Written by Trotsky, edited by Mish
This is part 2 of a 2 part series. Part 1 was Misconceptions
Imagine that you live on a small island mining the local salt mine, together
with Pete the fisherman and Tom the apple grower. You'd exchange your salt
for Pete's fishes and Tom's apples, while they would exchange fishes and
apples between them.
One day Pete says: "Instead of fish, from now on I will give you pieces
of papyrus with numbers marked on them. (Papyrus grows in near unlimited
quantities nearby, to the obvious benefit of Pete)." Pete continues
"One papyrus mark will represent 1 fish or 5 apples or 2 bags of salt
(equivalent to current barter exchange rates). This will make it easier for
us to trade among ourselves . We won't have to lug fishes, apples and salt
around all the time. Instead, we simply present the papyrus for exchange on
In short, Pete wants to modernize your little island economy by introducing
money - and he already has one of those $1 papyrus notes with him, which he's
eager to exchange for salt.
You'd laugh him out of the room, since you would realize that the papyrus per
se is not of any value. If you were all to agree on using the papyrus, its
value would rest on a promise alone - Pete's promise that papyrus he issues
is actually backed by fish. Since the stuff grows everywhere, he could easily
issue it by the bucket load. In fact, it's unlikely that any of the islanders
would ever come up with such an absurd idea.
More likely they would use another good for which there is an actual demand
(for instance, a rare type of sea-shell that is prized as an ornament and
only seldom found on the island) as their medium of exchange.
In short, a free market medium of exchange/store of value can only be
something with an already established demand. No worthless object would ever
emerge to function as money in a free market.
So how did it happen?
How did essentially worthless objects come into widespread acceptance as
money? To answer that question, we need to take a brief look at history.
Flashback: Rome 27 BC
Rome’s history of inflation and money debasement actually began with
Cesar’s successor Augustus, whereby his method was at least not a prima facie fraud. He simply ordered the mines to
overproduce silver in an attempt to finance the empire that had grown greatly
under Cesar and himself.
When this overproduction began to have inflationary effects, Augustus wisely
decided to cut back on the issuance of coins. This was the last time that a
Roman emperor attempted to honestly correct a monetary policy blunder, aside
from a brief flashing up of monetary rectitude under Aurelius some 280 years
Under Augustus’ successors, things began to deteriorate fast. Claudius
, Caligula and Nero embarked on enormous spending sprees that depleted
Rome’s treasury. It was Nero who first came up with the idea to
actually debase coins by reducing their silver content in AD 64 , and it all
went downhill from there.
It should be mentioned that Mark Anthony of Hollywood fame financed the army
he used in his fight against Octavian – then later Augustus –
also with debased coinage. These coins remained in circulation for a long
time, obeying Gresham’s
"bad money drives good money from circulation".
Left: An AD 275 specimen of
Aurelian’s Antonianus, 1 part silver to 20 parts copper .
In AD 274 Aurelius entered the scene with a well-intentioned monetary reform,
which fixed the silver-copper content of the then most widely used coin (the Antonianus)at
1:20 – however, just as soon as this reform was instituted, the silver
content resumed its inexorable decline.
Left: Emperor Diocletian the price fixer
In AD 301 Emperor Diocletian tried his hand at reform, this time by
instituting price controls, an idiocy repeated numerous times thereafter, in
spite of the incontrovertible evidence that it never works (Richard Nixon’s ill-fated
experiment being the
most recent example) .
Naturally, those price controls accelerated Rome’s downfall as goods
simply began to disappear from the market place. Merchants began to hide
their goods rather than accept the edict to sell them at a loss. This is of
course why price controls are always doomed to failure.
One recurring feature of Rome’s long history of debasing its money was
a perennial trade deficit due to overconsumption. Does this sound vaguely familiar?
The leap from clipping coins to outright
How was the leap from debasing coinage to outright fiat money accomplished?
There are two distinct intertwined historical developments that led
ultimately to the present system.
Goldsmiths become bankers
The idea of fractional reserve banking
was first introduced by the forerunners of our modern day banking system, the
Goldsmiths were used as depositories for gold and silver, and the receipts
they issued for such deposits soon began to circulate as the first bank notes
– especially once they hit upon the idea to make them out to the
‘bearer’ instead of tying them to a specific deposit.
Above: An early goldsmith bank receipt
The convenience of carrying these bank notes instead bags of gold and silver
soon caught on, and it didn’t take long for the goldsmiths to realize
that deposits were rarely claimed in great quantities. It followed that one
could temporarily lend deposits out and collect interest on such loans. So far
so good – this is the legitimate business of banks.
