Fiat money

In economics, fiat currency or fiat money is money that has value primarily because a government demands it in payment of taxes, and that government has credible enforcement of its demand.

The taxing government's choice of the form or origin of money it accepts may be somewhat arbitrary, but the unifying feature of all fiat money is that whatever form or origin, the market demand for it is dominated by the taxing government's demand for it in payment of taxes. For example, a coin may be considered fiat currency if its face value -- the value it has in payment of taxes -- is higher than its market value as metal. The term “fiat” money has been used to distinguish such money from representative money, which is pegged or fixed to a quantity or mass of precious metal. While representative money is often associated with a legal requirement that the bank of issue pay in fixed weights of a given precious metal or (in theory) fixed amount of any other precious good, fiat money's value is fixed only to its value in transactions controlled by government authority, such as taxation.

Fiat money is a subset of general credit money, but a special one in which a government, often through a central bank or reserve bank has taken the responsibility (monetary authority) of being the major creditor backing the currency. An economy may function on credit money which is not fiat money, such as United States paper currency during periods when the U.S. did not have a central bank, or the banknotes of the Scottish clearing banks, which function in Scotland as currency, even though not backed by the government of Scotland. Usually, a fiat-money currency loses value once the government which acts as the creditor, refuses to further guarantee its value through taxation, but a strong private banking system and consensus of the population may prevent this. For example, the so-called Swiss dinar continued to retain value as a type of credit money in Kurdish Iraq, as a result of backing by private banks and acceptance from individuals there, even after its fiat-money status was officially completely withdrawn by the backing government (the central government of Iraq).

History

The first historical example of paper as fiat money was in China. Chinese governments would produce “notes of credit” which were valued as tender for limited periods of time, in order to prevent inflation. The Song Dynasty (960–1279), however, created unlimited legal tender paper money, good throughout their empire, as a way of centralizing financial control, and preventing external trade. This money, however, was only as stable as the mandarinate that enforced it, and only as safe as the rigidity and integrity of the people who created it. Since it was easy to counterfeit and communication was slow, the Song experiment with paper money collapsed, as individuals preferred doing business through bank drafts or cheques, which were backed with gold or silver.

19th century

In the 19th century, increasing international trade made monetary standards based on more than one kind of specie gradually less stable, as individuals could engage in arbitrage, buying silver where it was cheap, and then redeeming it for gold where it was overvalued. This led to the gradual adoption of the gold standard among industrialized nations. While exact dates are often hard to fix, Britain’s adoption of the gold sovereign in 1816 began its move to a gold standard, and 1844 is generally dated as the establishment of the practical gold standard in the United Kingdom. Previously, silver had been the standard against which gold was measured, because Europe had had an influx of silver from mines in Germany and silver looted from the Inca and Aztec empires and because silver had been more readily available than gold in Europe during the Middle Ages.

An early form of fiat currency were "bills of credit." Provincial governments produced notes which were fiat currency, with the promise to allow holders to pay taxes in those notes. The notes were issued to pay current obligations and could be called by levying taxes at a later time. Since the notes were denominated in the local unit of account, they were circulated from man to man in non-tax transactions. These types of notes were issued in the British colonies in America, particularly in Pennsylvania, Virginia and Massachusetts. Such money was sold at a discount of silver, which the government would then spend, and would expire at a fixed point in time later. However, this restricted form of fiat money was prone to inflationary or deflationary cycles, as those entities which could tax in specie would do so, devaluing the notes as their expiration grew nearer.

Colonial powers consciously introduced fiat currencies backed by taxes, e.g hut taxes or poll taxes, to mobilise economic resources in their new possessions, at least as a transitional arrangement.

The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to specie backed money. Examples include the “Continental” issued by the U.S. Congress before the constitution; paper versus gold ducats in Napoleonic era Vienna, where paper often traded at 100:1 against gold; the South Sea Bubble, which produced bank notes not backed by sufficient reserves; and the Mississippi Company scheme of John Law. The abuse of paper money led most industrialized nations to either outlaw private currency, or strictly regulate its printing, such as the United States National Bank Act of 1863.

