Posted On March 31, 2017 By In Featured Writers With 1968 Views

The Unnatural Nature of Fiat Money

Imagine if you are doing this experiment; walk along the mall’s corridor while holding a packet of rice and approach the first shop assistant you see. Take out a piece of RM10 from your wallet and ask him or her which one is money; the rice or the RM10 note? Most of the time there is a good chance that they will choose the note. Now, imagine if you are repeating this experiment with someone who lives in the rural area but in another country. This time the outcome might be different. There are many definitions of money but basically money is supposed to be something of value that serves as a medium of exchange, recognized as a legal tender and acts as a means to save or store purchasing power. The RM10 note is considered as money in Malaysia because it is perceived to have value based on its legal tender status. However, not many people know that the more accurate description for this note is fiat money. This is because even when the government decreed it as legal tender, it is not backed by any physical commodity.

 

And guess what?

 

All currencies in the world are actually fiat money, meaning that none of them is actually backed by any commodity and certainly not backed by gold. Interestingly, it is still a rather new phenomenon. For many centuries, money has always been backed by various forms of commodities, such as gold and silver. In fact the last time such system existed was Bretton Woods agreement ratified in 1944 where most European country members agreed to peg their currencies to US Dollar and the US simultaneously agreed to peg 35 US Dollars to one ounce of gold[1].  This means that foreign governments and central banks were able to exchange dollars for gold. Unfortunately, this practice ended in 1971 when United States decided to terminate the convertibility of the US Dollar to gold in an event called the Nixon Shock[2], where huge amount of dollars were printed to finance the government expenditure for the Vietnam War, thus severely diluting the convertible rate of US dollar into gold. Since then, all the currencies of the world, including US Dollar and Malaysian Ringgit have become free-floating or known as fiat money.

 

You’d probably think that there is no harm in doing that.

 

After all, the government can print the money first to revitalize the economy and when they have collected the tax money, they are effectively in control of the money in circulation. Unfortunately, the physical printed money in circulation (defined as M0) only represented on average 5% of the total money available[3]. The rest is made up of deposits and loans created by conventional banks when they do lend to their customers.

Someone who had studied economics will see where this could lead to; as excess money in circulation will make them lose their value, which will bring inflation to the fore and can cause major problems in the form of rising unemployment as well as reducing national income. If the government did not seriously monitor this, or worse, instead abuse it by freely printing money, it can turn into something more sinister like a hyperinflation, where the monthly inflation rate exceeds 50%[4]. In the past 30 years, there were 37 incidents of hyperinflation recorded in various countries[5]. The current and still an ongoing case of hyperinflation is in Zimbabwe where the ongoing inflation rate is at a staggering 231 million percent[6]. Venezuela’s inflation rate on the other hand, has already reached 800 percent in December 2016 and is unlikely to recover in the immediate future[7].

 

When you have the power to print the money freely, you will also have the power to retract them. On 8th November 2016, the government of India announced the demonetization of 500 and 1,000 rupees because they wanted to curb the black market trading and the use of illicit and counterfeit cash to fund illegal activities and terrorism activities[8].  In Malaysia, the RM500 and RM1,000 notes were discontinued in circulation and ceased to be legal tenders in 1999 because of the Asian monetary crisis of 1997 when huge amounts of Ringgit were taken out of the country. 1 sen coin was no longer minted when the new series of coins were introduced in 2012[9].

 

Because of how easy it is to print this kind of money, any conquering nation can simply introduce its own currency in occupied territories. Our country was under Japanese occupation from 1942 until 1945. The Japanese issued a currency popularly known as ‘banana money’ at that time because of the banana tree picture on the 10 Dollars Japanese currency. Because of the ongoing war at that time, the Japanese government printed the money in huge amount until it caused a hyperinflation crisis within a short period of time and when they finally left in 1945, the currency became worthless[10]. The population then started to use the British currency again which they had stored in their safekeeping during the occupation.

 

Imagine such a power to create money out of nothing. The power that is supposed to be exclusively belonging to God only. The 17th century French writer, historian, and philosopher Voltaire once said, “All paper money eventually returns to its intrinsic value, zero“. And if we refer to the Qur’an,” . . . do not deprive people of what is rightfully theirs by diminishing the value of their things (such as their labor, merchandise, property etc).” (al-‘Araf, 7:85; Hud, 11:85; al-Shu’ara, 26:183), this is definitely something that looks like a daylight robbery.

 

If the whole world is using fiat money, is there an end to this problem via a workable solution? Various communities, agencies, NGOs and individuals have attempted to offer alternatives in the form of community currencies, commodity backed currencies or even something that is becoming increasingly popular nowadays such as cryptocurrencies. The solutions are already out there but in the end, it is the willpower of the people especially people who are supposed to be the leaders of their communities to make change happen. But who would like to give away the power of God?

[1] Edward S. Mason and Robert E. Asher, “The World Bank Since Bretton Woods: The Origins, Policies, Operations and Impact of the International Bank for Reconstruction.” (Washington DC: Brookings Institution, 1973), 29.

[2] Lowenstein, Roger (August 4, 2011). “The Nixon Shock”Bloomberg BusinessWeek Magazine.

[3] http://www.raineandhorne.com.my/pdf/Articles/Economic%20Indicators-Part1.pdf

[4] Phillip CaganThe Monetary Dynamics of Hyperinflation, in Milton Friedman (Editor), Studies in the Quantity Theory of Money, Chicago: University of Chicago Press (1956).

[5] Steve Hanke and Nicholas Krus, “World Hyperinflations”. Cato Working Paper no. 8, August 15, 2012. Forthcoming in: Randall Parker and Robert Whaples (eds.) (2013) The Handbook of Major Events in Economic History, London: Routledge Publishing. 

[6] http://thezimbabwean.co/2017/02/zimbabwe-bond-notes-stoke-fears-hyperinflations-return/

[7] http://www.tradingeconomics.com/venezuela/inflation-cpi

[8] “Withdrawal of Legal Tender Status for ₹ 500 and ₹ 1000 Notes: RBI Notice (Revised)”. Reserve Bank of India. 8 November 2016. Retrieved 8 November 2016

[9] “Doing away with one-sen coin payment”The Star. 14 November 2007

[10] “Banana Money Exchange”Newspaper SG. The Straits Times.

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Ahmed Razman Abdul Latiff

Dr. Razman, as he is commonly addressed by his MBA students, loves to read various genre of books but as he is getting busier lately, decided to focus only on graphic novels (no, they are not comics!). Blessed with a lovely wife and five kids, he somehow managed to find time to play football, watching movies, dueling Magic: The Gathering and collecting Lego figurines (for investment purposes, seriously).

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