How Did the U.S. Dollar Become a Fiat Currency?
The U.S. Dollar is a fiat currency, but what does that mean? The term “fiat” is a government currency not backed by a physical commodity like gold or silver. Instead, the money has value because the issuing government says it has value. The term “fiat” comes from Latin and means “it shall be.” A fiat currency’s value depends on the confidence people feel toward the issuing authority and its usefulness in transactions. If people stop using the Dollar, it will lose all value.
The opposite of a fiat currency is called a representative currency. A representative currency is backed by a commodity like gold, silver, or oil. The U.S. Dollar was partially a representative currency until President Nixon ended the gold standard in August 1971, but before 1933 was a total representative currency. Since being removed from the gold standard, the number of dollars in circulation has grown exponentially. The Dollar has lost more than 80% of its purchasing power since the end of the gold standard. Another way to think about it is that an item costing $100 in 1971 now costs $731.55.
At least, in theory, a representative currency controls government spending because laws exist concerning how many paper dollars can be in circulation. There is a ratio of dollars in circulation to the commodity held by the issuing authority, usually the central bank. Representative currencies can be exchanged for something else. When the U.S. utilized the gold standard, dollars could be taken to the bank and exchanged for gold. Proponents of fiat currencies say financial instruments like checks, money orders, and traveler’s checks are examples of representative currency because they can be traded for the value of stated dollars.
How Did We Get Here?
In 1907, the U.S. faced a worldwide financial crisis called the Panic of 1907. New York investment bankers caused the Panic of 1907 by trying to corner the copper market. The failed attempt to squeeze the market crashed the market and led to a run on the banks. Until this time, the public was staunchly against a central bank. However, J.P. Morgan loaned his money to bail out the New York banks again and public sentiment loosened. The public began calling for banking reform and a growing consensus for a centralized bank. On December 23, 1913, President Woodrow Wilson signed the Federal Reserve Act into law, and the Federal Reserve was born.
Over the next 20 years, the world got turned upside down. WW1 would devastate Europe and its economies. Most nations’ currencies were backed by gold before the war but needed to suspend their gold standards. Many European nations paid the U.S. with gold for supplies, which made the U.S. the largest holder of gold. The boom following the war led to the roaring twenties. Market mania led to uncontrolled speculation, which failed horribly and led to the Great Depression. During the Great Depression, 1 in 4 people lost their life savings, and more than 10,000 banks failed.
There was significant banking corruption leading to the Great Depression. Banks would loan money to companies and then sell the same company stock to depositors. The bankers could position the transactions so that the depositors buying the shares took all the loan risk without disclosing the bank’s conflicting interests. The companies failed, the depositors lost everything, and the bankers got rich. People were outraged at banks again. The anger led to the Glass-Steagall Act, which required separation between savings and commercial banks. A Chicago Tribune editor wrote, “the only difference between a bank burglar and a bank president is that one works at night.”
The Glass-Steagall Act, sometimes called the Banking Act of 1933, was passed on June 16, 1933. The Glass-Steagall Act changed the American economy forever. In addition to separating savings and commercial banks, Federal Reserve Notes now required government securities as collateral and created the FDIC. In other words, all dollars created would be a debt instrument against the taxpayers. The Glass-Steagall Act passed one month after Executive Order 6107 made hoarding gold illegal. When the government no longer honored gold and silver certificates, the status as a representative currency diminished. The Dollar was still technically a representative currency, but not for her people, just foreign creditors. (Side note: President Bill Clinton repealed sections of Glass Steagall in 1999, and economists still debate whether the repeal led to the bad loans associated with the 2008 Housing Crisis).
WWII began in 1939 and destroyed Europe again. Except for Hawaii, the war does not seriously affect the U.S. infrastructure. In 1944, 730 delegates from forty-four countries met in Bretton Woods, New Hampshire, to participate in the Bretton Woods Conference. The outcome of the Bretton Woods Conference is the creation of the International Monetary Fund (IMF), the International Bank of Reconstruction and Development (IBRD), and the establishment of the U.S. dollar as the international reserve currency. All other currencies became pegged to the Dollar, which was pegged to gold. The entire world economy used gold as its anchor via the Dollar.
As time passed, the U.S. government increased the ratio between dollars in circulation and gold held. Foreign governments, especially France, were not pleased with the U.S. government printing too many Dollars and devaluing the Dollar/Gold ratio. Through the later 1960s, there was a significant increase in countries coming to the gold window after receiving payment in Dollars. President Nixon recognized that the U.S. was in a precarious situation. The U.S. would eventually go bankrupt if countries continued trading their dollars for gold. By 1966, the U.S. only had $3.6 billion of gold holdings to cover $14 billion of foreign debt. In 1971, several European countries either left the Bretton Woods agreement or demanded large quantities of gold for their debt. On August 15, 1971, President Richard Nixon officially closed the gold window, nullifying the Brenton Woods agreement and defaulting on American debt obligations. The status of the Dollar was now 100% fiat. The entire global economy no longer had a flow-through anchor to gold. The entire world economy suddenly became built on a broken promise with no physical counterweight like gold.
A few things happened after the Dollar became a fiat currency. First, printing money became the norm without a legal mandate to maintain a ratio to gold. Second, debt skyrocketed. Third, gold was no longer a set price, and the price of gold climbed 2,428% from $35/ounce in 1971 to $850 in 1980.
How Do We Get Back to a Sound Economy?
People speculate about what returning to the gold standard would look like and if it is even possible. It is too expensive to return to a fully funded gold standard at current prices. The debt is just too high, and there are too many dollars in circulation. At today's prices and assuming the government was not to print another dollar, the U.S. would need around 2.9 billion ounces of gold to have a fully funded gold standard. The price would need to be $10,380 per ounce. The World Gold Council estimates there are only 2.5 billion ounces of gold on the entire planet, so the U.S. has a real problem. At best, only a minimally fractional gold standard might be possible. Any movement returning the U.S. to a gold standard or even in that direction of a fractional one would drive prices significantly higher than current levels.
It is unlikely the Federal Reserve would want to give up its monopoly to print unlimited fiat dollars, and the price of gold is too high. It is unlikely that the U.S. would voluntarily take steps toward a gold standard. However, increasing geopolitical forces and more countries conducting international trade outside the Dollar may force the government’s hand to return to representative currency. As countries move away from the Dollar, it is proof that nations are losing faith in the U.S. Dollar. Fiat currencies only have value because the issuing authority says it does, and the people trust that authority. Nations moving away from the Dollar is like the European countries demanding gold in the 1960s and 1970s. The other nations are again saying they don't trust the Dollar. It is unsustainable for the U.S. and will force a significant change soon.
Every fiat currency eventually goes to zero. When that happens, you will need something of value to buy the new currency. Gold is the most logical commodity to buy the new currency. What is the timetable? It is hard to say how long it will take, but today is one day closer to the fiat Dollar's reckoning.
What will happen to gold if the Dollar follows the path of every fiat currency in history? Will gold be more or less expensive than today? The world may reject sound money, but you don't have to follow the world to financial destruction. Why not establish a gold standard for your economy?
Call the U.S. Gold Bureau