Dedicated to Deposits: Deals, Data, and Discussion

Fiat Money – What Is It, What Is It Good For, and Does It Pose Any Risks?


The following is a continuation of yesterday’s post, The Basics of Money, from economics professor, Art Carden, examining some of the basic theory, development, and history of money and what lessons can be learned (or repeatedly forgotten) by looking through the longer-term lens of monetary history.

Fiat Money – What Is It, What Is It Good For, and Does It Pose Any Risks?

Take a dollar out of your wallet. What does that dollar say? What does it represent? You’ll notice a few phrases on the front of that dollar: "Federal Reserve Note" and "This Note is Legal tender for All Debts Public and Private." The dollars in your wallet and the dollars in your bank account are examples of fiat money. What is fiat money, and where did it come from? In what follows, we’ll discuss what fiat money is, why a lot of people think it is a good idea, where it comes from, and some of its drawbacks.

What Is Fiat Money?

Fiat money differs from what people have traditionally used as money because it isn’t backed by anything. It is money because the government says it is. People will accept it in exchange for real goods and services, and you can use it to pay taxes. Historically, people have used commodities (or claims to commodities) as money, but since the US closed the gold window in 1971, we have been on a fiat money system.

Where Did It Come From?

How did we make the transition? Understanding the transition requires that we first review what money is. Money serves as a medium of exchange, which in turn allows it to serve as a store of value, a unit of account, and a standard of deferred payment. Money emerged because it solves the problem of the mutual coincidence of wants. This basically means that barter is hard: if you’re going to barter with someone, you will only do so if he or she has something you want and if he or she wants what you have. A butcher who wants bread will need to find a baker who wants meat. If most of the bakers are vegetarians, he may have to do without—or he might have to consume a lot of time and energy looking for a baker who isn’t a vegetarian. This would be pretty costly.

Commodity Money, Commodity Standards, and the Transition to Fiat Money

Fortunately, the butcher has an alternative: he can get his hands on something the baker wants. This is how money emerged: people started to demand widely-demanded goods not simply because they are useful as such, but also because they are widely demanded. Some of these widely-demanded goods have emerged as money, and historically, people have used commodities like silver and gold because of their purity, their uniformity, their malleability, and their other desirable characteristics.

Using precious metals as money has drawbacks. First, precious metals are cumbersome. Hauling around bags of gold and silver might require you to clear space in your carriage that could otherwise be occupied by goods you want to sell, feed your horses a little more than you otherwise would so that they can handle the additional weight, or take other steps that divert you from your core business. Second, a lot of merchants roaming the highways and byways with carriages full of gold and silver are attractive targets for bandits. Third, gold and silver coins can get pretty banged up in transit, and if you’re dealing with potentially-unscrupulous merchants or governments, you have to beware of the temptation to debase the coins by mixing the precious metals with less-valuable alloys or by shaving and clipping gold and silver off the edges of the coins (incidentally, people started minting coins with milled edges in order to reduce this temptation).

Where there is a problem, there is an opportunity, and eventually people came up with ways to address these problems. Instead of hauling bullion or coins, people started putting their money on deposit with bankers who would then issue a claim certificate for the money. Instead of carrying bullion or coins, people could now simply carry these claim certificates, or bank notes, and use them as money substitutes. These certificates were circulating in place of gold and silver, but they still represented claims on actual gold and silver.

Commodity money is costly to mine, mint, and maintain. Getting gold and silver out of the ground, purifying it, coining it, and certifying their weight and purity is harder than simply creating an entry in a computer or printing new pieces of paper.

In textbook treatments, commodity standards have other widely-cited drawbacks. Commodity money is costly to mine, mint, and maintain. Getting gold and silver out of the ground, purifying it, coining it, and certifying their weight and purity is harder than simply creating an entry in a computer or printing new pieces of paper. The resources needed to store and guard gold and silver are also among the costs of commodity standards. Most importantly, gold and silver sitting in a bank vault is gold and silver that is not available for industrial uses. When we store gold and silver coins in a bank vault, we have to forego the silver electrodes, silver-zinc batteries, silverware, jewelry, silver-coated engine bearings, cell phone components, connectors, and fillings that could otherwise be produced with the gold and silver.