But the goldsmiths decided to go one step further, issuing additional
receipts for gold, even if they were not actually backed by a deposit. This
is what came to be known as ‘fractional reserves banking’ - lending
out far more ‘money’ than one actually has in the form of
Obviously this is fraud. Nonetheless, it’s perfectly legal today, but
in essence it remains the same fraud it has always been, with the main
difference being that today it's a more sophisticated as well as officially
When bank notes were backed (at least partially) by gold and silver on
deposit, fraud of this nature was frequently held in check by bank runs (or
from a banker's perspective, fear of bank runs). Nowadays, no such fear
exists. The ‘lender of last resort’ – the central bank
– can (at least in theory) prevent such bank runs by conjuring new
‘money’ out of thin air. In essence, a de facto insolvent banking
system is supported by this trick.
Tally sticks and Charles II
The other historical development that can be seen as an ancestor of the
modern day fiat money system is England’s application of the medieval
‘tally stick’ method of recording debt payments.
Taxes in the largely agricultural economy of the Middle Ages were usually
paid in the form of goods, and these payments were recorded with notches on
wooden sticks that were then split length-wise (one half remained with the
tax payer serf, as proof of payment). This was an ingenious method of
In AD 1100, King Henry the First ascended the English throne, and adopted the
tally stick method of recording tax payments. By the time of Henry II, taxes
were paid twice a year, and the tally sticks recording the partial tax
payment made at Easter soon began to circulate in a secondary discount market
– i.e., they began to be accepted as payment for goods and services at
a discount , since they could be later presented to the treasury as proof of
It didn’t take long for the King and his treasurer to realize that they
could actually issue tally sticks in advance, in order to finance
‘emergency spending’ (not surprisingly, such emergencies often
involved war – after the extortion of tax money the second big hobby of
The selling of these claims to future tax revenue created the market for
government debt – an essential part of today’s fiat money system
A wooden stick, masquerading as
By 1660, the English monarchy , after a brief hiatus of experimentation with
a pseudo-republican government under Cromwell, was reinstated and Charles II
began his reign but with vastly reduced powers, especially in the realm of
Since Charles had to beg for tax money from the parliament, he struggled
mightily with paying his vast pile of bills. Whenever Charles wrangled
permission to raise taxes from parliament, he immediately went to cash in the
future tax receipts by selling tally sticks to the goldsmiths at a discount.
This necessitated the introduction of previously referred to method of making
such debt payable to the bearer, which allowed the goldsmiths to sell it in
the secondary market to raise funds for more lending to the King.
They also began to pay interest to depositors, in order to attract still more
funds. At that stage of the game, the goldsmiths had a good thing going for
them, since the King was the equivalent of a triple A rated sovereign
borrower, who could always be relied upon to cover his debt with future tax
receipts. No one thought it problematic that the vaults soon contained more
wooden sticks than gold . There was an active market in this government debt,
and the goldsmiths profited handsomely.
The King meanwhile decided to circumvent parliament and began to issue tally
sticks as he pleased (as an aside, one half of such a stick, which originally
remained with the treasury had a handle and was called the
‘stock’ - the term that has evolved to describe shares in
publicly listed corporations today) .
Naturally, Charles was more than happy to exchange wooden sticks for gold,
and not surprisingly, soon kicked off a veritable credit boom by upping his
wooden sticks production.
Left: Charles II, the "Merry
Monarch", in all his splendor, eyes focused on the loot.
Why was he nicknamed the "Merry Monarch"? Well, you would be merry
too if you could kick off an enormous credit boom by exchanging sticks for
So what does a king do with all that gold he received for sticks? During his
25 year reign, he waged 3 losing wars (2 against the Dutch, one against
France); he survived 4 different parliaments (only the first of which
wasn’t hostile to him); he helped to establish the East India Company,
made shady deals with Louis XIV of France (his cousin), sired a horde of
illegitimate children of which he acknowledged 14, and was renown for his
hedonistic court. That's a lot of "merry".
Of course, there was a natural limit to this debt expansion. Once all the
money attracted from depositors had been transferred to the King, additional
deposits could only be acquired by means of offering higher interest rates
By 1671 the annual discount on the King’s debt had reached 10% and due
to redemptions nearly overwhelming funds raised by new debt issues, things
clearly had ceased to work for him. Charles suddenly and conveniently remembered
that there was a law against usury on the books, and lo and behold, interest
rates in excess of 6% were not permissible.
With all his recent loans carrying a far bigger discount, he simply declared
the debt illegal, and stopped payments on it (with a few judiciously selected
exceptions). Overnight, the King’s tally sticks reverted back to what
they had really always been – worthless sticks of wood.
