Fiat money

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Yuan dynasty banknotes are a medieval form of fiat money. Yuan dynasty banknote with its printing plate 1287.jpg
Yuan dynasty banknotes are a medieval form of fiat money.

Fiat money is a type of currency that is not backed by a precious metal, such as gold or silver. It is typically designated by the issuing government to be legal tender, and is authorized by government regulation. Since the end of the Bretton Woods system in 1971, the major currencies in the world are fiat money.

Contents

Fiat money generally does not have intrinsic value and does not have use value. It has value only because the individuals who use it as a unit of account  or, in the case of currency, a medium of exchange   agree on its value. [1] They trust that it will be accepted by merchants and other people as a means of payment for liabilities.

Fiat money is an alternative to commodity money, which is a currency that has intrinsic value because it contains, for example, a precious metal such as gold or silver which is embedded in the coin. Fiat also differs from representative money, which is money that has intrinsic value because it is backed by and can be converted into a precious metal or another commodity. Fiat money can look similar to representative money (such as paper bills), but the former has no backing, while the latter represents a claim on a commodity (which can be redeemed to a greater or lesser extent). [2] [3] [lower-alpha 1]

Government-issued fiat money banknotes were used first during the 13th century in China. [4] Fiat money started to predominate during the 20th century. Since President Richard Nixon's decision to suspend US dollar convertibility to gold in 1971, a system of national fiat currencies has been used globally.

Fiat money can be:

The term fiat derives from the Latin word fiat , meaning "let it be done" [lower-alpha 2] used in the sense of an order, decree [2] or resolution.

Treatment in economics

Most of the money in the economy is created, not by printing presses at the central bank, but by banks when they provide loans. [...] This also means as you pay off the loan, the electronic money your bank created is 'deleted'  it no longer exists. So essentially, banks create money, not wealth. [10]

Bank of England

In monetary economics, fiat money is an intrinsically valueless object or record that is accepted widely as a means of payment. [1] Accordingly, the value of fiat money is greater than the value of its metal or paper content.

One justification for fiat money comes from a micro-founded model. In most economic models, agents are intrinsically happier when they have more money. In a model by Lagos and Wright, fiat money does not have an intrinsic worth but agents get more of the goods they want when they trade assuming fiat money is valuable. Fiat money's value is created internally by the community and, at equilibrium, makes otherwise infeasible trades possible. [11]

In the Grundrisse, Karl Marx was among the first to consider the modern economic ramifications of a historical switch to fiat money from the gold or silver-commodity. Marx writes:

"Suppose that the Bank of France did not rest on a metallic base, and that other countries were willing to accept the French currency or its capital in any form, not only in the specific form of the precious metals. Would the bank not have been equally forced to raise the terms of its discounting precisely at the moment when its "public" clamoured most eagerly for its services? The notes with which it discounts the bills of exchange of this public are at present nothing more than drafts on gold and silver. In our hypothetical case, they would be drafts on the nation’s stock of products and on its directly employable labour force: the former is limited, the latter can be increased only within very positive limits, and in certain amounts of time. The printing press, on the other hand, is inexhaustible and works like a stroke of magic."

Commenting on the passage, economist and geographer David Harvey writes that "[t]he consequence, as Marx saw it, would be that "the directly exchangeable wealth of the nation" would be ‘absolutely diminished’ alongside of ‘an unlimited increase of bank drafts’ (i.e., accelerating indebtedness) with the direct consequence of ‘increase in the price of products, raw materials and labour’ (inflation) alongside a ‘decrease in price of bank drafts’ (ever-falling rates of interest)." Harvey notes the accuracy of the modern economy in this way, save for "…the rising prices of labor and means of production (low inflation except for assets such as stocks and shares, land and property and resources such as water rights)." [12] The latter point can be explained by the private exportation of debt, [13] labour, and figurative and/or literal waste [14] to the global periphery, a concept related to metabolic and carbon rift.

Another mathematical model that explains the value of fiat money comes from game theory. In a game where agents produce and trade objects, there can be multiple Nash equilibria where agents settle on stable behavior. In a model by Kiyotaki and Wright, an object with no intrinsic worth can have value during trade in one (or more) of the Nash Equilibria. [15]

History

China

China has a long history with paper money, beginning in the 7th century CE. During the 11th century, the government established a monopoly on its issuance, and about the end of the 12th century, convertibility was suspended. [16] The use of such money became widespread during the subsequent Yuan and Ming dynasties. [17]

Song Dynasty Jiaozi, the world's earliest paper money. Jiao zi.jpg
Song Dynasty Jiaozi, the world's earliest paper money.

