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An Explanation of Government Fiat Money

July 29, 2011

The theory of money has always fascinated me. Possibly the most counter-intuitive aspect of money is why do we use something essentially worthless to purchase everything of value? There are two halves to this question: Why fiat currency? and Why government currency?

Why fiat?
When people are deciding what to use as a money, they look at the goods they have and try to find one that is portable, durable, divisible and widely desired. As groups begin to agree on which good to use, network externalities develop. The more people use a money, the more people you can trade with using that money. Societies often quickly converge on one good to use for exchange. However, people don’t want to tie up valuable goods simply to maintain a store of value. For example, cigarettes used for money can’t be smoked. Almost all resources in society have alternative uses. If we use gold for money, we can’t use it for jewelery or circuit boards or anything else. I would argue that the reason gold was used as money in the past was precisely because it didn’t have many alternative uses other than to display wealth. You can’t build a house out of gold, nor a weapon. Societies evolve toward using pretty or rare items as a medium of exchange, but rarely practical items – think of Yap stones or cowrie shells. Modern examples of stateless fiat currencies include the Somali shilling and the Iraqi dinar used by the Kurds.

Money’s value comes from its ability to be exchanged for goods. Resources should only be devoted to producing money if they improve that ability. Commodity backing is just one of many ways to ensure that a currency holds its value: the exchange value can never be below the use value, otherwise people will just use the money for something other than exchange. Most modern economies use institutional contrains to ensure that the central bank stays committed to holding the value of money relatively constant. Ultimately, institutional constraints are all that matters. If a government is not institutionally constrained to printing a reasonable amount of money, they won’t be constrained from debasing the commodity backing of the currency either.

Why government?
Money is characterized by network externalities – the more people who use it, the better it gets. Once a good becomes widely used as money, it is very hard to break that equilibrium. The government is a clear focal point to provide a currency. It comprises a significant percentage of the economy, it has a comparative advantage in violence, so it can stop competitors and it can create demand for its currency by taxing as noted by the Chartalists. I don’t think any of these factors are conclusive by themselves, but combined create a powerful force pushing towards government fiat currency. Governments have a strong incentive to control the supply of money. By doing so, they gain the ability to monetize debts, finance spending in an emergency, gain seigniorage revenue, create short term economic booms and isolate themselves from external economic shocks (for example, if the U.S. used British pounds instead of dollars, the U.K. could hurt our economy by destabilizing the supply of pounds). From the demand side, people often trust the government. Elections give the populace some degree of control over politicians. If a government maintains a monopoly on money, the have an incentive to keep inflation somewhat low in order to maximize their revenue from printing money.

I don’t think people are capable of very much reverse induction. In the “Guess 2/3rds the Average” game, virtually no one guesses 0. While the long run value of any fiat currency is 0, most people don’t care. They just have to believe that they will be able to spend their money before that happens and they base their future expectations on past events. As with everything in economics, all value is subjective.

2 Comments leave one →
  1. August 2, 2011 3:37 pm

    Here’s another explanation of fiat money: There’s no such thing. Just think of a central bank that holds various assets worth 100 oz. of silver, and has issued 100 units of paper money (dollars). The bank doesn’t offer convertibility, but does promise that after n years, the bank will be liquidated and each dollar will be redeemed for (1+R)^n oz. of silver. This will make each dollar worth 1 oz. today, even though the absence of convertibility would leave some people saying that the dollars are not backed by any commodity.

    • August 2, 2011 7:03 pm

      I must admit, I am not familiar with the Real Bills Doctrine. I will read the papers on your website and respond once I feel I understand your position better. If money is eventually redeemable, then I agree that it is not fiat.

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