Debt vs. Equity

If you were to hand someone on the street a $1 bill and ask them if it had value, they’d probably laugh and wonder why you were asking such a silly question. It’s a dollar, of course it has value! But why? Where does that value come from, and what is it based on?

The Gold Standard

To answer that question requires a bit of a history lesson. Prior to 1933, the United States Dollar was backed by gold. This meant that $20.67 could be exchanged at any point in time for one ounce of gold. The government could only print more money if it had the gold in reserve to back it up, so that if everyone decided that they would rather have the gold, there would be enough to sell to everyone who was holding US currency at the same rate. This was called the gold standard. One dollar was an IOU for the equivalent amount in gold. In essence, the gold was a collateralized asset for the dollar. The dollar itself had the guaranteed value of the gold stored in reserve to back it. This meant that the dollar was technically debt-based, but since it was easily redeemable and was fully backed, there was no risk associated.

The End of the Golden Age

So why did we get rid of the gold standard? Who thought that was a good idea? Well, during the Great Depression, deflation, otherwise known as a scarcity of currency, caused people to hoard their money. Why spend it, when in a few months it could buy more? While more and more value was being added to the economy through business, invention and workforce growth, there was less cash to go around. This meant that prices continued to drop, and hanging on to your money was a smart idea, since it would buy more in a few weeks or months. Interest rates skyrocketed, since banks also wanted to hold their money instead of lending it. This made it difficult for people to afford loans, and people stopped stimulating the economy through spending. This in turn meant that companies began to downsize, stock prices dropped, people lost their jobs, and money was more scarce than ever. The Great Depression was in full effect, and quickly spiraling out of control. That is, until President Franklin Roosevelt stepped in with an idea. What if the dollar wasn’t tied to gold any more? The Federal Reserve could print more of it, and stimulate the economy towards spending again. This is exactly what happened, and most economists agree that it was the primary reason for the end of the Great Depression.

It’s important to note that up until 1971, foreign entities were still able to exchange dollars for gold from the Federal Reserve, but that practice was ended under President Richard Nixon to prevent foreign powers from draining the Federal Reserve of its gold supplies.

So What’s the Dollar Based on Now?

Now that the gold standard has been abolished, how does the dollar hold it’s value? What’s it based on?

I’ll give you a hint: it’s based on debt. In the next article in this series, I’ll explain exactly how that all works, and why the system is so flawed, but until then, share this article with your friends, and let me know what you think in the comment section!