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Fiat currency

The terms fiat currency and fiat money relate to types of currency or money whose usefulness results, not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government's order (fiat) that it must be accepted as a means of payment.

Historically, societies have relied on monetary systems where currency used in trade was either composed of a physical commodity (such as gold coin-- see commodity money) or else if not directly composed of the commodity, was exchangeable for a predetermined amount of a physical commodity. This could be a precious metal such as gold, silver, or copper, although some systems had representative money that was redeemable for a fixed amount of other commodity items such as crops, beasts of burden, or food. For more information on currencies made of, or backed by, commodities, see representative money, commodity money, gold standard and/or silver standard.

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 also been used to distinguish such money from the type of representative money which is fixed to represent a weight of precious metal (specie). While specie-backed representative money has been associated with a legal requirement that the bank of issue pay in fixed weights of specie or even (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 (money backed by promise to pay in goods or services controlled by the creditor). However, fiat money is a special type of credit money in which a government, often through a central bank or reserve bank, has taken the responsibility of being the major creditor backing the currency.

Fiat money is not necessary, or always used, for large countries. 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. An example of current currency of this type is the Pound Scots which functions as money in Scotland and elsewhere in the United Kingdom, even though not legal tender anywhere. A mixed case where a credit money note is only partly backed by the full credit of the government involves Banknotes of the pound sterling. Although only those pound sterling notes issued by the Bank of England are directly backed by government credit and thus technically "legal tender," the pound sterling banknotes issued by certain other authorized banks in the U.K. still function equally as money in the U.K. This is because there is an indirect mechanism of government backing where these other banks are required by law to have a sum of money in an account in the Bank of England equal to the total sum of sterling notes they have issued.

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).

Among many people who advocate for specie, such as gold, silver or a bimetallic standard, the term 'fiat money' is often used as a pejorative term.

History

Early history

The S'ung (or Song) dynasty was the first in China to issue true paper money in 1023. Though technically not a fiat currency - as the notes were valued at a certain exchange rate for gold, silver, or silk - in practice convertibility was never allowed. The notes were initially to be redeemed after three year's service, to be replaced by new notes for a 3% service charge, but, as more of them were printed without notes being retired, inflation became evident. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

18th and 19th century

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. Bills of credit were controversial when they were first issued, and have remained controversial to this day. Those who have wanted to highlight the dangers of inflation have focused on the colonies where the bills of credit depreciated most dramatically – New England and the Carolinas. Those who have wanted to defend the use of bills of credit in the colonies have focused on the middle colonies, where inflation was practically nonexistent.

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.

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.

Concepts

Feedback in credit-based monetary systems

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.

Convertibility

Michael Sproul has argued that some notions of fiat money are misconceptions of economists who have failed to understand that inconvertible paper money is backed by the assets of its issuer.

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. See representative currency. Financial convertibility: Units of currency can be returned to the issuing bank in exchange for that unit'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 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.

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.