The Fiat Standard
The Fiat Standard
Just to be clear from the start, this article is an expansive review and commentary on Saifedean Ammous’ “The Fiat Standard.” It isn’t intended to be an exhaustive summary of or substitute for the book itself, but it was an excellent read with countless insights, so I wanted to share some of its key takeaways and my thoughts around those takeaways.
The whole book is a critique of fiat as a form of currency and an explanation of how it perpetuates excessive credit, high-time preference thinking, and distortions in economies and societies more broadly. Despite that obvious bias being the impetus of the book, it presents a fair case against fiat with very sound and well-researched criticisms.
A good section of the book also discusses many of the indirect ways fiat affects economies, such as through education and food. Some of the claims around these topics tangential to economics are more contentious than the purely economic critiques of fiat, but many of those claims are still profound and worth mentioning.
Before I get into the actual takeaways and analysis, an important note to keep in mind about this book is the way Saifedean views and explains the fiat system. Rather than explaining it in traditional economic terms, he analogizes it to the structure of the Bitcoin network, with terms like fiat node, fiat mining, layer 2, et cetera, which brings us to the first takeaway.
TAKEAWAYS:
#1 Lending is the fiat version of mining, meaning you mine fiat tokens by issuing debt.
Mining in the sense Saifedean is using it here is the issuance or addition of new money into the system. With gold, new money is created through actual mining; with Bitcoin, new money is added through computer mining; and with fiat, new money is made through lending and credit creation.
One of the important things to keep in mind here is there is no cost to create fiat the way there is to create (find) gold or bitcoin. New money can be added with a simple keystroke via a bank issuing a loan, or with a keystroke of the Fed when they issue more currency or bonds.
In both cases, money is created through debt, not energy. Banks create money when individuals and businesses take out loans, and the Fed creates money when they issue more treasuries or print dollars.
#2 Fiat emerged because of gold’s low salability across space.
With all the criticism fiat gets, and rightfully deserves, it’s important to understand its strengths and why it was seen as an improvement upon the previous gold standard. Its primary advantage was simply that it was easy to settle.
Gold is heavy and lives in the physical world, whereas fiat is largely digital, which means transactions can settle all around the world with relative ease and at comparatively much faster speeds.
Without the salability across space that fiat provides, trade and international settlement would be much harder and likely fail to operate at the scale and speed we take for granted today.
#3 All fiat currencies are essentially a layer 2 derivative of the United States dollar.
After WW2 and the worldwide recognition of the dollar as the world’s reserve currency, every other fiat currency was redeemable for dollars, which, in turn, were redeemable for gold. At that point, the dollar was a layer 2 currency—with gold being its layer 1—and other fiat currencies were a layer 3 derivative of gold.
After the suspension of the dollar’s convertibility to gold, however, the dollar wasn’t redeemable for anything—it was just the new layer 1 currency. And with the dollar as the new layer 1 currency in the global monetary system, every other fiat currency moved up to a layer 2 currency as a quasi-derivative of the dollar.
This terminology is somewhat disingenuous insofar as fiat currencies don’t really act as derivatives of the dollar, but they are all generally viewed as lesser versions of fiat. Other fiat currencies can and do appreciate against the dollar, but dollars—and US treasuries more specifically— are the pristine asset of the world everyone wants to hold and use for settlement just like gold was under the gold standard.
#4 Under the fiat standard, each central bank has four important functions:
- A monopoly on its respective fiat coin in determining its supply and price.
- A monopoly on clearing international payments.
- A monopoly on authority over regulating domestic banks, holding their reserves, and clearing payments between them.
- Lending to its respective national government by buying its government bonds.
All these points are pretty self-explanatory, but they’re a good reminder of what a central bank actually does. It controls the money supply, the terms of international trade, how domestic banks manage their money, and it buys its government’s bonds to support deficit spending.
#5 There is a huge difference between a recession-induced deflation—which is only possible with an inflationary credit collapse—and productivity- benevolent-driven deflation.
