Questions on Mises V and VI: Two Questions on Fiat Money
Jason Kuznicki on Dec 12th 2006
Monetary self-education continues below the fold.
When Ludwig von Mises wrote The Theory of Money and Credit, it was unclear to him whether any country had ever employed a purely fiat currency — that is, a currency that was neither a commodity nor a promise to pay a commodity. The year was 1912; virtually all monies were then either actual commodities (ie, coins made of real gold or silver) — or they were credit money (ie, a promise to pay real gold or silver). Fiat currency existed for small change alone, while the gold standard predominated for everything else.
Today, however, I am fairly certain that there are no commodity currencies left, and that no major currency even entails a promise to pay a commodity. Fiat money is ubiquitous.
Now gold money is good both as a generic exchange commodity, or just as gold, which may be employed in art or industry. Paper money is good only as money; it is useful for very little else. How did we go from the one to the other, and what holds a system of fiat money up without a commodity support?
This is a difficult question: If I had a promissory note from you, under which you were obligated to pay me a kilogram of gold, then I should treat that note with almost precisely the same care that I would treat a kilogram of gold itself. Provided I knew that you would hold to your word, the two would be equivalent, except, of course, that the note would be more portable, which can often add to its convenience.
Yet if some court were to void the note, for example if it were found that you were not of a sound mental state when you issued it, then that note would be worthless to me. I might very well discard it, which I would never knowingly do to a kilogram of gold. Why do we not do the same to our paper money, when we know that it has ceased to be a promise of any commodity at all?
Using the scant data that he had, Mises answered the question of how a state might transition from commodity to fiat money by arguing that all monies must begin as commodities with an objective use value; without this value, there is no reason that anyone would come to use them as a commodity of exchange.
These monies may then proceed to become credit monies, as banks or governments issue promises to deliver a commodity which are printed on paper or on relatively valueless tokens which are then substituted for the commodity. Finally, at the end of the process, the promise to pay a commodity may be withdrawn, leaving a purely fiat money in the banks and pockets of the citizens.
But users of the money do not abandon it: The money retains its exchange value, even if its commodity value is nil.
At least in this volume, Mises seems to skip lightly over the question of what becomes of all of the gold that the state acquires in this transaction. Yet surely it must rank among the greatest of thefts ever perpetrated — unless, that is, nearly all of the worth of gold resides in its exchange value, while almost none of it resides in its commodity value. This seems highly doubtful to me, as the price of gold is still quite dear. Was the commodity value of all the gold in the world’s money supply stolen when the major nations abandoned the gold standard?
I am not sure, meanwhile, that exchange value makes any sense as an explanation for why fiat money is sufficient unto itself. Consider the following example:
“I’d like to buy this new car,” I say.
“Certainly,” answers the dealer. “What can you pay me with?”
[Rummaging through pockets.] “Dryer lint! I’ll pay you in dryer lint. And crumpled-up tissues!”
“You can’t be serious,” says the dealer.
“But I am,” I answer. “Don’t you see that there’s a value in just being able to trade stuff in the market, and that that this is what makes money so very valuable? Why, I’m doing you a favor by giving you this lint, because I am helping the economy to exchange goods and services.”
“Sorry, I only take U.S. dollars,” he answers.
So I produce from my pocket a quantity of plant fibers that are only somewhat different in their physical appearance, chemical composition, and origin. I hand them over and the sale is made.
One might object, perhaps, that lint is more easily manufactured than counterfeit money, that it is thus in greater supply than passable U.S. banknotes — and therefore the exchange value will rapidly approach nil. Very well — so we must choose something besides lint or old tissues, something harder to counterfeit and in limited supply. Let us use baseball cards, perhaps, at the following exchange rate: Any card manufactured prior to last year shall be equal to one dollar of U.S. money.
If “objective exchange value” were really what made fiat currency work, shouldn’t this work just as well? (The so-called “Tinkerbell Effect,” in which a legal institution only works because everyone believes it works, is not to be discounted here. But is it to be understood that this is a collective fantasy, and not a genuine source of value?)
I am inclined to think the real reason that a fiat money continues to work over the long term is one that Mises did not understand, as he did not live under a fiat money system: Fiat money works because, with almost every purchase we make, and with every dollar we earn, we are obliged to pay taxes. And these taxes must be paid in fiat money. If we consistently refuse to pay our taxes, or if we attempt to pay them with anything other than the fiat money, then large, surly men with guns will come along and put us in a small, unpleasant room for a very, very long time.
What is the objective use value of fiat money? It’s the ability to keep the tax collectors at bay. It is interesting, if a little revolting, to contemplate that our shared commodity of exchange is not gold or silver or even cowrie shells, but rather in steps from the prison cell door. And this leads me to my question: If, under a regime of fiat money, the obligations of the citizens to the government were somehow reduced to zero, would the value of the currency collapse?
Certainly its objective use value would drop to nothing. (Or would it? You could not defer indefinitely a promise to pay a given sum of fiat money, or the men with guns would arrive and lock you up for a different offense.) But at any rate, one very significant use of the fiat currency would disappear, and it is hard to see how this could fail to have an effect on the supply of money. Would it retain its exchange value? Or would it go the way of baseball cards and pocket lint? And if the latter, what would replace it?
(I will turn to some considerations on commodity money in my next post in this series, but in the meantime I would like to hear others’ thoughts on the system of fiat money, and particularly on my questions above. Bear in mind that I am still learning about monetary history, and that there is a good deal I do not know in this area.)
Filed in The Boardroom
The government ensures that people will use their Federal Reserve Notes because they have passed legal tender laws. For all debts that one may incur either public or private the FRNs will be legally recognized as having the equivalent value to what is owed, and if dollars are used for compensation it shall be counted as restitution.
