The Fiat Era and Inflation

The Sunday that changed money

On the evening of Sunday 15 August 1971, the President of the United States Richard Nixon appeared on television for an address carried by all networks. Among the various economic measures he announced to Americans there was one that, beneath its technical and almost anodyne formulation, marked the end of a millennial age: the United States suspended the convertibility of the dollar into gold. From that moment, foreign central banks would no longer be able to present their dollars to the American Treasury and receive gold in exchange, as the Bretton Woods system had promised since 1944. The link between the dollar and gold, the last thread that still kept the principal currency in the world anchored to precious metal, was severed. Nixon presented the measure as temporary, a defence against speculation; but temporary it was not, and that thread would never be tied again. With that Sunday announcement, made for contingent reasons and perhaps without its own authors fully grasping its historical reach, there ended not only Bretton Woods, but something much greater: there ended the millennia during which money had been, in one way or another, tied to a precious metal, and there began the era of fiat money, the money that no longer promises anything except itself.

It is worth explaining the term at once, because it is the key to the whole chapter. fiat money is an expression that comes from Latin: fiat means “let it be done”, “so be it”, as in the “fiat lux”, let there be light, of the biblical account of creation. Fiat money is money that is worth something by decree, by the declared will of the authority: it is worth something because the state says it is worth something, and imposes it as legal tender, not because it is made of gold or convertible into gold. Throughout the history we have told so far, money had been, in the end, anchored to something tangible: the gold coin was worth its metal, the convertible banknote was worth the promise to give you the gold. From 1971, for the first time in the history of humanity, the world’s money as a whole found itself suspended in the void, without any metallic anchor: no currency, from that moment, is any longer convertible into gold, and the value of money no longer rests on a precious substance, but only on trust in the authority that issues it. It is the point of arrival of the whole history this book tells, the complete dematerialisation of money, the “value from nothing” of the title carried to its absolute form: a money that is no longer even the promise of a thing, but only a sign that is worth something because everyone accepts that it is worth something.

This chapter tells what happened when money was freed from gold. It was, as we anticipated in closing the previous chapter, a gamble: the iron discipline of metal abandoned, the stability of money would henceforth depend only on the wisdom of those who governed it. And the first thing that happened, in the seventies, was that that wisdom proved insufficient, and the world plunged into the gravest wave of inflation in its recent history, which put to a very hard test the trust in the new money without anchor. We shall tell that great inflation, its debated causes, and the drastic and painful cure with which it was finally tamed; and from that affair we shall try to answer the underlying question that the fiat era raises: what gives value to a money that promises nothing?

Why Bretton Woods collapsed

To understand why Nixon severed the link with gold, one must recall the contradiction that, as we had seen, was inherent in Bretton Woods from birth. The system rested on the promise that the dollar was convertible into gold, and therefore on the trust that the United States would always have gold enough. But the world, growing and trading, needed ever more dollars, and the United States had supplied them in growing quantity, spending abroad, importing, financing its own military presence in the world and, in the sixties, a costly war and a great expansion of domestic public spending. In time, the mass of dollars circulating in the world ended by far exceeding the gold kept as guarantee: the promise of convertibility had become, in effect, impossible to honour, because if all the holders of dollars had demanded conversion together, American gold would not have sufficed even remotely.

It was the same contradiction of the fractional reserve we had met speaking of the banks, but this time on a world scale and with gold in place of liquidity: the quantity of promises (the dollars) grown enormously above the reserve (the gold) that should have guaranteed them. And like every fractional-reserve system, Bretton Woods too was exposed to a kind of international run on the banks: as it became evident that the United States did not have enough gold for everyone, foreign countries began to fear being left with dollars no longer convertible, and some — France first of all — began to demand to convert their dollars into gold while there was still time, draining the American gold reserves. It was the beginning of a run that, if not stopped, would have emptied the vaults of the United States. In the face of this haemorrhage and of the by-now manifest impossibility of keeping the promise, Nixon chose the only way that remained to him: to break the promise unilaterally, to suspend convertibility, to let the dollar — and with it all the currencies of the world anchored to it — unhook itself from gold. The Bretton Woods system, undermined by its original contradiction, thus collapsed in 1971, and after a few years of attempts at patching the world found itself in an entirely new regime: fiat currencies, non-convertible, whose mutual exchange rates were no longer fixed but floated freely on the markets [Eichengreen 2008].

