Fiat Money

July 9, 2009

by Gene Callahan

Again and again, I run across this complaint that fiat money “is money created out of nothing.” This is supposed to be an argument against fiat money, but, in fact, I take it to be a substitution of sloganeering for scientific analysis.

The reason the slogan works emotionally is “creating money out of nothing” appears to rely on some sort of black magic, and therefore to be evil. But that is a category error: creating money (or anything else) from nothing is not evil, it is impossible (except, perhaps, on the part of our Maker, should He exist). And, since it is impossible, it cannot really be what fiat money regimes are doing.

In fact, although this is an idea I haven’t yet had the time to pursue at length (which is why I’m blogging it rather than publishing it as an academic paper, at least at this point) I believe that fiat money is created from a government’s ability to collect taxes, combined with the fact that it promises to accept the pieces of paper in payment for those taxes. My hypothesis, as this point only a suspicion, is that the “backing” of fiat money is first and foremost its ability to pay tax obligations to the government, and that’s its value for other uses is anchored in this ability, just as the value of gold as money is initially anchored in its value in all non-monetary uses.

However, even if I turn out to be wrong about this, I am sure about one thing: the value of fiat money is not created “out of nothing,” because ex nihilo nihil fit.

42 Responses to “Fiat Money”

  1. donny Says:

    are you being sarcastic? because your hypothesis isn’t original. the idea is called chartalism or the state theory of money and it’s been around a long time.

  2. dg lesvic Says:

    Prof Callahan,

    You’re taking a figure of speech too literally. My claim to the throne of the Holy Roman Empire did not come out of nothing, but out of my fevered imagination.

    Strictly speaking, fiat money did not come out of nothing. It came out of the fiat, but not out of the market, as did gold and silver or cockleshell money. And whether it was real money or not, it was not the money of the market.

    Could it take the place of the money of the market?

    Yes.

    Then, what’s wrong with it?

    In one word.

    Politics.

  3. Gene Callahan Says:

    “are you being sarcastic? because your hypothesis isn’t original. the idea is called chartalism or the state theory of money and it’s been around a long time.”

    What I’m thinking about has very little to do, as far as I can see, with chartalism. I am asking the question of why fiat money has a value.

  4. dg lesvic Says:

    Because it’s legal tender.


  5. Gene Callahan asks an important question, worth study in my view. Milton Friedman said something to this effect: What works for money works for money. That seems true to me. Fiat money surely has problems, but I’m happy to take it for the work I do.

  6. teageegeepea Says:

    Sounds like what Mike Sproul has said. He’s a proponent of the Real Bills Doctrine, and denies that there is such a thing as fiat money (but in a different way from Steve Keen).

  7. dg lesvic Says:

    What’s to study?

    It has value because it’s legal tender.

    But, with or without that status, it would have value only so far as it was trusted.

    What’s so complicated about that?

  8. Mario Rizzo Says:

    I have deleted some comments above because they were plainly idiotic. Guys, be careful.

  9. Lee Kelly Says:

    It has always been my impression that when someone complains that fiat money is “money created out of nothing”, what they mean is that when the a government cranks the printing presses, the new units of money are not complemented by the creation of additional wealth.

    Although it is a rather misleading phrase, I think the concern that it expresses is quite sensible.

  10. Tom Says:

    Gene,

    I take the phase, “money created out of nothing” to mean that money has been created at zero or near zero cost. To increase the money supply when there was commodity money such as gold and silver, it was a rather expensive endeavor to increase the money supply by mining gold or silver. With fiat money the cost of increasing the money supply is cheap. Money can be expanded with only the cost of paper and ink being expended or the cost of pushing a few buttons on a computer at the Federal Reserve. I take the phase money created out of thin air or money created out of nothing to mean that the money supply can be expanded at very little cost.

  11. Tom Says:

    Gene,

    Your point about fiat money being “created from a government’s ability to collect taxes, combined with the fact that it promises to accept the pieces of paper in payment for those taxes” is a separate point different from the phrase “money being created out of nothing”. Here we are dealing where does the demand for fiat money come from. With commodity money, such as gold, it has demand first as a commodity in consumer and industrial applications. Gold is demanded both a consumer good and a producer good. The fact that it was used a medium of exchange created addition demand for gold.

    Fiat money is not a commodity and does not have demand in consumer and industrial applications as does gold. Mises as I recall (perhaps incorrectly) thought that Fiat money derived its demand from Gold because it could be used as a substitute for commodity money. Other economists have recently argued that Fiat money derives its demand, as you say, from the governments ability to collect taxes in the form of Fiat money and the requirement that Fiat money be accepted as a means of payment in transactions. An examination of colonial money issued by states (e.g., the Pennsylvania Pound) may be an area of examination to shed light on the origin of the demand for Fiat money.

