Tag Archives: fiat money

Why does money inflate?

People who live in developed nations have grown used to inflation of around 2% a year over the last few decades. Why do prices generally rise by that amount? What drives the purchasing power of money in these countries? Why can’t prices stay constant year-over-year rather than increasing?

To help answer some of these questions, let's go far back in time. We'll divide the last one thousand or so years into three monetary eras: the silver coin period, metal-backed notes, and fiat money. How would the nature of inflation have changed as you passed from one era into the next?

The medieval coin era

Silver coins were the chief medium of exchange in the first five or six centuries of the last millennium. Even though coins were composed of scarce metal, inflation was a fairly common occurrence in medieval times. Coins were not perfectly durable. They suffered from wear and tear, both from sweaty hands and as they came into contact with other coins while in a pocket or purse. Since the value of a medieval coin was ultimately determined by the amount of silver in it, the purchasing power of the coinage would naturally decline each year as it shed silver. So rising prices, or inflation, was inherent to medieval coin systems.

The wear and tear of the coinage would often be accompanied by deliberate attempts on the part of the public to remove silver from coins. This came in the form of clipping, in which people would cut small bits of silver from the coin's edge, and sweating, in which a bag of coins was shaken, the dislodged bits collecting at the bottom of the bag. Clipping and sweating were illegal and punishable by death during medieval times, but that didn't stop people from doing it.

Clippings from old coins

To make matters worse, from time to time kings and queens would adopt a policy of aggressively reducing the silver content of coins in order to raise revenues, mostly to fight wars. In medieval times, mints operated differently than they do now. Anyone could bring raw silver to the mint to be turned into coins, paying a small minting fee to the monarch. By reducing the silver content of the coinage, the monarch incentivized everyone to quickly bring in their old silver coins to be coined into new coins. After all, people could get more coins for each ounce of silver they owned, thus allowing them to pay off more debts than before. This would create a one-time spike in mint throughput, thereby boosting royal revenues from fees.

A Thousand Years of Prices: UK Consumer Price index

One of history's most aggressive medieval debasers was Henry VIII, who announced ten debasements between 1542 and 1551, each in the region of 30-40%. These diminutions were so successful in driving silver to the royal mints that Henry had to erect six new ones just to meet demand. Between 1541 and 1556, the English consumer price index rose by 123%. It's possible to see this spike in the chart above.

Not all kings and queens debased the currency. Every once in a while one of them would try to restore the standard by announcing a general recoinage. All citizens were obliged to bring in their coins to the mint where they would be weighed and then melted down into new coins. The new coins would have a restored amount of silver in them, thus undoing some of the wear-and-tear-induced inflation of previous years.

Finally, advances in silver mining technology and new discoveries had a major role to play in determining the level of medieval prices. If the supply of silver suddenly increased while demand remained unchanged, the price of silver would decline relative to that of other goods. And since coins were themselves composed of silver, their purchasing power would decline. Or, put differently, inflation would occur as all prices in the economy rose. Deflation, a fall in prices, was just as likely to occur under a silver coin standard. If the population was growing with the supply of silver failing to keep up, then the price of silver would have to rise, or a general deflation would set in.

To sum up, inflationary episodes during the medieval silver coin area could be explained by a complex combination of natural wear and tear of coins, debasement by kings and queens counterbalanced by the odd recoinage designed to restore the standard, and changes in the fundamentals of the underlying silver market. The strongest inflations occurred when all these forces were aligned. For instance, if a new drilling technique suddenly opened up deeper silver deposits for exploitation, and the monarch was simultaneously debasing the standard to help fund wars, then—combined with natural wear and tear—the result would be a rapidly increasing prices.

The metal-backed banknote era

Bankers soon learnt how to make money out of paper. This would begin to change the complexion of inflation.

As long as bankers maintained full convertibility of their banknotes into the underlying commodity, then the banknotes they issued could not have any direct influence on the economy-wide price level.  Alterations to the quality and nature of the coins themselves, as well as deeper changes in the underlying silver market, still dictated inflation, as they did in the coin era.