Most economists these days view deflation in one context: a depressive deflation similar to what we saw during The Great Depression. This kind of deflation occurs when credit (which is just another form of money) is destroyed. Credit can be destroyed either through paying off debt or by defaulting on it.
Credit creation is inflationary because it wills money into existence that wasn’t previously there, but paying off debt from credit is forcing that money back out of the system—money that could have been spent elsewhere in the economy. So rather than chasing goods and services, that money just vanishes, which means an economic contraction from lower overall economic activity.
Deflation of this kind is undesirable because economic contractions usually translate to fewer jobs and less overall wealth generation, which hurts the average citizen. And even though prices might be dropping, they are dropping because there is no demand or money to buy anything, so it’s not as if people are celebrating the low prices.
Productivity-driven deflation, however, is a great thing. It’s why TVs, memory storage, and all sorts of other advancing technologies become cheaper over time. More efficient production or design over time allows producers to cut costs and sell things for less than they once did. This kind of deflation is great for consumers because they generally get better products and their dollar goes further.
Productivity-driven deflation also doesn’t require demand destruction or job loss to achieve those lower prices—growth and economic activity can be trending up while prices go down.
#6 Harder money that grows in value over time relative to goods and services will discourage frivolous spending, but it won’t stop people from buying necessities. Even goods that aren’t necessary will be bought as there is still value in buying them today even though prices will fall in the future.
One of the critiques of using a hard money currency or deflationary currency is that it will kill demand because nobody wants to spend their money if it will be worth more tomorrow. While that point may seem sound on the surface, a large portion of what people buy they buy because they have to. Even if you know your money is gaining in value, you aren’t going to skip buying food or paying rent.
For this reason, a deflationary currency would mostly discourage unnecessary expenses. Justifying another superfluous shoe purchase is a lot harder when you calculate the money you will lose simply by selling your appreciating money to buy the shoes.
The second important point raised here is that the deflation we are already experiencing in various technologies hasn’t discouraged us from buying them. We still find enough value in computers and televisions to keep buying them today despite their downward trend in price.
A television will almost certainly be better a year from now and possibly even be cheaper with or without accounting for its advancements, but that hasn’t stopped consumers from consistently buying them.
#7 The biggest flaw of the CPI is it lacks any objective metric by which to measure prices. The CPI is just a mathematical tautology referencing prices in dollars as a way to measure the changes in prices in dollars.
This is a fascinating point because it shines a light on the idea that measurement of any kind is best done when you have an objective and constant unit of measurement (like centimeters, grams, or seconds). CPI, however, measures inflation with a constantly fluctuating unit of measurement: dollars.
Measuring things in this way makes contextualizing changes much more difficult because it redirects your focus to the near-term rate of change rather than the overall change.
Last year’s June CPI might be 5% and this year’s June CPI 7%, but the YoY CPI for June would only be 2% because of base effects. So rather than comparing inflation to a fixed value, the goalpost is always moving. There is no constant value to measure against the changes in prices that give an accurate estimation of how much prices are actually changing.
#8 CPI is based on consumer spending and won’t account for changes in spending habits due to increased prices. As prices soar and consumers can’t afford goods, the quality of those goods is usually lowered to balance out with the prices consumers can afford, which is not accounted for in CPI.
Because CPI only measures the price changes in goods, not the demand level, it doesn’t always capture the full story behind inflation. Prices in meat could surge to such a level that demand tapers off, which might slow or stop continued inflation, but that’s only because consumers transitioned to buying cheaper alternatives.
CPI also doesn’t adjust for lower-quality products. It makes sure to include hedonic adjustments which account for increases in quality (as that helps lower the CPI number), but it completely disregards its equally as important counterpart.
When prices and costs are too high for consumers, producers will cut whatever corners they can to counteract inflation and get prices back to where they were. That difference won’t show up in CPI, but it will contribute to worse products, meaning your dollar isn’t going as far as it used to, which is just another form of inflation.
#9 In many instances, success in a fiat system means accumulating larger negative cash balances.
This statement could sound confusing at first, but the point being made is that the person or entity able to take out the most debt wins.