  12. Gene Callahan Says:

    “I take the phase, “money created out of nothing” to mean that money has been created at zero or near zero cost.”

    Then why is the phrase used in condemnation? Surely to create something at low cost is a good thing, isn’t it?

  13. Tom Says:

    Fiat money is an economic good because it is demanded, but it is not a consumer or producer good. An increase in the amount of cars or oranges at zero cost is a good thing. An increase in the amount of money is not the same because it is not something that is directly or indirectly consumed. An increase in the quantity of money increases prices of goods but not the amount of goods available to consume. However, an increase in the money supply can cause idle resource to become available that weren’t available for use before. This has to do with why money is not neutral. It has an impact on real variables in the short run and not just nominal variables. Increasing the money supply is popular because it can give a short run boost to the economy by putting to work previously idle resources.

  14. dg lesvic Says:

    Tom,

    You wrote,

    “an increase in the money supply can cause idle resource to become available that weren’t available for use before.”

    How could they have been both idle and unavailable? Where were they, on the moon?

    You wrote,

    “Increasing the money supply is popular because it can give a short run boost to the economy by putting to work previously idle resources.”

    From Ludwig von Mises:

    “The attempts to lower interest rates by credit expansion…generate a period of booming business. But the prosperity thus created is only an artificial hot-house product and must inexorably lead to the slump and to the depression. People must pay heavily for the easy-money orgy of a few years of credit expansion and inflation.”

    I must confess that I don’t exactly follow Mises’ reasoning here. Assuming an otherwise completely free market, how could increasing the money supply and lowering interest rates increase business activity?

    There are idle resources because the complementary factors of production that are needed along with them are lacking. If land is idle, it is because the labor needed to work it is lacking. There aren’t enough workers to work all of the available land.

    Creating more money doesn’t create more workers. All it could do was shift them around from one occupation to another.

    Increasing the money supply brings idle resources into play only when they had been priced out of the market by public policy.

    A minimum wage law, for example, raising the wages of labor above market, equilibrium, full employment levels, drives marginal workers into unemployment. But, if, in the course of the credit expansion and inflation, the rise in wage rates lags behind the rise in the prices of commodities, unemployment will decline.

    “What makes it shrink or disappear is precisely the fact that such an outcome is tantamount to a drop in real wage rates.”

    Mises

  15. azmyth Says:

    Governments debase currencies slowly over time, using coecion to force people to accept the new coins at face value. If it were not for the threat of force, no one would accept the new coins.

    Gresham’s Law causes the non-debased currency to disappear from circulation. Over time the currency gets more and more debased until there is very little of the commodity left. The final transition to pure fiat is a pretty easy one because the value of the coin is almost entirely the exchange value, not the value of the commodity.

    Society benefits from sharing a common currency and not having to barter. Money is a coordination game. The opportunity cost of using a commodity standard is the foregone uses of that commodity. For example, gold used in coins can not be used for jewelery or for computer parts. There is practically no opportunity cost for fiat currency since the alternative is just using the paper to write on.

    The costs of a fiat system is the difficulty in preventing the government from inflating, but dealing with that requires public choice theory.

    George Selgin is very good on this issue, so I recommend checking his work out.

    -James Oswald

  16. Tom Says:

    “an increase in the money supply can cause idle resource to become available that weren’t available for use before.”

    How could they have been both idle and unavailable? Where were they, on the moon?

    Tom: Resources were idle an unavailable because they were under priced. The suppliers of those resources withheld them from production because they did not command a price that the owners wanted to make them available for production. These would be supermarginal suppliers.

    “If land is idle, it is because the labor needed to work it is lacking. There aren’t enough workers to work all of the available land. Creating more money doesn’t create more workers. Increasing the money supply brings idle resources into play only when they had been priced out of the market by public policy.”

    Tom: Again, under priced resources including labor, capital, and land will become available with an increase in the money supply and the bidding up of resources. Resources that were withheld from the market because the price those resources commanded were less than the owners of those resources desired now become available as the price is bid up due to an increasing money supply.
    For example, more money will “create” more people willing to work and for longer hours as the price of there services are bid up. This no mystery; it is the supply curve in action.

  17. joshmccabe Says:

    I never bought the argument that fiat money is demanded simply because of legal tender laws. If that’s true, why is it demanded outside the United States?

  18. dg lesvic Says:

    Tom,

    People work not for money but for what it can buy. And increasing the supply of it does not increase the supply of what it can buy and its purchasing power. There is no more attraction to a wage of $2 that will buy a loaf of bread than a wage of $1 that would have bought the same loaf.