It's worth investigating this point further. Inflation occurs when people have too much money in their wallets relative to demand. With nowhere to go, money becomes a hot potato. Merchant A doesn't want to hold an extra $100 bill or silver coin in their wallet, so he spends it at Merchant B's store, who doesn't want it so she spends it at person C's store, and on and on, each trade in this chain pushing up prices ever so much. The hot potato process only comes to a halt when all prices in the economy have been driven high enough that the $100 bill or silver coin is no longer unwanted, and it comes to a rest.

By providing an alternative exit for banknotes, convertibility short-circuits this hot potato effect. Say a banker had lent too many banknotes into circulation relative to demand. Rather than boomeranging through the economy hot potato-like, an unwanted $100 bill quickly returns to the issuing bank for redemption, long before it has exerted any influence on the price level.

Although they had no direct influence on the general level of prices, banknotes would have had an indirect influence on prices. As paper money gradually became more popular relative to coins, the demand for silver would have declined relative to the supply, and this would have put gentle downward pressure on the silver price and conversely upward pressure on the economy-wide price level. Second, as people opted to use paper money to meet their spending requirements, coins would have slowly disappeared into vaults. Since this mean that coins circulated less, the inflation that had historically occurred thanks to wear & tear, clipping, and sweating would have receded.

The real novelty in the age of metal-backed bank notes was when convertibility was temporarily suspended. During these periods, bankers and the banknotes they issued could have a direct influence on the economy-wide price level. With the traditional exit into specie or coin being severed, any banknote issued in excess of public demand would act like a hot potato. Rather than returning to their issuer, they caromed through the economy, pushing prices higher.

While there were a number of early paper money experiments, the most well-known include the Swedish experience under an inconvertible paper standard from 1745 to 1776, the British suspension of pound convertibility from 1797 to 1821, and the U.S. Greenback era from 1861 to 1878. Each of these periods of inconvertibility was accompanied by high inflation and coincided with major wars. For instance, in the mid-1700s the Swedes had entered into several conflicts including the Seven Years War, while by the late 1700s the British were on the verge of encountering Napoleon. In the U.S., greenbacks were used by the Union to finance their war against the Confederates.

A US $1 greenback note from 1862

Had banknotes remained redeemable during these conflicts, it would have been impossible for governments to issue large amounts of them—they would have quickly returned to the issuer. By severing the window, many more banknotes could be put into circulation than would have otherwise been the case.

All three suspensions were only temporary as they ended with a return to specie convertibility. It was only in the 20th century that the first permanently-inconvertible standards emerged.

The fiat money era

In 1971 President Nixon removed the ability of foreigner governments to convert U.S. dollars into gold. The world was now on a permanent fiat standard.

Under both coin-based monetary systems and fully-convertible paper standards, the monetary authorities had only a little bit of control over inflation. The key influences over the price level—wear and tear, clipping and sweating, and new precious metals discoveries—were things that happened to the currency, the monetary authority having little say in the matter. When they did exercise control, it was only through policies of coin debasement or attempts to restore the standard.

Under today's permanent fiat system, these external influences have all but disappeared. Instead of being foisted on the economy by chance, the economy's inflation rate is now created by the monetary authority.  Those who are in charge can choose to have the currency gain purchasing power over time (i.e. deflation), stay constant, or lose purchasing power over time (i.e. inflation).

In most western democracies, the monetary authorities have chosen a 1-3% inflation rate. This may seem odd, given that a constant price level is attainable. One drawback of perpetual 1-3% inflation is that people must constantly face losses on their holdings of coins and banknotes. This induces wasteful behaviour. For instance, people may choose to hold less cash than they would otherwise prefer. And they will have to constantly make trips to the bank and back to deposit banknotes in order to earn interest (this is what economists refer to as shoe leather costs). If inflation was 0%, or even -1 to -2%, the public would no longer have to worry about perpetual losses from cash and could choose to hold comfortable amounts of the stuff.

