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Post 7 - Hi$tory III - FIAT and FED (1973 to now)

October 6, 2023    .    3 min read

The move from gold money to FIAT money in the early 1970s was a big step for the United States and the world. Heralding it a great step forward is … premature.


The transition from gold to FIAT had been in the making for some time. With the beginning of widespread use of paper money in the 19th century, money was always partially shiny, partially shady. Banks and central banks issuing currency never held 100% of gold in the kitty to back the issued paper. The latter generally targeted to hold at least 30% of the value of issued notes in gold. The remainder was mostly “secured” by government debt. The mix was usually sufficient to make people see money as good as gold.


By 1973 it was all too obvious that the gold in the kitty of the US government was no longer anywhere near sufficient to make the US dollar at least appear “gold backed”.  The dollar had been “debased”. Since time immemorial rulers have “debased” money by lowering the content of whatever precious metal was backing a currency unit. The arrival of central banks rendered changing the precious metal content ratio, limiting or cancelling the right to exchange money for precious metal, particularly simple.

 
But for as long as money was linked to gold – be it during the regime of the real “gold standard” before WWI, the “gold exchange standard” during parts of the interwar period, or “Bretton Woods” after WWII – the creation of new money was subject to a modicum of limits. At least in principle, more of the yellow metal was needed to put more money into circulation. The end of Bretton Woods in 1973 brushed away any need or ambition to source more gold to back an increase in money. As a further result, currencies were now freely floating and their exchange rates constantly changing.


FIAT money is legal tender by decree and convertible into nothing. Holders take a leap of faith in the central bank’s capacity to uphold its value. Crucially, FIAT opened the tabs to money creation. In ultimate control of the tab is the central bank. This enormous power put central bankers at the center of the financial universe. We must learn about these Masters of the Universe if we want to master our own (financial) future.


Undisputedly, the US Federal Reserve (FED) is the most powerful central bank since it is the steward of the US dollar, the world’s most important currency. Surprisingly, though, the FED was a late comer. By the time it was founded in 1913, pretty much every other self-respecting power had had a central bank for decades.


Why did the first central banks come about? It was the usual culprit: war.


War is costly – then and now.


War leads governments to spend more money than they have. To help fix this inconvenience, having a central bank helps.


Sweden was first setting up a central bank in 1668 for this reason. While the concept of a central bank, or in the Swedish case the “Riksbank”, as it would be renamed later, eventually went global, the modicum the Swedes picked for money didn’t: Copper. It did not stand the test of time. It was too plentiful, clunky and easy to extract … and so didn’t keep its value against precious metals like gold or silver. To have a valuable piece of currency required minting heavy coins. The Riksbank minted a copper coin weighing almost 20 kilos[1]. Not great for its “salability”. No wonder the copper standard shared the fate of the Dodo.


The British went next, setting up the Bank of England (BOE) in 1694. The BOE was tasked to help manage the finances of the government and secure funding to allow rebuilding of the fleet, which the French had decimated in battle. Private lenders wanted assurances that money lent to the government would be soundly invested and repaid with interest. By the end of the 18th century, the Spanish and French had set up central banks. The Dutch followed early in the 19th century. By the end of the 1870s, Germany, Japan and most other powers had set up central banks and given them the monopoly to issue currency.


Centralizing control over money in a single institution came easy to countries with highly centralized power, which is always the case with monarchies; though not so with federal republics like the United States and my home country Switzerland. Their DNA made the issue of centralizing power over money a contentious one.


Swiss parliamentarians worried that a central bank “would allow for state socialism” and “public control of credit policy”. Libertarians were fiercely opposed to the idea of a central bank[2]. Eventually, the desire for a central bank to grease the wheels of commerce won the debate and the Swiss National Bank (SNB) was given a lease on life in 1907.


Before the arrival of the SNB, only coins and small denomination notes issued by Swiss commercial banks were in circulation. Businesses wanted larger banknotes for B2B deals, and a reliable supply in times of heightened money needs, such as on agricultural pay dates. Only a trusted central bank could provide that. Fear of too much power in the hands of central bankers was assuaged with the gold connection: for as long as money was tied to gold, central bankers’ hands to create it freely were somewhat tied.


Shortly after inception, the SNB issued a first series of banknotes with large denominations. It came with birth defects and was replaced with a second series in 1911. These notes would remain in circulation until the 1950s.


Why should you care?


Because you must meet my grandmother. See - she was right on this money, more specifically on the back of the 500 Swiss Franc note issued in 1912. She is sitting on the left stitching embroidery, one of the few professions open to Swiss women at the time. We will visit her again in a blog post.

 

Source:   Second banknote series (1911). (n.d.). Swiss National Bank. Retrieved September 26, 2023, from https://www.snb.ch/en/iabout/cash/history/id/cash_history_serie2#t3

The last country of the major powers hitching on the central banking wagon was the United States. Like the Swiss, US lawmakers went through convulsions before agreeing to set up a central bank. Not for the first time.


The United States had run trial balloons with a kind of central bank a century earlier. After founding the Republic, the “First Bank of the United States” was given a charter that differed from standard commercial banks. The charter was limited to 20 years. Its successor, creatively named “Second Bank of the United States”, received another 20-year trial period. At its expiration in 1836, President Jackson did not renew the bank’s license. Jackson worried that a central bank would be instrumentalized by powerful private interests (did he have a point? You bet!). The absence of a central bank did not stop the US from prospering for the next 70 years.


The US banking crisis of 1907 gave new firepower to those arguing for the need of a central bank. Foremost the institution should help solvent banks overcome a short-term liquidity crisis and so prevent bank runs and failures. In short, a lender of last resort was needed. Not surprisingly, powerful bankers lobbied strongly in favor of a central bank.


In 1913, Congress overcame its reluctance to bundle power over money in a single institution. To appease critics the US central bank was dressed up and sold as a “federal” entity and christened “Federal Reserve System”. The “system” was composed of 12 districts, each with its own Reserve Bank, which supposedly enjoyed substantial autonomy. Eventually, all levers of power got into the hands of a small group of people, headed by a Chair of the Board of Governors sitting in Washington.


With the FED, the US created what would arguably become the world’s most powerful institution.  That was not obvious at the FED’s founding when the gold standard still ruled. For the first 60 years, the FED’s powers were somewhat kept in check by money’s link to gold.


That all changed with the arrival of FIAT money in the early 1970s. Now the FED’s powers became God-like.


In the Latin version of the book of genesis, God declared “FIAT lux” … “there shall be light” … and so there was light and darkness had gone.

 
Similarly, with the collapse of Bretton Woods, central banks now received the power to declare “FIAT money”, i.e. “there shall be money” – et voilà – there is new money. They also got the right to delegate this enormous power to commercial banks.


How money is created in a FIAT system is subject of the next post. We also need to know just how much money is out there now. Ready yourself for big numbers.
 

 

References

 

[1] Historical timeline | Sveriges Riksbank. (n.d.). Riksbanken. Retrieved August 11, 2023, from https://www.riksbank.se/en-gb/about-the-riksbank/history/historical-timeline/.

[2] Abegg, W., & Baltensperger, E. (2007). The Swiss National Bank 1907-2007. Swiss National Bank, page 33

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