A brief history of money in the 20th century
To understand money in the 21st century, it is helpful to understand its
recent history. The twentieth century was notable in that it witnessed the
collapse of two international monetary regimes. These are especially prevalent in the context of ‘cryptocurrencies’, which adopt aspects of the gold
standard and revive arguments from the Austrian School of economics,
notably Hayek’s currency competition and Fisher’s Chicago Plan.
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| Source: steemit.com, 2017. |
A. The Gold Standard and the Adoption of Fiat Money
Money in the 20th century can broadly be divided into
three parts: 1900–1933 when the international gold
standard ensured that money was backed by the possession of physical gold, 1934-1971 when the dollar
devaluation and the Bretton Woods System emerged,
and 1972-1999 when fiat money was introduced and
adopted (Mundell, 2000)
The Gold Standard Era (1900–1933)
Under the gold standard, money is backed by the value
of physical gold held by a country. Because a given
amount of paper money can be converted into a fixed
amount of an underlying physical asset, in this case, gold, countries on the gold standard are prevented from
increasing the supply of paper money in circulation
without also increasing their holdings of gold reserves.
This system was effective in preventing any irresponsible governments from taking advantage of their monopoly on money by printing too much of it. This allowed holders of that money to feel that the value of
their paper money was ‘insured’, or ‘collateralized’ by
the underlying gold that backed it.
While the gold standard was generally regarded as an
essential source of economic trust and prosperity in the
late 19th and early 20th century, deflation and depression
in the 1930s revealed some of the defects of the inflexibilities in the gold standard. To understand why the
gold standard was abandoned, it is important to understand the deflationary bias of the gold standard, which
triggered deflation and depression in the 1930s. During
the gold standard era, gold flowed across different countries. As a result, some countries possessed more gold
than necessary for conversion against its total money
supply, in accordance to the fixed conversion ratio (the
gold-surplus countries), while others possessed less
than required (the gold-deficit countries). Economic
historian Peter Temin pointed out an asymmetry between gold-surplus and gold-deficit countries in their
monetary response to gold flows (Temin, 1989).
Since gold-deficit countries had more money supply
than could be supported by their gold reserve, they were
forced to reduce their money supply and deflate; failing
to do so could trigger people to worry about the convertibility of their domestic currency, scramble for gold,
and would eventually lead to a complete loss of gold
reserves in the country. Hence, gold-deficit countries
faced plenty of incentives to deflate their currency to
prevent devaluation. On the other hand, gold-surplus
countries had insufficient money supply for conversion
against their gold reserve. To prevent undervaluation
of their domestic currency given the fixed conversion
ratio, they were supposed to expand their money supply
and inflate. The asymmetry was that no sanctions prevented gold-surplus countries from sterilizing gold
inflows and accumulating gold reserves indefinitely
Such asymmetric dynamics led to a deflationary bias
in the gold standard. The bias was not obvious during
the pre-war periods, since the gold standard was centered around the operations of the Bank of England, which
as a profit-making institution strived to avoid gold
accumulation as opposed to interest-paying assets.
However, WWI led to the decline of the British economy.
Meanwhile, as economic historian Barry Eichengreen
showed, the two major gold-surplus countries of the
interwar periods, the United States and France, did
little to avoid gold accumulation (Eichengreen, 1986).
As a result, the deflationary bias of the gold standard
began to manifest itself by the end of the 1920s.
The Great Depression (the 1930s)
There exists a great deal of literature focusing on the
gold standard as a mechanism that “turned an ordinary
business downturn into the Great Depression.” (Eichengreen and Temin, 1997, p.1) argue that “the most important barrier to actions that would have arrested or
reversed the decline was the mentality of the gold
standard” which “sharply restricted the range of actions they were willing to contemplate.” The result of
this cultural condition was “to transform a run-of-the-mill economic contraction into a Great Depression that
changed the course of history” (Eichengreen and Temin, 2000, p.183). This was largely due to a reliance
on the tested usefulness of past money and risk aversion when it came to new methods of creating and
managing money.
