Fiat_currency - Celebrity Encyclopedia

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.^[1] ^[2]

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.^[3]

The unifying feature of all fiat money is its (typically exclusive) acceptability to the government for payment of taxes. Even a coin containing valuable metal 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 also applies to representative money whose face value exceeds the value of the commodity(ies) it represents. While 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 at all.

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 assumed the responsibility of being the major creditor backing the currency.

Geographical range of use

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 prior to 1913.

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. ^[4]

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).^[5]

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.^[6]

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.^[7]

18th and 19th century

An early form of fiat currency were "bills of credit." ^[8] 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.^[8]

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

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.^{[citation needed]}

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.^[9] In his view, confusion centers around two meanings of convertibility:

Criticism

Fiat currency is criticized for creating inflation, by devaluating the currency held by the public. Inflation decreases the purchasing value of money, thus depriving the public of its actual wealth. However, inflation is not an effect limited only to economies that use fiat money. It's an effect that occurs in many different economic environments.

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