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Paper Money in the Balance

December 13, 2002

The supposed non-value of paper currency is a common theme in conservative financial circles today. It seems that the "demonization" of the dollar has come into vogue among a host of financial writers, who term it a "worthless fiat currency."

Yet the concept of the paper dollar must rank as one of the most ingenious and important economic discoveries ever conceived. Its advent retired from use the cumbersome necessity of metal coins and other forms of currency including gold and silver. Money suddenly became portable, and commercial transactions were made faster and easier. The end result of a paper money system was a magnificent leap in economic and commercial progress and an outbreak of general prosperity unparalleled in history before its introduction.

European, Asian, and North American economies have relied on paper money as a principle means of exchange for hundreds of years, and it has produced a standard of living far in excess of anything ever experienced in the days before its existence. Gold and silver-as desirable as they are s stores of value and (at times) as investments)-even when they were the principal forms of money in an economy, never produced the degree of widespread prosperity and commercial expansion the world has seen over the past 200 years. This is because precious metals are of limited supply and can never be made to expand to keep up with a rapidly growing population and its economy. In other words, gold has limits when used as a principal monetary standard: the dynamics of a country's population alone at some point makes a workable gold standard impossible.

Paper money, on the other hand, has no such limitation. It can be easily expanded or contracted to meet the needs of commerce, and is cheaply produced and extremely liquid, not to mention portable. It is theoretically without limitations (provided it is properly regulated). Yet increasingly, the concept of a paper money-based economy is coming under attack from many different quarters in financial circles. The attacks emanate from those who maintain that a paper money system is synonymous with inflation. These critics further maintain that paper money issued by fiat is inherently worthless and can instantly lose all perceived value in times of economic turmoil or political crisis. In their distaste for paper money these critics fail to distinguish between the U.S. Federal Reserve Note (which is a type of bank note) and a true government-issued paper dollar (or "trade dollar"). This failure to delineate between trade dollar and bank note has resulted in a gross misunderstanding of the mechanics and benefits of a working paper money system and has clouded the minds of millions of people who might otherwise find it desirable to their commercial success and economic progress.

Before we can fully appreciate a paper money system, let's briefly look at the history of paper money usage. The Chinese were the first to invent paper money, which in its earliest form can be traced back to the 7th century. In the Year 812, the Chinese Emperor used it as a temporary solution because of a copper shortage. This money was called "flying money." It was so popular that by 970 it dominated as a monetary unit. These first trade notes carried a guarantee that it could be traded at any time for coinage. The name of this note was "cash." When Marco Polo came back from his travels in China (1275-1292), people in Europe didn't believe that the Chinese used paper for money. Paper money in Europe came 300 years later. The use of paper money in China stopped in 1455.

The history of paper money in Europe began in 1483, when the first emergency paper bills were issued during an economic crisis. The bills were used as a substitute for the regular money. Europe's first bank notes were pivotal in the 17th century.

The monetary system in times of crisis and emergency sometimes failed to function. In situations such as these the state, cities, or companies looking to solve the lack-of-money problem manufactured and used substitute money. After World War I, Germany and France circulated coins made out of aluminum, porcelain, or fine bone china, paper, cardboard, leather, linen and silk.

During World War II, Germany printed emergency coins made of zinc and iron to be circulated in the occupied territories. Postage stamps were, among other forms, also circulated as substitute money. The state-owned Meissen Porcelain Company also made emergency coins. [Source: moneymuseum.com]

Circulated emergency money helped immensely in time of monetary crisis, but when it was circulated in addition to normal money it heightened the danger of inflation. This brings us to the next observation of paper money systems: the two principal obstacles to a sound paper money system are 1.) inflation (i.e., failing to properly regulate the volume of circulating money and allowing the printing of excessive quantities of currency), and 2.) backing the money with a physical commodity, which at best isn't necessary and at worst can do enormous damage to an economy.

Let's address the first of the obstacles beginning with inflation. This is the chief objection of those who oppose paper currency, viz., that it can be inflated and thus lose value. But this can only happen when the circulating supply of paper money isn't regulated by an efficient and honest system of taxation, or else by a currency conversion scheme where, for example, two "old" dollars are exchanged for one "new" dollar by the monetary regulators at the appointed time. Such an exchange systems acts as a bulwark against runaway inflation and also prevents monopolization of the currency.

Taxation, when done fairly and in moderation, is another form of currency regulation. While never popular, it is nonetheless a necessary and effective means of removing excess currency from the economy and of preventing economic stagnation.

