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Answer by Harold Kingsberg:
Paper money is not a fraud. Sure, paper money seems weird at first glance (“So it’s this scrap of paper that someone says is worth something, so it’s worth something?”) but that doesn’t mean it’s a fraud. It’s just weird at first glance.
The key to understanding why paper money isn’t a fraud is to remember that value is not an intrinsic property. It’s not like density or conductance—properties of matter that don’t change depending on who’s looking or asking. To use an extreme example, you might think a gold brick is valuable, but that’s because you’re on dry land right now. If you were drowning in the middle of the ocean, that gold bar would have no value to you whatsoever. In other words, value is in the eye of the beholder.
That was an extreme example, but it’s pretty trivial to come up with less extreme examples. If 150 years ago you were filthy rich and wanted to rub everyone’s noses in it, you didn’t use silver cutlery at your fancy dinner party. Any rich person had that. You used aluminum cutlery. Aluminum. As in the stuff I drink my Diet Dr. Pepper out of and then recycle. Or, for another example, we now consider whales to be valuable alive, but go back 150 years, and we were killing them en masse for their oil, which we primarily used for lighting rooms. Really. Aluminum hasn’t changed in a century and a half, whale oil hasn’t changed. But their values have changed precipitously.
You can’t change this, either. You might think gold is different, but the truth is that it’s just a shiny yellow rock. It also has no intrinsic value—if it did, you’d still want it while drowning in the middle of the ocean—which means it can go the way of every other good. Between 1324 and 1325, Musa I of the Kingdom of Mali went on the hajj. Musa was a generous man, and wherever he went, he handed out gold. Sounds great, right?
Except it wasn’t. Musa gave out so much gold that in the cities of Cairo, Mecca, and Medina—wealthy trade hubs, the lot of them—that the value of gold plummeted. You stopped being able to buy as much with one gold coin as you used to be able to, and that wasn’t because the coins changed. This is actually the only time in recorded history one man controlled the gold supply in the Mediterranean, but it’s not the only time when coins lost value. The same thing also happened to the Spanish economy after the Spaniards plundered the gold and silver of the Americas. Despite the properties of gold and silver not having changed, you needed more of either to buy bread than you used to. Or, for example, in 1869, Jay Gould and James Fisk attempted to corner the gold market, driving up prices of gold massively—and that was when U.S. currency could be freely traded at set rates for gold. (More specifically, much of the United States’ currency could be freely traded for gold. Some of it was fiat currency. This doesn’t change the fact that the value of gold shot up like a cork, and then crashed, for reasons that had nothing to do with gold itself.)
History is littered with examples like this. No matter what you think might have some intrinsic value, trust me, it doesn’t.
So this brings us to paper money. It was invented by the Chinese during the Tang dynasty. Money back then was a copper disc with a hole in it, and your only way of carrying it around was to carry long, heavy strings of cash. This was pain in the neck—sometimes literally—to deal with, so people started using what we’d now considered promissory notes. You’d leave your cash with a trustworthy person, and he’d give you pieces of paper saying how much you’d left with him. You’d hand out the paper to other people when you wanted to buy things, and they could recover the coins at their leisure. Sort of like a check without a specific recipient and in standardized denominations. During the later Song dynasty, the government cut out the middleman and started issuing the paper money themselves. Thus, you had paper money that you could, if you were so inclined, redeem for copper coins. It was much more convenient for everyone involved—carrying around paper is easier than carrying coins, because it’s lighter and goes into a handy-dandy billfold really easily.
Skip ahead about 500 years to England during the 1600s. The same system of paper money existed there, but what bankers realized was that the chances that everyone would simultaneously demand their coins was actually pretty small. Thus, banks started issuing more paper money than they had cash on hand.
This may sound like fraud, but remember, the value of the paper money had always come from the fact that the institution that issued it was not a lying sack of crap. You had to fundamentally trust the institution issuing the paper money that it could somehow back up the value and that it wasn’t just printing paper money all willy-nilly.
But here’s the question: If nobody ever exchanges the paper for coins—and most people didn’t—then why bother having the coins at all? Remember, they’re not intrinsically valuable—I know, I’m getting nauseatingly repetitive about that, but it’s important—so if everyone’s cool with the paper anyway, why not use that and only that? This way, you don’t have to procure any substances and expend manpower to beat those substances into coins so that you can then give them to people who don’t actually want them.