Each cycle of inflation and panic would leave citizens vowing never to allow inflation again, until the next round of severe deflation caused business failure and hurt borrowers who had to pay back in much harder money than they had borrowed, with a good example being the abolition of the “Bank of the United States” by Andrew Jackson, where he declared paper money backed by the government “unconstitutional”. The two temptations to create inflationary currencies repeatedly hobbled economic stability.

20th century

World War I set the stage for a collision between specie currency and fiat money. By this point most nations had a legalized government monopoly on bank notes and the legal tender status thereof. In theory, governments still promised to redeem notes in specie on demand. However, the costs of the war and the massive expansion afterward made governments suspend redemption in specie. Since there was no direct penalty for doing so, governments were not responsible for the economic consequences of “running the printing presses”, and the 20th century found itself facing a new economic terror: hyperinflation.

The economic crisis led to attempts to reassert currency stability by anchoring it to wholesale gold bullion rather than making it payable in specie. This money combined pure fiat currency, in that the currency was limited to central bank notes and token coins that were current only by government fiat, with a form of convertibility, via gold bullion exchange, or via exchange into US dollars which were convertible into gold bullion, under the Bretton Woods system.

Bretton Woods

After World War II, the Bretton Woods system was set up, which pegged the value of the United States dollar to 1/35th of a troy ounce (888.671 milligrams) of gold (the “gold standard”) and other currencies to the U.S. dollar. The U.S. promised to redeem dollars in gold to other central banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fund. This system collapsed when the United States government ended the convertibility of the US dollar for gold in 1971.

Credit-based monetary systems, where feedback mechanisms prevent Fiat money

Global capitalism, wherein a currency is widely traded as a commodity in itself, is more likely to rely on credit money which can reflect both (commodity) supplies and protections of supplies (by states’ military fiats). It is not held stable by any one state but rather by tension between states, as investment migrates from currency to currency in an open “money market”. As long as there is an international feedback mechanism, such that states attempting to inflate their currency suffer a corresponding drop in international buying power, and an internal feedback mechanism, so that the government is liable for economic failures that stem from fiscal or monetary irresponsibility, the money system does not take on the characteristics of a fiat money system. However, to proponents of hard money such mechanisms are not to be trusted, and all money not directly based on specie redeemable on demand is “fiat money”. This means that today all the currencies are fiat money, because none is based on specie redeemable on demand (generally gold).

The regime of asset-based money, or credit-based money — in which banks create currency as intermediaries and governments, in turn, back the banking system — produces a different series of problems. In no small part because it is not immediately easy to differentiate sound currencies from unsound ones, and it is possible to convert credit-based money into fiat money by a legal act or regulation. The question of confidence dominates credit-based money, the confidence that a particular central bank or government will not act in a manner contrary to its national interest by allowing the money supply to rise or fall too much. Part of the system of confidence includes holding of reserves to be able to support a currency if attacked, and the issuing of debt to regulate the supply of currency.

The importance of fiat money as a concept

Main article: Real bills doctrine

Fiat money is typically backed by the good faith of the government maintaining or backing the money supply, importantly faith that it will accept the fiat currency in payment of taxes. Hence, the credibility of the government's policy would, in theory, impact the decisions of consumers and producers in a market economy. Under this assumption, economic actors might make decisions they would otherwise not make for fear that the currency or money that they hold will change in value radically. Managing this risk could produce economic distortions: when people convert money to other forms, increasing the demand for goods to be hoarded. Economic actors might also shelter income in other, more stable currencies or charge higher interest rates.

Under a fiat money system, money ceases to be a commodity like others, and begins to have special and peculiar properties. Instead of focusing on production, investment and consumption, economic actors begin to attempt to divine the actions of government. Since actors can have foreknowledge of government actions in a way they cannot have of a market, this could lead to efforts to bribe, control or curry favor with the entities holding fiat power.

