Today, American money is fiat money. But for many decades the United States had representative money. In 1879, the United States joined many other nations on the gold standard. The price of gold was set at $20.67 per ounce and the federal government pledged to exchange dollars for gold at that rate. In fact, printed on every American bill was the phrase: “Redeemable in gold on demand at the United States Treasury.”
But during the Great Depression, with Americans hoarding gold and commodity prices falling, causing a worsening of the economic contraction, President Franklin Roosevelt urged Congress to take the United States off of the gold standard. The idea was to get more money circulating through the economy by pursuing a deliberate policy of moderate inflation. Private ownership of large quantities of gold was prohibited, and the government no longer exchanged dollars for gold. The value of the dollar was still linked to a certain amount of the precious metal, but since it was now pegged at $35 per ounce, inflation occurred and prices rose as Roosevelt hoped.
After World War II, the United States government pledged to redeem American dollars held by foreign central banks in gold (still at the rate of $35 per ounce) in order to unite and stabilize the world economy. But in 1971, with America’s trade deficit growing and gold reserves rapidly depleting, President Richard Nixon suspended the redemption of American dollars for gold, fully severing the United States from the gold standard.
Ever since, the U.S. dollar has not been representative money. You can use it to buy gold at whatever today's market price is, but you can't redeem it for a fixed amount of gold. The dollar is now fiat money; its value comes from a credible government saying it's money, and from millions of people accepting that it is, in fact, money and can be used as such. So it really is just paper and ink... but paper and ink that we all agree is a little bit more special than other printed matter. Trying to buy your groceries with yesterday's newspaper isn't likely to get you very far.
Why It Matters Today
The trouble with fiat money is that it's only as good as the government that issues it. If the government acts responsibly -- and more importantly, if people around the world believe the government acts responsibly -- then there's no reason why the money shouldn't hold its value.
But if people lose faith in the government issuing the money, then the money itself can quickly lose its value.
During the Great Depression, the government of Germany had debts it could not pay and tried to pay them simply by printing more money that wasn't really backed by anything. People lost faith in both the government and the money. The result was hyperinflation -- a dollar today might only be worth a dime tomorrow -- and ultimately the collapse of the German state and its replacement with Hitler's Nazi regime.
So what's that got to do with us?
Maybe nothing. But the U.S. government is currently running very high deficits, and many economists and investors are beginning to sound the alarm about future inflation dangers. Hyperinflation like that which hit Weimar Germany almost certainly isn't in our future, but even regular old non-hyper inflation could cause severe economic distress.
Sometimes, a Song Says it Better: Silas Stingy, by The Who
The Who chats about a man who won’t be parted from his money.