The Evils of Paper Currency System

One of the main factors contributing to the global financial crises of the 1990s was that of the fiat (paper) currency standard. The South East Asia financial crises of 1997 led to the devaluation of the local currencies. The human costs of this crises was major hardship for the people, especially the poor, of the region. This period saw incredible rates of devaluation of the local currencies. These are summarised below.

Currency Devaluation - Exchange rates relative to the US Dollar on 16 February 1998 compared to end of June 1997

 

This sharp devaluation had impacted upon salaries, savings and the price of goods and services. It also raised the value of short-term debt, which was denominated by the US dollar. Then in August 1998 there was a devaluation of the Russian Ruble which devalued by 70% within just six months. Later in 2001 on Wednesday 28 February, a day to be dubbed black Wednesday, the Turkish lira was devalued by 30%. This resulted in 100,000 workers, and thousands of journalists, becoming unemployed. Within two months it had devalued by almost 50%.. The devaluation was due to a lack of confidence in the government.

More recently there is the ongoing currency crisis in Argentina. The Argentine Peso devalued by more than 100% compared to the US$ for which it was previously pegged . One of the main reasons for this was the decision to remove the peg of the peso to the dollar, which was seen as unsustainable in light of the IMF policies which were forcing a devaluation of the currency amongst other things. The Argentinian governments failed strategies led to the collapse of the government and daily riots with possible knock-on effects in other South American countries.

When we look at the devaluation of the currencies of the Islamic regions of the globe in the last five years. It should show us how vulnerable and exposed the Ummah has become. A small sample of Islamic countries may demonstrate this

Exchange rates of various currencies relative to the US Dollar

 

These are just some examples from recent history, which have led many economists to question the Fiat money standard. Some economists such as Tatyana Koryagina have even forecasted the collapse of the US dollar itself.

Russia realised the speculative nature of the currency markets and the instability that the fiat currency brings. In July 2001 the Russians started to circulate gold chervonets coins. The Bank of Russia -Central Bank introduced measures on July 10 making the gold chervonets legal tender. The short-term purpose of that move was to tempt Russians’ savings from the dollar to the Russian chervonets. This was in a country where $100 billion or more is held in cash (U.S. Federal Reserve Notes). Beyond that result, the Russian currency shift could become a stepping stone to more profound changes in international monetary policy—as nations seek safety from the disintegration of the Anglo-American-centred world financial system.

During the eight-month tenure of Yevgeni Primakov as Russian premier, various maverick economists proposed an international role for the Ruble, and for gold. Proposals circulated at that time included Monya Kantov's "The Ruble as a World Reserve Currency," and Artur Sazonov's plan for a "gold-backed ruble," linked to the Euro.

The problem with Fiat Currency

Fiat Money - is simply money that has nothing of substance behind it. According to Webster's New World Dictionary, fiat money is "currency made legal tender by fiat (sanction) and neither backed by, nor necessarily convertible into, gold or silver." It is a promise to repay nothing, over an unspecified period. This inconvertible paper currency system gives the central Bank the powers to issue and circulate paper money which has no intrinsic value. The government forces the people in the country to accept this currency in fulfilling financial commitments.

In America's first depression, 1819-1821, four US states (Tennessee, Kentucky, Illinois, and Missouri) established state owned banks, issuing fiat paper. They were backed by legal tender provisions in the states, and sometimes by legal prohibition against depreciating the notes. And yet, all these experiments, born in high hopes, came quickly to grief as the new paper depreciated rapidly to negligible value. The projects had to be swiftly abandoned. Later, the greenbacks circulated as fiat paper in the North during and after the Civil War. Yet, in California, the people refused to accept the greenbacks and continued to use gold as their money. Later when the Gold standard was abandoned the government forced the people to accept the fiat currency.

With fiat money the way is clear for the government to counterfeit money (i.e. create new money out of thin air). It can issue new notes at will to pay off government debts, start new projects, pay government employees and use it for any other government expenditure. It is a source of revenue that is unnoticed by the public and less hostile compared to taxation. Counterfeiting is nothing but another name for inflation.

