I did not initially intend to write this installment, but as I recently remembered a common misunderstanding, I have decided that perhaps I should add a new chapter. So, for those who are following my list of upcoming posts, move everything down one, as I am inserting an extra installment of Bad Economics.

Before I get to the topic itself, let me offer you a little hypothetical exercise. A man comes up to you and offers to sell you ten niblocks. Not knowing what a niblock is, you ask what they are. He explains that each niblock represents five lupongs. Again puzzled, you ask what a lupong is, and why you would want either niblock or a lupong. Smiling, the man explains that a lupong can be redeemed for 20% of a niblock.

Such self-referential definitions are clearly useless. By defining A in terms of B and B in terms of A, or, worse still, defining A in terms of A ("a niblock is a unit equal to one niblock"), we are left with no way to understand what the units represent. They are simply unmoored from the rest of reality, forming their own self-referential universe. (Actually, there is an even worse situation, which we will discuss below.)

And that is the problem with the dollar. At present, the dollar has no definition. Oh, we try to "set" a value in terms of foreign currencies, but as foreign currencies define themselves either against the dollar, or other foreign currencies, we are back at niblocks and lupongs, and eventually end up defining dollars in terms of dollars. Similarly, defining it in terms of what it will buy is absurd, as prices re defined themselves in terms of dollars, meaning we are saying "a dollar is worth what a dollar is worth". We are simply defining a dollar as being worth a dollar. It has no meaning outside of its own little closed system.

Actually, before I go on, perhaps I should clearly state the topic for the day. And that is the mistaken belief that the dollar is somehow backed by the government, that it has behind it the taxing powers of the United States. While, in one very broad sense, this could be arguably true, in reality, the dollar has nothing behind it, and is not even a defined unit. It is, as I stated in some responses to comments earlier this week, essentially a sham. A sham we mutually accept, and which is based on an older, legitimate system, but a sham nonetheless. It is nothing, backed by nothing. And it is because it is such a protean term, such an ill-defined, poorly delineated term, with so few checks upon its manipulation, that the government can indulge in rampant inflation.("Bad Economics Part 7")

It was not always so. At one time the dollar was a clearly defined unit of currency, redeemable in a fixed quantity of gold¹.A dollar was defined as 1/20 of an ounce of gold, later redefined by FDR to 1/35 of an ounce. Until the redefinition², a citizen could take 20 dollars notes to the issuing bank (or after 1913, the Federal Reserve banks), and redeem them for a one ounce gold coin. The dollar was defined in terms of a concrete physical asset³.

But that began to change. Salmon P Chase, treasury secretary during the Civil War⁴⁵ discovered he had a huge mass of debt and no market interested in buying it. There had been some earlier steps in the direction of a more centralized federal banking system, but Chase accelerated the development, creating a more consolidated system, which, despite reserve requirements set by law, allowed some banks to pyramid their currency expansion upon reserves held in other banks⁶. However, what matters for our purposes⁷ is that he also decreed that those banks could, for some percentage of those reserve requirement, substitute treasury bills for gold. In other words, instead of holding gold equal to, say, 35% of their outstanding obligations, they could hold 25% gold and 10% treasure bonds.

It was an expedient way to finance the war, and, for the time being, did not do any serious harm. If anything, it was far less inflationary than the national banking system itself. By allowing the pyramiding of reserves, the new banking system allowed many multiples of value to be piled on a tiny set of reserves. By comparison, expanding the reserve definition to include bonds was only very slightly inflationary. Nor did it change the definition of money. Dollars were still redeemable in gold. They might be backed by bonds, but a holder could still redeem them in gold. The bonds did not change the definition of what a dollar was, it was simply a government regulatory change.

But it had long term repercussions. When the Federal Reserve was founded, it was based upon the same rules as the earlier banking system, and so it used a combination of gold and bonds to back its notes. And it remained so until 1973, when Nixon finally closed the "gold window", that is admitted that dollars would no longer be redeemed in gold. At that point dollars were no longer defined in terms of gold. And, as they were not backed with gold, the only option left was to define reserve requirements entirely in terms of treasury bonds. Which meant instead of a mix of bonds and gold backing dollars, defined in gold, we were left with dollars backed entirely by bonds, without any definition at all.

