We mentioned a concept called 'fiat currency' before. Fiat currency serves as a medium of exchange where the medium itself either has no intrinsic value, or cannot be redeemed for a commonly exchanged backing (such as gold or silver). The United States (and much of the world) has shifted from specie (money that's backed up by the promise of an exchange for gold, silver, copper or some other commodity stored by the government) to fiat currencies.

The earliest use of fiat currency on record is the 11th century Song Dynasty, which offered paper notes backed by silk reserves. About three years after its institution, regulations requiring that only a percentage of taxes could be paid with such notes, by ten years, the number of notes in circulation vastly exceeded the amount of reserves available to back them with, and the value of the notes plummeted.

Similar experiences with credit notes drawn on governments were instrumental in the Colonial period of the New World, with the Carolinas and New England experiencing runaway inflation, and the Middle Atlantic colonies avoiding it for the most part. These experiences with runaway inflation were important fixtures in the minds of many of the Framers of the Constitution, and were one of the chief hindrances of the Federalists as they tried to expand the power of the Federal Government. Thomas Jefferson and Andrew Jackson were both hard currency absolutists. In spite of the financial chaos it would inflict on the country, Andrew Jackson allowed the Bank of the United States to fail, largely because he wanted to keep the power to shift to fiat money out of the hands of Congress.

Experiments with fiat money have always ended in an inflationary spiral, but it takes several countries using fiat money to create a hyperinflationary situation. Where 'normal' inflation is measured in percentage points per year, and usually reported as single digit percentage points in a year, hyperinflation is reported as double digits (and sometimes triple digits) in a shorter period of time, like weeks and months.

The US narrowly avoided hyperinflation during the 1970s, after Nixon went off of the gold standard in 1971, and the subsequent devaluation of the US Dollar, followed by strong inflationary pressures during the Ford and Carter administrations. However, history has shown several bouts of hyperinflation since the Great Depression, first with the WiemarRepublic, where, to save money, Reichsmark notes were printed on a single side, and you can still find stamps that have been overprinted to add zeroes to the mount.

Hungary in the 1950s, Brazil in the 1970s, and countless countries in Africa have experienced hyperinflation; the principle cause of hyperinflation is government debts. When a government borrows money, it has to make commitments to paying it back, just like you do when you borrow money on a credit card. As the debt levels rise, those commitments take up an increasing fraction of the US budget. When money is backed up by specie (gold and silver) there is a finite amount of debt that the government can take out, much like there's a credit limit on your card. When the portion of the budget that must be spent on financial services becomes the majority of the discretionary budget that's available, history has shown that hyperinflation is the next step.

The government usually has two choices – to repudiate its debts, or to devalue the currency in a mad frenzy to pay off the debts in devalued dollars. They effectively amount to the same thing – the government will not be paying back the debt to the same value of what was borrowed.

Hyperinflation leads to common effects: When paychecks come in, they get spent immediately, before the next currency devaluation strikes and prices rise again. This leads to a breakdown of the fundamental element of trust in the underpinnings of the economy, that a fair day's work will give a fair day's wage, and can lead to the economy seizing up.

This economic seizure can be seen as a market correction writ large, with no easy fixes. It can be liked to a hyperinflationary Great Depression.

This is one article of a five part series on the economy. Please use the links below to view the other economic articles in this series.

• Economic Recession
  
• Inflation
  
• The Depression

 © 2009 Robert Lee, all rights reserved