The Song Dynasty in China was the first to issue paper money, jiaozi , about the 10th century CE. Although the notes were valued at a certain exchange rate for gold, silver, or silk, conversion was never allowed in practice. The notes were initially to be redeemed after three years' 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 maintain the value of the paper money by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes became disfavored. [18]

The succeeding Yuan Dynasty was the first dynasty of China to use paper currency as the predominant circulating medium. The founder of the Yuan Dynasty, Kublai Khan, issued paper money known as Jiaochao during his reign. The original notes during the Yuan Dynasty were restricted in area and duration as in the Song Dynasty.

During the 13th century, Marco Polo described the fiat money of the Yuan Dynasty in his book The Travels of Marco Polo: [19] [20]

All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver... and indeed everybody takes them readily, for wheresoever a person may go throughout the Great Kaan's dominions he shall find these pieces of paper current, and shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold.

Marco Polo, The Travels of Marco Polo

Europe

Washington Irving records an emergency use of paper money by the Spanish for a siege during the Conquest of Granada (1482–1492). In 1661, Johan Palmstruch issued the first regular paper money in the West, by royal charter from the Kingdom of Sweden, through a new institution, the Bank of Stockholm. While this private paper currency was largely a failure, the Swedish parliament eventually assumed control of the issue of paper money in the country. By 1745, its paper money was inconvertible to specie, but acceptance was mandated by the government. [21] This fiat currency depreciated so rapidly that by 1776 it was returned to a silver standard. Fiat money also has other beginnings in 17th-century Europe, having been introduced by the Bank of Amsterdam in 1683. [22]

New France 1685–1770

In 17th century New France, now part of Canada, the universally accepted medium of exchange was the beaver pelt. As the colony expanded, coins from France came to be used widely, but there was usually a shortage of French coins. In 1685, the colonial authorities in New France found themselves seriously short of money. A military expedition against the Iroquois had gone badly and tax revenues were down, reducing government money reserves. Typically, when short of funds, the government would simply delay paying merchants for purchases, but it was not safe to delay payment to soldiers due to the risk of mutiny.

Jacques de Meulles, the Intendant of Finance, conceived an ingenious ad hoc solution – the temporary issuance of paper money to pay the soldiers, in the form of playing cards. He confiscated all the playing cards in the colony, had them cut into pieces, wrote denominations on the pieces, signed them, and issued them to the soldiers as pay in lieu of gold and silver. Because of the chronic shortages of money of all types in the colonies, these cards were accepted readily by merchants and the public and circulated freely at face value. It was intended to be purely a temporary expedient, and it was not until years later that its role as a medium of exchange was recognized. The first issue of playing card money occurred during June 1685 and was redeemed three months later. However, the shortages of coinage reoccurred and more issues of card money were made during subsequent years. Because of their wide acceptance as money and the general shortage of money in the colony, many of the playing cards were not redeemed but continued to circulate, acting as a useful substitute for scarce gold and silver coins from France. Eventually, the Governor of New France acknowledged their useful role as a circulating medium of exchange. [23]

As the finances of the French government deteriorated because of European wars, it reduced its financial assistance to its colonies, so the colonial authorities in Canada relied more and more on card money. By 1757, the government had discontinued all payments in coin and payments were made in paper instead. In an application of Gresham’s Law – bad money drives out good – people hoarded gold and silver, and used paper money instead. The costs of the Seven Years' War resulted in rapid inflation in New France. After the British conquest in 1760, the paper money became almost worthless, but business did not end because gold and silver that had been hoarded came back into circulation. By the Treaty of Paris (1763), the French government agreed to convert the outstanding card money into debentures, but with the French government essentially bankrupt, these bonds were defaulted and by 1771 they were worthless.