To get to the point where you can take out the most debt, you’ll have to build credit and accumulate capital, but the goal is to chase debt because it is structurally incentivized through inflation.
Inflation decreases the value of debt in absolute terms over time, so you are essentially paid to go into debt if you can secure an interest rate below the rate of inflation, which has been very easy to do for large companies over the past decade as rates have been mostly zero bound.
With borrowing rates below the rate of inflation, the more debt you can take out, the more money you make. Debt simply becomes a form of leverage that pays you to use it.
#10 Managing to secure debt at a lower interest rate is the most significant market advantage in a fiat system. This is why we see businesses issuing credit and attempting to arbitrage their low borrowing rate with higher consumer credit rates.
If you’ve ever wondered why so many companies have their own credit card (like an Amazon credit card, Best Buy credit card, Big Brand Tire credit card) it should be no surprise that it’s because it makes them money.
Large companies can take out debt at rates closely matching the risk-free rate, which these days is usually no more than a few percent (if that), but they can charge people a double-digit interest rate when they don’t pay their credit card on time.
In other words, they buy credit from the bank or in the repo market at a low interest rate and sell it to consumers at a higher interest rate to arbitrage the spread between the two. They pay 3% interest, and you pay 13% interest.
#11 Without fractional reserve banking, capital and labor would flow to the highest bidder and that tends to be the entrepreneur who uses capital and labor most productively.
Fractional reserve banking is how banks create money through credit. They have a certain amount of cash reserves from depositors, but they will lever up by issuing loans that far exceed those reserves.
In an environment where banks can lever up through fractional reserve banking and credit is relatively easy to come by, there isn’t as much competition for which person or company gets a loan—pretty much any entity that wants one can get one.
If banks were limited to spending only what their cash reserves would allow, however, they would be much stricter on who gets a loan, meaning only the most qualified and talented entrepreneurs would earn such a luxury.
In a world where funds are scarce, the banks are only going to give loans to borrowers willing to pay higher prices and those that present the least amount of risk. That means zombie companies, as they’re often called, would not be able to get an endless amount of credit—they would either be forced to improve their creditworthiness and returns to earn the credit, or they would have to stay alive without it, which often means they go out of business because they aren’t profitable.
Tightening the availability of credit is how you create an environment where only the strong survive. Bad companies are subsidized by cheap credit and they are weeded out through competitive credit.
#12 Fiat systems encourage high-time preferences in all areas of the economy, which is short-term serving and long-term damaging.
One of the qualities of fiat Saifedean references throughout his work is its tendency to drive people and economies to be very shortsighted. Inflation encourages spending rather than saving, which fosters an “earn more now rather than later” mentality.
If desperately outpacing inflation was no longer a concern, businesses wouldn’t be as inclined to spend money on share buybacks over R&D, fixate on quarterly rather than multi-year growth, and would find themselves incentivized to choose smaller short-term gains for larger long-term gains far more often.
With a fiat/inflationary system, however, everyone is caught up in the rat race that is beating inflation. Both businesses and consumers are conditioned to spend rather than save because their dollar is losing value over time. And when your money is losing value every day, you act in ways that are short-term serving and long-term damaging because there is no saving for the future outside of chasing aggressive risks and returns in markets.
#13 The fiat standard and tendency toward cheaper, lower quality food has brought us vegetable and seed oils, widespread use of corn and corn syrup, the prevalence of soy as a substitute for healthier and more expensive alternatives, a transition to low-fat foods, and the popularity of whole grain flour and sugar.
As inflation slowly squeezes money out of the consumer, they are able to afford less and less over time. Eventually, consumers are priced out of eating certain high-quality foods, and businesses accommodate the marginally poorer buyer with cheaper quality ingredients that keep prices low.
Because food is an essential good consumers can’t live without, inflation can only go so far, and lowering the quality of food is the easiest way to balance out some of those price increases.
