A fiat currency is currency that derives its value from government rather than the backing of a tangible commodity or resource. The currency does not have any intrinsic value, but is used due to government decree. A fiat currency only possesses a value through a social contract from those that will accept it. Most of the monetary systems in place today are a derivative of the fiat currency concept.
A fiat monetary system differs from a commodity or representative based monetary system. Please refer to the brief history of commodity and barter based systems here(first two paragraphs). In a commodity based system, money is created from a good (often a precious metal) that has uses other than a medium of exchange. In a representative based monetary system, the notes represent a claim on such a commodity. A fiat system is a much different animal indeed.
Contrary to popular belief, the history of the fiat currency concept is vast and has been documented throughout Asia and Europe. The original documented fiat currency occurred in China before 1000 AD in the midst of a copper shortage where they could not mint coins. The Chinese called it “flying money” because the paper notes could fly from your hands. At the time, the Chinese faced a consumption based import economy and the threat of invaders. Vast amounts of this paper currency were printed in order to pay for the imports and bribe the invaders. This resulted in high levels of inflation.
In medieval England, during the reign of Henry I (1068 to 1135), tally sticks were temporarily employed as fiat due to a gold shortage. The crown accepted these sticks as payment for taxes, which increased the demand for them and enhanced overall confidence. This fiat system had a long track record extending over 500 years, corresponding to a periodic debt issuance and service cycle. Eventually, this system failed when King Charles II declared that the higher interest charged on the debt incurred was illegal due to an antiquated law on the books banning usury. Shortly thereafter, the tally sticks were worthless in the secondary market, although their usage continued in a more limited fashion to the early 19th century.
There were short periods of usage throughout Persia, India, and Japan between the 1200s and the 1400s, but these were marked by trade halting as merchants eventually refused the money. From that point, there were reciprocating usages of temporary fiat measures versus “hard money” that met with varying levels of success.
Since I discuss failures at length, I will highlight some successes. The aforementioned tally sticks can be considered successful for a period of time due to the sheer duration in which the tallies were in usage. Another brief successful example of a debt free fiat currency was the Colonial Scrip from 1757 to 1764. This was used together with European currency in the colonies to boost the money supply, enhance economic activity, and alleviate the tax burden. The currency came to a halt when the British Parliament passed the Currency Act of 1764, which did not prohibit the colonies from printing paper money, but forbid these bills from being designated as legal tender for public/private debts.
A present day successful example is the Norwegian krone. The Norway government has zero debt, they are not part of the troubled European Union, and their currency is not pegged. The central bank of Norway also has one of the highest capital ratios on any central bank. For a fiat currency, this is as low risk as it gets.
Before we analyze fiat currencies, I will present famous quotes on both sides of the argument. French Enlightenment philosopher and writer Voltaire had a low opinion of fiat currency, writing “paper money eventually returns to its intrinsic value – zero”. Contrasted with that, Adam Smith discussed an early form of fiat currency backed by land in Pennsylvania used for approximately 52 years within the Wealth of Nations and said “The government of Pennsylvania, without amassing any treasure, invented a method of lending, not money indeed, but what is equivalent to money, to its subjects. By advancing to private people, at interest, and upon land security to double the value, paper bills of credit to be redeemed 15 years after their date, and in the mean time made transferable from hand to hand like bank notes, and declared by act of assembly to be legal tender…Pennsylvania’s paper currency is said never to have sunk below the value of gold and silver which was current in the colony before the issue of paper money.”
Disadvantages:
There are some critical disadvantages of this type of system which have manifest themselves throughout history and into the present day. These disadvantages are as follows:
- There is no restraint on the amount of money that can be created, resulting in unlimited credit and corresponding debt. False growth in demand and consumption can occur through the availability and usage of credit. However, once a corresponding contraction occurs, the economy will suffer. This type of credit easing policy has the effect of creating asset bubbles (e.g. tech, real estate, etc).
- There is volatility and this system results in cycles of inflation and devaluation when compared to other currencies and assets.
- Disintermediation is introduced which shields the availability of real economic inputs and market forces. Specifically, when there is fluctuation in the money supply, this provides a bottleneck for market forces to deal with the issues in wealth creation directly and efficiently.
- For fiat currency to work properly, it has to be shared by a very large group (e.g. nation, country).
- From a government standpoint, the expenses incurred and the encumbrances committed have corresponded to a growth in overall debt. By increasing debts in this manner, the benefits occur today and future generations must pay the prior incurred debt. This disconnects government and politicians who commit to the current spending from the consequences of their actions. Thus, there lacks an inherent control for fiscal discipline under many fiat systems.
- Hyperinflation and devaluation have been a death knell for various fiat currencies throughout history and occurred often enough that any fiat system must actively guard against it (e.g. Yugoslavia, Zaire, Venezuela, Ukraine, Turkey, Hungry, etc).
- These systems are prone to instability.
- Fiat money is open to counterfeit which, if uncontrolled, can have a devaluation and hyperinflation effect.
Advantages:
- Fiat currency is not subject to scarcity of quantity which results in additional flexibility. Historically speaking, runs in commodity/representative based currencies have threatened the underlying integrity of those systems and turned liquidity issues into strong recessionary/depression events. These are avoided, for the most part, in a fiat system.
- Unlike gold/silver/commodity, fiat money is cost efficient to produce, requiring no specific refinement to become valid tender.
- Fiat currency allowed for more rapid economic expansion and a higher degree of globalization.
- The supply of money can be quickly adjusted based on many demand scenarios.
- Fiat money is durable and worn bills are replaceable.
- Portability.
- Divisibility. Think different denominations of notes and receiving change.
- Uniformity.
Summary:
Each type of monetary system has advantages, disadvantages, inherent efficiencies, and limitations. A common argument made today is that all fiat monetary systems eventually fail. In studying the main types of monetary systems, fiat, commodity, and representative based are all plagued with specific failures throughout their respective history. However, there are successes that can be highlighted in each type of system. The main thing I have found is that certain systems can cause or exacerbate economic crises, while others have arisen as a solution out of the crisis at the time. There is no one classical monetary system that can be considered a panacea for every type of economic situation that may occur.
Now, that we have analyzed the gold standard in part 1 and fiat currency in part 2, the next part will be a hypothesis on what the “perfect” currency can look like. Is there a way we can capture the advantages of both types of systems while simultaneously minimizing the disadvantages?