Former chair of the Federal Reserve Ben Bernanke and
economic historian Harold James proposed a financial
mechanism in which deflation can trigger an economic
recession. For example, bank liabilities such as deposits
are fixed in nominal terms, whereas bank assets such
as debt instruments are fixed in real terms. In this case,
deflation reduces the value of bank assets disproportionally and heightens pressure on the bank capital. In
response, banks call in loans or refuse new ones, in turn
worsening the positions of borrowers. But borrowers
such as firms may lay off workers or curtail investments
to improve their financial positions, contributing to an
economic recession.5
Unfortunately, the United States
and other countries on the gold standard could not expand their money supplies to stimulate the economy.
Such unbearable inflexibility led Great Britain to drop
the gold standard in 1931, influencing many countries
to follow shortly thereafter
The Bretton Woods Era (1934-1971)
Influenced by economist and presidential advisor George
Warren, the United States adopted a flexible exchange
rate in 1933 for one year and devalued the dollar. It was
expected that the lower exchange rate would boost the
competitiveness of US products in the world economy,
assisting economic recovery. The rise of the price of gold
was also expected to raise the import price and thus the
domestic price level, as a measure to counter the deflation problem. As a result, the wholesale price level in
the United States did increase by almost 30 percent
between 1933 and 1937. With the official price of gold
raised by 69% to $35 an ounce, the United States restored
pegging its currency to gold in April 1934.
In 1936, the United States, Britain, and France signed
the Tripartite Accord establishing new rules for exchange rate management. These new arrangements
were eventually ratified at Bretton Woods in 1944. The
monetary system become a gold-dollar standard whereby the United States pegged the price of gold, and the
rest of the world pegged their currencies to the dollar
(Bordo, 1995). Consequently, the US dollar emerged as
a key reserve currency for the rest of the world, substituting for scarce gold as an international unit of account,
medium of exchange, and store of value.
For the system to operate smoothly it was crucial that
the United States maintain the stable monetary and fiscal
policy, which occurred until the 1960s. Based on Keynesian philosophy, the Kennedy and Johnson administrations
prioritized increasing US growth and reducing unemployment below 4% using aggregate demand management policies by expanding the fiscal deficits. Meanwhile,
the chairman of Federal Reserve William Martin, in the
1950s and 1960s prioritized cooperation with government
administration over central bank independence. In response to the Kennedy tax cut, and the build-up of government expenditure for the Vietnam War and the Johnson’s Great Society programs, the Federal Reserve
deployed expansionary monetary policy to accommodate
one-half of the increase in the fiscal deficit. This led to
a steady increase in the US inflation rate in the 1960s.
Martin pursued a contractionary monetary policy right
before he left the Federal Reserve, which contributed
to a recession during the Nixon administration in 1970
and soaring unemployment. Economic historian Michael Bordo argued that Nixon’s perception of why he
lost the 1960 election to John Kennedy had triggered
his paranoia about the political consequences of rising
unemployment. This in turn led Nixon to apply immense political pressure onto the new Chairman of
Federal Reserve Arthur Burns to reverse Martin’s policies and expand money growth in 1971 (Bordo, 2018).
The rekindled US inflation contributed to the undervaluation of gold. Under the significant balance of
payment deficit of the United States since WWII, Nixon
feared that the British would convert their dollar holdings into gold and threaten the US gold reserve. As a
result, Nixon announced his New Economic Policy on
15 August 1971, closing the US gold window and effectively declaring the death of the Bretton Woods System
The Fiat Money Era (1972-present)
Fiat money is a medium of exchange that is neither a
commercial commodity nor title to any such commodity. It is “not convertible by law into anything other
than itself and has no fixed value in terms of an objective standard” (Keynes, 1930). The value of fiat money
is derived from a premium based on a collective trust
in the continued existence and stability of the entity
issuing it. In simple terms, the difference between the
cost of producing money and its value to people who
own it is the trust they place in it
The fiat money era solved many of the problems of the
gold standard era by allowing policymakers greater
levels of flexibility to adapt to economic circumstances
and/or influence the economic decision-making of
households and corporations. The adoption of fiat currencies effectively expanded the central banker’s toolbox to allow adjustment of the supply of money through
interest rates and capital reserve requirements.