While monetary authorities understand the drawbacks of 1-3% inflation, they still choose it as a target because they see a much bigger threat in the form of sticky wages. In the simplest model of an economy, when a shock hits and demand suddenly disappears, prices fall until buyers are once again drawn back into the market. But if some of these prices are sticky, in particular the wage rate, then this downward trek in prices can never occur. Rather than reducing everyone's salary, employers will be forced to fire workers. General unemployment and gluts of unsold inventory—or a recession—are the result.

Central bankers believe they can offset some of these unpleasant effects. While a $20 per hour wage rate may be so sticky that it can’t adjust in the face of an economic shock, an inflation rate of 1-3% means that even though the nominal value of that wage stays constant next year, its real value will have adjusted down to ~$19.60. So in the event of a shock to the economy, a central bank that targets an inflation rate of 1-3% provides the missing flexibility to wage rates, and thus promotes a quicker readjustment period.

The second reason for adopting an inflation target of 1-3% is that at these levels, short-term interest rates have typically ranged between 3-6%. After all, lenders need to make a profit, and will demand a sufficiently positive interest rate to compensate for losses from inflation. The tool that modern central bankers use to guide the price level is the overnight interest rate on balances maintained by commercial banks at the central bank. This tool becomes useless when it falls much below 0%, the effective lower bound to interest rates. Once interest rates are reduced to around -0.75%, banknotes (which yields 0%) begins to look quite attractive as an asset. Reduce interest rates a little bit more and a mass exit from bank deposits into cash will begin, the banking system imploding in the process. So by targeting an inflation rate of 1-3%, central bankers are attempting to build a big enough cushion into interest rates so that they can be sure that their main monetary policy tool has little chance of becoming useless.

And that's why people in Western nations experience a 1-3% increase in prices each year.

What is in store for the future?

So if you had lived through the last 1000 years you'd have experienced a number of different monetary regimes, the price level dynamics different in each one. Even under commodity standards, inflation was a common occurrence. And even on a fiat standard, deflation is an entirely possible phenomenon.

In closing, will the current 1-3% inflation target that has been adopted by most Western monetary authorities ever change? In certain quarters, there is talk of central banks increasing their inflation targets to 4%- 5%. Over the last few years, interest rates have fallen close to—and even in some cases underneath—the 0% bound, muting the power of the central bank's interest lever. If inflation was 4%, say many central bankers, then short-term rates would be much higher (say 6-7%), thus building in an even bigger cushion for subsequent interest rate reductions come the next crisis.

Alternatively, central bankers might one day decide to target an inflation rate of 0%. This would mean that short-term rates would be very low, leaving little-to-no cushion for further policy rate reductions when the next crisis hits. But there are several ways to guide interest rates far below 0%. Some economists talk of banning cash (especially high denomination notes like the ones below), for instance, or introducing a digital alternative on which a negative interest rate can be imposed. These measures would allow a central bank to reduce interest rates to -3% or -4% during a crisis without having to fret over an exodus out of bank deposits into banknotes. During these episodes with deeply negative rates, the public  would flee into stocks or gold or cryptocurrencies—but this would be a sign that the desired hot potato effect was working. Having bought plenty of room to reduce interest rates into negative territory when a shock hits, central bankers could safely target 0% inflation rather than 1-3% inflation.

Singapore's S$10,000, one of the world's largest value banknotes

Finally, might we ever see inflation in the teens like we did in the 1970s? Western central bankers have exercised a large degree of independence from their political masters in the executive branch of the government over the last several decades. This has allowed them to maintain careful control over the price level. However, if some unforeseen event were to occur that led Western governments to require huge amounts of financing—say another world war—then governments may try to re-exert control over monetary policy. If so, keeping inflation under control could cease to be an important goal of the monetary authority, and the high inflation of the 1970s might return.

Saving in Gold vs. Investing in Gold

There are differing views on choosing the optimal percentage of gold to hold in an asset portfolio.

