The history of paper money is a history of failed experiments.
Authorities have sought to utilise the flexibility it gives their finances, but have often mismanaged it and brought catastrophe.
While fiat money is the norm today (now mainly digital and not actually physical paper), paper money has been less common in the past. Throughout much of human history, society has used some form of hard money. That is money that is hard to create and thus limited in its supply, such as precious metals like gold or silver.
The Chinese were the first to adopt paper money around 800 AD with the Tang dynasty and their “flying money.”
Paper money then appeared in Europe in 1661 and in America in 1690.
Initially paper money was redeemable for gold and silver and while the paper existed primarily for convenience, the real money was the metal.
However, things changed in the 20th century with the onset of World War One, as the major powers abandoned the gold standard in order to pay for the war through the printing press.
Governments learned that people would accept paper money with no convertibility into gold.
So today we live with a monetary system in which the US dollar is the global reserve currency but with the dollar having no tie to any hard asset. It exists entirely by fiat.
This works as long as the public maintain their confidence in both the soundness of the money and the authorities that issue the money.
How long we stay with the current system depends on how long governments and central banks can keep that confidence.
Table of Contents
What Is Paper Money?
Paper money is a currency where paper notes are used as the medium of exchange. Normally paper money is issued by a government or a central bank but sometimes it may be issued by commercial banks.
Traditionally, money has been some form of commodity, like gold or silver, that has some degree of natural scarcity and where it is quite difficult to increase the supply.
Unlike commodity money, the paper itself has no value but the currency gains value by the trust and confidence market participants give to the issuing authority.
Because the paper has no value, it is very cheap to create and new units can easily be added to the money supply.
The primary reason why paper money has been used throughout history is that it is more convenient than transporting a large amount of precious metals.
As Saifidean Ammous explains in his book The Fiat Standard, it has a high spatial salability. While it may not retain its value over time, it is very effective at transporting value over space.
Paper money is also referred to as fiat money. Fiat is Latin for “let it be done,” meaning that new units of money can easily be created by the issuing authority.
Before the digital era paper money actually meant physical paper. These days only a tiny fraction of the money supply is actually printed as physical cash. Instead most of it only exists as numbers on a screen in digital form. This is the modern day fiat currency which is still referred to by many as paper money.
And when governments and central banks increasing the supply of money it is often referred to as “printing money” even though the vast majority of the new money is digital.
This article on the history of paper money will start with the physical paper going back to the early Chinese paper money and will conclude with a look at modern fiat currency.
The First Paper Money in China
The first instance of paper money being used in China was during the Tang Dynasty (618-907 AD), which went by the awesome name of feiqian or “flying money.”
Around 800 AD the emperor compelled merchants to leave their cumbersome and heavy hard money in the public vault and issued them with a paper security instead. The security was the “flying money,” aptly named because of its tendency to blow away.
The flying money became a type of currency as it was able to be exchanged amongst the merchants. They were also convertible back into hard currency.
However it wasn’t intended to be used as a currency amongst the wider population and its use was rather limited.
After the Tang Dynasty there was a period of division in China before the Song Dynasty emerged in Southern China. (960-1279).
The Song issued the jiaozi, which were receipts given in exchange for the cumbersome iron money that was in circulation. The jiaozi was representative of an ounce of silver.
The government initially allowed 16 rich families to form a union to issue the jiaozi, before the later deciding to step in and take control themselves in 1024.
The jiaozi was limited to Sichuan and not used widely across the country. It was subject to counterfeiting and suffered from inflation caused by an expanding money supply.
In 1107 the jiaozi was discontinued and replaced with the qianyin.
After 1127 most of Northern China was conquered and the Song Dynasty shrank to almost half its size. The new northern empire, the Jin Dynasty, imitated the Song and issued their own paper currency, the jiaochao.
In 1161 in the now smaller Song empire, a new paper currency, the huizi, was issued. This was used throughout the whole empire with the exception of Sichuan, as they continued to use their own paper currency.
After initially controlling the money supply tightly, financial pressure and war caused the Song government to pursue an inflationary policy, beginning the first nationwide inflation in history.
The Mongols, who had already started using paper currency themselves, then took over China between 1279 and 1367 in what is know as the Yuan Dynasty. As the rulers of China they continued to use paper currency, also know as the jiaochao.
The first jiaochao issue was backed by silk and the second issue backed by silver. Like many great empires they eventually gave into the temptation to debase their currency. This was one of the reasons for the economic difficulties at the end of the Yuan Dynasty and their eventual demise.