#14 The government funding of schools disallows parents or students the opportunity to leave that school (take their money elsewhere) for another. Having no competition or voting system through spending choices leads to a decline in the quality of education. Though private schools are expensive, public schools generally spend more per student and return worse results. To solve this, governments should simply take that money and give it to parents as a school credit so they can choose where to spend it and foster a healthy marketplace of educational institutions competing for those dollars.
Because public schools are technically free to the average citizen, the cost per student doesn’t get much thought, but the government actually spends about $21,596 per student compared to an average of $15,658 per student spent at private schools.
This may seem strange considering private schools are usually thought of as offering better education than their public counterparts, and that would be the appropriate take.
The reason this price disconnect exists is public schools don’t have to compete to earn that money from the government. Funding isn’t contingent on student performance or the quality of the curriculum—schools are given the same amount so long as they are able to meet the bare minimum of academic standards.
If the incentive to meet the bare minimum was replaced with the incentives of a free and open marketplace full of schools competing for a government-issued grant of the same $21,596, schools providing only the bare minimum would go out of business.
Perhaps more importantly, schools would have less of a monopoly operating in a world where their performance was always being tested by new and better schools fighting for market share.
Only the schools with the best teachers, campuses, resources, and leadership would earn the votes of parents to secure that school credit from the government. It would be a race to the top rather than a pull toward the bottom.
#15 Academia has created a model where academics work to get published (for no direct financial gain) so publishers can profit off of their work. There is also no market feedback on the value of the work creating a huge disconnect between market-valued information and what the centralized publishers and committees decide is valuable.
The structure of academia is, in a lot of ways, diametrically opposed to the structure of free markets. For one, it’s a closed market aimed solely at appealing to a very centralized group of publishers rather than the much broader market of diverse individuals. Researchers and writers aren’t directly paid for their work, but the funding for their work is largely contingent on how much they’re published, so they are incentivized to appeal to that very niche audience rather than provide research a larger audience would value.
Second, there is no mechanism for legitimate market feedback. If there is no objective pricing system set by the market or the ability for the market to value a piece of academic literature through supply and demand, there is no signal to the producers of that literature that something needs to be fixed.
#16 The IMF’s ability and tendency to bail out foreign countries is akin to the Fed’s tendency to bail out its private sector, which inspires the recipients of the bailouts to take on more risk given they have a lender of last resort as a safety net.
Just like the Fed is the lender of last resort in the United States, the IMF (International Monetary Fund) plays a very similar role for emerging markets and undeveloped economies.
This is an important analogy because simply knowing you have a lender of last resort to bail you out motivates you to take more risks. This has been true of the banks in America and it’s true of the developing countries that know the IMF will provide funding if and when they default.
Having the safety net of a lender of last resort might seem like a good idea until you realize it actually encourages the behavior that leads to a lender of last resort stepping in. In other words, it’s a self-reinforcing relationship destined to get worse over time.
#17 You can classify the cost of fiat into four categories:
- The destruction of holders’ wealth through inflation.
- The destruction of the role of money in economic calculation.
- The increased power of the government to shape the economy and society.
- The increased cost and likelihood of conflict.
The first point on inflation likely doesn’t need further explaining, but let’s walk through the other three points. First, the destruction of the role of money in economic calculation refers to the government’s role in price distortions from their interventions. Money and the numeric values used to denominate goods and services are the signals markets and their participants need to act rationally and make appropriate economic decisions.
Second, the role government plays in a fiat system also gives them exceptional power over the economy as they largely dictate interest rates and can arbitrarily increase or decrease the money supply according to their own whims and desires.
As for the final point, economic distortions are what lead to income inequality, malinvestment, and misaligned incentives that foster conflict both domestically and abroad. When economies struggle, the people struggle, and that inevitably leads to greater and greater conflict.
#18 The benefits to fiat are primarily in the savings around not transporting gold.
As mentioned earlier, fiat currency’s principal advantage over gold was its salability across space. Prior to fiat, countries spent a significant amount of money just moving their gold around to settle transactions.
Just imagine having to pay to pay someone or having to pay to get paid by someone. The amount of money saved simply by eliminating the cumbersome process of constantly transporting a clunky, heavy metal can almost not be overstated.
