the gold standard cite these cycles as evidence of the failure of fiat currency, and demand a return to the gold standard. Although a lot of mouth-foaming accompanies criticisms of fiat currency, the more the Fed provokes asset bubbles, the more we need to wonder if something has gone astray with the Fed's monetary policies.

Fiat currency is paper currency not backed by gold, silver or any other physical asset. It derives its legal value from laws making it legal tender. These laws require creditors (including sellers) to accept fiat currency from debtors (and buyers). In effect, because a law says fiat currency has value, it has value. It's also possible for fiat currencies to have value as a matter of custom. The U.S. dollar is often considered more valuable in many parts of the world than the local currency, not because it is legal tender but because people simply consider it more reliable than the ruble or whatever.

The basic reason for fiat currency is that people need something as a means of exchange, and physical commodities like gold and silver aren't available in adequate supply. Currency (fiat or otherwise) is as an intermediate asset, held in between ownership of property that has use value (like food, clothing, heat, housing, etc.). Without currency, only barter exists as a means of trade. A producer of clothes needs only so much food, and a producer of food can't barter for clothes if the clothes producer already has enough food. But if a medium of exchange exists, the producer of clothes will accept currency from the producer of food because the currency can be used to buy heat, housing or other things the clothes producer does need. Both parties profit from the exchange.

When accepted currencies are not available in sufficient supply, substitute means of exchange come into use. Tobacco became a form of currency in Colonial Virginia because English currency was in short supply. Many private banks in 19th Century America issued paper currency because there was no national currency and bank customers needed a means of exchange. Currencies spur economic activity. The velocity of economic transactions increases when there exists a medium through which to transact. An abundance of currency should facilitate economic growth (which happened when tobacco came into use as currency in Colonial Virginia).

Central bank monetary policy, although implemented at an exponentially more complex level than tobacco-as-currency, is aimed at the same fundamental dynamic. By lowering short and long term interest rates, lending to banks and other financial institutions, and purchasing government and asset-backed securities, the Fed is increasing the supply of the medium of exchange in the hope of increasing the velocity of economic activity. The policy worked, spurring a tech boom, a real estate boom and a petroleum boom. Only it worked too well, and each boom ended in a bust.

Now, in 2009, we may be seeing the comeuppance of it all. The Fed has flooded the financial system with currency but economic activity remains moribund. Newly printed fiat money isn't increasing the velocity of economic activity. Banks aren't making new loans; indeed many credit card customers are having their cards cancelled without prior notice. (Sometimes, they find out when a merchant rejects the charge; we always thought the credit card companies were mean-spirited but this is a new low.) Trillions of dollars of toxic real estate-backed assets--the product of a Fed funded asset boom and bust--remain on the books of the major banks, crippling their ability to extend new credit. Nothing meaningful is being done to remove this tumor from the banking system. Official policy appears to consist of hoping that the real estate sector revives and boosts the value of these assets. But official policies to modify mortgages and otherwise revive real estate are, on good days, ineffectual. We don't have zombie companies, like Japan in the 1990s. We have zombie real estate assets, that reside more or less permanently on the books of the banking system, impairing lending and holding back the economy.

Although fiat currencies have true economic utility, central bank monetary policies can too easily take advantage of that utility and produce bipolar, destabilizing swings in asset values. Inflation, too, is a threat when the central bank floods the financial system with money. It hasn't materialized yet only because the consumer has been so thoroughly flogged by the recession that spending is almost painful and retailers dare not raise prices.

The ridge-dwelling, rifle-cleaning fringe of the gold standard crowd call for an end to central banking and fiat currencies. Neither will happen. But it's time to consider whether we've reached the limits of monetary policy. There seems to be a belief in an economic Holy Grail, that somehow the "science" of economics can simultaneously achieve stability in growth and prices, and full employment. Economists will be the last to suggest that this quest is impossible, because then none of them could achieve the purity of Galahad. But we should remember central banking's greatest hour, in 1980, when Paul Volcker, newly appointed as Fed Chairman, raised interest rates and threw the United States into a severe recession in order to break the inflationary spiral of the 1970s. A painful confrontation with economic reality, accompanied by struggle and sacrifice, produced the long prosperity of the 1980s and 1990s. There is no free lunch, no new paradigm, no magical printing of fiat money that will transport us to Avalon.

This past week, the Fed announced that, even as it continues to hold short term rates at zero, it will soon wind down its program of buying longer term U.S. Treasury securities. This may provide a tiny glimmer of hope, that perhaps the central bank is beginning to recognize the limits of its power. Let's hope so. The path out of today's stagnation won't be paved with further abuse of the fiat currency. It will be built on hard work and investment directed at boosting the capacity of the U.S. economy to produce tangible goods that Americans and others want to buy. The U.S. economy needs to produce more intrinsic value; it doesn't need more paper value.