  19. Tom Says:

    dg,

    While increasing the money supply will decrease the purchasing power of money this is not an instantaeous adjustment. It takes time for prices to adjust upward and those who receive the additional money first will be able to purchase things before prices have adjusted. Increasing the money supply will first impact output and only later will it impact prices. To argue that money supply increases only impact prices would be to argue money is neutral in the short run.

  20. dg lesvic Says:

    Tom,

    You wrote,

    “It takes time for prices to adjust upward and those who receive the additional money first will be able to purchase things before prices have adjusted.”

    Exactly. Increasing the money supply will take purchasing power from those who have earned it and give it to those who haven’t.

    Any other “benefits” of inflation?

  21. dg lesvic Says:

    joshmccabe,

    You wrote,

    “I never bought the argument that fiat money is demanded simply because of legal tender laws. If that’s true, why is it demanded outside the United States?”

    Would it be demanded outside the US if there were no legal tender laws within the US?

  22. Greg Ransom Says:

    I’ve made this argument on “Austrian” lists in the past, but I can’t say I’ve thought it through to the degree I’d like.

    What do you think of California’s ability to issue “IOU” paper in payment for money owed?

    Gene writes:

    “I believe that fiat money is created from a government’s ability to collect taxes, combined with the fact that it promises to accept the pieces of paper in payment for those taxes. My hypothesis, as this point only a suspicion, is that the “backing” of fiat money is first and foremost its ability to pay tax obligations to the government, and that’s its value for other uses is anchored in this ability, just as the value of gold as money is initially anchored in its value in all non-monetary uses.”

  23. Greg Ransom Says:

    Note that if a central government makes some item fungible as a means of discharging tax liabilities to the government, that almost immediately into an easily traded means of exchange.

    I can’t believe their isn’t a literature on this topic.

  24. Steve Says:

    The 17th century American colonies are a great time period to study in this regard.

    States varied in their approaches to backing their money and the results varied as well.

  25. Steve Says:

    18th century….

  26. dg lesvic Says:

    I wonder if the all the people here understand what legal tender laws mean.

    To say that the dollar is legal tender for all debts public and private means that you have to accept it as payment. You cannot say, I’m sorry, I don’t want your pieces of paper, I want gold or silver. You take those piece of paper, or nothing.

    So, what is the “backing” for fiat money?

    Its issuers’ power to collect taxes?

    Your right to pay your taxes with it?

    Not even close.

    Its sole backing, in one word:

    Monopoly.

  27. Gene Callahan Says:

    I wonder if all the lesvic’s here realize that saying you have to accept legal tender money:
    1) doesn’t always work; and
    2) in no way offers any explanation for how much of it you will demand.

  28. dg lesvic Says:

    I’m sorry, Prof Callahan, but I can’t make any sense and see any point to what you’re saying.

    “doesn’t always work”

    What does that mean?”

    “doesn’t explain how much of it you will demand.”

    Of course it doesn’t, but what does that heve to do with the question?

  29. Steve Says:

    I think what Prof Callahan meant by “doesn’t always work” is that…. it doesn’t always work.

  30. dg lesvic Says:

    Well, he’s the one advocating it, not me.

  31. Gene Callahan Says:

    Thank you for clarifying that, Steve.😉

    Mr, Lesvic, where in the world did you get the idea I am “advocating” fiat money by trying to scientifically analyze the source of its value? If a detective tries to determine how someone was killed, is he “advocating” murder? And if he rejects the people who are saying “voodoo killed him”, is that defending the murderer?

  32. Steve Says:

    Prof Callahan,

    How do you feel about Michael Sproul’s claim that American money isn’t fiat? I believe he claims that fiat money has never existed.

    His claim about American money is that the Federal Reserve hold’s financial securities in the amount of dollars issued. Just because money is not CONVERTIBLE doesn’t mean it isn’t BACKED…

    your thoughts?

  33. dg lesvic Says:

    Which one of us is crazy, because we can’t both be sane?

    Question:

    How did life on Earth come about?

    Answer:

    Living things somethimes die.

    True, but the answer has nothing to do with the question.

    Question:

    How do fiat money systems come into being?

    Answer: They don’t always work.

    True, but the answer has nothing to do with the question.

    Cart me off, please, because I’ll find more sanity in the looney bin.

  34. dg lesvic Says:

    Just explain to me how a fiat money system could come into being without a fiat, and continue without a monopoly.

  35. Tim Says:

    I suppose this must be a workable thesis. Think of economies with hyper inflation. People discontinue the use of fiat money (resort to barter exchange, often enough). But even in these places, where fiat money has lost almost all of its practical value, it is still good for one thing (besides toilet paper): Paying taxes.

