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Fiat money

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Fiat money or fiat currency, usually paper money, is a type of currency whose only value is that a government made a fiat (i.e. decreed) that the money is a legal method of exchange. Unlike commodity money or representative money it is not based in another commodity such as gold or silver and is not covered by a special reserve. Fiat money holds its value so long as holders of the currency feel that they can find an exchange partner for it at some later time. Fiat money, by definition, does not have any intrinsic value, nor is it backed by anything other than the confidence holders have in the economy which is covered by the government which decrees it to have value. Its value lies solely in the expectation of later use. As of 2004, most currencies in the world are fiat monies. However, the situation with major currencies, such as the euro, the United States dollar and the Swiss franc is more complex.


Debate over the term

What exactly is a "fiat" currency is a matter of some debate, with a spectrum of opinion that runs from hard money advocates which declare that anything other than a one to one currency basis is "fiat money", to a range of economic theories which hold that market dynamics enforce fiscal discipline. In general, ultra-conservatives define fiat money stringently, and an opposition to fiat money is coupled with an opposition to fractional reserve banking and governments having a central bank. Advocates of "debt-free money" argue, in contrast, that money which requires the issuing of central bank debt is a burden on the public. In essence, just as there is a school of thought which opposes any money which is not linked to specific, countable, and measurable reserves, there is a school of thought which denies the value of any encumbrance on the government's ability to issue notes at all.

Historical summary

Historically, specie based money — generally gold and silver — was the unit of account that governments would accept as "legal tender", and was struck into coins which were the "circulating medium". That is, the government would accept it as payment, and would enforce others accepting gold and silver coin, usually at fixed rates. Notes backed directly by currency became used by private banks and holders of specie, which were used as "drafts" to move or lend money. This system of drafts has never completely disappeared, and there are today high tech equivalents of it that use fax machines in place of bank notes. However, such hard currencies were frequently in short supply, leading to alternate currencies based on a promise to pay, such as "notes of credit", "bank notes" or stock in companies. Such money becomes fiat money when the central government backs, or requires others to back, such notes as legal tender without the promise to redeem in specie. Examples include stock in government monopolies and military scrip issued to soldiers. The general term "paper money" was used to cover such fiat money during the 18th and early 19th century, and its tendency to inflate led to hardened political opposition to any use of paper, even if backed by promise to pay, because such promises were easy to break, and hard to hold accountable.

In the 18th century, there was an increasing demand for international trade, which made monetary standards based on more than one kind of specie less and less stable, as individuals would take advantage of government determined exchange rates to buy silver where it was cheap, and then redeem 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 their 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. The word "dollar" comes from the name "Thaler" for a silver coin from the mines near the town of that name in Bohemia. These mines were the first significant discovery of silver in Europe since antiquity.

The first historical example of 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 (10th through 13th centuries), 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 both easy to counterfeit, and communication was slow, the Song experiment with paper money collapsed, as individuals preferred doing business through bank drafts, or checks, which were backed with gold.

Governments would often produce notes which were fiat currency, with the promise to allow holders to pay taxes in those notes, in effect, assuring at least one future trading partner for the note. These notes were also referred to as "debt" based money, and included the issuance of notes in the British colonies in America, particularly in Virginia and Massachusetts. Such debt based 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, even this more restricted form of fiat money was prone to inflationary or deflationary cycles, as those entities which could tax in specie would do so, leaving the debt based money to be devalued as its expiration grew nearer.

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 US Congress before the constitution, paper versus gold ducats in Napoleonic era Vienna, where paper often traded at 100:1 against gold, and South Sea Bubble of John Law which produced bank notes not backed by sufficient reserves. The abuse of paper money issued by banks led most industrialized nations to either outlaw private currency, or strictly regulate its printing, such as the United States National Banking Act of 1862.

Each cycle of inflation and panic would leave citizens vowing never to allow inflation again, until the next round of bone-crushing deflation caused business failure and squeezed borrowers who had to pay back in much harder money than they had borrowed. 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 and to allow reserves to drop from one-to-one to the expected rate of redemption of gold — repeatedly hobbled economic stability.

It was World War I which was the collision between specie currency and fiat money. By this point most nations had a legalized government monopoly on legal tender, and in theory governments promised to redeem notes in gold or silver on demand. However, the costs of the war and the massive expansion afterward made every currency effectively fiat money, since there was no reason for a government not to print as much money as it felt it could back with some fraction of its reserves. 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 hard money with a new kind of currency: asset-based money. This money combined aspects of fiat currency, in that there was limited convertibility, fractional reserve banking and a unit of account set by the government, with commodity based money, in that there were limits to the amount of money that could be put into circulation. However, many nations failed to create appropriate legal checks and balances, and they continued to suffer inflationary booms and deflationary busts as a result. One recent example was the Argentine bust which followed the unravelling of the "currency board". Instead of being linked to gold, the peso was linked to the dollar, which served as the hard money basis. When economic crisis hit, dollar reserves fled the country, causing the monetary basis to collapse.

Credit-based monetary systems

The asset-based money of the 1930's did not last long in practice by itself and was linked to a gold reserve system by the Bretton Woods Agreement. The value of the United States dollar was pegged to 1/35 troy ounces (888.671 milligrams) of gold (the "gold standard") and other currencies were pegged to the U.S. dollar. The US 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.

(See the main article on the Bretton Woods system)

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, whereby states that attempt to inflate their currency suffer a corresponding drop in international buying power, and an internal feedback mechanism, whereby 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 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.

Critiques of credit money expansion

Both Marxist economics and green economists view the evolution from fiat-centric to credit-centric regimes as fundamental to global capitalism, as direct imperialism and colonialism is replaced by more local intermediaries, and relations between rich and poor are defined more by debt.

Some groups (such as the anti-globalization movement or advocates of communism) characterize the shift as shallow and insincere. They argue that imperial or colonial powers (such as the United States or United Kingdom) retain full control of the military power, especially naval power critical to control of commodity trade, and delegate only local enforcement to their former colonies (now their "allies"). They also argue that the credit regime is biased very heavily towards nation-states avowing capitalism, accepting policy from the International Monetary Fund, clearing their currencies via the Bank for International Settlements (BIS), and belonging to the World Trade Organization. These, they argue, simply extend the existing military fiat and its unfair advantages from colonialism, such as setting commodity prices artificially low.

Neo-classical economists respond that no nation is required to belong to any of these organizations, and that states such as Cuba and North Korea retain a strict military fiat and retain their own absolute control of currency, especially hard currency easily traded for goods on the Western markets. They point to the difficult economic position of these nations as evidence of the futility of maintaining fiat money regimes in a world run by mutual credit capitalism. To which critics respond that position has been amplified by isolation, sanctions and boycott, and these nations have suffered collateral damage due to their affiliation with the Soviet Union during the Cold War. This argument, however, is quite unconvincing to classical economists, who reply in turn that isolated economies are practicing not only fiat banking, but also protectionism — practices which protect incompetent local competitors from competent global competitors.

The relation of fiat money, usury, debt interest , and commodity money is complex and must usually be established in a political economy as a whole. Competing national economies and their relative advantages and stabilities are reflected on global currency markets. There are moves to make the BIS employ credit ratings for nation-states to render them equivalent to corporations or landowners for the purpose of required reserves. This would "hardwire the credit culture" in the words of Andrew Crocket, former head of the Bank. It would also render it difficult or impossible to truly distinguish fiat money from credit money, as both would then rely on the hegemony of global capitalism and the nation-states that practice it. In effect, all hard currency would rise and fall based on the agreements behind the BIS itself.

Last updated: 10-23-2005 18:53:20
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