So say you’ve made a deal borrowing 100 ounces of gold, and you promise to pay back 105 ounces of gold at the end of some specified period of time. This represents a 5% interest rate. Imagine further that the government has mandated that the price gold shall henceforth be $20.00 for each ounce of gold.
Now say between the time you borrowed the 100 ounces gold the government inflates the dollar and the currency’s strength falls by 10%. You are now in a position to cheat the debt by offering devalued dollars in exchange for gold. If the person who is owed the 105 ounces of gold complains to the court that he has received $2100 that today is valued on the market only as much as $1890 at the time the deal was made (gold equivalent of 94.5 ounces), the government will simply point to their legal tender laws and say that he has been given the equivalent.
At this point Gresham’s Law kicks in. “Artificially overvalued money will drive out artificially undervalued money” People begin to hold on to the real valuable money (the gold), and spend the fiat money (the paper). Very quickly paper money is circulating basically unchallenged; and of course the only thing that makes any money valuable, whether gold or paper, is the fact that other people are willing to accept it for goods and services.
Even if the citizens’ financial obligations to the government were to disappear people would probably still use the FRNs because of legal tender laws and because of a built in familiarity with their use in transactions. The commodity value of gold will only disappear when people are either unwilling or unable to trade goods and services for it.
The government’s legal monopoly on the creation and definition of money cannot be underestimated here. Without competition where are people to go for alternatives? When people are punished for their use of alternatives, why would they continue to do so? The adoption of centralized government banks with a compulsory monopoly on the creation of money spelled the beginning of the end of freedom in the West.
Those are my thought on the matter, I’ll defer to an Austrian expert.
Clearly we did not get where we are by a single causal chain, so I think your theory about tax payments is also part of the answer; however, that doesn’t mean that Mises’s explanation isn’t also part of the answer. Black Bloke’s explanation plays a part as well.
As for your drier lint example, maybe I’m misunderstanding, but I don’t see how it disproves Mises’s point. The lint clearly doesn’t (currently) have exchange value, whereas, because of history and culture, fiat paper money does. Yes, it is in essence an illusion, but then isn’t that the fundamental basis of all of Austrian economics? That all value is in fact subjective - things are valued because an acting mind “imagines” that value.
Now, if we no longer had to pay taxes in fiat money, would the $ collapse? It depends (ha!). If it were managed well, the inertia of current beliefs about its value could theoretically continue in perpetuity. However, the reality of fiat money is that it is *never* managed well, because the temptation is just too great. So, most likely, yes, it would collapse, but only after someone had managed it poorly for long enough that people would begin to question its exchange value.
If, under a regime of fiat money, the obligations of the citizens to the government were somehow reduced to zero, would the value of the currency collapse?
I have empirical evidence to say that it would not. My dissertation was on the effects of fiat currency inflation, and to study it I set up an economic experiment. Subjects traded two fictitious commodities using “tickets” as a medium of exchange. In the first several rounds of each experiment, the tickets were backed with U.S. dollars (don’t get me started on the irony of “backing” a currency with a fiat currency) so that (ala Mises) subjects could find the equilibrium prices of the two commodities. In the fifth round, the tickets lost all of their backing. However, exchange continued pretty much unabated so long as I didn’t inflate the number of tickets in the economy.
This was due (I believe) to the two factors mentioned by Black Bloke and Quasibill. If subjects wanted to consume goods, they had to buy a commodity using tickets, the equivalent of a legal tender law. And even after the tickets became a fiat currency, there was a lot of inertia to keep trading at the backed ticket prices. (In fact, so strong was this tendency that in most experiments where the ticket supply was inflated, prices remained stable until more than halfway through the experiment, after a more than 300% growth of the number of tickets!)
By the way, Jason, I just wanted to thank you for this exercise - I’m enjoying it and learning from it. I’ve always found that I needed give and take discussion of an idea (even “easy” ones) to really internalize it. Since I am essentially an auto-didact in economic matters, I sorely need this type of thing. Thanks again.
very interesting point. but tinkerbell exists and will continue to for those among those who dont understand this, and will always exist among 90% of the population. Very similar in principle to the more recent post about a new american revolution. I like subway and nike. Im not gonna mess with it. Id love to but I wont.
Thank you for your excellent comments, all of you. Shaun, I’m glad you noticed the parallel to the American revolution post. It had been on my mind since yesterday, too.
As to the notion that Tinkerbell will always exist, this is not the case. Currencies do fail and become worthless. How do we explain this?
Currencies do fail and become worthless. How do we explain this?
Currencies typically fail when they become unstable, that is, when they hyper-inflate. Most often, this is due to irresponsible increase of the money supply on the part of the government. When prices keep going up day after day (ala 1920’s Germany), Tinkerbell starts to strain credulity among the populace. When prices are basically the same for long stretches of time, it’s very easy to believe she exists.
Fiat currencies will also fail when people suspect that the enforcer of the legal tender laws is about to fail. Think Confederate Dollars. If I’m sure that the boys in Richmond will be tried for treason in a year or so, I know that the fiat currency they issued me is going to be the equivalent of Monopoly Money in very short order. That probably means that I’ll start trying to trade as much of it for actual commodities as possible, and damn the price. It also probably means that I won’t be willing to accept it as payment for my labor or goods, and damn the legal tender laws; there’s little chance I’ll ever be prosecuted for breaking them. And if everyone is as sure as I am that the Confederacy is going to fail, then we will all stop using Confederate dollars, and probably revert to a barter economy, or gold/silver will be used as the de facto medium of exchange.