The Ming, who succeeded the Mongols, initially continued with paper money before being forced back onto a silver standard. Their successor, the Qing also halted the use of paper money during the early period of their reign, using silver and copper instead.
Paper Money in Europe During The Middle Ages
In Europe in the Middle Ages, money was mostly coins but could also be uncoined precious metals, other valuable commodities or even small squares of cloth.
The Italian city states were the first to experiment with paper money. Due to the dangers and inconvenience of moving large amounts of precious metals, they developed a system of promissory notes and bills of exchange.
These were debt instruments written on paper that included the details and terms of repayment.
In some sense these were seen as paper money but they did not circulate as currency.
The Development Of Banknotes In Europe
It wasn’t until the Swedish Riksbank issued notes in 1661 that Europe first started using paper money in the form of bank notes.
Back then, Sweden was a quite a powerful empire.
This issue was initially successful as the notes were redeemable in hard money, however it comes as no surprise that the bank started printing more notes, which led to a reduction in their value and inflation.
Eventually the bank failed and the central banker, Johan Palmstruch, was sentenced to death.
The Bank of England
The Bank of England was established soon after in 1694 as a private bank to provide loans to the government, primarily to fund the Nine Years War against France.
England had been performing poorly in the war and needed money to rebuild her navy. But with a lack of funds and poor credit the government was in a tight spot.
A loan of £1.2 million was provided to the government by a group of over 1200 lenders, with the lenders being given the right to incorporate the Bank of England as a private company with the ability to issue banknotes.
This was much to the frustration of the goldsmiths who had previously fulfilled the role of banker.
One of them, Richard Hoare, presciently commented that the Bank would:
“Engross most of the Ready Money in and near the City of London, which is the Heart of Trade, and so will amount in effect to a Monopoly.”
The Bank quickly evolved beyond its role as banker to the government and later in 1694 began commercial banking, allowing public deposits.
The goldsmith bankers attempted to make a run on the bank in 1696. After they had gathered a sizeable number of notes issued by the bank they simultaneously demanded gold and silver in exchange for the notes. The Bank denied them the gold and silver, although it did pay out to other creditors who weren’t trying to bring the bank to its knees.
Bank of England notes were convertible into gold for much of the banks early history, suspended only in 1745 due to the Jacobite Rising, between 1797 and 1821 to finance the Napoleonic Wars and then again in 1914 as World War One broke out.
Clearly war is bad for sound money.
The Bank of England continued to operate as a private bank until 1946, when it was nationalised by Clement Attlee’s Labour Government.
Paper Money In France
In France, paper money was first introduced by the Scotsman John Law.
Law had to flee his homeland at the age of 23 after killing a man in a duel and spent his time travelling around Europe and developing his monetary theory.
Eventually he ended up in Paris and made the acquaintance of the Duke of Orleans, the regent of the child king Louis XV.
Law believed that credit was like blood. Just as a body needs the circulation of blood to survive, so too society needs the circulation of credit to survive. To him, paper money was far superior to gold and silver. He was a Keynesian long before Keynes.
With the French government deep in debt after the War of Spanish Succession, this argument swayed the Duke and the Banque Generale was established in 1716. It had a limited note issue of 60 million livres and would only issue notes in exchange for gold and silver.
The Duke even mandated that taxes were to be paid with John Law’s banknotes, which gave them the status of government money.
Two years later the bank was reorganised from a private to a public institution and renamed the Banque Royale, with no limit to its right to issue banknotes other than the permission of the Duke.
In the short term, Law’s bank was a wild success, stimulating trade and increasing confidence in the economy. The Duke was impressed with Law.
But like any paper induced inflationary boom the good times wouldn’t last.
In 1717 Law had been allowed to gain a trading monopoly over the French territory of Louisiana, and he established the Mississippi Company. He acquired three other rival trading companies who had rights in China, the East Indies and Africa to give him a monopoly on all of France’s foreign trade.
Law sold shares in the Mississippi company, while at the same time the Banque Royale began issuing more and more bank notes.
This started a speculative mania that resulted in one of history’s most famous bubbles.
The shares started at 500 livres in January 1719, rising to 10,000 livres by December 1719.
A 1900% gain in less than a year.
They would peak at over 18,000 livres.
As investors started taking profits the share price began a precipitous decline. It fell to 2000 livres in September 1720, 1000 livres in December 1720 and by September 1721 the price was back to where it began at 500 livres.
Law had been printing paper money so the company could buy back the stock that other investors were selling. He had hoped this would stabilise the market but it had the opposite effect. All the money printing spooked investors and made them want to sell their shares, get out of paper money and back into gold and silver.
