Coined: The Rich Life of Money and How Its History Has Shaped Us

by Kabir Sehgal

  With more inflation came more questions. Would the United States honor its commitment to keep the dollar pegged to the price of gold at $35 per ounce? Foreign governments that held dollar reserves were increasingly doubtful about America’s ability to convert dollars into gold. In 1965, France and Spain redeemed millions of dollars for gold. In just over a decade, America’s gold reserves had dropped by half. The global economy was expanding briskly, yet the global gold supply couldn’t grow quickly enough.

  A gap emerged between the high market price of gold and the low mandated peg of $35 per ounce. In 1961, a group of central banks formed the London Gold Pool, which was intended to defend the Bretton Woods peg mostly by selling gold. But the gap became unsustainable, and the pool eventually collapsed in 1968. The United States provided most of the gold and didn’t want to sell it at such a low price level.128 The dollar needed to devalue, but it couldn’t be accomplished without jeopardizing the entire currency exchange rate regime of Bretton Woods; thus the dollar became increasingly overvalued and a contentious issue globally. For example, the strength of the dollar displeased European officials, since it enabled US corporations to more easily acquire European firms and assets.

  Other countries started to detach themselves from the system by revaluing, devaluing, and floating their currencies. For example, the German deutschmark and Dutch guilder were floated against other currencies. The United Kingdom needed to devalue the pound to try to boost exports. There were many attempts to keep the pound strong, but in 1967 it finally devalued more than 14 percent, a large drop during a time of relative currency stability. Investors asked: If the pound could devalue, why not the dollar? They bought gold in anticipation of a dollar collapse.

  President Richard Nixon took office in 1969 and was confronted with deficit spending, high inflation, and a constrained monetary system. To make matters worse, in 1970 the economy started to dip into recession, and the market anticipated an imminent devaluation in the dollar, despite denials by the Nixon administration.129 In 1971, he holed up with his economic advisers at a secret meeting at Camp David. Some of these advisers would become luminaries in their own right, including George Shultz, a future Treasury secretary and secretary of state; and Paul Volcker, future head of the Fed. The question facing his team: Should the United States honor an international agreement at the expense of national interest? Bretton Woods had become a monetary noose for the United States, and it became evident that it needed to be chopped and the dollar devalued. Secretary of the Treasury John Connally proposed “closing the gold window” by suspending convertibility of the dollar into gold. Even Congress issued a report that suggested the suspension of the gold standard.

  After a vigorous debate, Nixon determined his course of action. On August 15, 1971, he delivered a twenty-two-minute televised speech (on NBC it was just before the start of the hit show Bonanza) in which he blamed international speculators for creating monetary crises and targeting the dollar. He also unveiled his “New Economic Policy,” which called for a ninety-day wage freeze to limit inflation, a 10 percent surcharge on imports that would make foreign products less competitive in the United States, and a temporary suspension of the convertibility of dollars into gold. He translated his plan to the masses by appealing to patriotism:

  If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today. The effect of this action, in other words, will be to stabilize the dollar.130

  His policies became known as the “Nixon Shock” among international trading partners who were surprised by US protectionism. The onerous 10 percent tax acted like an immediate devaluation of the dollar. In response, Japan floated the yen, which appreciated 7 percent versus the dollar, resulting in a dramatic 17 percent increase in the price of Japanese goods sold in the United States, factoring in Nixon’s 10 percent tax.131 In America, the stock market surged and the press applauded Nixon’s measures: “We unhesitatingly applaud the boldness with which the President has moved,” stated an editorial in the New York Times.132

  Despite the creation in December 1971 of a new international monetary system known as the Smithsonian Agreement, which reprised a system of fixed exchange rates, it didn’t last, as the United States and other countries wanted more monetary policy flexibility when confronting domestic issues. By 1973, many currencies of the industrialized economies started to float against each other. Bretton Woods was dead. Gold was gone for good. The dollar was and remains soft. Economist Benn Steil notes the significance of these events:

  Though the bond between money and gold had been fraying for nearly sixty years, it had throughout most of the world and two and a half millennia of history been one that had only been severed as a temporary expedient in times of crisis. This time was different. The dollar was in essence the last ship moored to gold, with all the rest of the world’s currencies on board, and the United States was cutting the anchor and sailing off for good.133

  Central banks now steer this ship. They preside over a vast web of interlocking institutions that alchemize money. Henry Ford, who believed the dollar shouldn’t be manipulated by bankers, wrote in his 1922 autobiography, “It is a serious question how [the people] would regard the [monetary] system under which they live, if they once knew what the initiated can do with it.”134 It’s important to understand how our modern monetary system works so its complexity doesn’t obscure the Faustian bargain of soft money.