These different viewpoints depend on how one views gold. Those looking for a return on their money in currency terms perceive gold as an investment which they can sell at a currency price higher than what they bought it for.

We would however argue that the idea of trading your fiat paper currency for gold today, hoping to trade the gold for even more fiat currency in the future, defeats the purpose of owning gold in the first place. Saving in gold is an insurance against the failure of fiat currency, not a means of accumulating more of it.

The healthiest and most natural way of looking at gold is to view gold as savings or as a form of wealth preservation.

Saving in Gold

Gold is, and for thousands of years has been, the focal point for many prominent savers of wealth. The European aristocrats, the Middle East oil barons, the ultra-rich, and even the central banks, all save in gold to preserve generational wealth. They save in gold without thinking about the return in currency terms because they understand the fundamental principle of gold as a generational and long-term store of value. They understand that gold is not an investment but that its a form of money that cannot be printed or controlled by central bankers.

As the world's financial and monetary systems become increasing fragile, saving in gold is the ultimate safe haven for protecting you against a systemic collapse. In the inevitable transition that will follow such a collapse, holding gold as wealth is the ultimate strategy for survival.

Prudent savers understand that gold cements wealth over time which is why you do not need to care much about the ‘gold price’ as denominated in fiat currencies.

If you do not want to bear the high risk associated with chasing returns on the currency markets, you should save in physical gold because gold is the safest form of liquid money. Staying liquid is the same as keeping your wealth in gold. There is nothing wrong with investing, but buying physical gold is not an investment in the real sense – it is a timeless wealth-preserving asset.

When fiat currencies crash, your gold will become a truly priceless asset that will empower you through the transition.

A 100 trillion dollar note can't buy you any bullion. By saving in gold you can sleep at night.

Gold as Wealth

If you are trapped in relentlessly chasing paper profits while worrying about your positions, it is time to consider a shift of mind-set. To become a saver, you have to shift your focus from profit-seeking to sustainability, from chasing egoistic personal highs to becoming a family provider for generational wealth.

With a mind-set of viewing gold as a savings asset, you will not only solidify your own wealth but have the power to pass on your wealth to the next generation. This has been the case for many European aristocrats who were able to pass on wealth from generation to generation.

As we can appreciate from history, cash is not king when the cash is not backed by anything. In fact, the world’s fiat paper currencies have all lost 99% or more of their value in the last century.

Gold is the safest and most stable store of value known to man. No other asset class comes close to gold in terms of stability over history. Gold is not an investment per se. Gold is money. Gold is savings. Gold is wealth.

If you have the mind-set of a saver and want to minimise your risk, it is actually natural to keep most of your savings in gold. If you are unable to determine a favourable risk-reward ratio for any of your potential investments, you might even consider keeping close to 100% of your savings in gold. It is certainly better to keep 100% of one’s savings in gold than keeping one’s savings in the form of constantly depreciating fiat currencies. Ask yourself, are you buying gold as a means of generating fiat currency returns or are you acquiring currency as a means to buy gold (as wealth). We much recommend the latter.

Work and invest to acquire currency but hold your wealth in gold. This is the fool-proof strategy that has worked for thousands of years.

Saving in gold frees your mind. With gold, you can sleep well at night and do not need to worry about inflation, financial markets and currency risks. By saving in gold you can stand strong and avoid the flawed western mentality of chasing paper money returns.

Investing in Gold

If gold is viewed from a western investment portfolio perspective, studies have shown that the gold price is inversely correlated with the prices of most other financial assets. Adding gold into an existing investment portfolio can therefore lower portfolio risk. This use of gold as a risk-reducing strategic asset class has been empirically validated by numerous studies (such as studies by the World Gold Council), and from the perspectives of different classes of portfolios, different investor backgrounds, and varying base currencies. Optimal allocations of gold in multi-asset portfolios by these empirical studies are usually found to be in the 5 - 20% range.

The reason that there is a negative correlation between the gold price and other asset prices is due to the gold price not being as dependent on economic and business cycles as most other financial asset or commodity prices. Therefore, the gold price does not react to events in the same way as the prices of most other asset prices react.