This caused enourmous price inflation in France, at one point the monthly inflation rate reached 23%.
With not enough gold and silver to pay those wanting to convert their paper to hard money, Law, now the Finance Minister as well, made it illegal to hold large amounts of gold and silver, decreed that paper money could no longer be exchanged for hard money and devalued the paper currency by half.
This created a public uproar, causing the Duke to fire Law and place him under house arrest.
As he had done decades earlier, Law fled the country.
Traumatised by the John Law experiment, the French Crown returned to a monetary system based on gold and silver.
It stayed that way until the beginning of the French Revolution in 1789 when the dire state of the royal finances plunged the country into financial crisis and political chaos.
With tax reform and bankruptcy both politically unacceptable, the new National Assembly tried to solve the financial crisis by issuing paper money, known as the assignat.
The failure of John Law’s system was fresh in their memory, but they made the fateful and arrogant mistake in assuming that if they issued paper money they would be able to control it. They couldn’t and were seduced into issuing more and more paper currency.
The 1790s was a decade of political, economic and social chaos for France as the revolution led to the establishment of a republic, the killing of the king, massive inflation and a reign of political terror.
In 1795, five years after it was first issued, the value of the assignat had collapsed.
Eventually the assignat was abandoned and the silver franc took its place.
Napoleon, who had taken power in a coup in 1799, established the Bank de France in 1800. The bank established a new monetary system with gold and silver coins with the silver/gold ratio set at 15:1.
When Did The US Start Using Paper Money?
Before the formation of the United States of America, the 13 British colonies used British money. Britain at the time was on a silver standard.
When British money wasn’t always available, for example in rural areas, commodities were used as media of exchange. For example beaver fur, fish, corn rice and tobacco.
As the colonial economy grew more and more British coins made their way to America, as well as the gold and silver coins of other European nations. These foreign coins freely circulated as money until banned by Congress in 1857.
The first paper money in the colonial era was issued by Massachusetts in 1690 as a means to pay their soldiers. When they issued this money they pledged to redeem the notes in gold and silver and also to make no further issuances of paper money.
The government failed to meet both of those obligations.
The first issue was £7000 in 1690, followed by a second issue of £40,000 in 1691. This led to a loss of confidence in the government’s ability to repay in gold and silver, devaluing the paper money by 40%. Prices rose.
In 1711 there was another issue of paper, this time £500,000.
Between 1744 and 1748 the total amount of paper money in circulation exploded from £300,000 to £2.5 million.
Silver traded at 10 times the price it had in 1690 when the paper money was first issued.
By the late 1750s every other colony had followed Massachusetts down the same path, issuing paper currency and experiencing massive inflation.
Things only changed when the British forced the colonies to wean themselves off paper money, passing a law in 1751 for New England and in 1764 for everywhere else, prohibiting new issues of paper money and demanding the gradual withdrawal of existing notes from circulation.
It wouldn’t be long before paper money would make a return.
When the Revolutionary War broke out in 1775, the Continental Congress needed a means of financing it.
They decided that an emergency issue of paper money would be the way to go.
There was no promise of redemption for gold and silver. Instead, they promised to retire the notes in seven years and redeem them with future taxes.
In 1775, the money supply was estimated to be $12 million. The Congress issued a staggering $225 million of paper over the next four years.
Between 1775 and 1779 the paper dollars fell in value to the point where 42 paper dollars were needed to purchase 1 dollar in hard money. By 1781 it was 168 paper dollars.
Prices skyrocketed and price controls followed, leading to shortages.
Farmers refused to accept paper money in exchange for goods. The Continental Army just seized the goods instead.
Eventually the state and federal governments allowed the paper currency to depreciate until it was worthless, and all paper money was withdrawn by the end of the war.
Again, it didn’t last long before paper money would make a return.
The Bank of North America
In 1782 the Bank of North America was established. This was a private bank that was modelled on the Bank of England and it was granted a monopoly on the issue of paper money.
This paper money was redeemable in gold and silver but due to the lack of confidence in the bank their notes quickly lost value.
After just a year of operation, the first attempt at a central bank ended with the Bank of North America reverting to a commercial bank and all government debt to the bank being repaid.
With the establishment of the US Constitution, the power to coin money passed to Congress, with state governments prohibited from coining money or issuing paper. The Coinage Act of 1792 established a bimetallic standard with a silver/gold ratio of 15/1.