  Centralized Alchemy

  The world’s first central banker was sentenced to death. Johan Palmstruch, whose story predates and eerily anticipates that of John Law, was a foreigner who moved to another country to set up a banking system. Born in Latvia, trained in Amsterdam, he moved to Sweden and convinced King Karl X Gustav to charter Stockholms Banco in 1656. It was one of the earliest European banks to issue paper money. But like Law’s system, it overheated, and Palmstruch was imprisoned and banished to die. Yet he was eventually freed. Despite the bank’s demise, the Swedes weren’t ready to abandon the idea of having a central financial institution. After all, the bank had helped several companies secure financing, and paper money had proven popular with the public because it was convenient to use. The Swedes created Sveriges Riksbank, the world’s first central bank, which is still in operation today.

  Central banking has evolved from its wobbly start in Sweden into a central pillar of today’s financial system. Central banks have become the primary alchemists in the modern system of finance. In a monetary system not reliant on metals underground, they proverbially create money out of thin air. This newfangled alchemy doesn’t evoke images of chemists who mix metals but a complex diagram of the interlocking system of banks and government institutions: fewer funnels and more organizational flowcharts.

  In the United States, the alchemy of money creation involves the Federal Reserve System, the banking sector, and the Treasury. The Fed was established in 1913 by the Federal Reserve Act in response to the financial panic of 1907, which had led to several bank runs and bankruptcies. At that time, the banker J. P. Morgan came to the rescue of the American financial system. Officials realized that the United States needed a permanent institution to monitor, regulate, and even control monetary issues. The Fed’s role has expanded over the decades to cover several areas, from supervising the banking system to facilitating international payments.135

  The Fed is best known for setting interest rates, the price of money. Technically, the Fed sets a target for the “federal funds rate,” the rate at which banks lend to one another. It intervenes in the market to achieve this target rate. If the Fed wants to lower rates, it buys securities in the market, which serves to expand the money supply: more money, lower rates. If the Fed wants to raise rates, it sells some of its securities in an act to contract the money supply: less money, higher rates. Let’s say the Fed
wants to lower rates. It buys $1 million of US Treasury bonds from a bank like Citigroup with new money that it creates out of thin air. The $1 million of bonds are added to the Fed’s balance sheet. Citigroup, like all large banks, has an account at the Fed, and its account is credited with the $1 million it received for selling the bonds.

  For this new money to circulate more widely through the economy, Citigroup can loan some but not all of it to borrowers. Banks are required to keep a fraction of their deposits, about 10 percent, in the vault or as a deposit with the Fed. Citigroup must keep $100,000 of the $1 million in reserves. It can lend out the remaining $900,000. Let’s say someone borrows the $900,000 and deposits it in her account at Wells Fargo. Then $90,000 must be kept on reserve, and $810,000 can be lent. In this way, the “fractional reserve system” enables a multiple expansion of money, as the initial $1 million can be expanded up to ten times: A little money generates a lot of credit. And that’s how money is made.

  Because banks keep only a fraction of deposits on hand, they face the prospect of bank runs if depositors demand more cash than is held in reserves. It’s like when George Bailey confronts panicked customers in It’s a Wonderful Life and explains, “The money is not here… your money is in Joe’s house… and a hundred others.” In modern times, to increase the confidence of depositors, the government insures deposits up to $250,000.

  In its monetary operations, the Fed can buy assets from organizations that aren’t banks, such as insurance companies, but in this case new money might not remain in the banking system and would have a lower impact on the economy. The Fed can also use its invented money to buy securities like Treasury bonds directly from the US Treasury in a process known as “monetizing the debt,” an incestuous process whereby the government can raise funds by means other than raising taxes or selling bonds. In this way, increasing the money supply helps the borrower, the government, since the value of the dollar will likely be less in the future. That’s why governments have historically resorted to creating more money; it’s easier than raising taxes. But because more money can lead to inflation, the value of everybody’s money declines, acting as a covert tax on everyone.

  As for the movement of tangible money, the Fed acts as the distributor. The Bureau of Engraving and Printing creates paper notes, and the US Mint makes coins. Both are part of the US Treasury. When, say, SunTrust Bank in Atlanta anticipates an increase in cash demand during the holiday season, it asks the Fed for more money. SunTrust has an account at the Federal Reserve Bank of Atlanta, one of twelve regional Federal Reserve banks. The Atlanta Fed has a cash inventory; it debits SunTrust’s account and provides it cash. In 2012, the Fed processed 31.7 billion notes through its twenty-eight processing centers across the United States.

  It’s a big operation. Several institutions make up America’s expansive monetary system, and it’s fair to say modern alchemy is contemporary bureaucracy. Despite the complexity and apparent sophistication of the system, the Faustian bargain of soft money still lurks, and it’s incumbent upon the monetary authorities to use their powers wisely and cautiously.

  To Invisible and Beyond

  Kublai Khan, Johan Palmstruch, John Law, Benjamin Franklin, Abraham Lincoln, Franklin Roosevelt, Richard Nixon, and countless others recognized the benefits of soft money and controlling its levers. It can support a struggling economy by stimulating trade and commerce. It also helps avoid unpopular policy decisions such as raising taxes or reducing spending. But all monetary officials must be alert to the risks of soft money. During the 1970s, the move from hard to soft money likely played a role in generating “stagflation,” characterized by low growth and persistent inflation, which reached 13.5 percent in 1981. To tame inflation, Paul Volcker, who was now head of the Federal Reserve Board, instituted tough measures, raising the federal funds rate during a period of high unemployment.

