The U.S. and global economies have been flooded with massive, unprecedented amounts of liquidity. This is exactly what many economists have feared for years. Namely, that under pressure central banks would abandon all monetary discipline and simply print money to avoid a depression. It looks like they have done just that. And it isn’t just the United States that is guilty of running the money printing presses at full speed. European governments have approved a $5.3 trillion bank rescue package. This is more than the $3.3 trillion economy of Germany. And it is on top of the billions of euros pumped into the economy by the European central bank. China has also spent heavily on an economic stimulus package. It is working, but M2 in China grew at a 26% rate in April 2009 and 25.7% in May. Clearly the global economy is awash with liquidity. Now we will find out if all the fears about fiat or paper money are justified. We will discover if the fiat money system works or breaks down in a burst of unwanted, uncontrollable inflation.
During the great depression of the 1930s the United States and other developed countries were on the gold standard. The amount of paper money that could be printed depended on how much gold was in the treasury vaults. Studies in the 1960s and 1970s indicated that the countries that came out of the depression first and enjoyed the best recoveries were those that either abandoned or quickly modified the gold standard. Never-the-less the gold standard prevailed until world war two. After the war it was modified and replaced by what is called the Bretton Woods Agreement. That agreement established a regime for establishing exchange rates. The agreement introduced exchange rate flexibility but gold remained the principal backing for paper money. The 1960s became the stress test for the Bretton Woods Agreement and it failed.