However, we advice you to view gold as savings/wealth rather than as an investment. Gold has the power to change your life for the better. It can give you peace of mind like nothing else if you just let it sit there without worrying about it.


The misinterpretation of money

In its simplest form, money is a substitution for barter to make trade more efficient (formally: medium of exchange) but money is also a means for generating production by allowing for saving and investment (store of value) and for accounting and reconciliation (unit of account).

Different economic schools view money differently. Even for the doctrines advocating gold as money in some way, there's vast differences. An example is that followers of the Austrian school of economics propose that gold should be used as money generally whereas Freegolders view fiat money as the natural medium for exchange with gold as a store of value.


The distribution of money

There is no doubt enough resources for everyone to survive in the world.

Yet the monetary system is causing enormous disruptions. Western countries are debt stricken. Youth unemployment in Greece and Spain stands at about 60 %. Even when the population, like in Greece, gets sick of it all and votes for a new government or debt restructuring, nothing is changed. More credit. More debt. More unsustainability.

A far greater problem, although mostly ignored, is that there's 2,700,000,000 people in the world living on less than 2 dollars/day. More than 90 % of the population in Liberia, Burundi, Madagascar and Malawi has an income of less than 2 US Dollars/day.

Why are we facing these problems in a time when we have access to an abundance of resources and innovative capabilities?

I believe the monetary system to be the culprit. I can't conceive a monetary system worse than what we have today.

The 1729 quote from Voltaire "Paper money eventually returns to its intrinsic value -- zero" is as true today as ever. One of the most absurd contradictions in the 21st century is that people actually believe that fiat money has a value. Why would anyone believe that?

Credit money certainly shouldn't have any role as a store of value as it creates enormous imbalances between surplus and deficit countries when surplus countries save in debt instruments issued by deficit countries. For medium of exchange, it may be difficult to get rid of fiat money altogether but it's worth questioning if we wouldn't be much better off with the government just issuing the money debt free rather than issuing it as debt which can't be repaid anyways.

A much debated rhetorical and philosophical question is whether there is enough money. Opponents to the gold standard sometimes argue that there's not enough gold for it to work as a medium of exchange.

Followers of the Austrian economic school would argue that the quantity of money doesn't matter as gold can simply increase in value. Under a strict gold standard where the money supply is automatically governed by the supply of gold, price deflation should thus be the natural effect of productivity increases.

Followers of Freegold will argue that a gold standard is unrealistic as history has shown that governments will always eventually resort to credit money to finance whatever needs to be financed to guarantee them be re-elected. Freegolders oppose fiat money as a store of value as it is skewing trade and creating perpetual imbalances but not as a medium of exchange.

My suggestion is a simple one but perhaps utopian in these authoritarian times. Leave the monetary function to the market and there will always be enough money. Let people create their own medium of exchange as they desire. If people prefer credit money issued by a bank so let it be. But in doing so, they also have to be prepared to lose their wealth if the bank goes bankrupt. If people prefer cowry shells as money,  which I incidentally believe to be much better than bank credit money, so let it be.

The misinterpretation of money

Money is a vehicle and a facilitator. It can be saved for investment into automation, mechanization,  innovation and new products that makes our life more convenient.

But money is also information i.e. information spreading a message of  status and power. When your essentials are met, wouldn't it be natural that you pursue your dreams and passions? Paint a picture, watch the stars, swim in the ocean or play football. Yet so many people are living lives and working jobs they hate.

Despite all the technological advancement in the last century improving living standards in many countries, a lot of people don't feel that their life is getting more convenient. Sure, most people in developed countries can earn a living but money has become an obstacle rather than a facilitator. Money is used in the pursuit of status leading people to take jobs because of the money rather than choosing a vocation they are passionate about. 40+ hours of work per week in a job you hate to make money chasing the empty promise of status is a false premise for happiness.

It's a double edged sword though because if you follow your passion and become your own employer, governments and authorities are adding so much bureaucracy into all entrepreneurial ventures that you risk spending all your time on paper work.