The King’s creditors, chiefly the goldsmiths and their customers, had,
quite literally, "drawn the short end of the stick" (if you ever wondered where
this expression came from, this is it).
Left: Charles II as he is apparently
remembered today – a knight in shining armor, not the tyrannical thief
that he really was.
Although tally sticks were still used until the early 19th century, and even
formed part of the capital of the Bank of England when it was founded in
1694, the secondary market never truly recovered from this blow. Charles had,
with the stroke of a pen, killed the better part of London’s budding
banking system, and transformed countless of his creditors into destitute
involuntary tax payers.
To add insult to injury, he even gained a propaganda victory, as the public
tended to blame the goldsmiths for the mess (they were of course not entirely
innocent, and above all had been quite gullible).
What the tally stick system and its application by Charles II however did
achieve, was to plant the idea of how a fiat money system might actually be
made to ‘work’.
John Law’s fiat money experiment in
It was a Scotsman – John Law – ironically born in the very year
(1671) when Charles defaulted on his debt, who tried the first great fiat money
experiment inspired by these ideas. Living in exile in France, he found a
willing partner in Philppe II
Duke of Orleans' near
bankrupt state for putting his ideas into practice.
Left: Philippe II, Duc
d’Orelans, the Regent of France. When Louis XIV of France died in 1715,
Philippe d'Orleans became Regent to the five-year-old King. Together with
John Law, they combined to economically wreck France.
John Law's basic idea was that the more money in circulation the greater the
prosperity of a country. His ideas can be found in a treatise he published in
1705 entitled Money and Trade Considered.
Right: John Law - World's first Keynesian economist
In his words, "Domestic trade depends upon money. A greater quantity [of
money] employs more people than a lesser quantity. An addition to the money
adds to the value of the country."
With the above logic, John Law arguably became the world's first Keynesian
John Law became the comptroller general of finances and set up the Banque
Generale Privee (later the ‘Banque Royale’), which used French
government debt as the bulk of its reserves and began to emit paper money
‘backed’ by this debt – with a promise attached that the
notes could be converted to gold coin on demand.
In an effort to make the new paper money more palatable to a distrustful
public, it was decided to make it acceptable for payment of taxes (this idea
is key and we will get back to it). A credit and asset boom of vast
proportions ensued, especially after Law decided to float the shares of the
Mississippi company, which enjoyed a trade monopoly with the New World and
the West Indies.
Between 1719 and 1720 shares in the company rose from 500 to 18,000 livres. Then, predictably, the bubble burst,
and it lost 97% of its market capitalization in the subsequent bust. Enraged
and nervous financiers tried to reconvert their bank notes into specie in the
ensuing massive economic crisis, but naturally, the central bank’s
promise of convertibility could not be put into practice – it had
inflated the supply of bank notes too much (the notes traded at discounts of
up to 99% in the end).
The government at first tried to stem the tide with edicts forbidding the
private ownership of gold , but in the end, the enraged mob drove Law into
exile, and the fiat money experiment ended with the Banque Royale closing its
doors forever .
Above: 1720: Investors in Law’s
Mississippi Company scam want their money back
The crisis following the collapse of Law’s Mississippi enterprise
gripped all of Europe – the eloquent master of fiat disaster had
seduced investors from all over the continent, many of whom were suddenly
penniless. Confidence in other European corporations eroded as well, and a
great many bankruptcies took place.
The history of the world is filled with examples like the above.
Unfortunately time and space considerations will not let us detail the
backdoor coup that enabled the establishment of the Federal Reserve, FDR’s
sinister gold confiscation, Nixon’s dropping of the last
remnant of the dollar’s gold convertibility, or China’s
earlier experiment with paper money which ended in a disastrous hyper-inflation.
The brief monetary history of Rome is intended to establish the fact that the
State has sought to engage in theft from the citizenry via monetary
debasement from the very dawn of Western civilization. The focus on the 17th
century application of the tally stick system in the UK as well as the focus
of the transformation of London’s goldsmiths to bankers is meant to
establish from whence the idea of putting together a workable fiat money
system stems. This is an extremely important part of monetary history but is
generally a less well known one.
The above historical recap was written to fill in some additional as well as
essential information if one wants to understand how we arrived where we are
today. With that history lesson out of the way, let's now address the
question we asked at the top. How did worthless objects come into widespread
acceptance as money?
for Fiat Money
For a long time, States were forced to accept gold's role as money. The
absurdity of introducing unbacked paper money wasn't considered a viable
avenue of robbing the citizenry. Rather, heads of State resorted to
'clipping' their coins or diluting their precious metals content if they
wished to inflate. These early instances of inflation via reduction of the
precious metals content of coins were intimately connected to the downfall of
entire empires – most famously, the Roman empire. But along came
Charles II, followed by John Law who had a brilliant idea for gaining public
demand for fiat currency.
