Fiat money

Fiat currency (fiat money) is money that exists because an authority or custom declares it to be money. (From the Latin fiat, which means "let it be done"). It achieves value because a government says it can be used to pay debt or buy goods and services and because people trust that the currency will be reasonably stable. Fiat money is a subset of credit money (money backed by promise to pay in goods or services controlled by the creditor) in which a government, often through a central bank or reserve bank, is the major creditor backing the currency.

Overview with comparison to other forms of currency

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 was exchangeable for a predetermined amount of a named physical commodity, making it a representative money. The represented commodity could be a precious metal such as gold, silver, or copper, although some economies have had money that was redeemable for a fixed amount of other commodity items such as crops, beasts of burden, or food.

Whilst specie-backed representative money entails the legal requirement that the bank of issue redeem it in fixed weights of specie, fiat money's value is unrelated to any physical quantity. Even a coin containing valuable metal may be considered fiat currency if its face value is higher than its market value as metal. The term fiat currency also applies to representative money whose face value exceeds the value of the commodity(ies) it represents.

A feature of all fiat money is its (typically exclusive) acceptability to the government for payment of taxes.

Fiat money is not essential for large countries, nor is it always used. An economy may function on credit money which is not fiat money, such as United States paper currency during periods prior to 1862, before the first United States Notes were created and declared by the government to be legal tender.

Fiat money and the concept of legal tender

Banknotes do not have to be legal tender to be acceptable for trade. Retail transactions can be carried out via cheques, or debit or credit cards, none of which is a payment using legal tender. Acceptability as a means of payment is essentially a matter for agreement between the parties involved.

Millions of pounds' worth of sterling banknotes in circulation are not legal tender, but that does not mean that they are illegal or of lesser value; their status is of "legal currency" (that is to say that their issue is approved by the parliament of the UK) and they are backed up by Bank of England securities.

Bank of England notes are the only banknotes that are legal tender in England and Wales. Scottish and Northern Ireland banknotes are not legal tender anywhere (the concept does not exist in Scots law), and Jersey, Guernsey and Manx banknotes are only legal tender in their respective jurisdictions. The fact that these banknotes are not legal tender in the UK does not however mean that they are illegal under English law, and creditors and traders may accept them if they so choose.

In Scotland and Northern Ireland no banknotes, not even ones issued in those countries, are legal tender. Scottish and Northern Irish notes are 'promissory notes' (defined as legal currency), essentially cheques made out from the bank to 'the bearer', as the wording on each note says. They have a similar legal standing to cheques or debit cards, in that their acceptability as a means of payment is essentially a matter for agreement between the parties involved, although Scots law requires any reasonable offer for settlement of a debt to be accepted.

Value when a fiat money loses backing

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.

The Bretton Woods Agreement had to be abandoned because there was no longer enough gold to cover all the paper money in circulation. The Federal Reserve had printed far more money than they had the gold to back. Although their Federal Reserve notes were nonconvertible to gold for U.S. citizens, foreigners could still redeem gold with them. They did so to avoid losing out as the Federal Reserve printed even more money, making the money they owned less valuable due to its abundance. After the Bretton Woods agreement was abandoned, and the U.S. dollar was no longer convertible to gold, the dollar fell violently in exchange for other currencies, reflecting the decreased demand for the currency. The price of gold rose relative to the dollar during this period of time.

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.

US academic economist Michael Sproul states that there is no such thing as fiat currency, because he contends that currency is backed by the assets of the bank that issues the currency. In his view, 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.

Criticism

Fiat currency was anathema to American Presidents Thomas Jefferson and Andrew Jackson. Jackson went so far as to pass the Specie Circular in 1836, which required all payment for government lands to be in gold or silver coin. The Austrian School of Economics has long held that no sound economy can long endure under fiat money, with prominent Austrian Economist Ludwig von Mises arguing in this book Human Action that, "What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The credit boom is built on the sands of banknotes and deposits. It must collapse."

Ironically, Alan Greenspan, Federal Reserve Chairman from 1987 to 2006, was an early critic of fiat money arguing in his essay, Gold and Economic Freedom, that,

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

Fiat currency has also been criticized by some, such as G. Edward Griffin, Congressman Ron Paul, and Peter Schiff, the president of Euro-Pacific Capital Inc., for increasing the number and severity of boom-bust economic cycles, causing inflation, and allowing nations to initiate or prolong war.Peter Schiff was Right http://www.youtube.com/watch?v=2I0QN-FYkpw</ref>

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
• Money supply
• Private currency
• Public debt
• Tinkerbell effect
• Value Theory
• Veil of money