    Places with hyper inflation might be good “test” models to further this. Just a thought. Oh, and there is a bit of this from way back when, like Donny said above.
    http://home.manhattan.edu/~fiona.maclachlan//maclachlan26july03.htm

    I don’t like some of that, but it seems to give a good overview of some chartalism proponents, like G.F.Knapp.

  36. Bob Murphy Says:

    Gene, I think the more conventional usage says that the Fed creates money out of thin air. No logical problem there involving Latin phrases.

    And as others have said, the reason this is significant is that it shows no real wealth is being created. In contrast, when anybody else in society writes someone a check for a million dollars, we know that he must have previously produced something to acquire the money.

  37. Current Says:

    Gene is of course correct that the ultimate backing for our current fiat money is the state. That is what prevents long term competition from occurring.

    Read this end of this recent thread on MoneyIllusion:
    http://blogsandwikis.bentley.edu/themoneyillusion/?p=1791#comments

    This is all old theory.

    Note that Mike Sproul’s position is that fiat money is somehow “backed” by Fed assets. This is rubbish.

  38. darkness Says:

    I thought that the idea of fiat money was that it gave the government the ability to create more money without the creation of more real wealth.

    If the economy creates 5% more real wealth this year than last year, and the government (or its designated agents) create 5% more money, the prices of those goods and services should remain the same. If the economy creates 5% more wealth this year than last year and the government creates 10% more money, we should see inflation. If the economy creates 5% more real wealth this year than last and the government issues 2% more money, we should see deflation.

    I’m defining inflation and deflation as something different from a real rise or fall in the price of goods and services, as would be seen in the case of oil depletion (rise) or a new technology increasing productivity in some area (fall).

    In theory, fiat money should work, given a situation in which an honest government was able to measure real economic activity in terms of the production of real wealth and issued only as much new money as was justified by the creation of new wealth.

    But, as I like to say, if it doesn’t work in the real world, it doesn’t work. Governments always give in to the desire to please people by creating a false sense of wealth (since inflation takes a while to manifest). And measuring economic activity in terms of money is like using a rubber ruler that stretches or contracts based on what is being measured.

  39. lebron james Says:

    there is a big problem caused by fiat money because its inflationary and may also lead to a recession when you consider moneys function in general as a standard of deffered payment thats one of the cause of the credit crunch

  40. Bob V Says:

    It is true that nothing can come of nothing. Therefore, money is not created out of thin air. But things can be diluted by thin air; for example: meringue.

    The Fed doesn’t create money, or anything, out of thin air. It does dilute money.

    Fiat money is no more money than hamburger helper is hamburger.

    The trick is to add the hamburger helper, and thereby extend or dilute the real hamburger, very slowly, such that, the value of today’s ever more slightly diluted “hamburger” is imputed from yesterday’s ever so slightly less diluted “hamburger”.

    If the chef goes from a 100% hamburger “hamburger” yesterday, to 5% hamburger, 95% hamburger helper, today, he will have a hard time convincing anyone to accept what he offers as a “hamburger”. But, if by very small dilutions, he takes ninety-five years to bring about the same result….

    When hyperinflated currencies crash, is it because the sponsoring governments have lost the ability to tax? Or is it because they have created too wide a chasm for imputation to cross.

  41. Mike Sproul Says:

    Gene:

    You are correct in saying that so-called fiat money is actually backed by taxes. Some paper money is backed by a banker’s promise to pay out one ounce of silver, while other paper money is backed by the government’s pledge to accept that paper instead of one ounce. If the banker loses his assets, his money will lose value, and if the government loses its ability to collect taxes, its money will lose value. This is covered in several papers of mine, which can be accessed by clicking my name above.

  42. Silmarila Says:

    First of all, I believe fiat money is indeed fiat. Nothing more than just what it says its value is.
    To jump right to the point, when you’re saying that paying taxes backs up fiat money’s value, it destroys (and contradicts) the whole purpose of fiat money itself. Let me put this in perspective: if we’re paying some 30% of our income back to the government (in taxes), in effect, it advertently means the government can use the remainder 70% to pay all of us for our labor. All of us are being paid with paper money (fiat) that says what its face value is, regardless whether or not they have any to begin with. The value is only good when someone else accepts that payment from you. So my take is, the government (or any government for that matter) does this because this is the only way to keep the economic engine running, to make all of us believe that every hour and every minute of our toil is worth the value what that fiat money the government is printing brings. It’s nothing more than just a universal perception among the entire human race (except for those living in remote and primitive areas where money is never used to trade basic needs). The tax system is just there as a make-believe that it actually gives us the “virtual” value of our dollar. Personally, I think this inevitably would be the perfect trade-off for the government as it can spend away those printed money as much as it wants on virtually anything from wars to running budget deficits for decades, and still getting away with a credit rating of AAA while hanging like a monkey on the back of the labor of the masses.


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