War Brings a Return of Fiat Money

It is no secret that our government is spending billions of dollars to fight the war in Iraq and to “rebuild” it now that the war has “ended,” at least in the reality-challenged mind of our President.

President Bush has stated that he doesn’t intend to raise taxes but plans to make his previous tax cuts permanent.

So how will the disaster in Iraq, the war for liberation, be financed?

If history is any indicator, the answer is the printing press, or in other words, fiat money and the hidden tax of inflation.

Section II of The Creature from Jekyll Island by G. Edward Griffin is entitled “A Crash Course on Money.” It is the most remarkably clear discussion of money and how it has evolved over the course of history that I have ever read. He defines money as “anything which is accepted as a medium of exchange” and classifies it into four forms: 1) commodity money, 2) receipt money, 3) fiat money, and 4) fractional money. (pg. 138)

An example of commodity money is gold. Receipt money, evolved from commodity money:

When the [gold] coins were placed into the [goldsmith’s] vault, the warehouseman would give the owner a written receipt which entitled him to withdraw at any time. At first, the only way the coins could be taken from the vault was for the owner to personally present the receipt. Eventually, however, it became customary for the owner to merely endorse his receipt to a third party who, upon presentation could make the withdrawal. These endorsed receipts were the forerunners of today’s checks.

The final stage in this development was the custom of issuing, not just one receipt for the entire deposit, but a series of smaller receipts, adding up to the same total, and each having printed across the top: PAY TO THE BEARER ON DEMAND. As the population learned from experience that these paper receipts were truly backed by good coin in the goldsmith’s warehouse and that the coin really would be given out in exchange for the receipts, it became increasingly common to use the paper instead of the coin. [pg. 151-2]

Then along comes fiat money. It’s first record of it’s use was reported by Marco Polo during his travels to China in the thirteenth century. [pg. 155] Griffin explains the nature of fiat currency.

The American Heritage Dictionary defines fiat money as “paper money decreed legal tender, not backed by gold or silver.” The two characteristics of fiat money, therefore, are (1) it does not represent anything of intrinsic value and (2) it is decreed legal tender. Legal tender simply means that there is a law requiring everyone to accept the currency in commerce. The two always go together because, since the money really is worthless, it soon would be rejected by the public in favor of a more reliable medium of exchange, such as gold or silver coin. Thus, when governments issue fiat money, they always declare it to be legal tender under pain of fine or imprisonment. The only way a government can exchange its worthless paper money for tangible goods and services is to give its citizens no choice.[pg. 155]

I’m not going to get into fractional money in this post. I have discussed it previously in The Magic of Fractional Reserve Banking. I just want to quote a small portion of Griffin’s discussion of fractional money:

From this perspective [where banks create money out of debt and it is easier for people to go into debt than to mine for gold], we can now look back on fractional money and recognize that it really is a transitional form between receipt money and fiat money. It has of the characteristics of both. As the fraction becomes smaller, the less it resembles receipt money and the more closely it comes to fiat money. When the fraction finally reaches zero, then it has made the complete transition and becomes pure fiat. Furthermore, there is no example in history where men, once they had accepted the concept of fractional money, didn’t reduce the fraction lower and lower until, eventually, it became zero.

No bank can stay in business for very long with a zero reserve. The only way to make people accept such a worthless currency is by government force. That’s what legal tender laws are all about. The transition from fractional-reserve money to fiat money, therefore, requires the participation of government through a mechanism which is called a central bank [The Federal Reserve]. [pg. 168-9]

Now back to the question of how the government will pay for the War in Iraq, or put more accurately, how American citizens will pay for it.

We have only to look at our country’s first war for liberty. There is a lot of background for this small short passage and I’m not going to quote it all here.

War Brings A Return to Fiat Money

The War for Independence brought all of this [economic stability created by a return to coin] to a sudden halt. Wars are seldom funded out of existing treasury, nor are they even done so out of increased taxes. If governments were to levy taxes on their citizens fully adequate to finance the conflict, the amount would be so great that many of even its most ardent supporters would lose enthusiasm. By artificially increasing the money supply, however, the real cost is hidden from view. It is still paid, of course, but through inflation, a process that few people understand.

The American Revolution was no exception. In order to pay the bill for independence, both the Confederation and the individual states went heavily into the printing business. At the beginning of the war in 1775, the total money supply stood at $12 million. In June of that year, the Continental Congress issued another $2 million. Before the notes were even put into circulation, another $1 million was authorized. By the end of the year, another $3 million. In 1776, another $19 million. $13 million in 1777. $64 million in 1778. $125 million in 1779. And still more: the Continental Army issued its own “certificates” for the purchase of supplies totalling $200 million. A total of $425 million in five years on top of a base of $12 million is an increase of over 3500%. And, in addition to this massive expansion of the money supply on the part of the central government, it must be remembered that the states were doing exactly the same thing. It is estimated that, in just five years from 1775 to the end of 1779, the total money supply expanded by 5000%. By contrast, the amount raised in taxes over the five-year period was inconsequential, amounting to only a few million dollars. [pg. 160-1]

[…]

The first exhilarating effect of this flood of new money was the flush of apparent prosperity, but that was quickly followed by inflation as the self-destruct mechanism began to operate. In 1775, paper Continentals were traded for one dollar in gold. In 1777, they were exchanged for twenty-five cents. By 1779, just four years from their issue, they were worth less than a penny. The phrase “Not worth a Continental” has its origin in this period. Shoes sold for $5,000 a pair. A suit of clothes cost a million.[pg. 162]

Why is this a problem?

An individual must earn his money by labor. The government get money by taking it from those who earn it, or by printing it. Any money the worker then has left over must compete in the marketplace with the money that the government took from him or with money that it printed. In both cases, the value of the individual’s labor, represented by the money he earned, is devalued.

No laborer can compete with a printing press when it comes to making money.

Griffin sums it up well:

Fiat money is the means by which governments obtain instant purchasing power without taxation. But where does that purchasing power come from? Since fiat money has nothing of tangible value to offset it, government’s fiat purchasing power can be obtained only by subtracting it from somewhere else. It is, in fact, “collected” from us all through a decline in our purchasing power. It is, therefore, exactly the same as a tax, but one that is hidden from view, silent in operation, and little understood by the taxpayer. [pg. 162]

Once again, I encourage you to read Griffin’s book for yourself. The short passages that I’ve quoted don’t do it justice. I’ve only read about a third of it and would already rate it one of the most fascinating and informative books I have ever read.

Griffin concludes his discussion of “Fool’s Gold” with this lesson:

Fiat money is paper money without precious-metal backing which people are required by law to accept. It allows politicians to increase spending without raising taxes. Fiat money is the cause of inflation, and the amount which people lose in purchasing power is exactly the amount which was taken from them and transferred to their government by this process. Inflation, therefore, is a hidden tax.

This tax is the most unfair of all because it falls most heavily on those who are least able to pay: the small wage earner and those on fixed incomes. It also punishes the thrifty by eroding the value of their savings. This creates resentment among the people, leading always to political unrest and national disunity.