Which brings me to my original point. Dollars are akin to the niblock of my example. A dollar is a unit of currency backed by treasury bonds, themselves defined in terms of dollars, which will be redeemed in dollars. In other words, a dollar is worth one dollar of US government debt to be paid in dollars.

And that is why I say the popular understanding of the dollar is wrong. Most often you will hear the dollar is backed by the "taxing power of the government". Now, granted, the taxing power is used to pay off those bonds, but that is not really what backs the dollar. As the bonds are themselves to be paid in terms of dollars, dollars are backed by nothing but themselves. Were the dollar to collapse and the Fed decide to redeem the bonds they hold, the bonds would still be paid in dollars, worthless or not, as there is no provision for payment in kind. In other words, dollars are backed by nothing but other dollars, there is nothing else there. The system is entirely self-referential.

Of course, in practice, the dollar has a number of implicit definitions. Though not strictly redeemable, there is an implicit assumption that, in dire straits, the government may return to gold to pin the currency, so the dollar is often viewed as being implicitly backed by gold reserves, which helps to explain how we can establish any exchange rate against gold, and also helps to explain how a currency backed by nothing can be described as being stable or unstable. So long as the dollar inflates within limits that are supportable given US gold reserves the world market is not too troubled. When it exceeds those limits, then troubles begin⁸.

This should also make clear how easy it is for the government to inflate. Prior to 1934, banks, and later the central bank, had to keep inflation within some well defined limits. They had to keep enough gold on hand, relative to outstanding liabilities, that any notes presented could be redeemed on demand. Even between 1934 and 1973 there was still some check on inflation. Granted, as other currencies were defined in terms of dollars, inflation could be effectively "exported" to other nations, removing many of the ill effects from the US. But the Fed had to be careful. If they inflated too much, reduced the value of the dollar too greatly, foreign central banks would begin presenting their dollars for gold. Political pressure could hold this off for some time, but not forever. So, inflation had to be kept within certain ranges. Admittedly, ranges much greater than when private redemption for amounts of one ounce or more were possible, but there were still constraints on inflation.

Now, there is no limit. Since the dollar is defined only in terms of itself, and as the reserves backing it are themselves nothing but debt defined in terms of dollars, there is no way to tell whether inflation is proper or improper, nor is there any pressure keeping the government from inflating. Yes, when they inflated too rapidly it causes price increases that are politically unacceptable, and if the currency falls or rises against foreign currencies it can effect foreign trade, but provided politicians are willing to weather the storm brought on by those side effects, nothing prevents them from inflating as much as they wish. At least, not until the inevitable crash comes. But, other than a total loss of confidence, there is nothing to prevent inflation the way gold did under the gold standard.

I could doubtless go on and on about the ill effects of the transition from gold to fiat currency, but that was not my point. All I wanted to do here was to show that, rather than being backed by the government, or anything at all, our present dollar is really, when viewed rationally, backed by nothing at all. It is defined in terms of itself, and backed with bonds to be paid in dollars. It is a self-referential system, defined only in terms of itself, backed by nothing. And that was my point. It is impressive that it has lasted so long, and has functioned as well as it has in the 36 years since gold was removed from the equation.  Our recent economic history may show an accelerating "boom and bust" cycle, with ever more rapid rises and falls ("The Reagan Lesson ", "Not Entirely to Blame"), but given that our currency is wholly imaginary, I am impressed that it works at all.

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1. For this essay, I will ignore the chaos of bimetalism. Defining a unit in terms of both currency, or in any way forcing a legislated exchange ratio, is just asking for trouble. But, as bimetallism usually ended on its own thanks to Gresham's Law, there is little reason to consider it for now. Perhaps one day I will address that topic, though, given our current distance from any metallic standard, it seems an esoteric point. Though Gresham's Law itself does still have practical applications even today, so I may write about it yet.

