The Many Roads to Currency Ruination
Frank O. Trotter, Executive Vice President - EverBank
Total abject failure. Mad Max. Breakdown of society. Chaos.
How’s that for an upbeat start?
Failure is a tough thing to talk about, particularly here in the US where it’s all about optimism. What’s the best? Who's the fastest? Where should I put my money for the highest return?
But examining failures can help us avoid mistakes. So let’s take a tour of a few currencies and money systems that fell apart. We’ll learn some principles of sound money and hopefully, have a little fun.
What Is Money?
Even though we don’t think about it every day, we all know that money is a fiction. It is a medium of exchange – a token we pass back and forth instead of bartering, and a store of value that keeps score of our assets and debts. It is based on belief and faith—nothing more.
At times, money has been metals or tobacco or wampum. There are the famous Yap Island stones. At other times, like today, paper tokens with no intrinsic value stand in as money.
As we’ll see, people and societies have always experimented with money.
So, What Is a Failure?
One obvious sign of failure is that a currency is no longer usable as a medium of exchange or a store of value. It becomes worthless to everyone.
Currencies that create chaotic or unproductive behavior are also failures. Often, the collapse of a currency forces, or perhaps acknowledges, economic collapse.
What Are the Usual Causes of Currency Failure?
Aside from currencies that went extinct because their countries were conquered , there are two main reasons for failure—and they’re at opposite ends of the same spectrum.
On one side, we have a lack of supply. Maybe there aren’t enough coins to go around. Maybe the money supply is constrained. Price mechanisms can remedy this situation, but usually, society will shift to substitutes. If there’s not enough gold or silver, people will use tin, cows, or cigarettes. I won’t spend any more time on this because it’s so rare today.
On the other side of the spectrum, we have too much supply. In 9 out of 10 cases, overissuance has been due to war, because war is expensive.
As it still is today, joining the military has historically been one way out of a difficult situation. Joining the military was a way for a serf or pauper to make it big. Soldiers are usually paid—and paid relatively well—to put their lives on the line. Historically, soldiers have insisted on being paid in gold, delivered to the front or to a verified recipient on time.
Like today, this cost is usually above and beyond what the sovereign had in the vault. So the ruler had to borrow. Or cheat.
Cheating normally took the form of what I’ll call debasement—removing value from the currency by using smaller quantities of precious metals per coin. There was also the gangland approach of “borrowing” from the nobility or church.
Token debasement is about guessing the location of the edge of the cliff. Insert the right amount of tokens into the economy and it runs smoothly. A few more and maybe things will be okay. Too much and everything falls apart. Since tokens as currency have no intrinsic value or physical constraint on issue, there is always the temptation to keep making more. Surely increasing the money supply just a little bit more won’t hurt. Will it?
Failures
With over 600 extinct currencies, including over 150 that died due to overissuance or debasement, there are a lot of examples to choose from. I’ll go over a few below.
But first, let’s play a game. I’ll provide a series of hints through the rest of the article, and you try to guess the failed currency system. Hint #1: The ruler followed his father into power.
Failure #1: A currency can become worthless even when it contains precious metals.
The denarius in Rome is a great example. Around the year 0, it was 100% silver and was used throughout the empire. By 50 AD, it was 94% silver; in 100 AD, 85%. By 244 AD, just 5%.
Finally, when its silver content fell to less than 1%, the denarius was rejected by nearly everyone as a means of payment. Case closed.
Hint #2: The ruler waged a war without raising taxes and, in fact, initiated a tax cut.
Failure #2: Ineffective medium—the currency just doesn’t cut it.
In early Virginia, there was no specie, and the use of wampum had run its course. There was, however, a lot of tobacco. So in 1642, the colony declared tobacco its currency.
The problems started almost immediately. Among other troubles, some people tried to hide poor-quality tobacco leaves between decent ones. Virginia instituted bond warehouses so it wouldn’t get a bad reputation with its neighbors. But it was never able to solve the problem of fungibility, and the system collapsed.
Hint #3: His administration attempted to boost economic growth and employment by funding public works.
Failure #3: John Law
We should refer to Ponzi schemes as Law schemes, and stimulus spending as Lawsian instead of Keynesian. John Law was a pre-Keynes Keynesian.
Let’s compare John Law’s core beliefs with a modern commentator.
John Law
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Paul Krugman
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If money supply was increased by issue of bank notes for productive loans.
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If we could manage 4 or 5 percent inflation over that stretch, so that prices were 25 percent higher.
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If money supply was increased by issue of bank notes for productive loans.
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The real value of mortgage debt would be substantially lower than it looks on current prospect.
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The value of the money should remain the same.
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And the economy would therefore be substantially farther along the road to sustained recovery.
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Hmmm. John Law got into French finance to help clean up Louis XIV’s war debts from the War of Spanish Succession. An array of books, papers, and academic careers have been dedicated to the analysis of this disaster, much like the Great Depression. The abridged version is that French coins were replaced first with paper issued by France, then shifted to new banks, then moved to shares in Compagnie de l’Occident that promoted the Louisiana Company and Mississippi companies, resulting in a speculative boil much worse than our modern tech and housing bubbles.
After the scheme imploded, it was said that French people could not use the word for “bank” for nearly 150 years without adding a pejorative. Law was sent into exile.
One more hint, then I’ll reveal the answer: He confiscated gold and silver from citizens and replaced it with paper currency, issued briskly.
And the answer is…
Kublai Khan.
After taking over from his father, Ghengis, Kublai Khan (no known relation to the great squash players) consolidated control of China and the surrounding territories. He issued the first known unbacked paper money in recorded history in 1227.
The visiting Marco Polo reported that initially it was all going pretty well. The empire was prospering and there was enough “money” to stimulate economic activity.
But ultimately, inflation set in as Khan issued too much currency to pay for wars and to keep the populace happy. Polo’s final commentary noted that the system totally collapsed into chaos.
Another one bites the dust.
At the end of the day, currencies usually collapse due to overissuance. We have all worried since the US Federal Reserve began its quantitative easing that maybe this time we were going too far. But the massive expansion of the monetary base has not—yet—created hyperinflation or anything like it.
Will it happen eventually? If only we could predict the future.
I am still concerned that when and if the economy truly enters expansion, nasty inflation could return quickly. If it does, the decline of the US dollar will likely be the result.
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