Faith and Credit
#54: On the Politics and Pitfalls of the Fiat Era.
For most of the United States’ history, dollars were backed by precious metals - gold and silver - at least ostensibly. The conversion ratio changed from time to time, and the ability to actually convert depended on economic circumstances. Rarely would the actual gold reserves held by the Federal Reserve match the circulating paper currency.
Even during the Gold Standard, the government had considerable leeway to create “unbacked” money that widely diverged from its metal reserves. Greenbacks were always in some sense backed by trust. By accepting dollars, a counterparty was accepting the faith and credit of the country as whole.
Over time, convertibility waned as the government sought more flexibility in the issuance and control of the money supply. During the Great Depression, Franklin D. Roosevelt effectively prohibited the public from holding gold directly, forcing private holdings to be converted into paper currency. By 1971, Nixon nixed the last connection to the shiny stuff, ushering in the age of fiat.
Today, as a fiat currency, the dollar is backed by everything and nothing all at once. There is no direct convertibility, nor a limit on how many dollars can be created. Yet the dollar can be converted into everything - gold, goods, services, securities, or currencies - on a floating exchange rate sometimes known as price.
The Federal Reserve manages the quantity of money - both directly and indirectly through interest rate policy - in order to maintain relatively stable prices while encouraging economic growth.
This system has worked fairly well so far. While one can pinpoint the end of the Gold Standard on a chart of consumer prices, it is not apparent on a chart of real economic growth.
Yet, fiat’s flexibility brings new challenges. As the level of government debt has continually expanded, the question of faith and credit has taken new meaning.
One maxim of the fiat system is that a government can’t default on its own debt obligations because it can print unlimited funds.
While there is some truth to this, it oversimplifies modern money creation and government financing. Each debt ceiling standoff highlights the limitations that the Treasury faces. While the Federal Reserve can create new base money, the U.S. Treasury must raise funds through taxation or borrowing. The Treasury can’t create money on its own, nor does it have unlimited borrowing ability.
Even as the market would easily allow the government to raise new debt today, the limitation is congressional authorization. In other words, the practical limitation to the creditworthiness of the United States is political. The legislature must overcome its own dysfunction to avoid default.
When dealing with direct investments in sovereign jurisdictions, the largest risk is often political - particularly in emerging or underdeveloped markets. New administrations can renege on promises and contracts with little recourse and private assets can be seized.
Historically, stability and rule-of-law have benefitted the United States. The reliability of debts, contracts, and obligations attracts investment, confidence, and economic development. Never has the U.S. defaulted on its debts, but it could. At stake is the nation’s credit.
Implications of a U.S. default are unknown (and probably will remain that way). While an actual default would send short-term shock waves through financial markets, some of the darkest prognostications about economic chaos are likely posturing - a negotiation tactic to help encourage a resolution.
Nevertheless, the reputational damage to the country’s credit can’t be erased. In a system where money is created and controlled by people - the people in control matter. If the U.S. legislature forces a national default, it calls into question the reliability of government debt and the currency.
The dollar’s reserve currency status allows perpetual trade deficits, budget deficits, and cheap goods. The world’s demand for dollars allows the U.S. to print and spend more than it otherwise could, to the benefit of its citizens. A nation that defaults on its due and owed obligations as a result of political dysfunction - even for a short period - will weaken its standing and erode the privilege it enjoys.
As the nation’s credit is potentially jeopardized by politics, many have suggested alternatives to override the debt ceiling. But credit is only one side of the coin. Faith, as I define it here, is the defense of the value of currency over the long run.
If credit ensures that lenders are repaid, faith ensures that those repayments are worth something.