The philosopher’s stone
For centuries kings had a problem paying for their wars and their palaces: gold and silver could not be created out of nothing. They had to be dug out of a mine, and there was only so much. Some cut the metal in their coins, but merchants noticed and stopped trusting them.
What every ruler dreamt of was the philosopher’s stone: turning lead into gold, creating wealth out of nothing. The alchemists never managed it. Modern states found something close, and they did not need to make gold. It was enough to force people to use a currency with no backing and to control who issues it.
From the gold standard to fiat money
In 1944, at Bretton Woods, the Western powers agreed a new system: the dollar would be the world’s reserve currency, convertible into gold at 35 dollars an ounce, and the other currencies would be fixed to the dollar.
It was already a system imposed by states, and the government could change how much gold each dollar was worth. And the temptation to issue more dollars than there was gold proved too great: the United States paid for the Vietnam War and its spending at home by issuing more than its gold could back. When France and other countries started asking for gold in exchange for their dollars, there was not enough for everyone.
On 15 August 1971 Nixon suspended convertibility. Overnight, the currency the world traded in stopped representing any good. Since then we have lived with fiat money, from the Latin “let it be done”: it is worth something because the law forces you to use it.
How currency is created today
The central bank’s printing press is not the only source, nor the main one. Most new euros are created by commercial banks when they grant loans.
When a bank lends you 10,000 euros, it does not hand you money another customer has deposited. It writes 10,000 euros into your account, and with that entry euros are born that did not exist before. The loan creates the deposit, not the other way round. The Bank of England itself explains it in its 2014 bulletin, “Money creation in the modern economy”.
This works as long as not everyone wants their money at once. When that happens, in a crisis, the system wobbles, and the central bank rescues the banks with newly created currency.
The manipulation of interest rates
In a free economy, the interest rate would be just another price: the price of available savings. Plenty of savings, low rates; few savings, high rates. It is a signal to entrepreneurs: it tells them whether there are real savings to fund new projects.
Central banks do not let the market set that price. They set it themselves. And when they set it below where the market would, they send a false signal to the whole economy.
The business cycle
Ludwig von Mises explained, and Friedrich Hayek developed, what happens next. Hayek received the Nobel Prize in Economics in 1974. The process always repeats itself the same way:
The central bank cuts rates. Cheap credit floods the economy. Entrepreneurs launch projects that only pay off with cheap money. The prices of assets rise: shares, housing, commodities. Everyone feels rich. That is the boom.
But real resources, workers, materials and time, have not increased. At some point prices rise, the central bank has to raise rates, and projects that paid off at 0% stop paying off at 5%. The bad investments come to light. Companies go bust, unemployment rises, asset prices fall. That is the bust.
The crisis is not a failure of the market. It is the correction of the mistakes the intervention created. And the cycle repeats, because the political answer to every crisis is the same: cut rates again, create more credit and inflate the next boom.
The underlying solution
The gold standard was better than today’s system, because the currency had an anchor the government could not create out of nothing. But it was still imposed: the government decided which currency to use and how much gold it was worth, and when it suited, it changed the rule or scrapped it.
The problem is not only that the currency is badly backed. It is the state monopoly over the currency. In a free economy there would be monetary competition: several currencies and several issuers, and everyone would choose the one they trusted most, like medieval merchants. Competition improves the quality of money just as it does for any other good.
Next: Module 4. Why invest. Course contents.