Hence, some people argue, fiat money saves resources. Some people have also argued that the gold standard limits the government’s ability to conduct monetary policy and helped deepen and prolong the Great Depression (we will take that up in another article). Finally, since people weren’t trading with physical gold and silver but were instead trading paper bank notes and making entries in banks’ accounts, what was the point of warehousing so much gold and silver? Why not simply divorce the currency from the gold and silver—or, as economists like Murray Rothbard might put it, why not divorce the currency from the money?

Fiat Money Drawbacks

Why not, indeed? In 1989, New York University Press published a book titled Competition and Currency: Essays on Free Banking and Money by the economist Lawrence H. White. Professor White has written extensively on how the invisible hand handles money; in fact, he spoke at Rhodes College (my former employer) in 2009 (here is a link to video of his talk, and here is an article a student and I wrote based on his talk). Competition and Currency collects some of Professor White’s articles on the functioning of a competitive, free-market banking system that would include a competitive, free market in money. Throughout, he discusses the evolution of different kinds of money, including modern fiat money.

White claims that presumably, a government could create a fiat money system by allowing people to keep their gold and silver but then giving them fiat money in proportion to these holdings. Historically, however, fiat money "has come about by permanent suspension of redeemability of the central bank’s liabilities, enriching only the government" (p. 61). Fiat money emerged when the government suspended convertibility into gold and silver, and permanently; White calls this "a breach of contract that only a government or government-sheltered agency can commit with impunity" (p. 57). More specifically, he writes (p. 181):

The transition from a specie-based competitive banking system to a fiat-currency-based system is most readily made in two steps: government creation of a central bank, whose specie-redeemable liabilities displace specie as a commercial bank reserve asset; and suspension of redeemability for central bank liabilities. The supply of banking services may continue to be competitive, but the nominal quantity of money is now scaled to the central bank’s determination of the monetary base.
As White and others argue, fiat money brings its own set of problems that may be worse than the resource costs and policy constraints of a competitive system of note issue.

A fiat money system managed by a government monopoly is something many people, including many economists, take for granted. We shouldn’t. As White and others argue, fiat money brings its own set of problems that may be worse than the resource costs and policy constraints of a competitive system of note issue. Specifically, it is easier to pursue inflationary policies with fiat money, and as it has been said, "inflation is the cruelest tax" because it is harder to see than more direct forms of taxation. Whether we need a monetary authority like the Federal Reserve to manage the money supply remains an open question, and as George Selgin, William Lastrapes, and Lawrence White argued in a 2010 study, we should be exploring alternatives to central banks and fiat money.

Money serves important functions and has a fascinating history. The money we use today differs from the money people used just a few decades ago in that while money in the middle of the twentieth century was tied to gold in some fashion, the money we have used since closing the gold window in 1971 has been backed by absolutely nothing.



Comments
19 Comments.
Comment #1 by paoli2 posted on
paoli2
Very interesting and concerning article especially the ending line, "he money we have used since closing the gold window in 1971 has been backed by absolutely nothing."
Sooo, we are stressing ourselves over trying to find higher paying CDs for "play" money.  Sad but so true nowadays.   Thanks for taking the time to share. 

7
Comment #2 by Anonymous posted on
Anonymous
Inflation:
$1.00 the year of the Federal Reserve Act of 1913.
$23.95 in 2014.

4
Comment #3 by Anonymous posted on
Anonymous
Fiat money is backed by the full faith and credit of the issuing nation, nothing more, nothing less. To say is it is backed by absolutely nothing is simply untrue. Trust, though seemingly ephemeral, is absolutely essential in a modern world economy.       

6
Comment #4 by paoli2 posted on
paoli2
#3  I think you are misunderstanding the point the writer is trying to make.  I think he is trying to show the difference between when it was actually backed by gold and now it is, as you wrote, only backed by our "trust" in our nation.  That's like going into the store and owing the owner $200.00 for merchandise and asking him to just "trust" you for it.  I don't think you would leave that store with any merchandise.  It's only because society "has" to pretend the money is real that we all get to still use our Monopoly money to purchase items with.