  In the wake of the 2008 financial crisis, the Fed dramatically increased the money supply, yet high inflation hasn’t materialized. Nevertheless, one thousand years of monetary history teaches a convincing lesson: As societies move from hard money to soft money, as the “super-brain” forms new ideas about currencies, those economies risk failure. All of us, not just central bankers, must recognize the perils of the Faustian bargain—especially as money evolves in the digital age. Money is becoming more electronic and invisible. It has become so abstract that we risk forgetting the concrete lessons of history. As long as money remains a symbol of value, some will seek to control it.

  CHAPTER SIX

  Back to the Future

  The future of money

  Gold is a way of going along on fear… But you really have to hope people become more afraid in the year or two years than they are now.

  —Warren Buffett1

  When you’re using the iPad, the iPad disappears, it goes away. You’re reading a book. You’re viewing a website, you’re touching a website… The technology goes away… And the same is true with Square. We want the technology to fade away so that you can focus on enjoying the cappuccino that you just purchased.

  —Jack Dorsey2

  In our abundant future, the dollar goes further… This happens because of the dematerialization and demonetization… because each step up prosperity’s ladder saves time; because those extra hours add up to additional gains.

  —Peter H. Diamandis and Steven Kotler3

  A mobile phone–based payment system, M-Pesa enables millions of Kenyans to transfer money.

  A fortune cookie once advised me, “The more things change, the more they stay the same.” Not much of a prophecy. But it may describe how fortunes will be made in the future.

  Years from now, there will no doubt be new types of money and payment methods. But thousands of years of monetary history can be a guide for what to expect. The more money changes, the more it might stay the same, retaining properties—like being hard or soft—that we’ve already seen. It may also become increasingly digital, invisible, and intangible.

  The form of money will depend on how the “super-brain” of society changes. Let’s consider three possibilities of how the world may fare in the future: (1) a “bear case,” in which the world deteriorates because of several disquieting events, from financial crises to devastating terrorist attacks or natural disasters; (2) a “bull case,” in which the world progresses at a brisk pace as technology is developed and incorporated rapidly and broadly, much like it is right now; and (3) a “dream case,” many years in the future, in which the lines are blurred between man and machine.

  In the bear case, one could envision that money will return to being hard and intrinsically valuable. Financial writer Nathan Lewis advocates for hard, stable money in his book Gold: The Once and Future Money. During difficult times, people lack confidence in fiat money because they are concerned about the stability of institutions that issue and back it. They return to proto or hard money, like gold, with intrinsic worth and exchange value. Even though dollars still circulated, Americans hoarded gold during the Great Depression until the government prohibited it, largely because they thought it was a better store of value than dollars backed by the US government. What’s more, in periods of monetary uncertainty, people also resort to bartering and even create alternative currencies.

  In the bull case, technologists like Jack Dorsey conjecture that money will be increasingly digital, intangible, and invisible. In times of monetary stability, people go about their lives and don’t think twice about the paper, plastic, or electronic forms of payment. They have confidence in the technologies that facilitate transactions, the institutions that issue money, and don’t resort to hoarding or bartering. In this case, people adopt new technologies to make exchanges seamless. It’s a future in which technology enables millions more people to join the global marketplace.

  In the dream case, inspired by science fiction, futurists imagine a range of mind-bending possibilities.4 Maybe it’s a future in which new metals and materials are discovered on distant planets, replacin
g earthly metals like gold as hard money. Perhaps man and machine merge in some capacity: If one can embed a pacemaker in the body, why not a payment device? The blurring of man and money could spawn amazing new markets, currencies, and monetary systems. However, if these technologies are used in malicious ways, such a dream could turn into a nightmare.

  Let’s look into the crystal ball.

  The Bear Case

  Say there’s an asteroid strike or a nuclear world war that renders much of civilization dysfunctional, from roads and telecommunication systems to bank networks and government institutions that oversee the financial and monetary systems. In the bear case, there is hoarding of all valuables and a return to commodity money. With no official entity to issue soft money or mint coins, people revert to a system in which items are evaluated on intrinsic worth, as metallists have always insisted. Other proto-monies like food and furs may circulate, as they did in the earlier civilizations. Money would return to its evolutionary purpose, helping us survive, an immediate source of energy and shelter. It wouldn’t be an abstraction like it is today because we could no longer rely on the “super-brain” of society and institutions to issue and verify money. We would have to depend on ourselves.

  “I’m so embarrassed. I feel like one of those end-of-the-world crazies who stock up on toilet paper and canned goods,” said my friend, a portfolio manager who manages billions of dollars. “I just bought gold bars and hid them under my bed,” he explained.

  Civilization didn’t crumble during the global financial crisis of 2008, but I glimpsed how people react during an economic crisis. When I heard that my friend lacked confidence in the global monetary system, I feared the worst. He’s not exactly the type of guy you imagine appearing on National Geographic Channel’s Doomsday Preppers, a show about people preparing for the apocalypse.