What is money: Part 4 - The significance of what happened in 1971

In this episode we examine the significance of the decoupling of money and currency following the Nixon shock in 1971. Before we go on to examine the current state of money, we dedicate this episode to fit everything we have learned so far together. In order to do that, we build upon all previous episodes of the What is money series.

The need for money

In episode 1 we started our journey by discussing why the thing we call money not only arises naturally, but is a necessary tool for human progress. As a species we are more productive when we specialize and divide work, which creates the need for trade. We learned, that in order to improve our living conditions, human beings need a tool that enables us to trade with each other easily, resulting in the three fundamental requirements for the tool we call money:

• Medium of exchange: We need something to exchange the fruits of our work for those of the work of others. Barter can only take place if both parties desire and need the good that the other one possesses. This is often times not the case. The exchange into a neutral exchange medium, which everyone accepts and can afterwards exchange against all other type of goods, makes trade possible in all cases.

• Unit of account: To measure the value of the fruits of our labor and compare it to the ones of others. With a neutral medium of exchange as a unit of calculation, it is sufficient to determine a single exchange ratio for each good (the one in the neutral medium of exchange). This makes it much easier and more efficient to measure and compare the various goods and labor services.

• Store of vale: To store the value of our labor over time. There is always passing of time between the moment we perform our labor and the moment we want to exchange its fruits for other goods. The better the value storage property of the medium of exchange we are using, the greater the amount of time that can pass between the performance of our labor and the exchange of its fruits. This enables us to better plan for (and feel less uncertainty about) the future.

From pearls to gold

In episode 2 we looked at how randomly chosen tools of money competed against each other over time and learned that the search for a good tool of money follows an evolutionary process that has played out for every civilization throughout history.

Specifically, we analysed the European mass production of aggry beads (glass pearls), which illustrated the effects of an unequal distribution of power and control over the production of the thing used as money. This power distribution led to the transfer of wealth from the West Africans who could not produce the beads, to the Europeans, who could. An act that eventually culminated in the enslavement of millions of West African people.

We learned that human beings naturally try to make more of the thing that is being used as money because it gives them an advantage. For that reason, the best tool of money is whatever is the hardest thing to make. Only what is scarce, durable and immutable can preserve value. Gold historically outperformed every other tool that has been tried as money, in helping societies to improve their social and material living conditions. As trade expanded and went global in the 19th century, gold was effectively chosen as the universal tool for money.

From gold to fiat

In episode 3 we adressed the logically emerging question: If gold was universally chosen as money, then why do we not use gold as money today?

We explored that the currencies we use today were initially introduced as a representation of gold and a second layer to the winner of the "best tool of money" contest. This made sense in order to facilitate the transport and exchange of value through space. Due to its physical properties, gold was not well suited for global trade. Using currencies made it much cheaper and easier to move value across space, which in turn enabled us to trade faster and more.

In order to benefit from currencies, it was necessary to create trusted centralized entities to take custody of the gold and be granted the power to issue the currencies. Thus, we created banks and eventually central banks. Under these conditions, we were able to get the best out of gold as a tool of money. Because there was a 1:1 representation between banknotes and gold, every banknote was directly exchangeable back into the amount of gold it specified. The problem with this solution seems obvious. While the money (gold) could not change and multiply at will, the representation of the tool of money (paper bills) could. And because it could, it did (and it still does). With the creation of currency monopolies we had introduced a single point of failure in the whole monetary system. The paper bills soon rendered physical gold unnecessary in people's day to day life because it was just more comfortable to us them. Eventually we stopped checking for the real thing.

The institution we created now yielded the control over the production of the thing used as money in the day to day life, which is comparable to leaving your child in a candy shop. The temptation to take some candy is equal to the temptation to print some money... too great to resist.

The central bankers found evermore reasons and arguments to take advantage of their privileged position, leading to decades of struggle and half-hearted solutions to maintain some sort of gold standard. In 1971 the situation culminated in the Nixon shock, the final abandonment of gold as a tool of money.

"I have directed secretary Connally to suspend temporarily the convertibility of the dollar into gold..." - Richard Nixon

It does say temporarily. That was a bluff though. Neither the dollar nor any other currency is coupled to gol anymore. This is one of the many occasions where Milton Friedman's famous quote: "Nothing is so permanent as a temporary government program", proves right again.

The significance of what happened in 1971

In this episode we put all of these learnings together, because the significance of this event can simply not be overstated. From this moment on, for the first time in modern history, the world's money was detached from any physical asset. The currencies we use today are not connected in any way to the physical world. I believe that 1971 will go down in history as the start of the greatest wealth redistribution scheme humanity has ever seen. You do not believe me? I feel you. I have been struggling to understand this for a long time. It still leaves me absolutely speechless, and overflowed with all kinds of emotions ranging from anger to utter disbelief. Please bear with me and keep an open mind. Do not try to hold on too much to what you think you know. Try to look at this as objectively as possible, because if you do, then your mind will be blown.

Let's revisit the European mass production of aggry beads... It gave Europeans power and control over the production of the thing used as money in West Africa. This power inequality resulted in the transfer of wealth from the Africans who could not produce the thing used as money to the Europeans who could, effectively making the Africans work for the Europeans. Africans had to earn the pearls, Europeans could simply produce them. Now think about the enabling of the mass production of bank notes...

The decoupling of money and currency in 1971 gave all of the central banks the power and control over the production of the thing used as money in their respective nation states. Following the same logic, this power inequality leads to the concentration of wealth in the hands of those who control the money supply through the confiscation of the time and energy of those who are working to earn the thing used as money but are not able to produce it.

Yes, that is exactly what happened. We did not just leave the kid alone in the candy shop... We gave away the keys to the shop and then we stopped thinking about it.

Now let that sink in... Try to understand the gravity of this. Take a day or two. You will be in disbelief. That is okay. These days will most likely mark a turning point in the way you see the world.

When you are ready to accept this incredibly harsh truth, to deal with the consequences and to learn what to make of this going forward, feel free to come back and tune in for the next episode of the What is money series, where we will back all of this up with hard facts and data.