The Royal Canadian Mint still issues Playing Card Money in commemoration of its history, but now in 92.5% silver form with gold plate on the edge. It therefore has an intrinsic value which considerably exceeds its fiat value. [24] The Bank of Canada and Canadian economists often use this early form of paper currency to illustrate the true nature of money for Canadians. [23]

18th and 19th century

Adoption of 'Gold Standard' (Paper currency convertible into gold) [25]
CountryYear
United Kingdom 1821
Germany1871
Sweden1873
United States (de facto)1873
France 1874
Belgium1874
Italy1874
Switzerland1874
Netherlands1875
Austria-Hungary 1892
Japan 1897
Russia1898
United States (de jure)1900

An early form of fiat currency in the American Colonies was "bills of credit." [26] Provincial governments produced notes which were fiat currency, with the promise to allow holders to pay taxes with those notes. The notes were issued to pay current obligations and could be used for taxes levied at a later time. [26] Since the notes were denominated in the local unit of account, they were circulated from person to person in non-tax transactions. These types of notes were issued 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 date later. [26]

Bills of credit have generated some controversy from their inception. Those who have wanted to emphasize the dangers of inflation have emphasized the colonies where the bills of credit depreciated most dramatically: New England and the Carolinas. [26] Those who have wanted to defend the use of bills of credit in the colonies have emphasized the middle colonies, where inflation was practically nonexistent. [26]

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 purpose of such taxes was later served by property taxes. 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 money which represented specie.

Examples include the "Continental" bills issued by the U.S. Congress before the United States 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 representing sufficient reserves; and the Mississippi Company scheme of John Law.

During the American Civil War, the Federal Government issued United States Notes, a form of paper fiat currency known popularly as 'greenbacks'. Their issue was limited by Congress at slightly more than $340 million. During the 1870s, withdrawal of the notes from circulation was opposed by the United States Greenback Party. It was termed 'fiat money' in an 1878 party convention. [27]

20th century

After World War I, governments and banks generally still promised to convert notes and coins into their nominal commodity (redemption by specie, typically gold) on demand. However, the costs of the war and the required repairs and economic growth based on government borrowing afterward made governments suspend redemption by specie. Some governments were careful of avoiding sovereign default but not wary of the consequences of paying debts by consigning newly printed cash not associated with a metal standard to their creditors, which resulted in hyperinflation – for example the hyperinflation in the Weimar Republic.

From 1944 to 1971, the Bretton Woods agreement fixed the value of 35 United States dollars to one troy ounce of gold. [28] Other currencies were calibrated with the U.S. dollar at fixed rates. The U.S. promised to redeem dollars with gold transferred to other national banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fund (IMF).

The Bretton Woods system was ended by what became known as the Nixon shock, a series of economic changes by United States President Richard Nixon in 1971. These changes included unilaterally canceling the direct convertibility of the United States dollar to gold. Since then, a system of national fiat monies has been used globally, with variable exchange rates between the major currencies. [29]

Precious metal coinage

During the 1960s, production of silver coins for circulation ceased when the face value of the coin was less than the cost of the precious metal it contained (whereas it had been greater historically). In the United States, the Coinage Act of 1965 eliminated silver from circulating dimes and quarter dollars, and most other countries did the same with their coins. [30] The Canadian penny, which was mostly copper until 1996, was removed from circulation altogether during the autumn of 2012 due to the cost of production relative to face value. [31]

In 2007, the Royal Canadian Mint produced a million dollar gold bullion coin and sold five of them. In 2015, the gold in the coins was worth more than 3.5 times the face value. [32]

Money creation and regulation

A central bank introduces new money into an economy by purchasing financial assets or lending money to financial institutions. Commercial banks then redeploy or repurpose this base money by credit creation through fractional reserve banking, which expands the total supply of "broad money" (cash plus demand deposits). [33]

In modern economies, relatively little of the supply of broad money is physical currency. For example, in December 2010 in the U.S., of the $8,853.4 billion of broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money. [34] The manufacturing of new physical money is usually the responsibility of the national bank, or sometimes, the government's treasury.

The Bank for International Settlements published a detailed review of payment system developments in the Group of Ten (G10) countries in 1985, in the first of a series that has become known as "red books". Currently the red books cover the participating countries on Committee on Payments and Market Infrastructures (CPMI). [35] A red book summary of the value of banknotes and coins in circulation is shown in the table below where the local currency is converted to US dollars using the end of the year rates. [36] The value of this physical currency as a percentage of GDP ranges from a maximum of 19.4% in Japan to a minimum of 1.7% in Sweden with the overall average for all countries in the table being 8.9% (7.9% for the US).

