The Investment Scientist

The Fiat Money

Posted on: July 19, 2019

On August 15th, 1971, President Nixon announced that the US would no longer redeem US dollars for gold, thus formally ending the gold standard. During the gold standard, the dollar bill was a certificate of deposit of gold which was redeemable to the bearer on demand. Post-gold standard, the dollar bill is pure paper money, what the academics call fiat money. Read my previous article The Gold Standard.

One immediate consequence was that the government could now issue money at will. And indeed, since 1975, the US has increased the money supply tenfold. As you can see from the chart below, the money printing accelerated in 2009, after the Great Recession. With this level of money printing, we actually need a lot of cheap imports to keep inflation at bay or else there would be too much money chasing too few goods.

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The Trade Deficit: Who Is The Winner?

Under the gold standard, it is at least plausible to argue that the country that has a trade surplus is the winner and the country that has a trade deficit is the loser. (Though free-marketers would disagree.) What does the trade deficit look like under fiat money?

Now imagine a Chinese merchant who exports $100 worth of manufactured goods to America. In exchange for the manufactured goods that he worked his butt off to make, he gets a $100 bill, fresh off the printing press. Though this shows up as a $100 trade deficit, it is actually a win for the US since we exchanged printed paper for their manufactured goods.

The merchant wants to redeem his $100 bills for gold so he can bring his treasure back to China. But no luck there, we did away with gold standard long ago. We instead make this offer to him: if you lend us $100, we will pay you back $101 next year (that is worth only $99 since we keep printing money.) He doesn’t see the part in parenthesis, but even if he does, he really has no choice but to lend the money to us. This shows up as a $100 US debt to China. We all get massively upset about this, but I would call this another US win since we pay China negative interest.

Now let’s look at the actual evidence of this. I got the US Core CPI data and calculated the inflation rates for the past few years. For the nominal interest rate each year, I used the 1-year Treasury yield as a proxy. The real interest rate is simply the nominal interest rate minus the inflation rate (which is caused by money printing.) The intuition is this: if I earn 1% interest, but the inflation is 2%, the real interest earned is -1%, that is to say, I lose money. As you can see in the table below, the real interest rates of the US Treasury bills have always been highly negative.

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Some say trade is a win-win. I guess it’s the US who wins twice as far as the trade deficit is concerned.

In my next article, I will explain a macroeconomics concept – the balance of payments and what’s in it for China (and for that matter Japan, Mexico, Gulf countries and EU countries) to keep lending to the US at a negative real interest rate. I will also explain under what conditions this gravy train will come to an end.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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