One fact, however, survived the collapse, and it is essential to understanding the monetary order in which we still live: the dollar remained the reference currency of the world, even after losing every link with gold. One might have thought that, the golden anchor severed, the dollar would lose its primacy; and instead it kept its role as the principal currency of international exchange, of central-bank reserves, and of commodity pricing. Oil, in particular, continued to be priced and traded in dollars all over the world, and this link between the dollar and the most important raw material on the planet — sometimes evoked with the expression “petrodollar” — helped to sustain the demand for dollars and therefore their value. The primacy of the dollar, by now, no longer rested on the gold kept at Fort Knox, but on the economic, military and political power of the United States, on the depth and security of their financial markets, on the habit and the trust of the whole world. It too was a value founded on trust and on power, not on metal: the dollar became fiat money par excellence, accepted all over the world not because it promised gold, but because everyone accepted it and trusted whoever issued it. Whether this primacy of the dollar founded on trust is destined to last, or whether other powers and other currencies may one day undermine it, is one of the great open questions of our time, of which we shall speak in the last chapter.

Value without anchor

Before facing that question, it is worth describing the new monetary world that emerged from the rubble of Bretton Woods, because it is the world in which we still live. Unhooked from gold and from one another, the principal currencies of the world began to float freely: their mutual value was no longer fixed by decree, but determined from moment to moment by the currency markets, where currencies are bought and sold like commodities, and where their price rises and falls according to supply and demand, economic news, the movements of capital. It was the second solution of the trilemma we had stated in the previous chapter: to give up the fixity of exchange rates to reconquer the autonomy of monetary policy. Since then we live in a regime of floating exchange rates, in which the value of one currency against another changes continuously, and in which the currency markets, enormous and very fast, have become one of the most characteristic and most volatile aspects of global finance. In the same period, and not by chance, money continued its dematerialisation also on the physical plane: ever less paper and metal cash, ever more bookkeeping entry, electronic record, numbers transferred from one account to another through computer networks. The money of the fiat era has gone on becoming, besides unbound from gold, also progressively immaterial in its form: no longer even paper, but pure information that circulates among the computers of the banking system, anticipating that complete digitalisation of money of which we shall speak in the last chapters [Davies 2002].

There arises then the question that is the conceptual heart of this chapter, and perhaps of the whole book: what gives value to a money that promises nothing? If the banknote is no longer convertible into gold, if it is made of no precious metal, if it is only a piece of paper — or, more and more, an electronic balance, an entry in a computer — why on earth should it be worth anything? Why do we accept it in payment, why do we entrust our savings to it, why do we work to obtain it? The answer to this question brings us back to the great theories on the nature of money we have met since the first chapter, and shows how deep the credit, or chartalist, intuition of money was.

The answer is that fiat money is worth something for a combination of factors, none of which is metal. It is worth something, in the first place, because the state imposes it as legal means of payment and, above all, because it demands in it the payment of taxes. This is a subtle and fundamental point, which the chartalist theory had grasped: the money of the state is worth something also because the state demands it back in the form of taxes. Each of us must pay taxes, and must pay them in the money of the state; this creates a universal and inescapable demand for that money, which confers value on it independently of any metal. The fiscal monopoly of the state — its power to tax and to establish in what the taxes are to be paid — is one of the pillars on which the value of modern money rests. But fiat money is worth something also, and perhaps above all, for a simpler and more circular reason: it is worth something because everyone believes it is worth something and everyone accepts it. I accept the banknote because I know the shopkeeper will accept it; the shopkeeper accepts it because he knows his supplier will accept it; and so on, in a chain of mutual trust that sustains itself. The value of fiat money is a social convention that rests on its own generality: it is worth something because it is accepted, and it is accepted because it is worth something.