Demand for fiat money was
created by its acceptance for payment of taxes.
What we have here, is really no less than the explanation for why pieces of
paper with some ink slapped on them are not a priori laughed out of the room,
as we proposed would happen with Pete’s papyrus promises in paragraph
one. The demand for this paper is established by its acceptance for the
payment of taxes.
The two major pillars of the system are based on coercion: directly via the
legal tender laws (which decree that fiat currency must be used/accepted for
all payments of debt, public or private) and indirectly via the value imputed
to government debt which rests on the faith in the government’s ability
to extort enough future tax revenue to be able to repay its debt.
This latter point is extremely important for the system to function.
Government bonds are the tally sticks of our age, and serve as the main
‘backing’ of bank notes and their digital counterparts in
circulation. They are what is tying the government and the banking system
together, via the central bank.
The central bank has the power to ‘monetize’ such debt by
creating money out of thin air, however, this roundabout way of going about
it is an essential part of the confidence game, the creation of the illusion
Theft of Purchasing Power
Left: Fiat currencies in the 20th
century - monetary catastrophes unfolding at varying speed since the birth of
the Federal Reserve.
Image thanks to the Gold Eagle editorial Fiat Money
Systems. (click on
image for a better view)
Since the central bank’s balance sheet is largely composed of
government debt, it has an incentive to manage the public’s ‘inflation
expectations’ and inflate the currency as inconspicuously as
This does of course not mean that the inflation racket is inhibited per se.
The theft has merely been organized in such a way that the people don’t
complain too much.
If the government had to actually raise taxes instead of borrowing the
staggering sums of money it uses to keep its welfare/warfare programs running
(and keeping the vote buying mechanisms well oiled) it would have to raise
taxes by so much that it would face a rebellion.
Instead government resorts to inflation.
Inflation is nothing but a cleverly disguised tax and that is the real
meaning of that last chart.
The fox guards the hen house
Richard Russell, in a recent missive, reminisced about the $125 his first job
after college earned him per month and the then high $22.50 he had to
pay every month for his $10,000 GI life insurance policy. A new car cost
$450. Those were princely sums in the 1940’s, but have become what he
now calls ‘chump change’.
Obviously this hasn’t happened overnight although it can, as witnessed
by Zimbabwe. Rather the public has become used to and injured by the
‘inflation tax’ proceeding at what appears to be a snail’s
pace (at least according to the government’s official ‘inflation
data’, which is like the fox guarding the hen house). It is of course
not possible to measure an ‘average price’ of disparate goods ,
so this is just another part of an elaborate scam.
With the legal tender legislation in place, fiat money has also successfully
put gold out of circulation. After all, no one is going to use ‘good
money’ for transactions when he has the choice of using ‘bad
money’ instead. Indeed, what has happened is that gold has increasingly
shifted from the world’s monetary bureaucracies into private hands, as
a store of value.
On a global basis, only about 2.5% of all official central bank reserves are
in gold nowadays (obviously, some countries have far larger percentages of
their reserves in gold, most notably the US and many European countries
– even so, these reserves pale in comparison to the amount of fiat
money and credit they have issued).
Everyone is Happy
It is also important to note that although they are being subjected to a
hidden tax, most citizens actually are quite happy with things as they are.
As Gary North
has observed in a recent essay, everybody involved appears to be happy, the
robbers as well as the robbed.
The banks are happy to be part of a cartel led by the central bank, which
gives them immense latitude in indulging in consistent and flagrant over
trading of their capital – spurred on by the moral hazard created by
having a ‘lender of last resort’ at their disposal, with no
restrictions on how much ‘money’ it can conjure up out of thin
The politicians and the bureaucrats are happy because there is no restriction
on their spending and there is nothing stopping them from buying votes or
indulging in whatever ‘pet projects’ they happen to dream up.
And lastly, among the people who should actually rise in protest, there are
large sub-groups that are either wards of the State and dependent on its
largesse (the shameful secret of the welfare state is that it makes
irresponsible slaves out of previously free and responsible people), or have
been seduced by the banking cartel’s propaganda and amassed so much
debt in the pursuit of consumption that they are quite happy to see money
being devalued at a steady pace.
Producers Have No Say
In a nation of debtors, inflation is the politically most palatable form of
monetary policy – after all, everybody is focused on the short term
(politicians and bureaucrats on their terms of office, consumers on their
debt and their desire to buy more things they don’t need with money
they don’t have, and so forth).