When governments increase the supply of money then the purchasing power of that money drops, that is, the price of all goods rise. As for any commodity the price rises and falls with demand (increasing the supply will reduce the demand). This is the same with currency, the purchasing power of money rises and falls with demand. For example, if there are $100 in a society and there are 100 goods (e.g. TVs) then $1 will buy 1 good (TV). Then if the state prints another $100 for some government project, there will be now $200 chasing 100 goods now people will be willing to pay more for the same good as there is more money in circulation, the price of each item (TV) will be forced up to $2. Increasing the supply of money decreases the demand and hence the purchasing power, which leads to a rise in prices. The obstacle preventing the government from printing more and more money is the threat of hyper-inflation, the crack-up of the currency.

The impact of inflation on the economy

The government uses the newly created money to buy goods and services, giving local spending a boost. As the new money starts to work its way, step by step, throughout the economic system it bids prices up – this dilutes the effectiveness of each unit of currency. But this dilution takes time and is therefore uneven; in the meantime, some people gain and other people lose. In short, the counterfeiters (the government) and their local retailers have found their incomes increased before any rise in the prices of the things they buy. But, on the other hand, people in remote areas of the economy, who have not yet received the new money, find their buying prices rising before their incomes. The first receivers of the new money gain most, and at the expense of the later receivers. Inflation, then, confers no general social benefit; instead, it redistributes the wealth in favour of the first-comers and at the expense of the laggards in the race. And inflation is, in effect, a race—to see who can get the new money earliest. The latecomers—the ones stuck with the loss—are often called the "fixed income groups." Teachers, people on salaries, lag notoriously behind other groups in acquiring the new money. Particular sufferers will be those depending on fixed money contracts—contracts made in the days before the inflationary rise in prices. Retired persons living off pensions, landlords with long term leases, creditors, those holding cash or savings in an account, all will bear the brunt from inflation.

Inflation has other disastrous effects. It distorts that keystone of the economy - business calculation.

Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations. For example, accounting practice enters the "cost" of an asset at the amount the business has paid for it. But if inflation intervenes, the cost of replacing the asset when it wears out will be far greater than that recorded on the books. As a result, business accounting will seriously overstate their profits during inflationary times —and may even consume capital while presumably increasing their investments.

Inflation cannot go on forever - At first, when prices rise, people say: "Well, this is abnormal, the product of some temporary emergency. I will postpone my purchases and wait until prices go back down." This is the common attitude during the first phase of inflation. This notion moderates the price rise itself, and conceals the inflation further, since the demand for money is thereby increased. But, as inflation proceeds, people begin to realise that prices are going up perpetually as a result of perpetual inflation. Now people will say: "I will buy now, though prices are `high,' because if I wait, prices will go up still further." As a result, the demand for money now falls and prices go up more, proportionately, than the increase in the money supply. At this point, the government is often called upon to "relieve the money shortage" caused by the accelerated price rise, and it inflates even faster. Soon, the country reaches the stage of the "crack-up boom," when people say: "I must buy anything now—anything to get rid of money which depreciates in my hands." The supply of money skyrockets, the demand plummets, and prices rise astronomically. Production falls sharply, as people spend more and more of their time finding ways to get rid of their money. The monetary system has, in effect, broken down completely, and the economy reverts to other moneys, if they are attainable—other metal, foreign currencies if this is a one-country inflation, or even a return to barter conditions. The monetary system has broken down under the impact of inflation (hyper-inflation).

There is another factor feeding inflation, as the printing of new money leads to devaluation of the currency in relation to other currencies. The cost of imported goods greatly increases, this has a major impact on those countries which are not industrialised and are not self sufficient, as they are heavily dependant on foreign goods. Goods such as machinery for manufacturing, farming, building roads & railways, building ships, tanks, planes etc. Due to IMF policies of specialisation most Islamic countries need to import food as they only specialise in certain crops. Also most of the Muslim countries tend to import electrical goods or manufacture them locally by importing their parts. Electrical goods such as refrigerators, washing machines, air conditioning units, iron, cookers etc will all rise in price. The rise in price of these imported good will all feed the inflation and speed up the process to hyper-inflation

Fiat currency a source of government revenue

The revenue that governments gain from printing money, accounted for approximately 54 percent of total Argentine government revenues between 1985 and 1990, reaching a period high of 86 percent in 1987. The Argentine public, not wishing to hold a depreciating monetary asset, shifted out of pesos and into U.S. dollars. To protect its revenue base, Argentina’s government resisted unofficial dollarization, but often the form of the resistance—capital controls, for instance—compounded the inefficiencies associated with monetary instability.