One sees here, in its purest and most vertiginous form, the truth that runs through this whole book. Already in the first chapter, speaking of Mesopotamian debt, we had seen that money is in the end a record, a promise, a social convention, and not a thing. For millennia this conventional nature of money had been masked by metal: the gold coin seemed to be worth its substance, and one could believe that money was, after all, a precious thing. Fiat money tears away this mask and shows money for what it has always been in the end: pure trust, pure convention, value that exists only because a community agrees that it exists. The “value from nothing” is no longer, in the fiat era, a pathological exception as in the bubbles, but the normal and permanent condition of money: all our money, today, is value created from nothing and sustained only by trust. This is at once liberating and disquieting. Liberating, because it frees money from the physical limits of metal and allows it to be managed according to the needs of the economy. Disquieting, because a value that rests only on trust is exposed, like everything founded on trust, to the risk that trust may fail. And what happens when trust in money begins to waver, was shown dramatically precisely by the decade that followed the end of Bretton Woods.

The great inflation

In the seventies, the Western world was overwhelmed by a wave of inflation such as had not been seen for generations. Prices began to rise at rates that, for advanced economies accustomed to stability, were alarming: inflation, which in the previous decades had been contained, rose to double-digit percentages in many countries, eroding wages, savings, trust. It was a complex phenomenon, of multiple and still debated causes, and it would be a mistake to reduce it to a single, simplistic explanation. Several factors concurred. There was, certainly, the end of the golden discipline: freed from the constraint of gold, the monetary authorities could create money more freely, and in many cases did so in excessive measure, also to finance the growing public spending, feeding inflation according to the mechanism the quantity theory has taught us. There were the oil shocks: in the course of the decade, the price of oil — a fundamental raw material for every economy — underwent sudden and dramatic increases, which transmitted themselves in cascade onto all prices, because energy enters into the cost of everything. And there was a deadly psychological mechanism, that of expectations: once inflation has settled in, it tends to feed itself, because workers, expecting prices to rise, demand wage increases to defend themselves, and enterprises, expecting higher wages and costs, raise prices, in a spiral between wages and prices that spins on itself.

It is worth dwelling on what inflation means, concretely, for those who undergo it, because it explains why it is feared and why its defeat was experienced as a liberation. Inflation is, first of all, a silent erosion of the value of money, and therefore of savings and fixed incomes. Whoever has set aside a sum, whoever lives on a pension or a salary that does not adjust quickly enough, sees his purchasing power thinning month after month, without anyone having openly taken it from him: the money he possesses remains the same in number, but buys ever less. For this reason inflation has been called a “hidden tax”: it transfers wealth in a concealed way, without a vote of parliament, without a declared levy, simply by making money lose value. And its effects, as we had seen speaking of the price revolution of the sixteenth century, are not neutral: inflation harms creditors and those who hold money or fixed incomes, and favours debtors, who return in debased money what they have received in money of greater value. The first great debtor of every economy is the state, and it is for this that states have often a secret temptation toward a little inflation, which lightens the real burden of their debt: but it is a dangerous temptation, because inflation, once let run, tends to get out of hand and to destroy the very trust in money. In the seventies it was precisely this perception — that inflation was eroding savings, rewarding imprudence, undermining trust in money — that made the phenomenon politically intolerable, and prepared the ground for the drastic cure that would follow.

What made the seventies particularly bewildering, and what threw the dominant economic thought into crisis, was the combination of two evils that the theory considered incompatible: inflation and stagnation together. According to the prevailing economic view until then, largely inspired by Keynes, inflation and unemployment were in some way alternatives: when the economy was pulling and employment was high, prices tended to rise; when the economy stagnated and unemployment grew, prices tended to slow. One could, according to this view, choose a point of equilibrium between the two evils, accepting a little more inflation to have less unemployment or vice versa. But in the seventies the unthinkable happened: the economy stagnated, unemployment grew, and yet prices continued to rise. Stagnation and inflation together — a phenomenon for which the word stagflation was coined, stagflation. It was something the dominant Keynesian theory struggled to explain, and this failure opened the way to a revolution in economic thought, and to a new generation of ideas and policies [Ferguson 2008].

The monetarist revolution

To lead that revolution was an economist, Milton Friedman, and a current of thought, monetarism, which brought back to the centre of the stage the quantity theory of money we had met in the sixteenth century. Friedman’s thesis, formulated with great force and clarity, was that inflation is always and everywhere a monetary phenomenon: it arises, in the last analysis, from the creation of too much money relative to the available goods, and is fought by controlling the quantity of money. Against the Keynesian faith in the capacity of the state to govern the economy with public spending, the monetarists opposed distrust of state intervention and faith in monetary discipline: the priority had to be the stability of prices, to be obtained through a rigorous control of the growth of the quantity of money. The inflation of the seventies, according to this reading, had been caused by an excessive monetary growth, and could be tamed only by bringing that growth back under control, even at the cost of a recession.