Nevertheless, the fiat money era also opened opportunities
for abuse by irresponsible policymakers – under the gold
standard, policymakers were forced to demonstrate ownership of an underlying asset (gold) that could act as collateral against the paper money they printed. Fiat money,
however, is uncollateralized and thus is only as valuable as
people believe it to be. This potential for abuse was recently summarized by the Governor of the Bank of England
“ Most forms of money, past and present, have nominal values
that far exceed their intrinsic ones. And this gap has meant
that money has a long and sorry history of debasement. Over
the centuries, forms of private money, such as the notes
issued by American banks during the free banking of the 19th
century, have inevitably succumbed to oversupply and
eventual collapse.
–
Mark Carney, 2018 6
”
Episodes of extreme inflation caused by irresponsible policymakers are dotted throughout history, often causing long-lasting economic hardships on a country’s population, due to the irresponsible printing of new money (often to finance government debt). A few well-documented cases are shown below (Zimbabwe) and to the right (Mexico, Brazil, Venezuela)
6. Speech was given by Mark Carney, Governor of the Bank of England to the inaugural Scottish Economics Conference, Edinburgh University (2 March 2018)
B. Currency Competition and the Chicago Plan
Hayek and Currency Competition
Throughout the 20th century, money creation remained
a monopoly of government/central banks and commercial banks. History has taught us that a monopoly on
money coupled with irresponsible policymakers and/or
commercial bankers under a fiat currency monetary
system can create dire consequences for the populations
they govern. Hayek argued that competition would
alleviate this problem by producing “good money”. This
was attributed to the idea that competition is a discovery process with constant experimentation in which
various improvements are offered to users of money
(Hayek, 1978b). Of necessity, such improvements are
subjective and dependent on changeable market opinions and demands. As a result, economist Anthony
Endres suggests that there may be no point in drawing
a sharp distinction between what is money and what is
not; competition over different forms of monies should
result in discoveries, modifications and service innovations that no one currency producer anticipates or
intends (Endres, 2009). It would be unconvincing to
suppose that currency was invented in a manner that
determines its properties and uses for all times and
places. This viewpoint led Hayek to question the usefulness of any international agreement to adopt a monetary management system:
"Why should we not let
people choose freely what
money they want to use? …
the best thing we could
wish governments to do is
for, say, all the governments
of the Atlantic Community,
to bind themselves
mutually not to place nay
restrictions on the free use
within their territories of an
another’s – or any other –
currencies, including the
purchase and sale at any
price the parties decide
upon, or on their use as
accounting units.
– Hayek, 1978a.
“
Since currencies issued by governments pursuing responsible monetary policy would tend to displace gradually those of a less-reliable character, competition
would “impose the most effective discipline on governments” for the appropriate management of the quantity of currency in circulation (Hayek, 1978a, p.21),
protecting money from political manipulations such as
those of Nixon and Burns. To avoid the inflationary bias
inherent in any international monetary policy coordination, Hayek suggested that national currencies should
be related by a system of flexible, market-determined
exchange rates, and individuals should be allowed to
substitute between various currencies without government prohibition. As evidence, economist Benjamin
Craig showed that the Russian monetary authority in
the 1990s was induced to target a lower level of inflation
as dollars were increasingly held and used illegally by
residents (Craig, 1996).
As every currency is potentially capable of playing a
role as an international vehicle for quoting prices and
settling trades across national borders, Harvard political economist Benjamin Friedman sees that the diminishing effectiveness of national monetary policies are
inevitable, if not desirable. Diminishing loyalty to any
single central-bank-issued money, the growth of nonbank credit, and technological advances are weakening
the monetary control of central banks (Friedman, 1999).
In recent years we have already witnessed the emergence of various global digital currencies, in line with
the claim of economic historian Charles Kindleberger
who argued that the market will create additional money to suit it’s needs and where official sources limit it’s
supply, the market will react by producing more (Kindlegerger, 1989).” It seems the discovery process of currency competition envisioned by Hayek has been in full
force, and we are to expect more discoveries from private innovation in the dynamic process of opinion
formation in the market.