The printing of currency remained probably the single most important source of state revenue for Afghanistan. Banknotes printed under first contract in Russia and then by the American Banknote Company continued to be delivered weekly to the Rabbani government. The resulting devaluation of the Afghani and inflation were so severe that the government introduced new currency notes. Under Najibullah the official exchange rate had been af. 50 to the dollar, and the largest bill was the af. 1,000 note. By the summer of 1991, the Afghani was trading at about 1,000 to the dollar, and it continued to fall. The Rabbani government issued first a 5,000 and then a 10,000 Afghani note. Each time it did so the currency fell further. Hikmatyar forbade the use of the af. 10,000 note in bazaars under his control. The former communist ethnic Uzbek warlord of Northern Afghanistan, Abdul Rashid Dostum, had his own notes printed after breaking with Rabbani in January 1994. By September 1996, when Kabul fell to the Taliban, the Afghani was trading at 17,800 to the dollar there. Furthermore, the Afghani was worth even less (25,600/dollar) in Dostum’s de facto capital, Mazar-i Sharif.)

The currency in circulation in Pakistan showed an average growth rate of 10.6 percent during the 5 years period from 1991-92 to 1995-96. During this period the government gained a revenue of 97.173 billion Rupees from just issuing extra notes and coins.

In the time of war, nobody will accept paper currency as there is no confidence in the government, therefore the promise of the government has no value. The Chairman of the Federal Reserve, Alan Greenspan, said on 20th May 1999 to the House Banking Committee soon after Britain announced its decision to sell gold that - 'gold still represents the ultimate form of payment in the world'. Germany in 1944 could buy materials during the war only with gold. Fiat money in extremis is accepted by nobody. Gold is always accepted.

As stated earlier the fiat currency only holds a legal imposed value. It does not possess an intrinsic power, nor does it depend on an intrinsic power. It merely represents a unit that has been agreed upon as a means of circulation, and it is the law that gives it the power to become a means of circulation. That is a form of common exchange which allows a person to acquire goods and services. Its power is derived from the power of the state who issues it and who uses it as its currency. So, if the state demonstrates a sign of weakness politically, militarily or economically then this will weaken the currency. This will then lead to currency devaluation, if the central bank does not intervene. An example of this is Turkey in Feb 2001 when the government showed political weakness the currency devalued by 30%. Any instability in the country which leads to a lack of confidence in the government will start the devaluation of the currency.

Although some major problems associated fiat standardisation have been outlined here, this does not mean that standardisation is itself problematic. In point of fact standardisation is paramount to any monetary system. The problem lays with the choice of reference as a standard. The nebulous concept of fiat is actually a quasi-standard. A standard must contain some form of intrinsic value. This would lead to stability in the economy and avoid inflation. Gold and/or silver as a reference point fulfils such a robust standard. This bimetallic standard has been tried and tested for centuries. Past economies have not been at the mercy of the booms and busts of the fiat system. Islamic law is based entirely on this bimetallic reference point. Our laws, measurements, taxes, compensation payments etc all were revealed to Rasool-Allah (Sallalahu alaihi wa Sallam) using gold and silver as the standard. The solid Islamic bimetallic system contrasts sharply to the paper-thin flimsy fiat system. Moreover it is not only more stable but is it an obligation from Islam to return back the Islamic way of gold and silver.

[We intend to discuss the bimetallic standard and its position in the Islamic economic system in future articles]

Abu Musab

Comment:

After going through this article the readers might understand why the finance (or counterfeit) ministry is such a powerful entity in secular politics. Actually it is as powerful as the defence ministry. Perhaps this is reason why governments all over the world can pay government salaries on time,but not the private enterprises. From where do they get? Simple guess: print. The so-called "aids" which we receive from the colonialists is also nothing but money printed out of thin air (which cannot be represented by real wealth). Can this act of creating inflation be deemed as a crime? Capitalist system cannot answer such vital questions. It is a inconsistent, incoherent system which doesn't make any sense.