Fiat money

Keynes (1913, p. 26) famously remarked that the Indian rupee was "virtually a [bank]note printed on silver", by which he meant to suggest two things: that the intrinsic value of the silver did not determine the monetary qualities of the rupee - or even its purchasing power - and that, being a banknote, it was subject to the decrees of the Indian govern- ment. The rupee was indeed a means of payment, not because it was silver, but because government fiat declared it so. If this is the case for a silver coin, then most or all money may be, at least in part, fiat money, because of government decree.

A long tradition has distinguished money of intrinsic value (that is, money based on precious metals) from paper money and bank money. The former monies are "real", and the quantity and value depend on the working of markets; the latter are "fiat money", based on State declarations, and therefore subject to the whims and interests of inher- ently unreliable politicians. But perhaps these forms of money are not so distinct; perhaps fiat money also reflects the markets, and real money rests in part on the rules and policies of the State (Bell and Nell, 2003).

Indeed, this is the position of "State money" theorists, drawing on the work of Knapp (1924 [1973]), and reflected today in the so-called Modern Money Theory (MMT) approach. A sum of money is a number of units of account, which carry a stable value over time, and are generally acceptable in trade. These units of account are defined by the monetary authorities of the State, and are expressed in an official medium of exchange - gold, silver, other metals, paper, or even an intangible accounting system. The medium will bear a seal of authority, as when the monarch's image is stamped on the coin or appears on the specially designed paper. This matters: the value of a coin is normally greater than the value of the metal it contains. The seal serves as a guarantee that the coin, even if damaged, will be accepted at face value in paying taxes, or can be exchanged at the Treasury for a full weight coin. (This is sometimes referred to as the "fiduciary" element in the value of the coin.) Of course, the cost of minting the coin must be covered; in addition, the face value of the coin is "marked up" over the value of the metal it con- tains by what is called the "seigniorage". This covers the cost of maintaining the currency and preventing counterfeiting, and provides a profit to the crown. In fact, paper money has no intrinsic value, but its issue has to be carefully limited, and counterfeiting pre- vented. Properly managed paper money will be accepted in general use, because it is the medium in which taxes are paid. It is State money par excellence. Bank money, in turn, consists of deposits of State money, with the caveat that banks can create State money by making loans in accordance with the rules of the State-regulated banking system.

Mundell (1961) objected that national currencies often circulate outside their national boundaries, within a currency area, defined by the mobility of factors of production, especially labour. He was thus interested in defining "optimum currency areas". At the time he wrote, the Eastern United States and Eastern Canada were both primarily industrial and quite similar, while the economies of the Western parts of both countries rested primarily on mining and extractive activities. So instead of a US dollar and a Canadian dollar, there should have been an Eastern dollar and a Western dollar. Joint US-Canadian central banks, or monetary authorities, would be established in the East and the West to administer the currencies.

Within the framework of conventional neoclassical assumptions (sufficient informa- tion, foresight, and mobility to realize competitive equilibrium), this may make sense, but it only serves to highlight the inadequacy of these assumptions. For a currency to be accepted, it must be the case that it has backing and regulation. "Backing" means, at a minimum, that a sovereign entity - one with what Adam Smith called "police powers"- will accept it in payment of taxes, fees, fines and so on, and that these taxes and fees will be large enough to provide a guarantee that any holdings of currency can be passed along to agents who will need to pay the sovereign, or who can pass them along, again (and so on), to agents who will need to pay taxes and the like. "Regulation" means, at a minimum, that the sovereign uses its police powers to guarantee that transactions will normally be fair and honest, and that the institutions operating with money will act in accord with the laws. (The wild fluctuations in the exchange rate of bitcoins, and the unexplained disappearance of over half a billion dollars worth of them, illustrate what can happen when a currency has neither backing nor regulation.) A currency must be backed and regulated by a sovereign; a non-sovereign agency will not be enough when trouble strikes. The Articles of Confederation in the United States showed this in the eighteenth century and the present difficulties of the euro underline this point again today.

"Fiat money" is a misleading term: the "fiat" by itself, declaring a currency accept- able as tax payment, is not enough, as the Continental, the French assignat, and the Confederate dollar all demonstrate. They and many others found that a "fiat", even with promises of later convertibility to gold or land, did not render a currency acceptable. The government issuing the fiat has to be strong and stable, accepted as legitimate, so that the taxes will be legitimate, and, most of all, the currency itself has to be institutionalized: its issue must be limited and governed by rules, and transactions monitored. This means that the currency should not disappear or be redirected or stolen during the course of transactions. It cannot be counterfeited or faked. Banks must be monitored and deposits guaranteed. In short, a currency has to be regulated by a strong and legitimate govern- ment (Nell, 2011).

See also:

Bank deposits; Bank money; Chartalism; Modern Money Theory; Money and credit; Optimum currency area; State money.