The Bank of the United States
In 1791 a second attempt at a central bank was made with the establishment of the Bank of the United States. This was a private bank, although the Federal Government did own shares. The bank had the right to issue paper money, although this was redeemable for hard money.
The Bank of the United States promptly issued large amounts of paper dollars, triggering a significant rise of prices.
Between 1791 and 1796 prices rose 72%.
By 1811, when the initial 20 year charter expired, the bank had hard money assets of $5.01 million and paper assets of $12.87 million. Congress and Senate narrowly voted not to give it a new charter and the bank met its end.
The Second Bank of the United States
An enormous inflation began in the following year, triggered by the War of 1812. The US government issued a huge amount of Treasury notes as well as letting a large number of new banks, often illegal, to spring up and start issuing their own paper money.
When some banks, who had not been recklessly issuing paper, demanded to redeem the worthless paper for hard money (as was their right), the government permitted the money printing banks to suspend payments in gold and silver.
This suspension was allowed to continue for two and a half years.
As Murray Rothbard puts it:
“More important than this inflation, and at least as important as the wreckage of the monetary system during and after the war, was the precedent that the two-and-a-half-year-long suspension of specie payment set for the banking system for the future. From then on, every time there was a banking crisis brought on by inflationary expansion and demands for redemption in specie, state and federal governments looked the other way and permitted general suspension of specie payments while bank operations continued to flourish. It thus became clear to the banks that in a general crisis they would not be required to meet the ordinary obligations of contract law or of respect for property rights, so their inflationary expansion was permanently encouraged by this massive failure of government to fulfill its obligation to enforce contracts and defend the rights of property.”
With numerous small banks issuing their own paper, it was decided to try the central bank experiment once again and the Second Bank of the United States was formed, opening in 1817.
Yet the Second Bank did nothing to rein in the recklessness of the smaller banks and merely joined in the money printing party.
It is estimated that between 1816 and 1818 the total money supply in the country grew by over 40%. This triggered an inflationary boom, but eventually the Bank realised it was in trouble and began to behave more responsibly. It contracted credit, purchased millions of dollars of gold and silver and made sure its debtors paid in hard money.
The money supply was almost reduced by half.
This tightening then brought about the country’s first widespread depression in 1819. Defaults and bankruptcies occurred and there was a massive drop in real estate values as well as general prices
It was the first “boom-bust” cycle.
Out of the chaos of 1819 came the Jacksonian movement, dedicated to hard money and 100% reserve banking. In 1831 President Jackson vetoed the recharter of the Second Bank of the United States and in 1833 he removed government money from the bank, effectively destroying it as an institution.
Jackson’s successor Martin van Buren established the independent treasury system, where the government kept its funds in hard money in its own Treasury vaults.
This separation of the federal government and banking would last up until the Civil War.
The Emergence of Legal Tender
The 19th century saw legal tender laws emerge in both Britain and the United States.
Legal tender is when a government designates a currency as acceptable for settling debts, transactions and obligations.
In effect this makes the legal tender currency a mean of payment that must be accepted.
Legal Tender In Britain
The Bank of England Act of 1833 established notes issued by the Bank of England as legal tender and gave the bank a monopoly on the issue of bank notes.
This was further reinforced by the Bank Charter Act of 1844.
No new banks were allowed to issue notes, however banks with existing rights to issue notes were allowed to continue with some restrictions.
But by 1921 this ceased and the Bank of England had a complete monopoly.
Legal Tender In The United States
In 1862, during the Civil War, Congress passed the Legal Tender Act, authorising the printing of $150 million of “United States Notes” which would become known as “greenbacks.” This was to fund the ballooning war deficits.
Congress hoped that this would just be one emergency issue. But once the printing starts it is very hard to stop.
A second $150 million was issued later in 1862 with another $150 million to follow in 1863.
Naturally the greenbacks fell in value against gold and silver but, rather than acknowledge that, the government placed the blame on gold speculators. This gave them an excuse to try and regulate the gold market and, when that failed, they tried to destroy the gold market altogether. All this did was destroy confidence in the greenback which depreciated further.
Over the course of the Civil War, the total money supply (including both hard money and paper) expanded 137.9%. Prices rose 110.9%.
The Civil War also spawned another important development – the creation of a national banking system. While this was established under the guise of a war time emergency, it was to have a permanent effect.
The national banking system had three tiers. Central Reserve City was the first tier and that was only for New York. Reserve City was the next tier for any city with 500,000 residents. Country was the final tier for all other national banks.