Again, though, this requires significant trust in the organization that issues the currency. The currency has value because you trust the organization to not do anything stupid. And during the 1800s and early 1900s, banks did a lot of really stupid stuff when it came to paper money, which they were allowed to issue. But if you have, say, the U.S. federal government, issuing currency, well, that’s an organization you can trust to not be an idiot. So over the years, the federal government really stepped up its game with regard to paper money, and individual banks stopped printing it. Similar things happened elsewhere in the world.
This system, where the money is worth something because you trust the people who issued it, is called “fiat currency.” Paper isn’t worth very much. A promise from the U.S. government, though, is worth a lot. (Promises involving balance sheets, I should specify.)
But couldn’t the government just print a buttload more money, thus increasing the supply massively without changing any demand for money? Yes. This has happened in history. It’s called hyperinflation. It is something scary. However, Ebola is also scary, but you don’t want to design a hospital whose first concern is making sure Ebola doesn’t spread—it’s rare, and you don’t want to bother testing everyone who comes into the emergency room for it. Or, to put it more plainly, just because something is scary doesn’t mean all of your decisions should be based on the possibility of it coming to pass.
And it’s not even like not using fiat currency prevents hyperinflation. Remember Musa of Mali in Egypt? Hyperinflation. Spain? Hyperinflation. You don’t even need to change the gold supply to get to this problem. Rome spent most of the 200s, during a time called “the crisis of the third century,” experiencing overly high rates of inflation, not because there was suddenly a lot more silver and gold in the Mediterranean, but because it kept dropping the percentage of gold and silver that made up each coin. (You generally would never want a coin that was 100 percent gold. Gold is soft and malleable, which is not a desirable attribute of a coin. So you mix the gold with some other substance to form an alloy of some kind.)
OK, so why not just ban changing the amount of gold in each coin? This sounds like a really obvious solution, so you have to ask yourself: If it’s that good a solution, why don’t people implement it?
They don’t, because as it turns out, it’s not that good a solution. See, inflation actually isn’t bad. Hyperinflation? Terrible. Unchecked inflation? Also bad. But a low rate of inflation is actually really, really good. Let’s say you leave your money in a mattress for 10 years. If there’s no inflation, it can buy the same amount of stuff at the end of 10 years as it could before. If there’s some inflation, it’ll buy less. What this means is that you’re not going to keep your money in that mattress—you’ll spend it, you’ll invest, you’ll just generally use it. This use allows other people to start or grow businesses, which employ other people, which means more jobs, which means more people getting paid. In other words, without some inflation, you’re going to have a tough time with economic growth, and with deflation, you’re pretty much doomed. Just ask Japan how the past 25 or so years have gone for an example of that.
Besides, people can sometimes demand inflation. The defining issue of the 1896 U.S. presidential election was that farmers wanted inflation, and they wanted it badly. The basic idea was that this would lead to a raise in crop prices, but their debts would not be inflation-adjusted. It was inflation as debt relief, and it was extremely popular, with the candidate who supported the idea losing the election by less than 5 percentage points in the popular vote. The reason why it wasn’t so popular an issue in 1900? Improvements in gold refining techniques brought on inflation without any laws really needing to be passed.
This brings us to a really important feature of fiat currency: You don’t have to worry about discoveries screwing with the value. Consider the idea of a currency that was entirely aluminum coins 200 years ago. That currency would be worth virtually nil 100 years later, not because of any actual policy, but because scientific progress in aluminum refining would have made the stuff really easy to find. You could say similar things about a currency where paper could be exchanged for aluminum—sure, you could adjust the rate of exchange, but you’d have to do it quick and repeatedly, and at that point, well, why bother? You might not think this could happen to gold, but I’m pretty sure those fancy aristocrats didn’t think their descendants would think of aluminum cutlery as being worth less than water and syrup. On the other hand, none of that impacts the supply of fiat currency. Policy, and policy alone, dictates how much of that is floating about.
So actually, when you get right down to it, coins have all the same disadvantages as fiat currency and then some. And because nothing is intrinsically valuable—again, just ask a guy drowning in a lake if he’d rather have a large block of styrofoam or a large block of gold—why not use fiat currency?
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