The following is a continuation of yesterday’s post, The Basics of Money, from economics professor, Art Carden, examining some of the basic theory, development, and history of money and what lessons can be learned (or repeatedly forgotten) by looking through the longer-term lens of monetary history.

Take a dollar out of your wallet. What does that dollar say? What does it represent? You’ll notice a few phrases on the front of that dollar: "Federal Reserve Note" and "This Note is Legal tender for All Debts Public and Private." The dollars in your wallet and the dollars in your bank account are examples of fiat money. What is fiat money, and where did it come from? In what follows, we’ll discuss what fiat money is, why a lot of people think it is a good idea, where it comes from, and some of its drawbacks.

What Is Fiat Money?

Fiat money differs from what people have traditionally used as money because it isn’t backed by anything. It is money because the government says it is. People will accept it in exchange for real goods and services, and you can use it to pay taxes. Historically, people have used commodities (or claims to commodities) as money, but since the US closed the gold window in 1971, we have been on a fiat money system.

Where Did It Come From?

How did we make the transition? Understanding the transition requires that we first review what money is. Money serves as a medium of exchange, which in turn allows it to serve as a store of value, a unit of account, and a standard of deferred payment. Money emerged because it solves the problem of the mutual coincidence of wants. This basically means that barter is hard: if you’re going to barter with someone, you will only do so if he or she has something you want and if he or she wants what you have. A butcher who wants bread will need to find a baker who wants meat. If most of the bakers are vegetarians, he may have to do without—or he might have to consume a lot of time and energy looking for a baker who isn’t a vegetarian. This would be pretty costly.

Commodity Money, Commodity Standards, and the Transition to Fiat Money

Fortunately, the butcher has an alternative: he can get his hands on something the baker wants. This is how money emerged: people started to demand widely-demanded goods not simply because they are useful as such, but also because they are widely demanded. Some of these widely-demanded goods have emerged as money, and historically, people have used commodities like silver and gold because of their purity, their uniformity, their malleability, and their other desirable characteristics.

Using precious metals as money has drawbacks. First, precious metals are cumbersome. Hauling around bags of gold and silver might require you to clear space in your carriage that could otherwise be occupied by goods you want to sell, feed your horses a little more than you otherwise would so that they can handle the additional weight, or take other steps that divert you from your core business. Second, a lot of merchants roaming the highways and byways with carriages full of gold and silver are attractive targets for bandits. Third, gold and silver coins can get pretty banged up in transit, and if you’re dealing with potentially-unscrupulous merchants or governments, you have to beware of the temptation to debase the coins by mixing the precious metals with less-valuable alloys or by shaving and clipping gold and silver off the edges of the coins (incidentally, people started minting coins with milled edges in order to reduce this temptation).

Where there is a problem, there is an opportunity, and eventually people came up with ways to address these problems. Instead of hauling bullion or coins, people started putting their money on deposit with bankers who would then issue a claim certificate for the money. Instead of carrying bullion or coins, people could now simply carry these claim certificates, or bank notes, and use them as money substitutes. These certificates were circulating in place of gold and silver, but they still represented claims on actual gold and silver.

Commodity money is costly to mine, mint, and maintain. Getting gold and silver out of the ground, purifying it, coining it, and certifying their weight and purity is harder than simply creating an entry in a computer or printing new pieces of paper.

In textbook treatments, commodity standards have other widely-cited drawbacks. Commodity money is costly to mine, mint, and maintain. Getting gold and silver out of the ground, purifying it, coining it, and certifying their weight and purity is harder than simply creating an entry in a computer or printing new pieces of paper. The resources needed to store and guard gold and silver are also among the costs of commodity standards. Most importantly, gold and silver sitting in a bank vault is gold and silver that is not available for industrial uses. When we store gold and silver coins in a bank vault, we have to forego the silver electrodes, silver-zinc batteries, silverware, jewelry, silver-coated engine bearings, cell phone components, connectors, and fillings that could otherwise be produced with the gold and silver.

Hence, some people argue, fiat money saves resources. Some people have also argued that the gold standard limits the government’s ability to conduct monetary policy and helped deepen and prolong the Great Depression (we will take that up in another article). Finally, since people weren’t trading with physical gold and silver but were instead trading paper bank notes and making entries in banks’ accounts, what was the point of warehousing so much gold and silver? Why not simply divorce the currency from the gold and silver—or, as economists like Murray Rothbard might put it, why not divorce the currency from the money?

Fiat Money Drawbacks

Why not, indeed? In 1989, New York University Press published a book titled Competition and Currency: Essays on Free Banking and Money by the economist Lawrence H. White. Professor White has written extensively on how the invisible hand handles money; in fact, he spoke at Rhodes College (my former employer) in 2009 (here is a link to video of his talk, and here is an article a student and I wrote based on his talk). Competition and Currency collects some of Professor White’s articles on the functioning of a competitive, free-market banking system that would include a competitive, free market in money. Throughout, he discusses the evolution of different kinds of money, including modern fiat money.

White claims that presumably, a government could create a fiat money system by allowing people to keep their gold and silver but then giving them fiat money in proportion to these holdings. Historically, however, fiat money "has come about by permanent suspension of redeemability of the central bank’s liabilities, enriching only the government" (p. 61). Fiat money emerged when the government suspended convertibility into gold and silver, and permanently; White calls this "a breach of contract that only a government or government-sheltered agency can commit with impunity" (p. 57). More specifically, he writes (p. 181):

The transition from a specie-based competitive banking system to a fiat-currency-based system is most readily made in two steps: government creation of a central bank, whose specie-redeemable liabilities displace specie as a commercial bank reserve asset; and suspension of redeemability for central bank liabilities. The supply of banking services may continue to be competitive, but the nominal quantity of money is now scaled to the central bank’s determination of the monetary base.

As White and others argue, fiat money brings its own set of problems that may be worse than the resource costs and policy constraints of a competitive system of note issue.

A fiat money system managed by a government monopoly is something many people, including many economists, take for granted. We shouldn’t. As White and others argue, fiat money brings its own set of problems that may be worse than the resource costs and policy constraints of a competitive system of note issue. Specifically, it is easier to pursue inflationary policies with fiat money, and as it has been said, "inflation is the cruelest tax" because it is harder to see than more direct forms of taxation. Whether we need a monetary authority like the Federal Reserve to manage the money supply remains an open question, and as George Selgin, William Lastrapes, and Lawrence White argued in a 2010 study, we should be exploring alternatives to central banks and fiat money.

Money serves important functions and has a fascinating history. The money we use today differs from the money people used just a few decades ago in that while money in the middle of the twentieth century was tied to gold in some fashion, the money we have used since closing the gold window in 1971 has been backed by absolutely nothing.