Why fiat currency?

Recently I was talking to my Bubbie on the phone, telling her about my work in finance, when suddenly she interrupted me. She started asking me if she ever told me about her cousin Harry. Apparently, her mom had a cousin named Harry. He had worked for the US treasury and did some work with the Bretton Woods agreement. Later, I found myself gobsmacked reading that my great, great cousin once removed or whatever, Harry Dexter White, not only worked on Bretton Woods, but he was one of the two main architects, the other being none other than John Maynard Keynes!

Bretton Woods, as a refresher, defined the economic order from 1944 to 1971. It pegged most of the world's currencies to the dollar and the dollar to gold at a stable $35 an ounce. This allowed for 25 years of incredible growth.

Before we get too into the weeds, let's address the title of this piece. What is fiat currency? Simply, it's money that is not backed by any physical commodity, like gold or silver. Its value comes solely from the trust of whatever government backs it. The paper in our wallets (if anyone else still carries physical money) doesn't stand for something of intrinsic value. It only has value because we all agree and believe it does. That's fiat.

So why do we use fiat currency instead of commodity money? To answer this question we need to go back through history a bit. We need to understand the collapse of Bretton Woods, what it was, and also why it worked so well when it was created. But before even getting to the start of Bretton Woods, we need to know a bit about the crises of the great wars, the crash of the depression, and the interwar period. And before then we need to know what the state of the world was just before WWI. Let's start there.

From 1870 to 1914 the advanced economies had commodity monies, currencies defined by their convertibility to a fixed weight of gold. Citizens would still use paper bills, but at any moment, at least in theory, that paper could be redeemed for gold. It represented gold, a true store of value.

Let me take a quick detour to state why gold supposedly has intrinsic value and has been used for eons to back money over other commodities or goods. Firstly, gold is scarce, but not so scarce that more can't be obtained. It's durable, divisible without losing any value, as in it can be melted down into smaller units, and it's uniform. Lastly, it's verifiable and portable (you can carry a fortune in your pocket!). Previous societies have used other goods, but there's a reason that precious metals stuck around as the most popular option.

So, gold is the center of the global system at the turn of the 19th century, but it wasn't NYC's streets it flowed through, it was London's. London, with its Pound Sterling was at the center of a global gold standard system, settling trades between countries and creating the stability which was at the foundation of the new push for globalization.

The gold standard worked incredibly well! Prices were remarkably stable and cross-border investments became predictable. This led to enormous growth. In the book Slouching Towards Utopia, J. Bradford DeLong explains that the "long 20th century" begins with this period from 1870 to 1914 where global GDP per capita roughly doubled after centuries of being flat. Before then any technological improvement was eaten up by a growing population. From 1870 on, for the first time growth meant fewer people starved. The gold standard was a major piece in slaying that Malthusian devil.

That is, of course, until there was war and panic.

In this section we're going to focus on mechanisms. Then in the next section we can tie it into the history.

So gold creates stable prices and cross-border trade, but it has a fatal flaw, its rigidity. Let's say a crisis hits. What's the first tool we would turn to today to right the ship of the economy? Have the central bank flood the market with cash so people aren't afraid to spend, businesses can continue to invest and hire people, banks can keep lending. We cut interest rates! None of this is available on the gold standard. Because the country has to have gold to back its currency you can't get more currency unless you have more gold. In essence, the gold standard locks you in, and one of the worst ways it locks you in is that it's structurally deflationary.

So let's focus on deflation for a moment. I'll ask two questions: why is the gold standard deflationary and why is deflation bad? Let's start with why it's bad.

There are a few reasons why deflation is bad, but I'm just going to focus on one here. Deflation can be described as goods getting cheaper over time. This sounds great, right? But it ignores what happens to debt. Say you took out a $1,000 loan a year ago and prices have since fallen 10%. We've had 10% deflation. You still owe $1,000, but those dollars are each worth more. You need 10% more goods, more labor, more value than was required last year to pay it off. The debt has become heavier in real terms. When we start to expand this idea from the individual to the scale of the economy we start to see the devastating impact it has. I'll cover more of this in just a moment.

