Inconvertible Paper Standard

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An inconvertible paper standard is a monetary standard based on paper money, either bank notes or government currency that cannot be converted into any commodity or precious metal at an official rate. Inconvertible paper money is called fiat money and it bears a face value that may or may not be expressed in metallic terms.

The inconvertible paper standard evolved directly from precious metal standards. Originally paper money circulated as something resembling warehouse receipts representing titles to ownership of gold or silver safely secured with a goldsmith or bank. Exchanging titles of ownership was less risky and costly than physically transporting precious metals. From those warehouse receipts evolved bank notes, ancestors to the contemporary Federal Reserve Notes and other bank notes of modern central banks.

War and other national emergencies often forced governments to put heavy claims on domestic gold and silver reserves, and in turn governments granted banks the privilege to suspend convertibility of bank notes into precious metal. England suspended convertibility during the Napoleonic Wars and the United States suspended convertibility during the War of 1812 and the Civil War. Suspended convertibility was invariably attended with some currency depreciation, but often the patriotic fervor of war helped maintain some monetary order. Government assurances of return to convertibility at war’s end also helped protect currency values from a wave of inflation.

Two famous cases of paper money fiascoes occurred toward the end of the eighteenth century, the hyperinflations of the American and French Revolutions. France had already had one paper money disaster early in the eighteenth century with the episode of John Law’s bank. The memory of these episodes acted as a constant reminder of the monetary insanity lurking beneath the surface of an inconvertible paper money standard, and encouraged governments to accept inconvertibility only as a temporary measure.

Between 1866 and 1881 Italy apparently made good use of inconvertible paper money to assist in the financing of economic development. The episode was called Il Corso Forzoso, or “forced currency,” and it was accompanied by a modest depreciation of the lira of 10 to 16 percent. Nevertheless a new government felt the need to promise a return to convertibility, which was accomplished in 1881.

By the beginning of World War I the world was on a gold standard. Countries banned the export of gold, suspending convertibility for international trade, and the right of domestic convertibility was rarely exercised. At the end of the war returning to an international gold standard became an important goal of the world’s major trading partners.

The world was on a gold standard in the early 1930s when worldwide depression shook the foundations of the international monetary system. It was during this era that inconvertible paper standards became virtually universal among the world’s major trading partners. These countries went on inconvertible paper standards for domestic purposes but remained on a gold bullion standard for international purposes. In the United States private citizens could no longer convert dollars into gold, and private ownership of gold for anything but industrial purposes was illegal. The United States and other countries continued to redeem domestic currency into gold at the request of foreign central banks. After 1971 the world’s major trading partners went on inconvertible paper standards for international as well as domestic purposes, severing the last ties with convertibility.