Critics of Hayek have argued that bad money will drive
out good money. This has become known as Gresham’s
Law, which argues that when two forms of commodity
monies are in circulation, and both are accepted as
legal tender with the same face value, the intrinsically
more valuable money will gradually disappear from
circulation as people hoard their ‘good money’ and
spend their ‘bad money’. The principle was demonstrated in the United States when older half dollar coins with
90% silver were hoarded and melted down by the public after the government had introduced newer ones
with only 40% silver in 1965. These newer coins eventually also disappeared from circulation when the
government gave up including any silver in half dollar
coins in 1971. This shows that legal tender laws could
motivate buyers/debtors to offer only money with the
lowest commodity value (bad money), since sellers/
creditors are required by laws to accept such money at
face value.
In absence of effective legal tender laws, Gresham’s Law
could also work in reverse. This was demonstrated in
post-WW1 Germany when consumers fled from cash to
hard assets as circulating medium of exchange after
the hyper-inflation in 1922 (a similar trend was observed during the hyper-inflation events in Zimbabwe).
Given the choice of what money to accept, sellers/creditors can now demand only money with the highest
long-term value, further reducing the acceptability and
value of bad money. This coincide
-------------------------------------------------------------------------------------------------------------------------
that when the government does not intervene in people’s
choice of money in transactions, competition naturally
produces good money. Robert Mundell therefore proposes modifying Gresham’s Law into “bad money drives out
good if they exchange for the same price.” (Mundell, 1998)
The Fractional Reserve System
As the international monetary system evolved in the
20th century, fractional reserve banking has remained
widespread. In fact, the practice dates as far back as the
1300s, 8 but is not well understood by the public or academic textbooks.
The fractional reserve system is a banking system in
which all depository institutions-commercial banks,
credit unions, and other banks—are required to maintain reserves against transaction deposits, which
include demand deposits, negotiable order of withdrawal accounts, and other highly liquid funds. Reserves against these deposits can take the form either
of currency on hand (vault cash) or balances at the
Central Bank.
Fractional reserve banking
can be simply explained using
the scenario to the left where
1,000 units of central bank-issued ‘base money’ is deposited at a commercial bank.
Where the bank is required to
hold a percentage (10 in this
case) of their loan liabilities in
reserves, they can loan out
900 units backed by a 100-unit
deposit (first row). If we suppose that the household taking the loan purchases a house
from another household, the
house seller will likely deposit those funds back in the
bank. In this case, the bank
can again lend out 90% of
those new deposits (second
row). As this cycle continues,
the amount of ‘broad money
in the economy grows significantly (second and third row).
In the last row, there are now
3,439 units of the total money in
the economy from the initial
1,000 units in central bank-issued money.
To give a practical example, in
the UK about 97% of the broad
money supply is made up of
uncollateralized loans, with
only about 3% supported by
actual cash. This system comes
with both advantages (more
liquidity for small businesses
and households) and disadvantages (the moral hazard problem and boom-bust cycles).
Central banks still maintain
control over the supply of money but this is through a combination of influencing interest
rates and setting capital reserve requirements and adequacy ratios.
 |
| (a) Balance sheets are highly stylized for ease of exposition: the quantities of each type of
money shown do not correspond to the quantities actually held on each sector’s balance
sheet. (b) Central bank balance sheet only shows base money liabilities and the corresponding assets. In practice, the central bank holds other non-money liabilities. Its non-monetary assets are mostly made up of government debt. Although that government debt is actually held by the Bank of England Asset Purchase Facility, so does not appear directly on the balance sheet. (c) Commercial banks’ balance sheets only show money assets and liabilities before any loans are made Source: Mcleay et al., 2014 |
The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the Bank of England’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy. As a result, the Bank of England is able to ensure that money growth is consistent with its objective of low and stable inflation.
Mcleay et al., 2014.
Much like the move from the gold standard to fiat money, fractional reserve banking relies on an uncollateralized reliance on public trust – as long as there are no
runs on the bank, fractional reserve banking can function well, with commercial banks creating new money
through uncollateralized loans to finance innovative
new companies. The flexibility in creating loans and
money facilitates business borrowing and investment,
hence further expanding economic activities during
booms. However, fractional reserve banking is a double-edged sword: the very same flexibility can also
aggravate economic contraction during busts.