Banknotes and coins in circulation (as of 31/12/2015)
CountryBillions of dollarsPer capita
United States$1,425$4,433
Eurozone $1,210$3,571
Japan$857$6,739
India$251$195
Russia$117$799
United Kingdom$103$1,583
Switzerland$76$9,213
Korea$74$1,460
Mexico$72$599
Canada$59$1,641
Brazil$58$282
Australia$55$2,320
Saudi Arabia$53$1,708
Hong Kong SAR$48$6,550
Turkey$36$458
Singapore$27$4,911
Sweden$9$872
South Africa$6$113
Total/Average$4,536$1,558

The most notable currency not included in this table is the Chinese yuan, for which the statistics are listed as "not available".

Inflation

The adoption of fiat currency by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have occurred in a number of countries, producing hyperinflations – episodes of extreme inflation rates much greater than those observed during earlier periods of commodity money. [37] [38] The hyperinflation in the Weimar Republic of Germany is a notable example. [39] [37]

Economists generally believe that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. [40] Presently, most economists favor a small and steady rate of inflation. [41] Small (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly to a recession, and reduces the risk that a liquidity trap (a reluctance to lend money due to low rates of interest) prevents monetary policy from stabilizing the economy. [42] However, money supply growth does not always cause nominal increases of price. Money supply growth may instead result in stable prices at a time in which they would otherwise be decreasing. Some economists maintain that with the conditions of a liquidity trap, large monetary injections are like "pushing on a string". [43] [44]

The task of keeping the rate of inflation small and stable is usually given to monetary authorities. Generally, these monetary authorities are the national banks that control monetary policy by the setting of interest rates, by open market operations, and by the setting of banking reserve requirements. [45]

Loss of backing

A fiat-money currency greatly loses its value should the issuing government or central bank either lose the ability to, or refuse to, continue to guarantee its value. The usual consequence is hyperinflation. Some examples of this are the Zimbabwean dollar, China's money during 1945 and the Weimar Republic's mark during 1923. A more recent example is the currency instability in Venezuela that began in 2016 during the country's ongoing socioeconomic and political crisis.

This need not necessarily occur, especially if a currency continues to be the most easily available; for example, the pre-1990 Iraqi dinar continued to retain value in the Kurdistan Regional Government even after its legal tender status was ended by the Iraqi government which issued the notes. [46] [47]

See also

Notes

  1. See Monetary economics for further discussion.
  2. Fīat is the third-person singular present active subjunctive of fiō ("I become", "I am made").

Related Research Articles

A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a system of money in common use within a specific environment over time, especially for people in a nation state. Under this definition, the British Pound sterling (£), euros (€), Japanese yen (¥), and U.S. dollars (US$) are examples of (government-issued) fiat currencies. Currencies may act as stores of value and be traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are either chosen by users or decreed by governments, and each type has limited boundaries of acceptance; i.e., legal tender laws may require a particular unit of account for payments to government agencies.

<span class="mw-page-title-main">Hyperinflation</span> Rapidly accelerating inflation

In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as they usually switch to more stable foreign currencies. When measured in stable foreign currencies, prices typically remain stable. Effective capital controls and currency substitution (“dollarization”) are the orthodox solutions to ending short-term hyperinflation; however there are significant social and economic costs to these policies. Ineffective implementations of these solutions often exacerbate the situation. Many governments choose to attempt to solve structural issues without resorting to those solutions, with the goal of bringing inflation down slowly while minimizing social costs of further economic shocks.

<span class="mw-page-title-main">Gold standard</span> Monetary system based on the value of gold

A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the late 1920s to 1932 as well as from 1944 until 1971 when the United States unilaterally terminated convertibility of the US dollar to gold, effectively ending the Bretton Woods system. Many states nonetheless hold substantial gold reserves.

<span class="mw-page-title-main">Inflation</span> Devaluation of currency over a period of time

In economics, inflation is a general increase in the prices of goods and services in an economy. This is usually measured using the consumer price index (CPI). When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of CPI inflation is deflation, a decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index. As prices faced by households do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose.

<span class="mw-page-title-main">Gresham's law</span> Monetary principle, "bad money drives out good"

In economics, Gresham's law is a monetary principle stating that "bad money drives out good". For example, if there are two forms of commodity money in circulation, which are accepted by law as having similar face value, the more valuable commodity will gradually disappear from circulation.

<span class="mw-page-title-main">Commodity money</span> Money with value derived from composition from a commodity (such as silver or gold coins)

Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects having value or use in themselves as well as their value in buying goods. This is in contrast to representative money, which has no intrinsic value but represents something of value such as gold or silver, in which it can be exchanged, and fiat money, which derives its value from having been established as money by government regulation.

