Fiat:  A Car and a Currency

Fiat Currency.  Global Reserve Currency.  Gold Standard.

You’ve heard terms like these on the news and in the paper, but what exactly do they mean?  How does the mess in Greece and Europe relate to what’s happening here and why should I even care?  We’re going to spend some bytes in the next several articles laying out the basics of the ongoing financial crisis – no, it never actually went away – and what it means to us.

But first, let me share a true story.

My father once bought a third car because his eldest child, my sister, was now driving.  Since he was having what I now recognize as fully blossomed mid-life crisis, he pulled into the driveway one evening in a sporty, low-slung, forest green convertible, proud that he thought he’d bagged a two-fer.  This car was a 1973 Fiat Spyder and it looked fabulous, the best that he could afford with the money available.

We soon learned the joke that Fiat was an acronym for "Fix It Again, Tony" and it was a car that demanded unrelenting vigilance and discipline, more than any other vehicle we’d owned.  It was a mechanically unforgiving auto and if it wasn’t assiduously maintained it would wind up at the shop.  There were still times that it was in the shop despite my father’s best efforts.  Because the engine didn’t like the Pennsylvania climate, he kept it in the garage and covered the engine itself with a canvas tarp in cold weather.  so the morning routine was the enter the garage, lift the hood and remove the tarp, recite a Hail Mary and then turn the ignition.

This car remained in the family until one winter morning when Mom needed to drive it.  She was running late, so she drove the Spyder for a quick run to the local bank.  She sat waiting in the drive-thru lane when she noticed the window teller banging on the glass and yelling at her while pointing furiously at the hood.  Mom glanced ahead to see that smoke was billowing out from under the hood where the tarp – which she hadn’t removed – was burning.  After the tarp caught fire, the engine soon followed and in a quick few minutes, there was a toasted Fiat blocking the bank’s drive-thru lane.

Fiat:  A Currency As Well As A Car

The dollar, as are all of the world’s currencies, are fiat currencies;  it isn’t an acronym, but actually the Latin term for "faith".  Each is considered a fiat currency because it is backed by the globe’s faith and confidence in the ability and will of that particular country to support it in terms of competitive ability, resources and capacity to service its debt.  That faith is demonstrated in the daily global transactions involving the buying and selling of the various currencies.  All manner of entities engage in currency transactions – companies, banks, hedge funds, individuals and central banks – and it’s the number at which buyers are willing to pay versus what sellers will accept that the valuation occurs.  And with world-wide networked computers, valutation occurs quickly and globally.  Because the Norwegian Krone is used by a country with solid governmental finances and an oil exporting economy, the world demonstrates its respect by valuing that currency higher than the Argentina’s, whose government burned international investors by defaulting on its debt.  It takes far more Argentinian Pesos to buy one Krone now than it did ten years ago.

And that’s the key to my father’s Fiat and today’s currencies.  Fiat currency is based, to a significant degree, upon the perception and faith of others.  Maintaining that faith and supporting that perception requires self-discipline and vigilance on the part of the owner to assure that it continues to be deemed worthwhile by others.  If a country’s currency gets a poor reputation, like the Italian car, then the global economies vote against it by valuing it less than other currencies.

How Did We Get To a Fiat Currency?

For most of our history, the dollar – like all of the other currencies – was backed by gold and silver and its control was mandated in our Constitution.  What that literally meant, after paper notes were issued, was that somebody who held a dollar was able to go into a bank and trade that paper dollar for a fixed amount of metal, either silver or gold.  People learned to accept the dollars because the amount of the metal was fixed and also because it was simply easier to carry paper bills than deal in gold.  Because the dollar bill was backed by the metal for which it could be exchanged, it had a steady store of value that buoyed the people’s confidence in it as a currency.

This gold standard was a staunch enforcer of discipline upon the international markets.  For instance, if America purchased more from England in 1866 than England purchased from America, then England could take all of the dollars that it had received and return them to the US Treasury for an equivalent amount of gold from the American government’s vaults.  Consequently, the US government would have less gold than could support the number of its own dollars in circulation, running the risk of default should enough citizens trade paper for bullion.  Dollars would have to be withdrawn from circulation and the result would be less money around for the citizenry.  So countries had to live within their means or develop new ways to garner wealth.

We’re not finished with the gold standard yet, but we need to cover something else first that makes the final days of the gold standard understandable.

What’s a Global Reserve Currency?

Many live by the rule that simpler is better and that runs to international financial transactions as well.  To keep from having to constantly recalculate the value of one currency to another in these transactions, banks and merchants long ago opted to assure that international transactions were usually handled in one currency only.  This is referred to as the Global Reserve Currency (GRC) and it’s a role presently held by the dollar because it serves as the medium of exchange for almost all international business transactions.

The status of GRC is bestowed by the world upon that currency which, it is view, is the steadiest and best able to weather the various storms – political, economic, natural – that occur.  The dollar became the GRC at the end of the Second World War after a meeting of allied financial ministers at Bretton Woods, after which the subsequent agreement was named.  At that time, the US was literally the last country standing after a second global war which devastated dozens of nations and exhausted the country with the existing GRC, Great Britain.  It was agreed that going forward, all international transactions would be handled in dollars.

Remember something.  The dollar was now the GRC but it was still backed by gold.  The dollar’s status as the "anointed one" was only peripherally related to its backing and it had not yet become a fiat currency.  At that time, the US had roughly 20000 tons of gold in the government’s vaults.

This system lasted for almost thirty years.  And in that time, the country began to persistently run trade and government deficits so that we were sending more dollars overseas than we were bringing in from elsewhere.  Our standard of living rose dramatically and we dreamed big dreams and tackled big projects but that meant that periodically, our gold flowed out of Fort Knox.  Financing the Vietnam War, the Great Society and Apollo took huge sums of money and those dollars printed were returned by foreigners for gold. 

And this was where the gold standard ran into problems.

Gold to Fiat

Somewhere around 1969, the government acknowledged that the US was going to run out of gold if things weren’t brought under control.  There was yet another meeting of international finance ministers and they hashed out what’s now referred to as Bretton Woods II.  The dollar – still the biggest kid on the block – continued as the GRC but it was agreed that all of the currencies would "float" in valuation against one another.  Gold would no longer be used to back the store of value as it once had.  Those valuations would be set by tracking transactions within the global markets and updated by computer, which now made this possible.  The dollar’s value now floated against other currencies, which was good because we’d lost over half of our gold reserves in the preceding thirty-odd years. 

The flip side was that if our country didn’t pay attention, exercise discipline and maintain our fiat, it would eventually become toast as others punished it in the global marketplace.

So What Do You Need To Remember Going Forward?

  • The dollar is a fiat currency with a value based solely upon the willingness of people to accept it.  That means that perceptions, beliefs and biases play a major role in how well it holds value – especially to pay for things like oil.
  • The dollar is the Global Reserve Currency, which means that almost all of the world’s business transactions occur in the dollar.  It also means that the dollar’s value is determined not just by folks in this country, but by others throughout the world.
  • Financial systems can change and if there’s a pressing enough reason, change relatively quickly.  We went through two major changes – Bretton Woods I and II – within a thirty year period.  It might seem like a long time personally, but it’s a blink of history’s eye.
  • Covering a Fiat with a tarp is ultimately bad for the Fiat.

Coming Soon:   Rising Debt – I Have To Repay This? 

Thanks to Jesse at Jesse’s Cafe Americain for reviewing this article.  All errors are mine and mine alone.

Thanks also to Kay, Molly and Burt for their input.

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