To understand the mechanism, notice that money (demand deposits) in a fractional reserve banking system
is either backed up by cash or created through bank
loans. Whenever a bank loan is repaid, the total amount
of cash remains unchanged. A reduction in bank loans
hence implies a reduction of money supply in the system.
In other words, bank loan reduction – either by repayment or declaration as bad debt - destroys money.
The negative effect of such monetary contraction channels was demonstrated in the United States during the
Great Depression. As the stock market crash in October
1929 made it difficult for businesses to repay their loans,
the balance sheets of many US banks eroded. To satisfy the legal reserve requirement, these banks had to
call loans to reduce their demand deposits, which led
to even more bad debt, given many businesses were
already experiencing financial difficulty. As a result,
panics spread and generated the first wave of bank runs
in late 1930, with 352 banks failing in December 1930
alone.
The origins of the Chicago Plan can be attributed
back to the United Kingdom where the 1921 Nobel
Prize winner in chemistry, Frederick Soddy shifted
his focus to the inefficiencies and unfairness inherent in fractional reserve systems of ‘virtual wealth’
(Soddy, 1933). The ideas of Soddy were embraced by
Professor Frank Knight in 1927 at the University of Chicago. In practice, however, the challenges of fractional reserve banking are made clear only during
times of panic or financial crises. In the aftermath
of the Great Depression, a significant conglomerate
of University of Chicago economists, along with
prominent monetary economist Irvin Fisher at Yale,
supported Knight’s proposals to reform the financial
system and sent a detailed memorandum to President
Roosevelt in November 1933 (see Simons et al.,1933).
Following the Great Depression, Fisher envisioned
the Chicago Plan as “a way to use monetary policy
to affect debtor-creditor relations through reflation,
in an environment where, in his opinion, over-indebtedness had become a major source of crises for
the economy”. (Benes and Kumhof, 2012). Fisher was
a pioneer in advocating for the requirement of a 100%
cash reserve behind all demand deposits, a proposal
subsequently known as the Chicago Plan (Fisher,
1936; Simons, 1946). Fisher observed that the volume
of demand deposits was highly unstable because of
the fractional reserve banking system. By eliminating the possibility of bank runs, he believed the
proposal would speedily and permanently prevent
an economic recession from spiraling into depression by i) increasing control of sudden increases and
contractions of bank credit and of the supply of
bank-created money, ii) eliminating the possibility
of bank runs, iii) dramatically reducing the net public debt and iv) dramatically reducing private debt
(as money creation would no longer require simultaneous debt creation) (see Tobin, 1985; Minsky, 1992,
1994; Benes and Kumhof, 2012).
In simple terms, under the Chicago Plan, all demand
deposits held by commercial banks must be matched
by an underlying asset such as cash. This means that
these banks cannot lend out customers’ demand deposits as they do under the fractional reserve system,
which would significantly decrease liquidity in 100%-
backed reserve countries (for example 97% of the money
in the UK would need to be replaced with central bank
base money). As banks can only lend against proven
reserves, the risk of bank runs would vanish, so banks need not call loans during the economic downturn
to worsen the liquidity of businesses. On top of resolving the coordination failure of banks during bad times,
banks could also benefit from such arrangements, as
more savings and time deposits would be brought to
banks due to freedom of the economy from great booms
and depressions.
More importantly, the government could regain its
sovereign power over money under the Chicago Plan.
By prohibiting banks from manufacturing the money
they lend, but still allowing banks to lend money as
they please, the government could nationalize money
without nationalizing banking. With a 100% cash reserve requirement, all the money on deposits now
fully belongs to the depositors, so banks act merely as their trustees or custodians. The absence of leverage in the Chicago Plan, Fisher believed, could therefore prevent the freezing of loans during a depression,
and effectively eliminate the management and domination of the industry by banks during bad times. In the
words of Martin Wolf, chief economics commentator
at the Finance Times, this will end the “too big to fail”
for banking (Wolf, 2014).
