For decades America dominated global economics, enjoying what seemed to be the boundless advantages of issuing the global reserve currency. While every other nation on Earth had to play by the fundamentals of foreign exchange, we were free to consume the world’s bounty without the need to supply in equal measure.
There is nothing mystical about foreign exchange. What a nation pays out in its currency must be replenished in kind, as must its reserves of foreign currencies. Trade may also be conducted using some commodity as the medium of exchange – gold, oil, or anything else that is mutually agreed upon.
Any currency other than that of the trading nations used as a medium of exchange must itself be considered a commodity. Problems will inevitably arise if such currency is fiat money, produced at will by the issuing country and not redeemable except for more of the same.
All US currency denominations are bearer debt instruments, of value only to the extent that faith exists that the debt will be honored. To illustrate, suppose a man universally know to be worth $10 billion were to issue an IOU for $1000. Such an IOU would be widely accepted, so he would likely receive the face value for goods in exchange. Even if he issued a similar IOU every day that would remain the case for several years.
If the billionaire’s wealth grew in proportion he could keep writing notes indefinitely. But if he used them for indiscriminate depreciable purchases the number of notes in circulation would grow to represent a sizeable portion of his wealth. In light of the aggregate debt they represent, people would begin to accept them only at a discount – and the value of every other note in circulation will fall as well.
Those who hold the billionaire’s notes would then begin to demand redemption at face value. At first that would pose little problem. But with each redemption his wealth diminishes, fueling ever greater concern over his ability to repay. Given time the billionaire may well have been able to honor his debt, but that is no longer of consequence.
In the rush to salvage what remains of the value of his notes, the billionaire’s wealth will rapidly diminish to the point that his notes become worthless. If he is fortunate his friends may help forestall the inevitable, but in the end he will be left impoverished. Those who had placed faith in him will have been harmed, but they will move on.
Clearly the warning signs appeared long before the billionaire’s fate had been sealed. Had he heeded the signs, the outcome may well have been averted. In hindsight he undoubtedly would have chosen to accept his losses before everything was lost.
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