It swept away the Jacksonian system and replaced it with a centralised system controlled by Washington and Wall Street. Murray Rothbard argues this was the precursor to the Federal Reserve system we have today, which was to be the natural next step from a central banker’s point of view.
The structure of those banks and the reserve requirements meant that the system by its nature was inflationary. Murray Rothbard explains how it worked:
“Before the Civil War, every bank had to keep its own specie reserves, and any pyramiding of notes and deposits on top of that was severely limited by calls for redemption in specie by other, competing banks as well as by the general public. But now, reserve city banks could keep half of their reserves as deposits in New York City banks, and country banks could keep most of theirs in one or the other, so that as a result, all the national banks in the country could pyramid in two layers on top of the relatively small base of reserves in the New York banks. And furthermore, those reserves could consist of inflated greenbacks as well as specie.”
In other words, individual banks used to be limited in issuing paper money by their own gold and silver reserves. Now, as part of a system of banks they could use each others reserves, meaning the reserve requirement was less and they could print more paper money.
After the Civil War the US faced the twin problem of massive debt and a huge circulation of paper. Those who argued for a return to hard money were shouted down and the national banking system was bedded in for good.
Between 1865 and 1873 the total supply of state and national bank notes and deposits grew by 135.2% before leveling off in the panic of 1873.
In 1873 the US went onto the gold standard. This was the era in the industrialised world known as the classical gold standard. All major powers tied their currencies to gold or pegged their currency to a country who had tied theirs to gold.
The gold standard was threatened in the 1890s but survived the decade intact. It would continue this way until 1933 when Roosevelt famously took the US off the gold standard, although the dollar would retain a link to gold until 1971 when Nixon cut the last ties.
The Evolution of Paper Money Into Modern Fiat Currency
The Gold Standard
The era of the 1870s to 1914 was known as the classical gold standard. With Britain on a gold standard and the new country of Germany going on a gold standard, other countries followed suit.
This was a system where countries fixed the value of their currencies to gold at a defined weight or fixed their currency to another country that did so.
The role of central banks under this system was to maintain the ability to convert paper money into gold at the fixed price.
This system put a check on the ability of central banks to issue too much currency, which in turn limited the boom and bust nature of inflationary monetary expansion.
A financial panic in the United States in 1907 increased the clamour for a central bank in the US modelled on the European central banks. After years of planning this culminated in the Federal Reserve Act of 1913 which established the Federal Reserve system in 1914 as we know it today.
Rothbard argues that this was:
“A governmentally created and sanctioned cartel device to enable the nation’s banks to inflate the money supply in a coordinated fashion, without suffering quick retribution from depositors or noteholders demanding cash.”
In the same year as the Fed was established, war destroyed the classical gold standard that had served the world so well for two generations.
The outbreak of World War One in 1914 meant the belligerents abandoned the gold standard. The European powers thought they were engaging in a short war and did not want to fund it with increased taxation.
The solution was to pay for the war through the printing press.
The expected short war lasted for four years, leading to immense hardship and suffering, the downfall of four empires and devastating economic consequences.
Debt exploded, prices rose, shortages occurred and the money printing continued. Russia went into a hyperinflation under the Bolsheviks (and again in 1992 after the collapse of the Soviet Union), as did Germany under the new Weimar Republic.
With the European powers all off the gold standard, only the USA remained with its pre-war monetary system, although the Fed had doubled the money supply to finance the war when the US entered in 1917.
With this chaotic fiat experience, Europe looked nostalgically at the pre-war classical gold standard.
By 1920 Britain had the least inflated currency with only a 35% depreciation relative to its 1914 value, compared to 64% for the French Franc and 71% for the Italian Lira. The German mark had lost 96% of its value and it was about to get much worse for them.
At the 1922 Genoa conference, the European powers hammered out a new monetary system for the post-war environment, setting in place plans to return to gold and calling for the establishment of central banks in countries where they did not exist.
In 1925 Britain, seeing the fiat system as intolerable, led the way and returned to the gold standard.
But they got the price horribly wrong.
Hoping to return to the pre-war classical gold standard they set the price at the pre-war level £4.86 per ounce. With the wartime money printing double the money supply not accounted for, this resulted in a significantly overvalued British Pound and undervalued gold. This made British exports very expensive.
The only way to make this work would have been to contract the money supply back to the pre-war level. But they did not, continuing with a policy of inflation and cheap money.
Rothbard argues that, aside from the issue of price, this was not a true gold standard anyway. Because of the mechanisms in how it was set up, it did not prevent money printing and inflation.
It is instead known as the gold exchange standard.
