Fiat Currency Collapse Dynamics
By: Alasdair Macleod
May 21, 2012
The reason we accept paper money as a store of value is habit. This habit has its origins in history, when banks took our gold as deposit and issued paper receipts for it. The gold has gone, but the paper with its habitual value remains, and we accept it without question. The only backing is a vague government promise.
There is no sound theoretical basis for why unbacked government-issued money should retain a store of value: it depends for its value on a market-based acceptance of financial credibility. So it follows that if a government loses all financial credibility in markets, its paper becomes worthless. This is confirmed by experience in all paper money collapses.
The fact it can and has happened elsewhere confirms that all faith can theoretically disappear from the dollar, pound, euro or yen. This is a very different understanding about currency values compared with what is commonly accepted. Instead, we assume that any change in purchasing power is tied firmly to price inflation, and we factor out any reliance upon faith. But this is a cop-out, a way of not addressing the basic assumptions that uplift the value of government-issued money from zero to what it will actually purchase.
It is vital to understand that price inflation and maintenance of fiat currency premiums are only loosely related. In a sound money economy, an economy where the medium of exchange is backed by gold, changes in the available quantity of money will affect the prices of goods and services exchanged for it. This is because sound money is itself a commodity, whose function happens to be to act as a medium of exchange. However, you cannot say this of fiat money, where the link with value is based entirely on faith. It is a mistake to assume that supply and demand factors that give sound money its value as a means of exchange also apply to unbacked government money. The value of fiat currencies is purely subjective.