Jake Towne analyzes why that piece of paper holds the power to purchase and why those pieces of paper purchase less as time goes on.
Open your wallet and take a look at the money you have inside. Hopefully you have some metallic coins and slips of paper (actually, its linen).
Take a closer look at the top. In large letters, it reads:
FEDERAL RESERVE NOTE
The Federal Reserve is the central bank of the United States. Although, it has the word ‘federal’ in the title, the Federal Reserve is a private bank — or company delegated the power (by Congress) to manipulate the money supply. It is no more federal than Federal Express — or Wal-Mart for that matter.
Far more curious is the use and definition of the financial term, ‘note’.
A ‘note’ is: a written promise to pay a specific sum of money on a certain date.
A ‘note’ is actually a form of debt — i.e. you are owed its worth by the Federal Reserve.
The linen also has text:
THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE
“Legal Tender” is a legalese that means: money that cannot be refused by law when you are paid or go to buy something.
But what is this note for debt actually worth?
A common fallacy is that the worth of the dollar is indirectly tied to the gold at Fort Knox. Dead wrong!
Another is that the dollar is tied to the nation’s GDP/GNP/purchasing-power parity. (There is some truth to this, as the dollar’s worth ‘floats’ or fluctuates with the exchange rates of other currencies like the Euro and Yen.)
But, what is a dollar actually worth?
Well, fortunately, the Federal Reserve is kind enough to tell us:
“If in [year], I bought goods or services for [$1.00] then in [year], the same goods or services would cost [$x.xx]”
Try the year 2008. How much was a dollar worth in 1913?
Holy smokes, just a nickel!
Well, perhaps, that was just because it was way before you were born.
Try ‘2008’ again. How much was a dollar worth in 2000?
Just $0.80 worth of goods and services? That kind of sucks. Eight years isn’t all that long for the value to drop by 20%! Something is a little fishy here.
- Imagine that $100 is the total worth of our economy.
- If we print an additional $100 the money supply will increase from $100 to $200.
- The price of everything doubles.
After reading Murray Rothbard’s [.pdf], one discovers that inflation is defined as: “any increase in the economy’s supply of money not consisting of an increase in the stock of the money metal.”
In other words, ‘inflation’ is NOT rising prices. Rising prices are merely the effect from increasing the money supply — printing more money.
However, the second part of Rothbard’s definition doesn’t really apply. There is no tie between the US dollar and a ‘money metal’. The Federal Reserve reports [.pdf]:
The government still holds millions of ounces of gold and silver, but citizens and foreign governments can no longer exchange their US paper money for it. The government’s gold and silver are considered valuable assets rather than forms of money. Today’s coins and paper money are backed by the “full faith and credit” of the US government.
If that makes you a little uneasy, try the following exercise: put a ten-dollar bill and a blank piece of paper on a tabletop, and ask people to choose between the two.
Chances are, everyone will choose the ten-dollar bill.
Why? After all, neither the ten-dollar bill nor the blank piece of paper is backed by gold or silver.
The difference is that people all over the United States will accept the ten-dollar bill as payment if you want to buy something. But you would have a hard time finding someone willing to accept the blank piece of paper. That’s because the ten-dollar bill is backed by the promise of the United States government, and to most people, that promise is as good as gold.
So, “full faith and credit” is the answer?
Faith is just the ‘belief’ that the government will pay you back, as the Fed excerpt hints. Faith, alone, in the value of the money is certainly not acceptable.
Credit is a different matter and the only reason why people would have faith in the first place is that they trust the government’s promise to back it up. As renowned economist, John Williams, testified to Congress on July 24, 2008 [.pdf]:
The relative value of a nation’s currency is a measure not only of its trade position, but also of global capital flows that mirror how the rest of the world views that nation’s economic strength, financial system integrity and political stability… Underlying fundamentals that drive the relative value of the US Dollar, against the currencies of its major trading partners, could not be much more negative.
In today’s monetary system, all currencies float against each other making a strong American dollar (USD) is very important.
A weak USD would enable other foreign countries to have a higher purchasing power and buy up American goods and assets cheaply — boosting our exports — and depressing our purchasing power, domestically.
Also, cheap imported goods from China and oil will become relatively more expensive for us — as we buy in USD — and other countries’ purchasing power will be stronger and it will be easier for them to outbid us for the goods….
(I need to pause here for a moment to describe just how important purchasing power really is. If you had $100,000 in 2000 and could buy ten cars, but $100,000 in 2010 can only buy one car, you have the same amount of dollars in ’00 as in ’10, but you have lost 90% of your purchasing power. So, please rid yourself of the preconception that your wealth is calculated by how many USD you have — and that your home is worth as much as you think it is. Real ‘monetary wealth’ has, and always will be determined, by your purchasing power — how much you can buy. Real ‘materialistic wealth’ is a combination of your ‘monetary wealth’ combined with all of your property and assets.)
Later in this series, we will delve into the above more. For now, just note that each parameter that influences the USD is fairly soft. There is nothing concrete that stipulates exactly how much a dollar is worth.
Still believe the Fed’s claim that the dollar is “good as gold”? Even if there is really no gold or other tangible backing?
Let me now introduce the US Dollar Index (USDX). The USDX is a weighted basket of six (6) freely floating currency exchange rates with the US dollar – the Euro, Yen, Swiss Franc, British Pound, Swedish Krona, and Canadian Dollar. The index was originally set to 100.00 when the index was started in 1973.
On January 14th, 2000, the Dow Jones hit a contemporary high of 11,723 with the USDX at about 105.
In October 2007, the Dow set its all-time high of 14,164 – in dollars, that is. The USDX was about 75.
If priced in USDX units, the Dow was only worth about 10,100 — 11,600 in ’00 USD.
1 Aug 08, the Dow was at 11,326 with the USDX at 73.36. Price the Dow at Aug ’08 in the USDX, and it lost 30% in less than nine years.
It is worth just 7,900 in 2000’s USD.
Most Americans have been robbed in this decade — the saver, the investor, the speculator, the one who chooses to eat — due to the loss of purchasing power in the USD. Anyone upset?
To succinctly answer the question posed: a dollar is worth whatever Americans and the international community believes it is worth — which is based on its scarcity. There is no hard way to calculate its true purchasing power.
Increasing the money supply (or inflation) is debasing the dollar at significant rates. A dollar bill’s intrinsic value is no higher than any other slip of paper. In fact, from the Fed’s comparison above, the blank piece of paper may be worth more.
It’s a commodity that can still be written on.
(The next article will review a basic question: what is money and its properties?)
Jake is also a contributor to Nolan Chart.