Bear Stearns, fiat money, and regulation

So, what's the cause of this mess? Essentially, it is that large parts of the fiat currency mechanism were allowed to elude government control.

First of all, a definition. Fiat currency is currency which has no intrinsic value. The U.S. dollar has value only because the U.S. government accepts it in payment of debt and taxes and issues it in payment of its own debts, and the rest of the world agrees that it has value. Otherwise it's just green toilet paper with pictures of dead Presidents on it.

What happened with the Bear Stearns case was that some chickens came home to roost. Bear Stearns created money via its function as an investment bank. All banks create money when they lend, this is called the fractional reserve multiplier effect. A dollar lent out by a bank gets deposited in another bank, which then lends out a fraction of that dollar to someone else, and it all goes 'round and 'round until the last fraction is lent out by some bank way down the line. The problem is that investment banks like Bear Stearns were not regulated. Thus large parts of the fiat currency creation mechanism were allowed to elude government control. The problem is that fiat currency, by definition, only "works" because it is tightly controlled by the government. When private businesses are allowed to create fiat currency by basically turning on the printing presses, which is what Bear-Stearns was fundamentally doing via issuing all these bogus "mortgage-backed securities", the whole scam collapses. And when the scam collapses, all the fiat currency produced by the scam evaporates into thin air -- causing deflation, which is good for very rich people, but bad, very bad, for poor and middle class people whose debts suddenly became much more expensive and unpayable (thus allowing the rich to take possession of their homes and properties for pennies on the dollar). Which is why Bear Stearns could not be allowed to collapse.

In short, what is necessary for a stable fiat currency is tight regulation of all mechanisms for creating money. You can either have a tightly government-controlled fiat currency with all parties capable of producing fiat currency tightly controlled by the government (and remember, any entity which accepts deposits and issues loans is basically producing fiat currency due to the "fractional reserve multiplier effect", see Econ 101), or you can have the sort of alternating inflationary/deflationary spirals that typified the U.S. economy prior to the 1940's. Or you can abolish fiat currency altogether, but it's just so darned useful in a modern economy to have some sort of government-backed currency whose supply rises with economic production so that prices stay relatively stable or at least predictable. Without predictability it is difficult to make long-term investment plans, and it's impossible to predict the production of gold and silver if you want to go back to a hard-metal standard, not to mention that multiplier effects still exist there anyhow so you just change a few details of the problem, you don't eliminate it. So fiat money, as much as folks like to carp about it, is here to stay. Given that, the necessity of putting all entities capable of producing fiat money under tight government control is a necessity. Allowing just any ole' bloke to turn on the printing presses at will simply doesn't work!

- Badtux the Economics Penguin