But now let's turn to why the gold standard is fundamentally deflationary. In normal times we have two interrelated rates: the rate of the increasing size of the money supply and productivity growth. Ideally they would match so that the dollar of tomorrow can buy the same amount of stuff as today. However, they don't usually match and more often productivity grows faster than the increase in the gold supply. This means that bank notes, dollars, need to increase in value and slowly be able to buy more and more goods, deflation!

Irving Fisher called this the debt-deflation spiral. When prices fall, the value of debts gets heavier in real terms ("real" as in adjusted for purchasing power). This leads to some percentage of businesses being unable to pay those debts, right? When that happens, some of those businesses need to declare bankruptcy, meaning that the banks that provided loans to those businesses don't get made whole. If enough businesses fail, then banks collapse, or at the very least they stop doling out credit. This shrinks the supply of money sloshing around the market, meaning that now there are even fewer dollars in the system chasing after the same goods, making prices fall further. And around and around we go, spiraling downward.

If this situation were to happen today, we have a battle-tested solution to stop the spiral, flood the market with liquidity, primarily with the central bank, in the US that's the Federal Reserve. But under the gold standard you can't flood the system with cash. In fact, you're legally obligated to do the opposite! In order to defend the peg and entice gold back into the system, the Fed needs to raise rates and tighten credit. This not only doesn't help in a crisis, it actively makes it much worse.

So the gold standard can create stability in a boom time or throw gasoline on the fire of bad times. It isn't neutral, it transmits and deepens crises. If one country tightens, enticing gold from its neighbors, they will be forced to tighten too.

So that's the theory, let's move onto the history.

From WWI through to WWII we saw countries abandon their gold pegs, return to them in the interwar period, and then drop them again in the 30s. I'm going to zoom in on two moments that show the same flaw of the gold standard but from opposite directions.

At the start of WWI each combatant country required enormous sums of money in order to fund armies, munitions, and food, but tax revenue couldn't cover it. So what could they do? They had two options: borrow or print more money. They did both.

Under the gold standard money creation is capped by gold reserves. Within weeks of joining the war, each country suspended the gold standard. It was immediate and universal. Their survival was at stake and it's telling that the gold standard was the first thing to go.

So pitfall number one: the gold standard doesn't allow an economy to inflate its currency. So if that's required, the standard has to be dropped.

Before we move onto the second example, the great crash and the depression, let's consider for a moment why countries returned to the gold standard after WWI, a system that had just failed them. Recall that before WWI the advanced economies had their longest, largest period of sustained growth in the history of the world. The war was understood to be a brief respite from the gold standard and going back to it was obviously just a return to normalcy.

So why did it break? In 1929 there was the biggest stock market crash to date. To aid in the recovery, similar to the wartime need but distinct, the economy needed more credit, lower rates. It needed stimulus! Instead, gold pushed them to do the opposite, raise rates and tighten credit.

Why? In order to defend their peg to gold there are two things that happen at once. Domestically, depositors pull money out of banks, a bank run. This causes banks to fail, and credit collapses, the credit multiplier working in reverse. The effective money supply has now shrunk. Internationally, holders of the currency lose confidence and start redeeming the currency for gold. This causes gold to physically leave the country. To stop the gold flight, central banks raise rates to entice foreign investors to keep their money in, but this also crushes domestic credit further, deepening the domestic crisis.

This crash played out in slow motion across many countries over the course of the 1930s. Britain left the gold standard in '31, followed by the US in '33, and France in '36. France had the weakest recovery and Britain the strongest, showing pretty clearly that the longer a country held onto the old system, the worse they did.

So pitfall number 2: when the economy needs to loosen, lower rates, gold doesn't allow it.

So by the mid-1930s it was clear that rigid commodity money didn't work anymore. It was incompatible with modern economic management. So the question remained, what should be built instead?

By 1944, the failures of commodity money were clear, but so were its virtues. The pre-WWI gold standard had undergirded world-beating growth, in part because it disciplined governments. Money couldn't be printed at will if a politician wanted to win an election by juicing the economy with cheap credit or to bail out a favored constituency. It was structurally constrained. This discipline, stopping a government that wants to inflate, is a powerful tool that disappears when moving to a fiat system. I'm not normally very persuaded by such libertarian arguments, but it is clear they have a point.

