At first glance, this quote from Christine Bogdanowicz-Bindert on the impact of the debt crisis seems very apt. However, the above citation is far from recent. The words were uttered in 1985, when debt crises erupted in Latin America and Africa. Attentive readers may have noticed already that this quote has no bearing on the crisis that started in 2008. So Europe (in particular) has been muddling through for five years already, while the US has lost millions of jobs, instead of a million. That is to say, the present crisis is far worse. In addition, in the 1980s, the major countries (or blocs) – the US, Japan and Europe – could still extend a helping hand to the ‘small fry’, now they themselves are hit. And, unlike Mexico and the other troubled countries 30 years ago, they face a daunting obstacle: demographic ageing.

Fiat money fatally flawed?

Doom-mongers believe politicians will choose the easy way out and put pressure on central banks to crank up the printing presses. If so, inflation will rise, ie the size of the debt mountain will decrease in real terms. The inflation scaremongers often point to the weakness of the (international) monetary system, because it is based on fiat (soft) money. The pessimists think a monetary system based on fiat money will rarely, if ever, exist for long because hyperinflation is inevitable.

The first use of fiat money was chronicled as early as the 10^th Century AD when the Song Dynasty in China issued paper money that remained valid for three years. Subsequently, it could be converted into new money, at a cost of 3%. In the long run, too many notes were issued whereas not enough ‘old money’ was handed in. Inflation hit and the fiat money lost its appeal.

Source: Orcam Financial Group, LLC

Next, the Yuan Dynasty issued paper money on a large scale in the 13^th Century. Eventually, the regime printed far too many notes and hyperinflation reared its ugly head. Still, the Yuan money was used for quite a long time and only abolished in 1455 by the Ming Dynasty.

Horror and success stories

Fiat money made its entry into the western societies in the 17^th Century, first in Sweden and the Netherlands, and then later in America in the 18^th Century. The so-called Continentals, issued after the start of the American Revolutionary War (1775-1783), are a case in point for those who believe that fiat money is a nightmare. Owing to a lack of co-ordination between Congress and the individual states, not to mention sabotage by the British (who printed heaps of counterfeit money), within a few years the notes were one-fortieth of their nominal value.

Yet such horror stories are but one side of the coin. At the end of the 17^th Century in the Netherlands, the Amsterdam Wisselbank (AWB) created a successful fiat money regime that existed for over a century. It slowly bled to death and went under as a result of the Fourth Anglo-Dutch War in 1780.

In 1862, the US notes, also known as greenbacks, were introduced in order to fund the American Civil War. In its original form, the greenback was a fiat currency that was issued until 1971. The greenback hovered between ‘hard’ and ‘soft’ until fiat money became the norm. In other words, the idea that in all cases fiat money is doomed to an early failure should be taken with a grain of salt.

Hard money far from perfect

Meanwhile, hard money is also far from plain sailing. Several economists blame the gold standard for both World Wars. The (indirect) gold standard that was introduced after World War II was abolished in 1971, when US President Nixon decided that dollars could no longer be converted into gold.

So monetary systems built around fiat money may not be inherently stable, but gold standards can be fickle too. Whatever the nature of the money, rash political actions and/or waning investors and consumer confidence can prompt a disastrous spiral leading to hyperinflation, recessions and in the worst case, war.

So far, we have not seen such a spiral. However, anxiety is growing that the US, Europe and Japan will crank up the money presses and opt for competitive devaluations. It remains to be seen if holders of dollar debt will continue to believe in the US currency and the creditworthiness of the US government if the Federal Reserve conjures money out of thin air in order to reduce the debt. This is the same story for the Eurozone and Japan.

Source: Thomson Reuters Datastream/Fathom Consulting

Imagining the unimaginable

Presently, it is still almost inconceivable that the markets would lose all faith in US, European and Japanese government securities. But that does not mean it couldn’t happen. In 1961, Robert Mundell – one of the most respected and influential monetary economists the world has known – wrote that “it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favour of any other agreement.” Yet a few decades later the European leaders did precisely that when they decided to introduce the single currency.

So we should think twice before labelling certain developments as “impossible“. Take the run-up to World War I. In 1914, markets were convinced that war was out of the question because countries were interconnected economically and therefore mutually dependent. Panic only broke out after the first shots were fired.

Over the past Century, the international financial system has collapsed twice: in the 1930s and the 1970s. The first time, the outcome was catastrophic. The second time, no world war broke out but the rate of inflation soared until it was contained, around the end of the decade, by Federal Reserve chairman Paul Volcker.

Positivism will not last

Should politicians decide to drive up inflation in order to tackle the structural problems, and the markets hit the roof, this could result in a long period of high inflation that will eventually be brought under control. This is the more optimistic prognosis. At worst, political tensions will rise quickly as states try to steal a march on each other through devaluations, inflation policies and trade wars. If so, we can only hope that the calamities of the last century are still fresh in the collective memory – otherwise a doom scenario may well occur.

For the moment, the markets are giving the politicians the benefit of the doubt. The US, Japan and the ‘strong’ EMU countries are borrowing at record low interest rates, inflation is still low and there are no currency wars or large-scale protectionism. The Eurozone crisis has, momentarily, calmed down.

The general sense of optimism may persist for another while but eventually we expect mounting Eurozone tensions, a deepening political struggle in the US, more geopolitical unrest in Asia, and continuous instability in the Middle East. In addition, the major players in the global economy will continue to face gigantic fiscal problems that are more difficult to solve because of the impact of aging populations.

We should monitor closely what happens in Japan as Europe and the US may be forced to go down the same road. Japan’s national debt amounts to 230% of GDP; its population is ageing rapidly. Instead of tackling the problems, debts are stacked up to the heavens. It will be increasingly hard to pay these off, as the ratio between the number of workers and the number of retirees (who are living longer than ever) is in decline. Many fear that Prime Minister Shinzo Abe wants to pull Japan from the quicksand through higher inflation and a depreciation of the yen. But how far will he be prepared to go? Are Europe and the US doomed to follow suit? The answers to these questions will determine how the financial markets fare in the medium and long term.

Source: Thomson Reuters Datastream/Reuters graphic/Scott Barber, 13^th December 2012