What are the effects of turning a backed currency into a fiat currency?

I hear a lot of debate over the removal of the U.S. Dollar's precious metal backing and the subsequent inflation rates, but is there any proven relationship between unbacked currency and extreme inflation or is fractional reserve banking by individual corporations more to blame?

In short, what are the real effects of the removal of precious metal backing from the U.S. money supply?

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A policy of low inflation. –  JoeHobbit Oct 16 '11 at 4:23

...or is fractional reserve banking by individual corporations more to blame?

The majority of money created in the US (and indeed, the world) is created by private banks through fractional reserve lending, not by central banks creating fiat money.

Monetary base refers to money that banks hold in their accounts at the federal reserve as well as currency in circulation -- in other words the money that the government has the most control over.

M2 is a measure of money that includes bank lending. Although the ratio of M2:BASE has fallen in the last few years, M2 is still clearly far bigger than BASE.

Now back to the first part of your question:

is there any proven relationship between unbacked currency and extreme inflation

Depends what you mean. Unbacked currency doesn't lead to runaway inflation in all cases. Look at all of the major currencies today: slow and steady inflation for most of the last 100 years.

In a few cases, unbacked currency has been involved in runaway inflation. Typically runaway inflation is not strictly a monetary phenomenon, but also involves political factors. (See Zimbabwe). I wouldn't call this "proven", however.

There are also some instances of hard monies experiencing dramatic inflation throughout history. European monarchs accomplished this by debasing pure gold and pure silver coins with cheaper metal alloys. The US had a number of financial panics related to rapid increase and then collapse of money supply even when on a supposed "gold standard", e.g. the Panic of 1819.

The Panic of 1819 is a controversial topic. Although it does indicate short comings of a "gold standard", it is essential to remember that the government was still manipulating the money supply even in 1819, and therefore the gold-backed money was still not a free market money.

I'm not aware of any cases in history where a commodity money or commodity-backed money experienced hyperinflation on the scale of Zimbabwe.

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I would enjoy looking at the graph of M2 and BASE around the transition years from Gold to fiat. –  JoeHobbit Oct 16 '11 at 4:25
Cowrie shells were a commodity-based currency but experienced massive inflation when Europeans introduced vast numbers from previously unexploited sources into the African economy: historyworld.net/wrldhis/PlainTextHistories.asp?historyid=ab14. Maybe not quite on the scale of Zimbabwe, but still what I would call hyperinflation. –  Mike Scott Feb 6 '12 at 7:38
@MikeScott That's a great point. That reminds me I read once that salt has been used as a commodity currency, apparently in time before the world realized how common NaCl actually is. I can't find a great reference, but here's a decent one: mygeologypage.ucdavis.edu/cowen/~gel115/salt.html. I'll have to take back my statement "I'm not aware of any cases…" Commodity currencies can inflate quite significantly. –  mehaase Feb 6 '12 at 18:22
This was rather confusing to me "the government was still manipulating the money supply even in 1819, and therefore the gold-backed money was still not a free market money" The U.S. government hadn't existed for many years at that time. Had there ever been a time when the U.S. government didn't manipulate the money supply? This manipulation pre-dated the founding of the Federal Reserve by a century, AND the U.S. was on the gold standard, yet you say the dollar even then was not a "free market money"? –  Ellie Kesselman Mar 20 '12 at 11:48
@FeralOink In the years leading up to 1819, money was mainly issued by private banks. Each bank issued its own notes, and the notes were ostensibly backed by hard metals (specie). There was no Fed, but there was The Second Bank Of The United States, chartered in 1816. The Second Bank created its own notes as well, and by backing private banks it increased the money supply by about 40% between 1816 and 1818. The speculative bubble popped in 1819 and many states allowed private banks to not redeem in specie--a state intervention that defies the free market principles of liquidating bad debts. –  mehaase Mar 22 '12 at 3:43

The quantity identity says

money times velocity equals prices times real gdp.

Fixing velocity, inflation is the difference between changes in money and changes in gdp. (to see it take logarithms).

Now we need theory. Take simple monetarism.
I'd argue: with gold-backed dollars changes in money (M) are fixed to gold discoveries. Once you switch to fiat currency central bankers can choose any M they want.

So, a priori, the change is neutral. If central bankers choose M to be lower than it would be with gold, fiat-currency would be deflationary. If central bankers choose higher M, it would be inflationary.

