U.S. Federal Reserve Notes: “Money” Backed By Nothing

At one time, the U.S. monetary system was backed by gold. Now it’s not backed by anything.

But most Americans don’t realize this. In fact, nearly a third of respondents to a recent survey believe the U.S. dollar is still backed by gold. Only 7 percent of the people polled got the answer right – the dollar isn’t actually backed by anything.

Meanwhile, 29.3 percent said the dollar was backed by gold, 4.1 percent said it was backed by oil, 5.8 percent said it was backed by bonds and 23.6 percent confessed that they simply didn’t know.

Thirty percent of those polled answered that the dollar is backed by the U.S. government. While technically correct, that’s a distinction without a difference. When you strip away the semantics, this still means it’s not backed by anything.

The dollar is what is known as a fiat currency. That means it is not backed by a physical commodity such as gold or silver. Fiat currencies derive their value from the fact that the issuing governments say they have value. They sustain their value because the government maintains monopoly power over money – dictating that only its fiat currency can serve as “legal tender.”

Currency in the United States used to be backed by gold. You could exchange your dollars for a fixed weight of metal. But under Pres. Franklin D. Roosevelt in the 1930s, the government began to move away from gold-backed currency. In 1971, Pres. Nixon severed the tie altogether.

Why?

Because gold or silver-backed money poses problems for governments. They cannot easily inflate the money supply. There always has to be a sufficient amount of metal to back the currency in circulation. But governments and central banks can print fiat currencies at will. In a nutshell, fiat currencies allow governments to create money out of thin air to fund their vast expenditures. The warfare and welfare state in America would be impossible with the fiat currency and the central bank facilitating debt monetization.

When he announced the closing of the gold window, Nixon said, “Let me lay to rest the bugaboo of what is called devaluation,” and promised, “your dollar will be worth just as much as it is today.”

This was also a lie.

According to the Consumer Price Index data released by the Bureau Labor of Statistics, the dollar has lost more than 80 percent of its value since Nixon’s fateful decision. Meanwhile, the dollar value of gold has gone from $35 an ounce to about $1,500.

The purchasing power of the dollar continues to diminish every day, but this is just a shadow cast by the real truth — the dollar is effectively valueless.

Paul Krugman stumbled on this truth in a rant against bitcoin. The Keynesian economist said cryptocurrency was actually a step back in the evolution of money because its value isn’t “tethered to anything.” In other words, there is nothing underlying its value.

But as a fiat currency, the dollar isn’t tethered to anything either. It has value because people have faith that it has value. When you boil it all down, dollars are nothing more than pieces of paper and numbers in computers.

When Krugman bashed bitcoin because it isn’t “tethered to anything,” he must have realized he was backing himself into a corner, because he went out of his way to emphasize dollars are backed by the “full faith and credit” of the U.S. government and we need dollars to pay our taxes.

The value of a dollar doesn’t come entirely from self-fulfilling expectations: ultimately, it’s backstopped by the fact that the U.S. government will accept dollars as payment of tax liabilities — liabilities it’s able to enforce because it’s a government. If you like, fiat currencies have underlying value because men with guns say they do. And this means that their value isn’t a bubble that can collapse if people lose faith.”

But this is demonstrably false as the Germans learned during hyper-inflation of Weimer Republic and more recently experienced by the people of Venezuela.

In effect, there is no floor on how weak the dollar can become in terms of purchasing power merely because the IRS insists on receiving dollars for its tax bills. Economist Robert Murphy explained why the value of fiat currencies can fall to near-zero in an episode of the Contra Krugman podcast.

If by assumption, the dollar’s very weak, then that means you could sell one hour of your labor to get a trillion dollar bills. So, the fact that you need to hand over to the IRS a bunch of dollar bills, by itself does not tell me any information about the relative strength of the dollar. That’s consistent with the dollar being worth, you know, $1 gets you a loaf of bread or you need a quadrillion dollars to get a loaf of bread. That’s equally consistent with the fact that I have to pay my taxes in dollars.”

The “lack of tethering” argument Krugman makes against crypto applies equally to fiat dollars. Despite men with guns, the dollar’s value can still decline virtually zero. Again, we just have to look at countries like Venezuela and Zimbabwe as they suffer through hyperinflation to see this truth. Government backing does not guarantee value.

And unlike government-created fiat money, a cryptocurrency like Bitcoin has a limited supply of 21 million coins, so its purchasing power cannot be reduced like the US dollar by printing more.

Financial guru Jim Grant wrote that the reason the gold standard is so often demeaned by modern economists and politicians is because, “The modern sensibility quakes at the rigor of such a system.”

But those “rigors” are exactly what we need. Sound money forces governments to maintain fiscal discipline. It limits spending and ultimately, the growth of government itself. It’s no wonder that the political class rejects any kind of commodity-based money.

Instead, politicians have replaced the gold standard with another standard. Grant calls it the “Ph.D. standard,” a system run by politicians and central planners.

That system features monetary oversight by former university economics faculty — the Ph.D. standard, let’s call it. The ex-professors buy bonds with money they whistle into existence (“quantitative easing”), tinker with interest rates, and give speeches about their intentions to buy bonds and tinker with interest rates (“forward guidance”).

This is exactly what politicians like Nixon, Ford, Carter, Reagan, Bush I, Clinton, Bush II, Obama and Trump wanted — the ability to spend without restraint and grow government with no limits. The result: massive national debt and devalued currency that buys the average person less and less every year.