Seigniorage, also spelled seignorage or seigneurage, is the difference between the value of money and the cost to produce and distribute it. The term can be applied in two ways:

A monetary system is a system by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.

<span class="mw-page-title-main">Currency Act</span> British legislation regulating colonial money in America

The Currency Act or Paper Bills of Credit Act is one of several Acts of the Parliament of Great Britain that regulated paper money issued by the colonies of British America. The Acts sought to protect British merchants and creditors from being paid in depreciated colonial currency. The policy created tension between the colonies and Great Britain and was cited as a grievance by colonists early in the American Revolution. However, the consensus view among modern economic historians and economists is that the debts by colonists to British merchants were not a major cause of the Revolution. In 1995, a random survey of 178 members of the Economic History Association found that 92% of economists and 74% of historians disagreed with the statement, "The debts owed by colonists to British merchants and other private citizens constituted one of the most powerful causes leading to the Revolution."

Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must be exchanged.

International finance is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.

The history of the United States dollar began with moves by the Founding Fathers of the United States of America to establish a national currency based on the Spanish silver dollar, which had been in use in the North American colonies of the Kingdom of Great Britain for over 100 years prior to the United States Declaration of Independence. The new Congress's Coinage Act of 1792 established the United States dollar as the country's standard unit of money, creating the United States Mint tasked with producing and circulating coinage. Initially defined under a bimetallic standard in terms of a fixed quantity of silver or gold, it formally adopted the gold standard in 1900, and finally eliminated all links to gold in 1971.

<span class="mw-page-title-main">Hungarian pengő</span> Former currency of Hungary, used 1927–1946

The pengő was the currency of Hungary between 1 January 1927, when it replaced the korona, and 31 July 1946, when it was replaced by the forint. The pengő was subdivided into 100 fillér. Although the introduction of the pengő was part of a post-World War I stabilisation program, the currency survived for only 20 years and experienced the most serious case of hyperinflation ever recorded.

<span class="mw-page-title-main">History of Chinese currency</span> History of money in China

The history of Chinese currency spans more than 3000 years. Currency of some type has been used in China since the Neolithic age which can be traced back to between 3000 and 4500 years ago. Cowry shells are believed to have been the earliest form of currency used in Central China, and were used during the Neolithic period.

<span class="mw-page-title-main">Early American currency</span> Money in the English/British American colonies and the pre-1789 United States

Early American currency went through several stages of development during the colonial and post-Revolutionary history of the United States. John Hull was authorized by the Massachusetts legislature to make the earliest coinage of the colony in 1652.

<span class="mw-page-title-main">Money</span> Object or record accepted as payment

Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are: medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment.

Metallism is the economic principle that the value of money derives from the purchasing power of the commodity upon which it is based. The currency in a metallist monetary system may be made from the commodity itself or it may use tokens redeemable in that commodity. Georg Friedrich Knapp (1842–1926) coined the term "metallism" to describe monetary systems using coin minted in silver, gold or other metals.

<span class="mw-page-title-main">Hyperinflation in the Weimar Republic</span> Occurrence of hyperinflation in early 20th century Germany

Hyperinflation affected the German Papiermark, the currency of the Weimar Republic, between 1921 and 1923, primarily in 1923. The German currency had seen significant inflation during the First World War due to the way in which the German government funded its war effort through borrowing, with debts of 156 billion marks by 1918. This national debt was substantially increased by 50 billion marks of reparations payable in cash and in-kind under the May 1921 London Schedule of Payments agreed after the Versailles treaty.

<span class="mw-page-title-main">Hyperinflation in Zimbabwe</span> Period of currency instability

Hyperinflation in Zimbabwe is an ongoing period of currency instability in Zimbabwe which, using Cagan's definition of hyperinflation, began in February 2007. During the height of inflation from 2008 to 2009, it was difficult to measure Zimbabwe's hyperinflation because the government of Zimbabwe stopped filing official inflation statistics. However, Zimbabwe's peak month of inflation is estimated at 79.6 billion percent month-on-month, 89.7 sextillion percent year-on-year in mid-November 2008.

<span class="mw-page-title-main">United States dollar</span> Official currency of the United States

The United States dollar is the official currency of the United States and several other countries. The Coinage Act of 1792 introduced the U.S. dollar at par with the Spanish silver dollar, divided it into 100 cents, and authorized the minting of coins denominated in dollars and cents. U.S. banknotes are issued in the form of Federal Reserve Notes, popularly called greenbacks due to their predominantly green color.

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