C. How does this fit into the
era of digital currencies?
We can get a better idea of the role that trust has come to play in money by examining four simple scenarios from
a balance sheet perspective.
The first scenario involves a transaction between the central bank and household under the gold standard (or any
other asset-backed money such as stable coins). Because paper money is backed by physical gold (or another
valuable asset), this scenario does not require households to have an implicit trust in the central bank, as each
unit they borrow is backed by a unit of physical gold of the same value
The second scenario involves a similar transaction between the central
bank and a household under fiat
money. Because paper money is not
backed by physical gold, there is now
a difference between the cost of producing the paper money and the
value to its users. This creates a premium (seignorage) which requires a
relationship of trust and confidence
in the issuing authority.
In the third more realistic scenario,
the central bank lends 100 in fiat
currency to a commercial bank who,
under fractional reserve banking,
can lend out more money than they
hold on deposits (say 90%). In this
case there now exists several relationships of trust between commercial banks, depositors, borrowers,
and the central bank
At this point, there exists 100 units
in central bank (narrow/outer)
money, which requires a relationship of trust between the central
bank and households, and 900 in
commercial bank (inner) money
which requires a relationship of
trust between households and commercial banks. As noted above, the
only time where the vulnerabilities
are exposed in the fiat currency
fractional reserve system is when
trust in these institutions erodes.
Lastly, in scenario 4 we can impose
the Chicago Plan restrictions on
scenario 3, which now requires commercial banks to hold an equivalent
value of assets to their liabilities
(demand deposits). In this case,
commercial banks would need to
borrow at least 900 units from the
central banks in order to fulfil the
100% reserve requirement.
Comparing this with a peer-to-peer issued cryptocurrency, like Bitcoin, in scenario 5 no liability is created when
a bitcoin is mined. For example, the supply of bitcoin is increased by rewarding those who successfully validate
transactions making it a transaction and not a financial contract (as was the case with bank money). The issuer
is not an institution or entity and the currency is not backed by any authority. This creates a challenge when
accounting for Bitcoin. One option is to treat it like monetary gold, which is the only existing financial asset with
no liability. But as noted by the BOE,9 gold is a tangible asset that you can physically store.
A second option, shown in scenario
6, used by stablecoins (i.e. Libra), is
to fully collateralize all-digital money with other liquid assets such as
high quality government and corporate bonds, in which case the scenario is similar to that under the gold
standard from scenario 1, where
there is no need for a relationship of
trust to be created given the backing
of that digital currency by other high
quality financial assets
6. Stablecoin Cryptocurrency Issuer creates 100 units backed by 100 units of underlying assets and sells to household
Once cryptocurrencies have been acquired, users do not need to rely on
trust between themselves or any institution to ensure its value because
of the collective security embedded in the blockchain technology. This
means that miner 1 can make transactions with miner 2 without any
requirement that they trust each other. (see scenario 7 below) Again,
this is similar to trading with physical gold (or under the gold standard)
but does not require a physical validation of the legitimacy of the gold.
7. Cryptocurrency owner 1 makes the transaction of 100 with other network members 2
Note that cryptocurrencies in this example are limited to transactions and not financial contracts. This means
that no financial relationships are created and no liabilities will exist on anyone’s balance sheet. In the case of
Bitcoin, these tokens are created by a mining reward algorithm and backed by the collective pool of people who
own it. If that collective pool loses trust in bitcoin, its value diminishes. In the case of stablecoins, the collective
pool is assured of the value of their currency by the holding of high-quality assets of equivalent value.
In summary, the leveraged way in which money is currently being created has the potential to (again) destabilize
financial systems only when trust in those institutions erodes. These destabilizations often lead to short revivals
of Austrian school ideas regarding the role of money and banking in society (for example, Fisher's seminal paper
following the Great Depression). It is likely no coincidence that the Nakamoto (2008) paper emerged at the same
time as the most recent financial crisis was occurring. In fact, one of the core motivations of Bitcoin’s creators
was the eradication of middlemen and/or money creators who profit from these activities
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