Fiat money is also closely tied to government borrowing for expenditures that do not have a clear social return, or which may have negative expectations, such as wars of conquest. Governments could pay for wars using fiat money, rather than in hard currency or specie, on the belief that the returns of war will be sufficient to pay promised notes, and that during wartime shortage and austerity, goods are not available in any case. This has seldom proven to be the case in the absence of strong inflationary controls. Instead, the usual cycle is for the value of fiat notes to trade at a significant discount to portable and stable forms of exchange, specifically those that will be tender regardless of the winning side in the conflict. A variation on this was the use of fiat occupation currency to place the burden on other areas.

Fiat money is also associated with attempts to control trade: If individuals possess notes which are not redeemable outside of the control of a government, the idea is that they will have to purchase preferentially within the boundaries of the nation, rather than importing; see Protectionism. It was David Hume who first argued that this merely leads to inflation by the quantity theory of money, even if the money is backed by specie.

Another aspect of fiat money is its relation to property rights. Many economists argue that since a government that has control over its territory can requisition, confiscate or otherwise ban the use of specie within its boundaries, or suspend promise payments — as has often happened in the past — the presence of fiat manipulation of money is seen as being a signal that a government is intent on abrogating property rights for other purposes.

The opposing view is that governments do not immediately intend to confiscate or ban the use of specie within its boundaries, nor reduce the property rights of its citizens. Instead, a government may be oblivious to the root cause of hyperinflation (excessive increase in the money supply). Worse still, a government may be aware of the cause, but choose to ignore the problem as it is not one that will come to light in its current political term.

Some political economists argue that there is no such thing as fiat money, that governments can create fiat currency, but that the amount of money is determined by the valuation of the market place, and that attempts to create fiat currency beyond the demand for money generate inflation. In the words of Keynes, “Money doesn’t matter,” meaning that control of the money supply beyond limited boundaries will be adjusted for in the marketplace; see IS/LM model.

The idea that there is no such thing as fiat money is also consistent with the real bills doctrine. In this view, all paper and credit money is backed by the assets of the entity that issued it — usually by the gold and bonds of the central bank or the tax collecting ability of the government that issued it. Since all modern central banks do in fact maintain assets as collateral against the money they issue, one has to ask why these assets are universally held if, as quantity theorists claim, they are irrelevant to the value of the central bank’s money.

Convertibility

The real bills doctrine says that economists have wrongly claimed that because a money is inconvertible, it must be unbacked. Most of the confusion centers around two meanings of convertibility:

Physical convertibility

Units of currency can be presented to the issuing bank in exchange for a physical amount of gold, silver, or some other commodity.

Financial convertibility

Units of currency can be returned to the issuing bank in exchange for that unit's worth of the bank’s assets.

Template:Totally-disputed-section The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold — for example, when the Christmas shopping season has ended. If the local currency unit is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted currency units to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper units. For example, if the community has $100 of unwanted paper money, and if people intend to redeem the unwanted $100 for silver at the bank, the bank could simply sell $100 worth of bonds or other assets in exchange for $100 of its own paper dollars. This will soak up the unwanted paper and head off peoples’ desire to redeem the $100 for silver. [The symbol $ is used here as a generic currency unit].

Thus, by conducting this type of open market operation — selling bonds when there is excess currency and buying bonds when there is too little — the bank can maintain the value of the dollar at one ounce of silver without ever redeeming any paper dollars for silver. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued. Thus, it is an illusion that any physically inconvertible currency is necessarily also unbacked.

However, the financial assets obtained from such transactions only have derivative value from their yield of fiat currency, or from yet other financial assets. Therefore the integrity of the financial system requires that there be a different ultimate form of backing, such as the acceptability of the fiat currency in payment of tax.

See also

• Central Bank
• Chartalism
• Digital gold currency
• European Central Bank; Federal Reserve
• Fractional-reserve banking
• Full-reserve banking
• Gold standard; Silver standard
• Money illusion
• Private currency
• Public debt
• Tinkerbell effect
• Value Theory
• Veil of money