This post addresses the question: What is fiat money? Once we have answered this question, we consider a much harder question – how to maintain confidence in the fiat money belief system?
What is fiat money?
Fiat means ‘let it be‘ or ‘let there be’. In the bible, God says ‘Fiat lux’ – let there be light. The Lord’s prayer says, ‘fiat voluntus tua’ – thy will be done! In a sovereign country, the Sovereign says ‘Fiat money’ – let there be money. In a democracy, the Sovereign is the state which means all of us. We say let there be money and there is!
Illustrated by Cohenbaum.
The government – elected by us – says this is money, and it is in all of our interests to believe them because fiat money is a collective good that helps us to get on with what we want to do. A feature of fiat money is that it is not linked to anything physical. In the past (see A brief history of money), we used a gold standard where the value of money was pegged to an amount of gold. However, this proved too inflexible – we do not want “what we can do” to be limited by the amount of a particular metal. Consequently, all countries abandoned the gold standard in the early ’70s and we have had ‘let it be’ money ever since. Fiat money is not linked to anything physical – it is information*, a collective memory, an IOU, a promise to deliver, nothing more.
Fiat money is created out of nothing – as and when we need it – but with the condition that someone promises to do something. The promise allows money to be created, it is the I promise to pay on our banknotes! If you like, there is a magic money tree but it has strings attached – take its fruit and you are forever connected in a web of relationships until you have made good on your promises.
Illustrated by Cohenbaum.
Fiat money creation comes with a promise which is a demand on future economic activity. We might call this demand a debt, but unfortunately the word debt became associated with sin. Whereas, in Wycliffe’s 1389 version of the Lord’s prayer we asked God to forgive us our debts as we forgive our debtors, in later versions, the word debt was replaced by trespass or sin, and so we began to regard debt – a promise – as a sin, something negative. Given that all new fiat money is created as either government or private debt, and that a growing economy requires a growing amount of money, someone (government, businesses or individuals) has to promise something – has to take on more debt – in order for the economy to grow. Our promises or debts are the seeds of growth! Not delivering on our promises may be bad but it may still better to try and fail than not try at all. Far less attractive is a World where money creation limits what is possible – where money is a constraint. The only limit on what we can do should be human desire and ingenuity.
Nothing more than belief
If fiat money is a promise then it follows that the value of fiat money is based on the belief that we shall deliver on our promises.** In this web of promises we believe that someone will accept our promise – our money – for goods or services in the future. The teacher promises to teach the children, the roofer promises to fix the roofs, the baker promises to provide the bread. We could organise all this without money but it is so much easier to let money ensure that everyone does their ‘fair’ share. Underpinning belief in this web of promises is the idea that society will function tomorrow in the same way as it did today. Fundamentally, this a belief in the rule of law – that we shall be held accountable for our promises.
One of the most interesting but often overlooked properties of money is how it connects the present with the future. Whereas the past and the present are known, the future is unpredictable and this can create a problem. No one, neither government nor individuals can predict the future. Despite our best intentions we may not be able to deliver on our promises. If we promise too much and money is created too fast, the real economy needs time to catch up – a boom is followed by a bust. A debt crisis arises when some or many fail to deliver on their promises, and the system needs time to correct. During this debt overhang, few want to take on more debt, there are too few borrowers, less money is created, and the economy cannot grow as fast. In extreme cases – Japan since 1990, the US and EU since 2008 – this can take years or decades to correct. Either we can wait while the economy stumbles along, or the government can try to act as borrower of last resort and stimulate the economy as in Roosevelt’s New Deal. Opinion is still divided on whether this kind of fiscal stimulus really works, mainly because it depends on how it is implemented and how we respond.
Keeping the faith.
The government – elected by us – has sole responsibility for maintaining stability of the system of money. Although a part of this responsibility can be devolved to a central bank or regulators, it is the government that establishes these structures and can reform them. The finance minister or Chancellor is the high priest of the money system, and it is important that they take their responsibility seriously. A key role of the high priest is to maintain confidence in the fiat money belief system such the unit of exchange – the pound, the euro, the dollar, etc. – is not devalued. If we all believe, it works, if there are doubts, the currency may be devalued.
There are some rules that the high priest most follow in order to maintain confidence – in particular, not creating too much money too fast. But as the future is uncertain, how much is too fast is uncertain too. How should the high priest manage this? One of the most influential economists of the latter half of the twentieth century Paul Samuelson made use of the analogy between fiat money belief and religious belief, and put it like this [see John Maynard Keynes: Life, Ideas, Legacy By Mark Blaug]:
“one of the functions of old-fashioned religion was to scare people by what might be regarded as myths into behaving in a way that long-run civilised life requires.”
And so it is with money – myths are thought necessary to maintain belief and ensure long-term stability. Imagine two almost identical countries called Agnotology and Ontology. In Agnotology, only the high priest understands about fiat money and the magic money tree, whereas in Ontology everyone knows.
Agnotology enjoys the stability and fiscal rectitude of the gold standard World, and the high priest can take a holiday. Meanwhile over in Ontology, there is an expectation that the high priest can solve all problems by creating more money – by taking more fruit from the tree. Aside from the moral question of truth, the more interesting question is which country will enjoy greater prosperity over the long term? Answers in the comments please.
Whether in Agnotology or Ontology, the high priest has the responsibility of regulating the rate of new money creation via monetary (new money creation by the private banking sector) and fiscal policy (new money creation by the government sector). The balance between public and private is a political choice between the collective and the individual. A collective – where risk is shared – is less volatile than individuals, consequently governments can borrow more cheaply than you or me. Public debt is cheap and if spent on stuff we want offers good value. So why not use it? The argument of the libertarian right is that governments limit freedom by making decisions on our behalf (and sometimes make bad decisions), but this is where democracy saves us – if we are no longer happy with a collectively agreed decision we can elect a new government. Democratic freedom is the best we can hope for.
- Fiat money is nothing more than information – its value is based only on belief.
- The stability of this belief system is vitally important to all of us.
- Our elected representatives have primary responsibility for maintaining stability of the belief system.
- How they should achieve this is a matter of political expediency, however, democratic freedom requires that we are informed of the choices we are making.
- We should not tolerate a World where money creation limits what is possible. The only limits on what is possible must be human desire and ingenuity.
* Note that in physics, information is physical in that the creation of destruction of information costs energy.
** Note that the value of gold is based on belief also and is not that different.