No, Fiat Has No "Real" Backing

A different take on currencies in general

The other day I had a talk with the CEO of an organisation that is doing, and has done, a lot of good work supporting Durban and South African born SMEs. As soon as I started talking about blockchain and crypto he became uneasy. He mentioned he was a believer in blockchain technology but hated the idea of cryptocurrencies because they aren’t backed by anything. In comparison, he suggested that if you go to the South African Reserve Bank (SARB) they’ll exchange your rands for gold. I didn’t stop him to dissect that statement because I didn’t want to take focus from the point of our entire talk, but that statement has been bugging me since.

For a while I’ve mentioned the importance of bitcoin and why bitcoin is better than fiat (a government issued currency). The idea of “no backing” is something I’ve tried to debate in many ways, so I did some digging to put together some basic facts to try explain it another way -  and I have a few thoughts.

I’ll tell you the conclusion now and go on to show you how I got here.

Conclusion:

1. All government issued currencies are backed by “nothing.”

2. Currencies in general are only backed by a community of believers

3. The value in cryptocurrencies like bitcoin vs traditional currencies, is that bitcoin is not native to any one country.

Lets dive in…

I’m trying to show that fiat currencies aren’t backed by anything. A currency is essentially an IOU by the issuing entity/country. With regards to fiat, the IOU is that you can redeem that rand note, or US dollar note from the South African Reserve Bank (SARB) or the Federal Reserve Bank (Fed) respectively. Lets say that citizens of a country wanted to withdraw and redeem their domestic savings for gold.

This first table shows the total US dollar value of Gross Domestic Savings (GDS)¹ by country, and then looks at that as a percentage of GDP.

This second table looks at the US dollar value of gold reserves² by country and compares that to GDS.

Using the United States as an example, if all US residents wanted to redeem the dollar value of all of their savings from the Fed, the Fed only has enough gold reserves to redeem 12% of domestic savings. Canada wouldn’t be able to redeem any Canadian dollars for gold, and South Africa has enough gold to redeem only 14% of domestic savings.

But that’s only if everyone stood in orderly queues at a commercial bank or the central bank and redemptions were on a first-come-first-served basis where once the gold reserves are depleted, people are “ok” with it and everyone goes back to their normal lives.

However, in reality it wouldn’t work that way. Initially people would be calm and patient with the process, but once word spreads that reserves are low, panic would set in and chaos would break out in the streets as people charge towards the bank doors. People would withdraw bank deposits in spades until the banks close their doors. The value of the domestic currency would fall relative to international currencies and the economy would plunge into disaster. We saw that in the Cyprus Bank Disaster which you can read about here and here, the Venezuela Bank Disaster, and Iceland’s financial crisis.

In each of those cases, residents lost a lot of money as banks and the domestic economies struggled.

In the rest of the world, and in financial markets, traders would try profit from the weakening currency and huge sell orders from traders would break the central bank and domestic currency, a la George Soros.

If you look at the value of total foreign exchange reserves³ for each country, the picture gets a little brighter for some countries, but still worrying in general.

Foreign exchange reserves include:

• Gold

• A specific currency (other than the domestic currency)

• Special drawing rights (for IMF members)

• Government bonds

• Corporate bonds

• Equities

• Foreign currency loans

Using Switzerland as an example, if citizens wanted to redeem their savings they would all be made whole, and then some. The United States would only be able to redeem 19% of GDS if all reserves were used and depleted.

But we shouldn’t forget that in the instance where all citizens want to redeem their Swiss Franc holdings, Switzerland has become a failed state. Same with the United States. The interpretation of this data is nuanced and the takeaway for me again is that the belief in a currency and the issuing country is the only thing really backing the currency in question. To attract that belief from users the issuing country will

• set business-friendly fiscal and monetary policy

• generally create an environment where people feel safe, meaning they

  • have access to gainful employment

  • can benefit from the enforcement of property rights (homes and other assets)

  • have protection from crime and violence through enforcement of law and through legal recourse

  • can exercise freedom of speech

  • can exercise freedom of exploration (entrepreneurship)

  • believe the country generally has a positive growth trajectory

Cryptocurrencies and ecosystems in crypto industries work in a similar manner.

For example if everyone wanted to redeem their bitcoin the price of bitcoin would fall drastically. We saw something similar with Terra which you can read about here.

The belief in bitcoin and other cryptocurrencies comes from the fact that

• bitcoin is not native to any one country

• bitcoin ensures safety for users because

  • the technology executes as initially deployed and cannot be altered in a malicious way - enforcing property rights

  • the technology by which bitcoin operates is transparent - enforcing property rights

  • people can explore and build value on top of the bitcoin network (gainful employment and entrepreneurship)

  • people can transact without fear of exclusion or coercion from powerful nations or other actors (exercise freedom of speech and exploration)

The points listed above are what form the basis of belief in bitcoin and other cryptocurrencies, making cryptocurrencies more valuable than fiat currencies. Practically fiat currencies are more valuable in the short term because adoption is high vs cryptocurrencies - but in the long term cryptocurrencies will play a much larger role in general society.

The crypto industry is more transparent and welcoming of people seeking growth. Additionally, the strongest cryptocurrencies (like bitcoin) don’t belong to any one entity or country, meaning no one operating in the bitcoin ecosystem has a monopoly on violence - unlike with fiat currencies and their issuing countries.

In addition to the characteristics of bitcoin listed above, an ideal backing for a currency would probably be if the reserves behind the currency are enough so that if all holders of that currency wanted to redeem the currency for another asset (that which is part of reserves) they would be able to do so. The worst outcome here would be the project (country/entity) fails. The best outcome is that every holder of the currency is able to exchange their currency for another asset, all reserves are depleted, but the project goes on - which is unlikely because if everyone chooses to redeem they are really saying they want nothing to do with the project and the project technically fails.

In conclusion:

1. All government issued currencies are backed by “nothing.”

2. Currencies in general are only backed by a community of believers

• Fiat currencies are backed by the faith in the issuing country

• Cryptocurrencies are backed by the faith in the technology

1. The value in cryptocurrencies like bitcoin vs traditional currencies, is that bitcoin is not native to any one country. For example;

• China and the US are the two largest exporters of goods and services in the world

• Every country in the world participates in international trade

• Every country in the world therefore needs to have US dollar and/or Chinese Yuan currency holdings

• Every other currency of every other country in the world is therefore exposed to/is affected by the value of the dollar or the yuan

• The US and China are the only countries who can distribute and recall dollars and yuan respectively

• Every country in the world can therefore be coerced by the US and China into doing whatever those two countries want

Crypto vs Fiat: Pick your player!

1. World Bank, Gross Domestic Savings: https://data.worldbank.org/indicator/NY.GDS.TOTL.ZS

2. World Bank, Total Reserves excl. Gold: https://data.worldbank.org/indicator/NY.GDP.MKTP.CD

3. World Bank, Total Reserves incl. Gold: https://data.worldbank.org/indicator/FI.RES.TOTL.CD?most_recent_value_desc=false