2. Until citizens were legally prevented from holding monetary gold in 1934. See Murray Rothbard (with whom I do not always agree 100%) on this topic here. After that time, gold could only be obtained by foreign banks and government, and only in bars of bullion. Which certainly made it easier to inflate without fear of bank runs, at least until inflation scared even foreign bankers. But that is the topic for another essay.

3. I won't discuss why gold is a good choice in any detail. Suffice it to say gold has innate utility (not just decorative, it is also the first choice for many non-corrosive contacts, such as in air bags), which tends to give it value to most people outside of its use as currency. It is easily divisible, and the divided units are directly proportional to the original. (Eg. Cutting a diamond in half does not give two diamonds worth half of the original, and joining two diamonds is entirely impossible.) Being non-corrosive it is even less perishable than other metals, and much less perishable than non-metal choices. (Eg. Tobacco receipts once used in the colonies. Or the practice in many early agricultural communities of using perishable grain or even bread.)  And it has a high unit value, making transportation of large denominations easy, but not so high that small denominations become uncomfortably small (at least under the 1/20 ounce dollar). There are many more arguments, which I shall examine in detail in a future essay. For the present, my post "Why Gold?", does examine some some of them.

4. Before any conspiracy theorists fond of blaming Jewish bankers latch on to the "Salmon" part, yes it is a variant of "Solomon", but the name "Solomon" and its variants were common among many Christian denominations at one time. And Chase was, as far as I can tell, Episcopalian, at least the uncle who raised him was a bishop in that church. So, despite the name, no way to tie this to the Elders of Zion.

5. Chase later served as chief justice of the Supreme Court, and had already served as governor of Ohio and US senator.

6. This is covered in more detail in "Explaining Past Crashes", "The Best Historical Example" and "The Inflation Engine".

7. He also issued the first national paper currency in the history of the US, in the form of Civil War era "greenbacks", eventually retired by Grant. In addition, he is responsible for the first national income tax, noteworthy as it was passed without benefit of the 16th amendment. Something to recall when arguing about the FairTax being tied to the repeal of the 16th.

8. There are other factors as well. As other currencies are equally ill-defined, the dollar can inflate well outside the limits of its reserves, so long as the other currencies of the world are even more unstable. Stability is effectively a two tiered test. First, is the dollar objectively stable compared to physical reserves? Second, is the dollar less unstable than the other currencies? Passing either test is usually enough to prevent currency panics, though not always. As with any economic phenomenon, humans behave unpredictably, and with a dollar backed by nothing there is nothing to prevent panic from breaking out at any time. It may be more likely when the dollar is poorly managed, but there is no guarantee it will not collapse at any time.

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POSTSCRIPT

The earlier Bad Economics posts were:

Bad Economics Part 1 - A discussion of how prices disprove theories of resource depletion
Bad Economics Part 2 - A debunking of the many theories based on "defective" or "damaging" competition
Bad Economics Part 3 - An examination of the many absurd claims about deregulation
Bad Economics Part 4 - An examination of problems with economic studies and empirical evidence
Bad Economics Part 5 - An examination of consumer protection and the harm it does to consumers and others
Bad Economics Part 6 - A rebuttal of claims offered in support of various types of farm price supports and other aid
Bad Economics Part 7 - A discussion of what inflation is and is not

You can also read them in reverse order, starting with part 7, as each post contains links to the previous chapters.

POSTSCRIPT II

If this sounds slightly confused, please blame it on the circumstances, not the author. The problem in explaining our current monetary system is not a lack of understanding, but what we are trying to understand. There is simply no logic to our current system. Our currency is effectively undefined, or defined only in terms of itself, representing not some amount of commodities, but representing nothing. It is an absurd situation, one only academic economists and government officials could find reasonable. And that is why any attempt to explain it comes out sounding absurd. Unfortunately, the situation itself is absurd, and has been so for three and a half decades.