It is important, for honesty and for consistency with the balanced approach of this book, not to turn this affair into a fable in which monetarism triumphs over the Keynesian error thanks to its superior truth. The reality was more nuanced. Monetarism grasped an important point that the Keynesianism of the time had neglected — the role of the quantity of money and of expectations in inflation — and its ideas proved effective in combating the inflation of those years. But the causes of stagflation remain the object of debate among historians and economists, and there concurred in it, as has been said, different factors, among them the oil shocks, which were by no means of a purely monetary nature. Moreover, the rigid application of the monetarist recipes would later show its own limits, and subsequent economic thought would absorb elements of both Keynesianism and monetarism, without either school being able to call itself the absolute victor. What is certain is that, toward the end of the seventies, the intellectual and political climate was ripe for a turn: inflation had become intolerable, trust in the old recipes had collapsed, and the conviction made its way that a drastic cure was necessary, founded on monetary control, to break the inflationary spiral. That cure had a name and a face.

The Volcker cure

The face was that of Paul Volcker, appointed to the head of the American central bank, the Federal Reserve, toward the end of the seventies. Volcker was convinced that inflation was the supreme evil to be combated, and that to break it a monetary squeeze of unprecedented severity was necessary, whatever its cost in the short run. And so he did: the Federal Reserve under his guidance brought interest rates to very high levels, never seen, drastically contracting the quantity of money and credit. It was shock treatment, and its immediate effect was exactly what one could expect: a grave recession, with high unemployment, bankruptcies, widespread suffering. Volcker knew that his policy would provoke a recession, and he provoked it deliberately: the recession was the price to be paid to break inflation, the very means of the cure. By raising rates and suffocating credit, the economy was slowed, unemployment was made to rise, and this broke the spiral between wages and prices: in the face of recession and the fear of losing their jobs, workers stopped demanding increases, enterprises stopped raising prices, and inflation, deprived of its fuel, began to fall.

The cure was painful and unpopular — Volcker was the target of protests and anger during the years of the squeeze — but it worked. In the course of the early eighties inflation, which had risen to alarming levels, was brought back under control, fell to tolerable percentages, and trust in the stability of money was gradually re-established. The price, as has been said, was a heavy recession and high unemployment; but the result was the end of the great inflation and the beginning of a long era of relatively stable prices, which would last for decades. The lesson drawn from it, and that would shape monetary policy for a generation, was twofold. In the first place, that inflation could be tamed, but at a high cost, and that the determination to pay it was essential: a central bank had to be willing to inflict a recession, if necessary, in order to defend the stability of prices. In the second place — and it is the point that brings us back to the theme of the fiat era — that in a world without golden anchor, the stability of money depended entirely on the credibility and the determination of the central bank: it was the firmness of Volcker, not a metallic constraint, that served as the anchor of money. Gold had been replaced by the credibility of an institution.

Independence as the new anchor

From this experience was born the doctrine that would govern money for the following decades, and that is the point of arrival of the evolution this book has told: the idea that, in the fiat era, the anchor of money is no longer gold, but the credibility of an independent central bank, devoted to the stability of prices. We had met, in the chapter on central banks, the tension between the independence necessary to guarantee stability and the political control necessary to legitimise power. The experience of the inflation of the seventies and of the Volcker cure tipped the balance, for a long season, in favour of independence. The conviction took hold that, precisely because fiat money no longer had the brake of gold, a substitute brake was needed, and that this brake should be a central bank independent of political power, capable of resisting the temptation to print money to finance spending or to win consensus, and committed in a credible way to keeping inflation low. The credibility of that commitment became the new anchor: if everyone believes that the central bank will not allow inflation to get out of hand, then inflation expectations remain low, and inflation itself remains low, in a virtuous circle that is the exact opposite of the spiral of the seventies.