“In this way, for a few years Britain could have its cake and eat it too. It could enjoy the prestige of going back to gold, going back at a highly overvalued pound, and yet continue to pursue an inflationary, cheap-money policy instead of the opposite. It could inflate pounds and see other countries keep their sterling balances and inflate on top of them; it could induce other countries to go back to gold at overvalued currencies and to inflate their money supplies; and it could also try to prop up its flagging exports by using cheap credit to lend money to European nations so that they could purchase British goods.”
By 1926 39 countries had followed Britain onto the gold exchange standard and by 1928 that number was 43.
The USA had been inflating throughout the 1920s, the theory being that Britain’s new gold standard would be more workable if the USA had higher prices. This accelerated in 1927 and, along with artificially low interest rates, poured fuel on the fire that was the American stock market.
By the late 1920s, England was suffering from the effects of returning to gold at the pre-war price. With an overvalued pound and high wages due to unionism, British exports continued to suffer. With an outflow of gold from London, the British pleaded with the USA to keep inflating and they obliged.
Despite the best effort efforts of central banks to inflate, this undervalued gold exchange standard resulted in deflation and eventually in
a collapse of money and credit. It was a key cause of the Great Depression.
Jim Rickards argues:
“Gold did not cause the Great Depression; a politically calculated gold price, and incompetent discretionary monetary policy, did. For a functional gold standard, gold cannot be undervalued. When gold is undervalued, central bank money is overvalued, and the result is deflation.”
Or as Rothbard describes it:
“The international monetary framework of the 1920s collapsed in the storm of the Great Depression; or rather, it collapsed of its own inner contradictions in a depression which it had helped to bring about. For one of the most calamitous features of the depression was the international wave of banking failures; and the banks failed from the inflation and overexpansion which were the fruits of the managed international gold-exchange standard. Once the jerry-built pyramiding of bank credit had collapsed, it brought down the banking system of nation after nation; as inflation led to a piling up of currency claims abroad, the cashing in of the claims led to a well-founded suspicion of the solvency of other banks, and so the failures spread and intensified.”
The Fed tried its best to inflate its way out of the Great Depression but despite their best efforts the money supply actually fell. Americans began a run on the banks and foreigners, losing confidence in the dollar, withdrew gold. Fractional reserve banks could not meet the demands of their customers and failed in enormous numbers.
This triggered a death spiral. As Rothbard explains:
“The more that Hoover and the Fed tried to inflate, the more worried the market and the public became about the dollar, the more gold flowed out of the banks, and the more deposits were redeemed for cash.”
After experiencing bank runs, Austria and Germany went off the gold standard in 1931.
Britain too came under pressure in 1931 as those holding pounds demanded redemption in gold. Under the classical gold standard Britain could have tightened her monetary policy to restore confidence but instead after just 6 years Britain abandoned the new gold standard and inflated her currency further.
The pound fell by 30%.
25 countries followed Britain off the gold standard and onto floating exchange rates.
Incoming US President Franklin Roosevelt followed suit in 1933. He ended the official gold standard, confiscated gold from US citizens, put an embargo on the export of gold and devalued the dollar by raising the price of gold from $20.67 to $35 per ounce.
The US Dollar was still linked to gold, but since citizens could not convert their dollars to gold it was not a true gold standard. Instead it has been described by some as a quasi gold standard.
A big shift in the global monetary system then occurred during World War Two at the Bretton Woods conference. The 1930s had been a period of monetary nationalism and the USA sought to re-establish an international monetary system.
With Europe devastated by war, the Bretton Woods agreement saw the US Dollar replaced the British Pound as the supreme currency of the world. Foreign currencies were to be set at fixed exchange rates based on the dollar. This system would last until 1971.
The Bretton Woods system initially worked quite well as European currencies were inflated and overvalued. The US Dollar, still linked to gold, was, as Rothbard says, the “hardest currency” and the US had accumulated a vast quantity of gold that had fled Europe during the war.
Yet in the 1950s, as the USA continued her inflationary policies, several European countries became more conservative, in particular West Germany, France, Italy and Switzerland.
With the dollar still fixed to gold at $35 per ounce, the inflationary policy of the USA meant that US dollars were overvalued relative to gold. The Europeans, who held a lot of US Dollars were concerned.
As the dollar became more inflated and more overvalued, it’s role as the global reserve currency came into question as confidence in it collapsed.
Rather than hold dollars, these European countries would rather hold gold. Most notably France, under President Charles de Gaulle, and Switzerland were selling overvalued dollars and buying gold. This led to a worrying outflow of gold from the USA.