The second obstacle to a sound paper money system is when the currency is backed by a physical standard, such as land, gold, silver, or other commodities. While it may seem logical to back a currency with a tangible asset, it actually becomes problematic when the money can be exchanged for its face value in gold, land, or whatever. When an economy becomes so large as to demand a huge quantity of fiduciary media (i.e., money) it then becomes impractical to back the money with commodities since, for instance, there can never be enough gold to meet all the demands of a highly developed commercial system. It also poses the additional problem of monopoly men who would hold the economy hostage by accumulating as much money as they possibly can and then demand the exchange of that money or its equivalent in gold. The monopolization would then be free to leave the country destitute and in possession of nothing more than worthless paper. History is rife with such examples.

Does this mean then that money should be un-backed? Certainly not. All forms of currency must have a reliable backing if they are to enjoy widespread acceptance. And what greater form of backing can there be than the guarantee of the issuing government that the value of the currency will be upheld and not diluted through inflation. As no system of money can stand except trust be first present among all members of the economy, trust that the government issuing the currency in question is honest and upright and will not do anything to endanger the monetary system. Trust is inherent in any monetary system and in all functioning economies and cannot function without it.

At this point it should be obvious that some form of government is necessary to issue money and regulate its supply (though not necessarily its value). It is further self-evident that the issuing government must be composed of men of the highest moral standing, and ideally should be Christian in composition. Moreover, the government that issues money should represent the men and women who compose each segment of the economy and be held accountable only to them. This is the ideal conceived by the Founding Fathers when they framed the Constitution and set up the fledgling American government as a government by representation of the people, by the people, and for the people. At that time Christianity held sway over the minds and morals of men, and they could therefore be trusted to represent the best interests of the people and issue paper money. But as Christianity has lost its influence over men, and as the government no longer represents the best interest of the people, the ability of the government to issue money has likewise been compromised.

In this vein, it should also be obvious that the more localized the issuing government is, the more likely it is to represent the interests of the people and to efficiently maintain the money system. Paper money is most successful when it circulates in a small, self-sustaining closed economy. A small island community, for instance, can most easily make use of a paper money system when all participants of the island economy agree to exchange goods and services for the agreed upon circulating currency. When all members of the economy are neighbors, and when their very livelihoods, property and public peace depend on the goodwill and cooperation of each inhabitant, the money system is safe and sound. The local government in charge of its maintenance can then be trusted since even they have a vital interest in its acceptance and success.

The local economy, then, is where paper money finds its greatest prospect for success. A large federalized economy such as the United States, on the other hand, is inimical to the success of paper money since the interests of the regulators is not tied in with that of the people and since there is far less accountability, making it easier to inflate the currency.

What then is the answer to the currency conundrum? Simply this: that in order for a paper money system to work, cities and towns must take matters into their own hands and maintain the value of their own currency. One cannot wait for monetary reform to begin from the top down-it must begin from the bottom up.

It has been suggested by some that the way to ensure the integrity of the money system is to return to a gold or other commodity standard where new money cannot be printed except there first be enough gold in reserve to back the money. Yet this system has proven to be a failure in every case due to the inevitability of a run on the gold supply, thus rendering the currency worthless. But when paper money is backed by the strong bond of trust in the integrity of the system which issues the money and the people behind it and in the knowledge that the money cannot be hoarded except it be taxed back into circulation, cannot be damaged through exchange rate manipulation, cannot be carried out of the local economy by greedy men, and cannot be inflated without first consulting the demand of commerce, then there is the beginnings of a truly workable system of paper money and one that cannot be easily destroyed.

Before proceeding further with out discussion of the "Paper Money Question," we would like to address a concern that may have arisen at this point concerning the value of gold. By no means should our defense of the paper dollar be construed as an attack against gold. To the contrary, gold has made an excellent investment vehicle throughout history up to the present time and is often an extremely useful store of value in times of monetary crisis (especially in an economy where a paper money system has been abused or otherwise improperly implemented). But gold doesn't necessarily always make good money, especially when the demands of commerce are very large. The limitations of the gold supply alone render it typically ineffective as a principal medium of exchange. Our main argument is that paper money, even though it has no inherent value, is by far the most efficient and reliable medium of exchange the world has ever known.

It must always be kept in mind that the essential basis behind any economy is nothing more than the exchange of goods and services. Money is therefore the means to an end, not the end itself. You cannot eat paper money anymore than you can eat gold. Yet both have been used-with varying degrees of success-as means of exchange. This is what the paper money system aims at accomplishing, the smooth, efficient exchange of goods and services with the least amount of effort. To date, nothing has ever exceeded the usefulness of a sound and properly maintained paper money system in the context of a localized economy.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including “2014: America’s Date With Destiny.” You can view all of Clif's books here. For more information visit www.clifdroke.com.


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