In Japanese, the word “kamikaze” means divine wind. It originally referred to the typhoons that repelled the invading fleets of Kublai Kahn, the Mongol founder of the Yuan dynasty in 13th century China.
Kublai Kahn financed his wars with fiat money — paper money assigned a value by government decree (fiat). Fiat money has no intrinsic value; rather, its status as legal tender relies solely on the confidence market participants have in the issuing government. The Mongols were quite persuasive on this point: refusing to honor their paper money was punishable by death.
The first widely circulated paper money was issued in China around 960 AD, during the Song dynasty. Five hundred years later, hyperinflation put an end to both paper money and the Yuan dynasty. China, of course, also pioneered the printing process, thus enabling this unhappy tale.
Our own reliance on fiat money began only in 1973, with the collapse of the Bretton Woods system that followed World War II. Before that, most of the world’s currencies were fixed to the US dollar, which in turn was backed by gold.
The early years of fiat money were characterized by soaring inflation in developed countries, and even hyperinflation in some emerging economies. Happily, since the beginning of the 1990s, inflation has been held in check around the globe. But we should remember that we only have a few decades of experience with paper money, compared with China’s five centuries of fiat money.
Governments find paper money awfully convenient. It has a face value as legal tender but since it has no intrinsic value. Governments are free to create as much as they want, or dare. The Republic of Zimbabwe has been testing the limits of this freedom in recent years. With an inflation rate of 13 billion percent per month at the end of 2008, which means prices double every 15.6 hours, new and ever bigger bank notes are printed regularly in a hyperinflationary spiral of historic and, on a human level, tragic dimensions.
Given the inherently inflationary nature of paper money – more can always be printed - it may seem odd that markets and the media currently obsess about deflation, a fearsome spiral of steadily declining prices that chokes off economic growth. Aren’t governments around the world doing everything they can to revive their slumbering economies? Interest rates are near zero in the US, Japan and Switzerland, and at their lowest level in the UK since the Bank of England was founded in 1694. Government deficits on both sides of the Atlantic are reaching levels never before seen in peace time. The printing presses are primed and ready, too.
But the bizarre experience of Japan in the 1990s should remind us that, even when the printing presses are running, deflation can still prevail.
Why? Paper money is built on the psychological factor of confidence. Inflation and deflation reflect another psychological factor, namely, our expectations for the future. And these can sometimes become self-fulfilling.
In the 1990s, Japan never managed to convince market participants that it was serious about combating deflation. Its policies stuttered, one year focusing on fiscal stimulus, the next on fiscal discipline. Such an erratic course did a poor job of managing expectations, at home and abroad.
The Japanese experience explains why the US government, among others, is responding so vigorously, and visibly, to the financial crisis. They want the world to know that they are not asleep at the wheel. Between the lines of every statement, the message is, “You can be confident in our actions.” We wish them every success, with the important proviso that we fervently hope they will not overshoot and print themselves into a sea of trouble. Remember, it’s only paper.
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