In response to this the USA could have raised the price they fixed their currency to gold, in other words devalued their currency. They could have restrained their inflationary policies and increased the soundness of the dollar.
Instead, on a Sunday evening in August 1971, President Richard Nixon famously “closed the gold window.” In practice this meant that foreign central banks were no longer able to convert US dollars into gold at the fixed price of $35 per ounce. This effectively ended the post-war monetary system and by 1973 the Bretton Woods system had completely collapsed.
The Fiat Currency Era
What followed the Bretton Woods system was a global monetary order of floating exchange rates with no link to a hard asset – fiat money.
Since most people were accustomed to using paper money and, since it was still paper money, it seemed the same as it was before.
But it wasn’t.
The US had moved from paper money backed and freely convertible to gold, to paper money backed but not freely convertible to gold, to paper money neither backed nor convertible into gold.
Paper money that is convertible to gold, however tenuous that link, is very different to paper money that exists by fiat or by decree.
This system that emerged in 1971 is still the system we live in today and exists entirely on fiat money and confidence in central banks.
Saifedean Ammous makes the point that the public’s acceptance of this money was only possible because the paper was originally redeemable in gold or silver:
“No fiat money has come into circulation solely through government fiat; they were all originally redeemable in gold or silver, or currencies that were redeemable in gold or silver. Only through redeemability into salable forms of money did government paper money gain its salability. Government may issue decrees mandating people use their paper for payments, but no government has imposed this salability on papers without these papers having first been redeemable in gold and silver.”
Although now the vast majority of money in the system does not exist on physical paper but is digital instead. Nevertheless the issue remains the same. The increase in quantity of fiat money is not restrained by any link to gold. The public accepts this digital fiat money only through its historic link to gold and the confidence that is currently given to central banks.
Since 1971 the US Dollar has continued to be inflated, as have all other fiat currencies, and the market price of gold is well above $35 per ounce. In fact, it is not that gold has risen in value, it is that dollars have fallen in value relative to gold.
Yet even though the world’s currencies have no formal link to gold, most of the world’s major central banks continue to hold gold as reserves. Even while they disparage it in public, they recognise its value. So in a way, there is still some form of gold backing.
Jim Rickards calls this the “shadow gold standard.”
The history of paper money entered a new era with the establishment of the Euro.
In 1991, the Maastricht Treaty was signed, an agreement between the 12 members of the, then, European Community. They agreed to form an economic and monetary union.
This would become the European Union, with the Euro adopted as the common currency. National currencies would be phased out.
In 1998 The European Central Bank was established and the Euro began its life in 1999 first as a bank currency, with notes and coins following in 2002.
While the European Central Bank does hold gold reserves, and these are in fact increasing, the Euro is a fiat currency.
Like the Federal Reserve and other central banks, the ECB engages in an inflationary policy.
However, what makes the Euro particularly interesting is the disciplining effect it has on national governments. Without their own central bank to print money and lower interest rates, politicians have to confront economic reality in a way that countries with national currencies do not.
While the European Union and Brussels bureaucrats are unpopular in Europe, the population is very supportive of the single currency. This is particularly the case in Southern Europe, whose populations remember the bad old days of the inflationary Greek Drachma, Italian Lira and Spanish Peseta.
Austrian economist Jesus Huerta de Soto has even gone so far as to argue that this restraining function on governments acts in a way that is similar to the gold standard, although obviously inferior.
However, while that may apply to national governments, the same restraint does not apply to the ECB, which has more than tripled the money supply over its short lifetime.
What Is Paper Money Backed By?
For most of paper money’s history it has represented and been convertible into hard money in the form of gold and silver.
In this sense paper money isn’t backed by the hard asset. Instead it is representative of the hard asset because it can be exchanged for it. It is what hard money economists and historians call a warehouse receipt.
However, when paper money is not convertible into a hard asset, we tend to talk about what it is “backed” by.
In many times in history paper money has been backed by gold and silver even if it has not been convertible. This is when governments and central banks have been restrained in the amount of money they can print based on the amount of hard money they have in their vaults.
However, this raises the question of why people would use paper money if it is not convertible into hard money.
The answer is that people have faith in governments and therefore are willing to accept government paper. In that sense we can say that paper money is “backed” by faith and confidence in governments and central banks.
How Did Paper Money Impact The World?
The impact of paper money on the world has been a predominantly negative development.
Its one key benefit is that it improves salability across space. That is, it is easier and more convenient to transfer value across space in the form of paper money than it is in the form of cumbersome heavy precious metal coinage.