#19 A curse of inflation is attracting investors to unprofitable investments through nominal profits despite them boasting negative real returns.
One of the more surreptitious qualities of inflation is how it distracts you from real returns. It’s much easier to focus on nominal values like up 5% or down 3%, but that doesn't actually mean what it sounds like it means. With every investment, inflation has to be accounted for in one’s end performance.
Investors might be happy with their 5% paper gains, but if inflation is at 5.5%, they actually lost 0.5% that year. It’s that sneaky calculation that is frequently overlooked and tricks investors into thinking they or the assets they are invested in are performing better than they actually are.
#20 Fiat’s proof of work is military might and awards the winner the accounting system for all of society. This system incentivizes countries to engage in power contests rather than purely economic ones.
For those unfamiliar with the concept, proof of work is how a system generates value. In the case of gold or bitcoin, there is a certain amount of energy required to mine it that creates a price floor and holds up its value. In other words, the work that goes into creating it gives it value.
For fiat currency, however, there is no work or energy required to mine or create it. The energy upholding its value is the military behind that currency that enforces its use or value.
In that sense, then, fiat promises the most powerful military will have the most valuable currency and, thus, encourages a never-ending arms race.
#21 Money optimizes liquidity at the expense of risk and return and equity optimizes return at the expense of liquidity.
This is a simple but profound statement. Cash is the king of optionality by providing you with the most liquidity as it has the largest number of willing buyers. Someone is always willing to accept your cash for something, meaning you will likely never have to worry about a huge no-bid drawdown.
That safety and liquidity, however, means you won’t be earning a return at all comparable to riskier investments. Generally speaking, the more liquid a market is, the less volatile and risky it is, and the more illiquid a market is, the higher the chance is for volatility and bigger returns.
#22 Under a hard money system, there will be growth in cash balances as 0% nominal returns become positive real returns and companies see cash as a more attractive financial instrument than debt.
In a hard money system where the currency is deflationary, holders of the currency will grow their wealth without any investment at all. 0% growth with 4% deflation means you grew your wealth by 4%. In a scenario like that, businesses will feel more comfortable holding cash.
Not only would they not be losing money to inflation, but the money they would be gaining through deflation would change how they view taking risks. For any investment to justify its risk, it would have to earn at least a few percent over 4%.
This is in stark contrast to what we see now with pervasive inflation because companies are discouraged to hold cash and encouraged to hold debt they eventually pay back in smaller absolute terms.
#23 The abundance of cash will also reduce the return on lending, meaning naturally lower interest rates.
Building off the previous point, in a world where cash increases its purchasing power over time and more people are driven to hold it, the amount of money available to lend will be considerably higher.
When there is more money available to lend, all those lenders are competing for relatively fewer debtors, meaning natural market forces drive the cost to borrow (interest rates) down.
#24 Without a lender of last resort or the bank’s ability to create money through credit, savers will be exposed to unlimited downside and very limited upside when storing a deposit with that bank.
Unless banks offer access to the upside of the investments its depositors’ money is being allocated toward rather than the traditional minuscule fixed interest rate they offer now, there will be little incentive to use banks.
If there were no Fed backing all the banks and guaranteeing deposits, everyone using banks would be at risk of losing all their money held at the bank. In such a scenario, the interest rates banks offer would make absolutely no sense. If you are at risk of losing your whole deposit and only set to gain a few basis points of interest each year, nobody will choose to store their money with the banks.
For that reason, if the lender of last resort were to disappear, bank interest rates would have to increase dramatically to entice depositors.
CONCLUSION
Well, that does it for all my takeaways.
While there is undoubtedly a lot more I could discuss on “The Fiat Standard”, this should have covered the most important points. I encourage you to read the book in its entirety because it really is a wealth of information, but you can consider this an expansive Spark Notes that hopefully supplements the book very well.
And with that I will leave you with a short and sweet quote by Saifedean himself:
“Money that is easy to produce is no money at all”