It is the choice of M that matters for inflation, rather than the backing.
You can argue that Phillips curve targeting made central bankers choose very high M in the past, resulting in inflation.
But M is such a critical variable for the economy that you can argue pretty much what you want, as long as you have a theory to back it.

Overall I'd say that fiat money gave a new important tool to whoever control the money supply to affect the economy. I'd also say that the benefits far outweigh the costs.

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Agreed, the complexity of the modern economy is such that there is no real way for monetary policy to be always perfect. But the original question had to do with hyperinflation and I'd say that Central Banker's independent control of M seems to have solved that problem for the moment. –  Turukawa Oct 11 '11 at 21:31
The downside of this theory is that in reality V is not constant. Not even close. Notice that during the 2008 recession, V dropped off very quickly, offsetting the Fed's attempts at money supply growth. research.stlouisfed.org/fred2/series/M2V?cid=32242 –  mehaase Oct 12 '11 at 4:34
Monetarism is but a theory, and a discredited one at best. But keep this in mind: velocity is measured indirectly. That is, it is measured just by taking PQ/M. As such registered "changes in velocity" might just be due to lags in the three other variables to adjust to one another. –  CarrKnight Oct 12 '11 at 11:59

In 1945 at Bretton Woods, the war-time allies agreed on an international gold standard to stabilise the world's economy. Gold was fixed at \$35 / ounce and all other currencies were pegged to that price via the US dollar. The US became the reserve currency of the world. The problems for the US began immediately. In order to ensure liquidity – an availability of US dollars that other nations could use for exchange between each other – they had to run a massive deficit. And, while the currencies had to maintain their pegged rates, gold was freely traded. To ensure that continued price of \$35 / ounce was extremely expensive and, ultimately, futile.

The dollar became extremely overvalued while, despite their now equal importance to the world's economy, Japan and Europe found their currencies undervalued. In 1971 Richard Nixon unilaterally delinked the US dollar from gold and allowed it to float.

Gold, freed from its constraints, began to run. In 1971 gold was \$44/ounce, in 1972 it was \$70/ounce and – by 1980 – it was \\$641/ounce.

Fractional reserve is not a problem as far as inflation is concerned. Governments print money via their Central Banks. Independent Central Banks are less likely to go on printing sprees ("quantitative easing" aside) and so accountable democracies are unlikely to suffer from hyperinflation. Private banks are constrained by law in terms of the reserves they must hold in order to lend. After the recent economic crisis, these laws are likely to tighten up.

Hyperinflation tends to start as deliberate government policies to pay debts through debasing the currency rather than through economic growth.

The real effects of the US dropping the gold standard was the longest and greatest period of economic growth in world history.

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The last line seems to be at best a subjective opinion and at worst an example of the post hoc ergo propter hoc fallacy. –  Michael McGowan Oct 11 '11 at 20:34
Agreed Michael. It's just as easy to reverse the perspective and instead of saying "gold was free to run" saying "the dollar was free to drop" - a gallon of gas still costs 20 cents in 90% silver dimes, for example. The value of things relative to precious metals hasn't actually changed much, but the price of everything in dollars sure seems to be changing. –  David Perry Oct 11 '11 at 20:42
While I agree to an extent with the conclusion, I also agree with Michael that the argument supporting it is not quite there. –  Matthew Read Oct 11 '11 at 20:43
I think the "gold bug" argument is just rather tired, I suppose. It's one of those debates that - like evolution or climate change - is just never going to satisfy the doubters. Gold is just another commodity. It doesn't have any super powers to prevent inflation or create some mythical objective value system. –  Turukawa Oct 11 '11 at 21:29
Keep in mind that we actually came off the gold standard in the 30's (not the 70s!) when FDR confiscated privately held gold and outlawed private gold ownership. US banks were no longer required to redeem notes in specie after that. The only change in the 70s was that the US eliminated redemption in specie to foreign banks as well. –  mehaase Oct 12 '11 at 4:36

Rolnick and Weber of the Minneapolis Federal Reserve research department have a paper where they examine inflation during the classical gold standard and after the gold standard ended. They found that average inflation during the classical gold standard was somewhere between -.5 and 1% per annum. Average inflation after the end of the gold standard is 7.5-8.5% even when removing all cases of hyperinflation. That is a pretty significant upward bias in inflation rates during the era of central banking.

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