Entrepreneurs in many, if not most, countries are drowning in bureaucracy killing their original sincere intention and passion.

I'm a strong supporter of free enterprise. Free enterprise is a model for happiness. That's one of the reasons I have emigrated from Sweden, where most ambitions for small scale private enterprise is killed due to massive bureaucracy, to run BullionStar in Singapore. Singapore is the best country in the world to buy and store gold & silver. When you buy gold & silver in Singapore, there's no taxes whatsoever and there's no reporting requirements. If you store gold & silver in Singapore, you'll benefit from low costs as insurance is comparatively cheap due to the low crime rates, strong rule of law and strong property ownership rights.

Back to Basics: Money 101

Money's a matter of functions four,
A Medium, a Measure, a Standard, a Store.

- William Stanley Jevons, Money and the Mechanism of Exchange (1875)

As this simple poetic stanza rolls off your tongue in military-like cadence, it encapsulates the very definition of money with unrivaled precision and simplicity. This is Money 101.

Money is:
1. A Medium of Exchange
2. A Measure or Unit of Account
3. A Standard of Deferred Payment
4. A Store of Value

1. Medium of Exchange
If money was not used as a medium of exchange, goods and services would have to be exchanged through a barter system. Of course, the inefficiencies of that would mean that one must want exactly what the other has to offer, when and where it is offered, so that the exchange can occur. Money, as a medium of exchange, would fill that gap - hence medium - so that it can be used to facilitate a sale, purchase or trade between parties.

2. Measure or Unit of Account
Money helps us to assess and determine the value of goods or wants. It provides a unit of account by having a standard system that can measure goods or service of vastly different value with it's different denominations - 10 cents, 1 dollar, 5 dollars, 100 dollars, etc.

3. Standard of Deferred Payment
A standard of deferred payment is the accepted way to settle a debt in a given market – a unit in which debts are denominated. Simply put, it is a standard for buying now and paying later. It is one of the defining functions of money; for example, while the gold standard reigned, gold or any currency convertible to gold at a fixed rate constituted such a standard. At present, as US dollars are not backed by gold or any other commodity, they draw value from being legal tender which allows the dollar to be used to pay off debts (See the inscription in the picture of the dollar notes below). What you get now is essentially debt used to pay off more debts and other debts. This is why our entire monetary system now is entirely debt based. We will touch more on this in subsequent posts in our Back to Basics series.

4. Store of Value
A store of value is the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved and in transferring purchasing power from the present to the future. While our paper money at present is an asset that can store value - however questionable - Gold and Silver have acted as stores of value for thousands of years and remains so today. Let's take a brief look at the origins of money.

A Brief History of Money
Myths, legends and rumours aside, the earliest administration of money that we have preserved till today is the Code of Hammurabi which was created ca. 1760 B.C. in ancient Babylon. This code formalised the role of money by setting interest on debts, fines for wrongdoing and compensation in money for various infringements of law back then.

The economy was based on commodity money, whereby animals, agricultural commodities and metals were used as money. Metals - where available - were favored for use as money over animals or some agricultural commodities because metals are durable, portable and easily divisible.  The use of gold as money has been traced back to 4000 B.C. when the Egyptians used gold bars of a set weight as a medium of exchange. This is why our very own BullionStar® Gold 100g minted bars are inscribed with the text "Money since 4000 B.C."

BullionStar Mint - Gold Bars with No Spread - 100 g


At present, even terms frequently used as a unit of account for money, such as Dollar, Shekel, Pound, originate from terms used to describe a set weight of a precious metal. For example, the British Pound was originally defined as a one-pound mass of silver.

Money Then Money Now
This is a dollar note from the 1935 shown below. Notice that it says "This certifies that there is on deposit in the treasury of the United States of America one dollar in Silver payable to the bearer on demand"

Silver Certificate

This is a dollar note now from the 2009 Series. Can you spot the difference? What exactly does this note give you now?

Dollar Note