For decades, from the eighties on, this model seemed to work admirably: inflation remained low and stable in the advanced economies, the independent central banks enjoyed great prestige and trust, and it seemed that the age-old problem of the instability of money had finally been solved through the combination of fiat money and independent central bank. It was a period of such stability that economists gave it complacent names, speaking of a “great moderation”. But it would be imprudent to conclude that the problem has been solved once and for all. The history this book tells teaches that monetary stability is never a definitive acquisition, but an ever-precarious conquest, exposed to new threats. The great financial crises of our century, of which we shall speak in the next chapter, would test that model in new and unforeseen ways; and the return of inflation, after decades of quiet, would remind us that the problem had not been eliminated, only suspended. Fiat money, unbound from gold and entrusted to human wisdom, remains a historically young experiment, whose long-term outcome is still, in large measure, to be written.

When trust dies

There remains to address the most terrible face of inflation, the one that shows what happens when trust in a money does not simply waver, but collapses entirely: hyperinflation. One speaks of hyperinflation when prices do not rise by a few percentage points a year, but multiply at a vertiginous rate, doubling in the space of months, weeks, or in the most extreme cases even days. It is a phenomenon qualitatively different from the high inflation of which we have spoken: it is not a money that loses value gradually, but a money that dies, that ceases to function as money because no one wants to hold it any longer, knowing that it will be worth less tomorrow than today. In hyperinflation people run to spend money as soon as they receive it, before it depreciates further; money burns in the hands; and in the end one returns in effect to barter or to the use of foreign currencies, because the national money has lost every capacity to perform its function.

The most famous historical example is that of Germany in 1923, during the Weimar Republic, when the German mark knew one of the most extreme hyperinflations in history. The images of that period have entered into legend: prices that changed several times a day, banknotes of astronomical nominal values, people who carried money with a wheelbarrow or used it, it is told, to light stoves because it was worth less than firewood. Here, however, the caution that this book has always recommended in the face of stories too perfect is needed. Many of the most extreme anecdotes about the Weimar hyperinflation have been repeated and amplified over time until they cross into legend, and the precise figures of that monetary collapse are so large as to be almost devoid of intuitive meaning. It is well to stick to the substance, which is already shocking enough without need of exaggerations: the German mark lost, in the course of 1923, so vast a fraction of its value as to become in practice waste paper, the savings of an entire middle class were annihilated, and the economic and social trauma was so deep as to leave lasting wounds in German society. Hyperinflations, moreover, were not a unique phenomenon of Weimar: history records several of them, in different times and places, down to recent cases in various countries, and the systematic study of monetary crises shows that they recur, with similar characteristics, whenever certain conditions occur [Reinhart & Rogoff 2009].

What causes a hyperinflation? Almost always, at the root, there is a state that has lost the capacity to finance itself normally — through taxes or debt — and that resorts to the printing of money as a last resort to cover its expenses. It is the mechanism we had glimpsed speaking of seigniorage and its temptation, carried to its extreme outcome: the state prints money in growing quantity to pay its debts, but by so doing it destroys its value, and must therefore print still more of it to obtain the same purchasing power, in a spiral that feeds itself until total collapse. Hyperinflation is, in this sense, the point at which the “value from nothing” reverses into its opposite: the state, creating money from nothing without limits, ends by reducing that money to nothing. It is the extreme and tragic demonstration of the fact that fiat money, precisely because it is worth something only by trust, can lose all value when that trust is destroyed by abuse. And it is also the deep reason why the fiat era has needed to invent the independent central bank, the substitute discipline of gold: because without a brake, the temptation to create money from nothing can lead, at the extreme, to the very death of money.

So closes the circle opened with Nixon’s announcement. Freed from gold, money has become a pure instrument in the hands of man, capable of great good — because it can be managed for the welfare of the economy, as Keynes had hoped — but also of great evil, because it can be abused to the point of destroying it, as the hyperinflations demonstrate. The fiat era is the era in which the responsibility for the value of money is entirely in human hands, without any longer the safety net of metal; and it is an era that oscillates, continuously, between the liberating power of this responsibility and the danger of its abuse. The story of this oscillation is not over: it continues in the great financial crises of our century, to which we now turn, and in the new forms of money that would be born precisely from distrust of fiat power, and of which we shall speak in the last chapters. Money without anchor is our present condition, and to live with it — to enjoy its benefits without undergoing its dangers — is the monetary challenge of our time.