No one considers for a moment, that in the long run, this policy means ruin.
Over time, the middle and lower classes will see their real incomes and
living standards shrink ever more, while the true beneficiaries of inflation
– those who get first dibs on every dollop of newly created fiat money
– amass more and more of the wealth that is stolen from its producers
Not surprisingly, the small elite that actually profits from the fiat money
system is quite content to take the long term view for itself.
The actual producers of wealth are a very small group, too small to have a
decisive voice in how things should be run. They would have to pull a John Galt type stunt and all go on strike if
they wanted to exercise some pressure. Unfortunately, big business is usually
in bed with the State and also happy with the status quo.
One must always keep in mind that big corporations are generally not in favor
of truly free, competitive markets. They give lip service to the idea, but
concurrently lobby for anti-competitive regulations all the time.
Decades of successful propaganda
The propagandistic effort in support of the fiat money system has been
enormous over the decades, and has been extremely successful.
Left: Greenspan unlocks the secret of making fiat money "as good as
When Alan Greenspan told Ron Paul on occasion of his semi-annual testimony in
Congress that he believed "we have had extraordinary success
in replicating the features of a gold standard" he knew quite well that this
was a bald-faced lie.
And yet, no one outside of Ron Paul would have even thought of questioning
this absurd assertion.
As to why it is obviously a lie, consult the chart above. The dollar has lost
96% of its purchasing power since the Fed has been in business.
Let us also not forget that there still is a remnant of a market economy
operating alongside the huge swathes of economic activity that have been
appropriated by parasitic entities such as the State and its dependents.
It is this remnant that produces all of our wealth, in spite of the fiat
money system. It involuntarily supports the system’s continued
viability by doing what it does best – enhancing productivity, and
thereby exerting downward pressure on the prices of goods and services (which
works against the upside pressure on prices created by monetary inflation).
This in a nutshell shows why the system ‘seems’ to work –
and actually does work on a short term basis.
Economic Interventionism vs. the
Apologists of the current system tend to laud its "flexibility". In
reality this argument is nothing more than an argument for economic
interventionism which history proves time and time again can't work in the
Another commonly heard argument is: "If the economy is to grow, so must
the supply of money", as if that were immediately obvious. In fact, most
people who hear this sentence do believe it to be a truism. In reality,
increasing the supply of money confers no benefit whatsoever on society at
large. It is not important how much money one has in terms of number entries
in one’s bank account, it is important what this money can buy. Didn't
John Law's experiment prove this beyond a shadow of a doubt?
It is not 100% certain that a modern free market economy would settle on gold
as its money. In fact, it is not important what would emerge as money. What
is important is that the decision on what should be used as money would be
arrived at voluntarily by the collective actions of market participants.
That said, it seems highly likely that the previous historical period of
trial and error that has led to the establishment of precious metals as money
would still be accepted as having produced a satisfactory outcome by a modern
free market economy. After all, we know that gold trades in the marketplace
as if it were money. See Trotsky on Gold - Misconceptions about Gold for
In a free market with a relatively stable supply of money, the supply and
demand for money would still be subject to fluctuations similar to that for
other goods, depending on time preferences. The free market interest rate
would at all times correctly signal to entrepreneurs what the state of time
preferences was at a given point in time, allowing them to allocate capital
in the most efficient manner.
A fiat money system with interest rates administered by a bureaucratic
central economic planning agency meanwhile constantly sends wrong signals to
entrepreneurs about expected future demand and the true cost of capital and
thereby encourages malinvestment.
The phases during which credit expands and malinvestments proliferate are
known as "economic booms", and everybody loves them. When the
liquidation phase occurs, otherwise known as "busts" few people are
aware that it is the preceding booms that are at fault. And so the cry for
more monetary and fiscal intervention arises, which lengthens and deepens the
malaise by putting malinvested capital on artificial life support.
On the other hand, the free market tends to consistently lower the prices of
goods and services over time. That is the logical result of increasing
productivity. This is why the widely accepted tenet that we "need some
inflation of the money supply to enable the economy to grow" is a
Government mandated fiat currency simply does not work in the long run. We
have empirical evidence galore – every fiat currency in history has
failed, except the present one, which has not failed yet.
Nonetheless, the current fiat system
is more ingeniously designed than its predecessors and has a far greater amount
of accumulated real wealth to draw sustenance from, so it will likely be
relatively long lived at least as far as fiat money systems go.
How long can this one last?
Bernanke shows us...
"It will work this long."
In a truly
free market, fiat money would never come into existence. And that is why
Greenspan is wrong. Governments can not create something "as good as
gold". History clearly shows that that only the real thing will do.