Why would you take a piece of paper that says $20 on it in exchange for goods and/or services? Answer; because you have confidence that the paper can be traded for goods and services that you want when you next pull out that piece of paper. You have faith in that paper because you have faith in the government that issued it. But that faith can vanish overnight...like Venezuela or many others before that.
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Doing “whatever it takes” to save the global economy from the coronavirus pandemic is going to cost a lot of money. The U.S. government alone is spending a few trillion dollars, and the Federal Reserve is creating another few trillion dollars to keep the financial system from collapsing. A custom Bloomberg index measuring M2 figures for 12 major economies including the U.S., China, euro zone and Japan shows their aggregate money supply had already more than doubled to $80 trillion from before the 2008-2009 financial crisis.
These numbers are so large that they no longer have any meaning; they are simply abstractions. It’s been some time since people thought about the concept of money and its purpose. The broad idea is that money has value, but that value is not arbitrary. Former Fed Chairman Paul Volcker once said in an interview that “it is a governmental responsibility to maintain the value of the currency they issue. And when they fail to do that, it is something that undermines an essential trust in government.”
The dollar has no real intrinsic value, backed only by the full faith and credit of the U.S. government. Under a fiat currency system, the government says that a dollar is a dollar. Its value relative to things such as other currencies and gold is determined on global markets. Gold is considered to be an objective store of value, and the metal’s rise in dollar terms can be expressed another way, which is that the dollar fell in gold terms. That implies the market has rendered a decision on the value, or rather, the purchasing power of the dollar.
The three main functions of a currency are as a unit of account, a medium of exchange and a store of value. It is that last function that is most important. Ideally, a central bank would want its currency to retain its value over time. The era of flexible monetary standards, however, allow central banks to manipulate a currency’s value to help fight recessions as well as smooth out and lengthen business cycles at the expense of inflation. But even low inflation, say on the order of 2%, will greatly erode the purchasing power of a currency over time.
And if there are too many dollars in circulation, the monetarists would say that the value of those dollars has diminished, eventually leading to higher prices for things. That theory hasn’t worked too well in the last decade, because inflation has been low and stable, but it is too soon to declare it discredited. The transmission mechanism that results in inflation is not well understood, even 45 years after the last great period of inflation.
It took a while, but it seems as though the U.S. government has decided that it has no constraints on its spending, as long as the Fed continues to monetize government borrowing by purchasing the debt issued to finance expenditures. It’s not crazy to think government spending may reach $10 trillion – for just one year! And the numbers will go up from there.
Nobody really knows how this is going to turn out. In smaller economies, runaway government spending has resulted in hyperinflation and social unrest, such as well-documented cases in Venezuela and Zimbabwe. Many think that wouldn’t be possible in the U.S. given the dollar’s role as the world’s primary reserve currency. Perhaps, but it’s not one of those questions we’d really want to experiment with.
https://finance.yahoo.com/news/money-losing-meaning-100023306.html
