Fiat currency

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In economics, fiat currency or fiat money is money that enjoys legal tender status derived from a declaratory fiat or an authoritative order of the government. It is often associated with paper money because, without government fiat, bank notes are not a legal tender in payment of debt, and only specie is unlimited legal tender for money debts. However this is not universally true, as some currencies, (notably sterling issued by Scottish banks), are not legal tender but are accepted by longstanding confidence.

A bank of issue whose notes enjoy legal tender status by government fiat can use its own notes, making their redemption in specie optional — a matter of the 'monetary policy' of the bank in question. Historically, the institution of fiat currency has preceded and enabled the demonetisation of specie, via a monetary policy decision not to offer payment in specie at par, e.g. by suspension, devaluation or redemption in bullion or foreign currency instead. Eventually this leads to no form of payment, redemption or exchange whatsoever being offered by the issuer and a system of irredeemable freely floating national currencies.

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[edit] Debate over the term

The term “fiat” currency is also used specifically to refer to a currency that is not pegged or fixed to a mass of precious metal, and similarly the term “gold standard” is used to refer to fiat currency with a gold bullion exchange system, or to a parallel gold coin/fiat currency with a law that requires the fiat currency bank of issue to pay in gold coin.

[edit] Value of paper money

The inherent value of paper money is zero, except when it is measured against the value of consumables the bearer can exchange for each unit of currency in his or her possession. Additionally; paper money has an intangible value that is directly related to the condition of need of its bearer. While a one hundred dollar currency may be inconsequential to a person with little material need, the same may be the governing factor with regard to homelessness, health, and even life for another with lesser means, hence, priceless. Simply put, paper money is valued at the maximum amount of consumable goods for which it can be traded, either directly or indirectly.

[edit] Historical summary

Historically, the names of the individual coins and the names of the unit of account were identical, e.g. a shilling was both a type of coin and a unit of account. The law would therefore recognise tender of those coins as legal satisfaction for debts denominated in that unit of account. Different-mass coins of the same metal could explicitly be recognised as being legally valued at fixed multiples of each other in their names (e.g. in the case of the crown and half-crown) or simply by reference to their legal masses (e.g. the legal mass of a florin is twice that of a shilling). A government could legislate for the minting of a system of metallic currency, including the fineness of the metal and the legal and original masses of the coins, without legislating for legal tender or legal values of the coins themselves — they can be discovered or implied by the ratios of legal masses of fine metal in each species of coin.

Coins of different metals naturally resist incorporation into a common unit of account, and therefore of a common legal tender value system. Governments have historically attempted to fix the legal values of different metallic coins to create a unified unit of account and standard of legal tender for payments large and small. Two mechanisms have been used in this connection: multi-metalism and token coinage. The former took the form of bimetallism, where both gold and silver coins were given legal values in terms of each other. e.g. gold coin was legally valued by nominal mass at 15 times silver coin. As market forces changed the actual value of gold in relation to silver, one coin would become overvalued in reference to the other. For example, suppose there were two coins, a shilling being 6 grams of fine silver, and a sovereign being 8 grams of fine gold. If the unit of account were the shilling, then the legal value of a sovereign would be 20 shillings, and a debtor could discharge a debt of 100 shillings with five sovereign coins or 100 shilling coins, at his option. Debtors will nearly always choose the cheapest way to discharge their debts, and this results in the constant threat of demonetisation of a legally over-valued metal. Token coinage adopts the coins of the higher value metal as the monetary standard, and limits the lower value metal coins to fractional currency. This is done by deliberately over-valuing the legal tender value of the lower value metal coins and limiting the total amount for which they can be legal tender in any one payment. For example in 1816 the English silver currency was lightened by 6% and the limit of the legal tender of 40 shillings per payment was imposed. Such token currency is clearly fiat currency, as it is only by government fiat that the coin can be received at its legal value.

Over time multi-metallism was replaced by gold mono-metalism, via composite standards where gold coin was unlimited legal tender and silver and copper coins were lightened, limited and converted into tokens.

Bank notes as legal tender by government fiat originate from the advent of central banking. Central banks are banks of issue that are owned, sponsored or favoured by the government. Bank notes are negotiable instruments, being promissory notes issued by a bank and payable to bearer on demand. Central banks are generally favoured with monopoly rights to issue bank notes, and/or for these notes to have the status of legal tender. Alternatively, currency notes can be issued directly by the government or its non-bank agencies, and/or the government can favour selected commercial banks by making their notes legal tender (as in Hong Kong). It is important to note that paper money and fiat currency are not the same. For example, Scottish commercial banknotes act as money, but are not legal tender and therefore not fiat currency.

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 (9601279), 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.

In the 19th 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 Joachimsthal in Bohemia. These mines were the first significant discovery of silver in Europe since antiquity.

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 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 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 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, 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.

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 bank notes and legal tender thereof, and in theory governments 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 (see below).

[edit] Credit-based monetary systems

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.

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 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.

[edit] Critiques of credit money expansion

Both Marxian economists 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 and advocates of communism) characterize the shift as shallow and insincere. They argue that imperial or colonial powers (such as the United States or the 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.

Neoclassical 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. Critics respond that the difficult economic position has been amplified by isolation, sanctions and boycott, and that 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 local competitors from global competitors who have greater comparative advantage.

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 Bank for International Settlements 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 Crockett, former head of the BIS. 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.

[edit] The importance of fiat money as a concept

In a market economy, individuals should ideally make decisions based on the tradeoff between desires, particularly the tradeoff between having a good, service or license, and having the liquidity of money. When the role of the government in maintaining or backing the money supply is in question, the issue of credibility enters decisions. Economic actors begin making decisions they would otherwise not make for fear that the currency or money that they hold will change in value radically. This risk produces economic distortions: people convert money to other forms, increasing the demand for goods that are not meant to be used, but hoarded. Economic actors will shelter income in other currencies, or charge higher interest rates. There may be a depression as money which is perceived to be of more durable value leaves circulation, governments may stop striking metallic coins that are retained by individuals.

Fiat money then calls into question the veil of money: 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 leads to economic 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 choose to pay for war in 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.

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.

The real bills doctrine [1] 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
A unit of paper or credit money (a “dollar”) can be presented to the issuing bank in exchange for a physical amount of gold, silver, or some other commodity.
Financial convertibility
A dollar can be returned to the issuing bank in exchange for a dollar’s worth of the bank’s assets.

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 dollar is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted dollars 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 dollars. 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.

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.

[edit] Notable quotes

  • "Lenin was certainly right. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.." —John Maynard Keynes, `The Economic Consequences of The Peace'
  • “Fiat money is the cause of inflation, and the amount which people lose in purchasing power is exactly the amount which was taken from them and transferred to their governments by this process.” —G. Edward Griffin, “The Creature from Jekyll Island”
  • “A fiat monetary system allows power and influence to fall into the hands of those who control the creation of new money, and to those who get to use the money or credit early in its circulation. The insidious and eventual cost falls on unidentified victims who are usually oblivious to the cause of their plight. This system of legalized plunder (though not constitutional) allows one group to benefit at the expense of another. An actual transfer of wealth goes from the poor and the middle class to those in privileged financial positions.” —Congressman Ron Paul (R-TX), "Paper Money and Tyranny"
  • "It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." —Henry Ford
  • "I believe that banking institutions are more dangerous to our liberties than standing armies. Already they have raised up a monied aristocracy that has set the government at defiance. The issuing power should be taken from the banks and restored to the people to whom it properly belongs."—Thomas Jefferson

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