4
Comment #5 by Anonymous posted on
Anonymous
"full faith and credit of the issuing nation" ?  Basically equals "0" when it comes to the U.S.  We are trillions of dollars in debt, beyond the point of any meaningful resolution other than eventual bankruptcy.  And we used to laugh at other nations and their fiat money. 

1
Comment #10 by Anonymous posted on
Anonymous
Millions of investors, bond holders and financiers disagree with you each and every day. And, they do so with their money.

3
Comment #13 by Anonymous posted on
Anonymous
It doesn't mean they are right and I am wrong.  Time will tell and I don't believe we will have to wait too many years.

1
Comment #19 by QED posted on
QED
Have to disagree with you.  The USA would be in fantasmagorically great shape if we were at "0" as you state.  It would be wonderful!!

In reality the USA is so far under water that no bathyscaphe extant could reach us.  The unborn great-grandchildren of today's Americans are hopelessly in debt.  The "full faith and credit" of America is a sick joke, just like the leaders of this failed, but once great, enterprise.  We're in a deep hole . . . . and digging furiously!!  

4
Comment #9 by Anonymous posted on
Anonymous
What does "full faith and credit" mean?

1) That someone is guaranteed to receive a dollar bill to replace one that is lost?  2) That the federal reserve note is guaranteed to lose its buying power over time as a result of the US central bank's intentional fomentation of inflation?

According to actual text of the Federal Reserve Act of 1913, each note is an obligation of the central bank (ie: the Federal Reserve) redeemable in so-called "lawful" money. But, if it is redeemable in lawful money, then the notes, per se, are NOT lawful money, or at least were not considered to be that at the time of the writing.

In fact, Art. 1, Sec. 10 of the US Constitution is quite clear. It states that no state shall "...make anything but gold and silver coin a tender in payment of debt". The Federal Reserve Note, therefore, is NOT a dollar, but is merely a temporary corruption of requirements set down by the Founding Fathers.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            %2

3
Comment #11 by Anonymous posted on
Anonymous
Full faith and credit means as a nation we pay our debt obligations. In an age of digital currency (most of your savings is simply represented in binary on one or more machines) trust is more important than ever.  

4
Comment #12 by Anonymous posted on
Anonymous
There is no "Trust" when referring to politicians and our countries government.  Why is it I can not even redeem my silver certificates for silver bullion from the Federal Reserve never mind the fiat paper money they have been printing for years.? 

3
Comment #14 by Anonymous posted on
Anonymous
Because the law regarding silver certificate redemption was changed. You can convert your dollars into gold or silver anytime you wish...at current market prices.

3
Comment #15 by Anonymous posted on
Anonymous
Yes, on the open market, not at the Federal Reserve.  You just proved my point.  Our own federal government can not be trusted.  Those in power changed the law after they issued the silver certificatesAnd to make maters worse, their printing press opened the flood gates of nothing but fiat money backed by empty promises.

2
Comment #20 by Anonymous posted on
Anonymous
Well, they sure couldn't change the law before they issued silver certificates. Policies change, some for better some not. I'm shocked so many constantly see the sky falling while they live and breathe in the finest country the planet has ever known.

1
Comment #6 by Anonymous posted on
Anonymous
I think it is obvious that the US dollar, along with the Euro, yen, British pound and most other fiat currencies are now in a race to the bottom. The ECB just agreed to print up to 1 trillion Euros in one fell swoop. It did so by ending the sterilization program that previously worked alongside the LTRO liquidity project. Now, they have a negative interest rate and the money is being made part of the M3 money supply. Meanwhile, the Bank of Japan is continuing on its plan to print trillions of yen, China looks likely to print yuan, and the USA will start up heavy printing activity, yet again, the moment its economy takes a significant downturn. Gold might be inconvenient to carry around, but it is the only game in town if you want an easily liquidated form of value storage.  Land is also good, but not easily turned into cash.

4
Comment #16 by Anonymous posted on
Anonymous

3
Comment #17 by Anonymous posted on
Anonymous
What makes gold so valuable? Because someone says it is valuable? Can't eat gold, can't live in gold. The only thing that is valuable in life is to have enough food, heat, a place to live and the most important thing is health and family. 

3
Comment #18 by Anonymous posted on
Anonymous
Right.  But if you cannot provide those basic necessities on your own, you must buy them from somebody.  Thus, you need something of value for trade.

2