This is the main reason that paper money was developed in China in the first place and why it continued in many parts of the world.
However, that advantage came with many downsides.
The critical downside is that paper money is very poor at holding its value over time. That is because new currency creation is very easy and every new unit of currency created dilutes the value of existing units.
Therefore, individuals who save in paper money see a loss of purchasing power over time.
Additionally, paper money confers huge power onto governments. Instead of raising revenue through the constrained mechanisms of taxation and borrowing, governments can raise revenue through money printing.
This enables them to spend beyond their means and pass the bill onto the population in the form of an inflation tax. Future generations pay for the current largesse by price rises in the future.
This has enabled governments to spend in a reckless manner while only consideration for the short term.
Ultimately this has resulted in capital destruction, a lower standard of living and negative social impacts than would otherwise have occured under a hard money standard.
So what does all this mean?
Well, what the history of paper money shows you is that its existence has been short lived, and that hard money has been the enduring and dominant medium of exchange in human societies.
In modern history, gold and silver have been the currency of choice, while paper money was only used in emergency situations, often induced by war and often with disastrous results. The paper money that worked the best was the paper money backed by gold.
As the printing presses churn, consumer prices rise. Hard-earned savings disappear. Rising prices often leads to calls for price controls, which then leads to shortages. The political consequences can sometimes get ugly.
The John Law experiment, the Assignats of Revolutionary France and the experience of America in the colonial, revolutionary and Civil War eras, demonstrates the short life of paper money.
That the global paper money experiment that we are living in now has lasted so long is a bit of an historical aberration. Most of the world has been off gold from the early to mid 1930s, with the USA finally severing the last tie to gold in the 1970s.
That is a long time.
Yet the continued existence of this monetary system depends on the wisdom of central bankers and the confidence the public has in them.
If they can maintain a degree of soundness in the fiat currencies and confidence in the institutions, then the system will continue.
If they make the wrong move and confidence is lost, then a change will be necessary.
Every paper money system that has come into existence has eventually perished. Ours will go the same way, although no one knows when. It might only have a short time left or it might have many decades.
When that day comes don’t worry. Civilization won’t collapse in a heap. Life will go on. The real economy will always survive, although it might be battered and bruised.
History shows that in the collapse of a paper money system, people flee to the safety of gold and silver. If the past is anything to go by, we will probably go back to a hard money system for a few generations.
Eventually though the lessons of history will be forgotten and a new generation will be seduced by the short term allure of paper money and the cycle will repeat itself all over again.
Ammous, Saifedean. The Bitcoin Standard : The Decentralized Alternative to Central Banking Hoboken, New Jersey: John Wiley & Sons, Inc, 2018.
Antipa, Pamfili M. “How Fiscal Policy Affects Prices: Britain’s First Experience with Paper Money.” The Journal of Economic History 76, no. 4 (November 17, 2016): 1044–77. https://doi.org/10.1017/s0022050716000978.
Huerta de Soto, Jesús. “In Defense of the Euro: An Austrian Perspective (with a Critique of the Errors of the ECB and the Interventionism of Brussels).” Journal Des Économistes et Des Études Humaines 19, no. 1 (January 3, 2013): 1–28. https://doi.org/10.1515/jeeh-2013-0012.
Kindleberger, Charles P. A Financial History of Western Europe. London: Allen & Unwin, 2006.
Kynaston, David. Till Time’s Last Sand : A History of the Bank of England 1694-2013. London: Bloomsbury, 2020.
Lui, Francis T. “Cagan’s Hypothesis and the First Nationwide Inflation of Paper Money in World History.” Journal of Political Economy 91, no. 6 (December 1983): 1067–74. https://doi.org/10.1086/261201.
Pickering, John. “The History of Paper Money in China.” Journal of the American Oriental Society 1, no. 2 (1844): 136–42. https://doi.org/10.2307/3217743.
Rickards, James. Death of Money. Portfolio Penguin, 2015.
———. The New Case for Gold. London: Penguin Business, 2019.
Rothbard, Murray N. A History of Money and Banking in the United States : The Colonial Era to World War II. Auburn, Ala.: Ludwig Von Mises Institute, 2005.
Spufford, Peter. Money and Its Use in Medieval Europe. Cambridge: Cambridge University Press, 1988.
Von Glahn, Richard. “Re-examining the Authenticity of Song Paper Money Specimens.” Journal of Song-Yuan Studies, no. 36 (2006): 79-106.
The Bank of England is in the public domain
Franklin Roosevelt is in the public domain