The Fiat Standard

1. The fiat standard emerged from government default on gold obligations

With this obscure and largely forgotten announcement, the Bank of England effectively began the global monetary system's move away from a gold standard, in which all government and bank obligations were redeemable in physical gold.

Historical transition. The fiat standard originated in 1915 when the Bank of England suspended gold convertibility. This marked the beginning of a shift from a gold-backed monetary system to one based on government decree. The transition was gradual, occurring over several decades:

• 1914: Bank of England suspends gold convertibility
• 1922: Genoa Conference establishes gold-exchange standard
• 1931: Britain abandons gold standard
• 1934: U.S. devalues dollar against gold
• 1944: Bretton Woods Agreement establishes dollar as global reserve currency
• 1971: U.S. ends dollar's gold convertibility, completing transition to fiat

Motivations and consequences. Governments abandoned the gold standard to gain monetary flexibility, particularly for financing wars and welfare programs. This shift allowed for inflationary policies and increased government control over the economy, but at the cost of long-term monetary stability.

2. Fiat money is created through lending, distorting economic incentives

New money is not created when currency bills are printed, but rather whenever new debt is issued.

Money creation process. In the fiat system, most new money is created when banks issue loans. This process, known as fractional reserve banking, allows banks to lend out more money than they hold in reserves. The consequences of this system include:

• Increased money supply through credit expansion
• Economic booms and busts as credit expands and contracts
• Incentives for individuals and businesses to take on more debt
• Difficulty in measuring the true money supply

Economic distortions. The fiat system's money creation process leads to several economic distortions:

• Malinvestment: Easy credit encourages investment in unprofitable ventures
• Business cycles: Credit expansion and contraction cause economic instability
• Wealth inequality: Those closest to new money benefit most (Cantillon Effect)
• Moral hazard: Banks take excessive risks, knowing they'll be bailed out

3. Fiat encourages debt and discourages savings, raising time preference

Fiat has effectively destroyed savings as a financial instrument, with enormously negative consequences.

Shift in financial behavior. The fiat standard has fundamentally altered how individuals and societies approach saving and borrowing:

• Saving becomes less attractive due to currency devaluation
• Borrowing is incentivized by low interest rates and inflation
• Individuals are pushed towards riskier investments to beat inflation
• Short-term thinking (high time preference) becomes more prevalent

Societal impacts. These changes in financial behavior have far-reaching consequences:

• Reduced capital accumulation for long-term economic growth
• Increased financial fragility for individuals and businesses
• Erosion of long-term planning and investment in society
• Changes in architecture, family structure, and cultural values

4. Government intervention in food and energy markets has negative consequences

The net result is that the third world is not just centrally planned; it is also accountable to foreigners instead of locals.

Food market distortions. Government policies and subsidies have significantly altered food production and consumption:

• Promotion of industrial agriculture and processed foods
• Subsidies for crops like corn and soy, leading to overproduction
• Flawed dietary guidelines based on questionable science
• Decline in nutritional quality of food and rise in obesity rates

Energy market interference. Fiat-funded government interventions in energy markets have led to:

• Subsidies for inefficient "renewable" energy sources
• Underinvestment in reliable energy infrastructure
• Rising energy costs in countries with aggressive green policies
• Increased energy insecurity and grid instability

5. Fiat financing corrupts science and academic research

The misery industry grew enormously while destroying the economies of the third world and bringing them to bankruptcy, and it also thrived while "rescuing" them from their debt crises.

Academic incentives. The fiat system has altered the incentives in scientific research and academia:

• Emphasis on publishing quantity over quality
• Research focused on securing government grants rather than pursuing truth
• Proliferation of meaningless or fraudulent studies
• Growth of administrative bloat in universities

Development economics. The field of development economics, funded by fiat institutions, has had negative impacts on developing countries:

• Promotion of unsustainable debt-financed development models
• Imposition of foreign-designed policies on local economies
• Creation of dependency on international financial institutions
• Neglect of market-based solutions and local knowledge

6. The fiat system enables unsustainable government spending and debt

By turning government credit into money, the fiat standard has acted as a continuous drain of resources from productive members of society to governments that spend with very little accountability.

Government expansion. The fiat standard allows governments to finance spending through monetary expansion rather than taxation:

• Growth of welfare states and military-industrial complexes
• Ability to wage prolonged wars without immediate economic consequences
• Expansion of bureaucracies and regulatory agencies
• Accumulation of massive public debts

Global implications. The fiat system's enablement of government spending has global consequences:

• U.S. dollar as global reserve currency, allowing "exorbitant privilege"
• Growth of international organizations (IMF, World Bank) promoting fiat policies
• Increased geopolitical tensions due to monetary imbalances
• Erosion of fiscal discipline in many countries

7. Bitcoin offers an alternative monetary system with unique properties

Bitcoin is the implementation of this concept to international transfers and monetary policy.

Key innovations. Bitcoin introduces several innovations that set it apart from fiat money:

• Fixed supply schedule, immune to political manipulation
• Decentralized consensus mechanism (proof-of-work)
• Borderless, permissionless transactions
• Separation of money creation from lending

Potential impacts. The growing adoption of Bitcoin could lead to:

• Reduction in monetary inflation and return to sound money principles
• Increased financial privacy and resistance to censorship
• Disintermediation of traditional financial institutions
• Global, neutral monetary standard not controlled by any government

8. Bitcoin mining consumes energy but incentivizes cheap electricity production

Bitcoin isn't "consuming" the world's energy; bitcoin is providing a powerful market incentive for energy producers worldwide to increase the production of cheap energy.

Energy consumption. Bitcoin's proof-of-work mining does consume significant energy:

• Current estimates range from 100-150 TWh/year
• Comparable to the energy consumption of small countries

Positive incentives. However, Bitcoin mining creates unique incentives in the energy market:

• Encourages development of stranded and wasted energy resources
• Provides demand for off-peak electricity, stabilizing grids
• Incentivizes investment in cheap, reliable energy sources
• Acts as a buyer of last resort for excess energy production

9. Bitcoin's difficulty adjustment ensures security and controlled supply

The difficulty adjustment simply takes everything in the economic reality of the world and presents it to the bitcoin network in one metric: the block time.

Adaptive security. The difficulty adjustment mechanism is crucial for Bitcoin's security and monetary policy:

• Automatically adjusts mining difficulty to maintain 10-minute block times
• Ensures that increased mining power doesn't lead to faster coin issuance
• Maintains the predictable supply schedule regardless of total network hashrate

Economic implications. The difficulty adjustment has important economic effects:

• Makes Bitcoin the only asset with perfectly inelastic supply
• Ensures that the cost of mining tends towards the value of the block reward
• Creates a self-reinforcing security model as Bitcoin's value increases

10. Bitcoin enables a new financial system with full-reserve banking

A financial system built on full cash reserves would not experience such liquidity crises.

Financial system transformation. Bitcoin's properties could lead to a fundamentally different financial system:

• Return to full-reserve banking, eliminating fractional reserve risks
• Separation of money and credit, reducing systemic financial risks
• Emphasis on equity financing over debt financing
• Reduction in moral hazard due to absence of a lender of last resort

Societal impacts. A Bitcoin-based financial system could lead to:

• Increased economic stability and reduced business cycles
• Higher savings rates and lower time preference
• More efficient allocation of capital based on true market signals
• Reduction in government ability to finance deficits through monetary inflation

Last updated: September 30, 2024