What grows out of 1944 is Bretton Woods, an attempt to marry the discipline of the gold standard with the flexibility that the interwar period illustrated was necessary. Not pure rigidity, nor pure freedom.

The Bretton Woods conference featured two competing visions, one British, the other American. The British vision, led by famed economist John Maynard Keynes involved a true international currency, the "bancor", and had the IMF as the global central bank. The American vision, led by my great, great cousin once removed or whatever, Harry Dexter White, involved a system where the dollar was at the center, gold was the anchor, and the IMF had a more limited role.

There was a bit of a power struggle, but keep in mind, the US had just helped win the war. It was the undisputed world hegemon. It had roughly 2/3rds of the world's gold at the time, the most surviving industrial capacity, and was funding post-war rebuilding. Power decided design.

So what was the design of Bretton Woods? The US Dollar was pegged to gold at $35 an ounce. Any dollar could be converted to gold at that price. Then the other currencies would be pegged to the dollar with a 1% band of wiggle room. The key innovation was that the pegs were no longer immovable. A country could request permission from the IMF for a re-peg. It was, of course, terribly embarrassing for the country/administration doing the re-peg and so they'd do it later than they should, but it gave a release valve to the system. It combined the stability of the gold system with the flexibility to overcome some of its biggest flaws.

And it worked. Tremendously! The world entered into what is known as the 30 Glorious Years. The Advanced Economies had some of the highest sustained growth rates in world history, driven in part by Germany and Japan's industrial recovery and integration into the allied economic order. Stable exchange rates and expanding globalization led to unprecedented prosperity across the developed world.

But it couldn't last and slowly the world changed in a way that the system couldn't sustain. In the US, Vietnam spending, LBJ's "The Great Society" programs, and Cold War spending created persistent balance of payments deficits. This was the Triffin Dilemma playing out which I'll explore in greater depth in another piece. What Robert Triffin explained was that in order for the US, the owner of the global reserve currency, to supply the world with enough dollars, it had to run persistent deficits, which in turn would slowly undermine confidence in the dollar's gold backing.

The US was importing more than it was exporting, so dollars were piling up overseas. As part of Bretton woods, foreign governments could go up to the US Treasury and redeem those dollars for gold at $35/ounce, which they did, aggressively. Every year the US saw more gold leave its shores and it had a destabilizing effect. By the late 60s far more dollars existed globally than gold could back at that $35 price. The US had started the Bretton Woods period with more than enough gold, but as it dwindled, policy makers got nervous and traders could begin to find gold priced at $40/ounce on private markets, an arbitrage that further put pressure on the system.

One way to release some of the pressure was through the Eurodollar system. This is also something I want to go deeper into in the future, but in brief, Eurodollars are simply dollars held in banks outside the US, originally London. They create a pool of dollar liquidity that wasn't originated in the US and isn't redeemable for gold. The important piece to note is that they effectively expand the dollar money supply without requiring more gold! This allowed the system to limp on a bit longer than it otherwise would have.

In 1971, the situation was no longer tenable and Nixon closed the gold window, signaling that dollars were no longer redeemable for gold. We had entered an age of fiat currency. Though not immediately; there was a period of transition till roughly 1976 before the advanced economies had a stable floating-rate system. And it is argued that switching to a floating-rate system was part of the cause of the inflation of the 70s and 80s, so we didn't immediately see utopia. But from then on fiat currency has given us incredible tools to counteract crises: flooding the market with liquidity like in 2008 and 2020, and relief from fears of running current account deficits without concrete "running out of money" concerns. Monetary policy is now a usable tool, something that wasn't true in 1914 or 1931.

Fiat currency isn't a choice, it's a residue. The world tried to have gold; they tried in the interwar period and with Bretton Woods, but gold just wouldn't work for the world we had.

The fiat system solves the rigidity problem and has great benefits, but it also has real issues: inflation risk, political pressure on central banks, and a deeper question of trust that the system now depends on. The discipline that the gold standard provided was real, but we've traded it for flexibility, which is still the right trade off.

I've loved learning about finance the last year or two, but thought of it mostly as a hobby. As I heard my Bubbie speak with pride about how this distant relative played such a pivotal part in not just the country, but in the making of the modern world, I felt a hand reach out from the past and pull me in. Digging into the history and understanding the system is like discovering parts of myself.