Fiat money
Fiat money is a type of government-issued currency, authorized by government regulation to be legal tender. Typically, fiat currency is not backed by a precious metal, such as gold or silver, nor by any other tangible asset or commodity. Since the end of the Bretton Woods system in 1976 by the Jamaica Accords, all the major currencies in the world are fiat money.
Fiat money generally does not have intrinsic value nor a use value. It has value only because the individuals who use it agree on its value. They trust that it will be accepted by merchants and other people as a means of payment for liabilities.
Fiat money is an alternative to commodity money. Fiat also differs from representative money. Fiat money can look similar to representative money, but the former has no backing, while the latter represents a claim on a commodity or a tradable investment, and can be redeemed to a greater or lesser extent.
Government-issued fiat money banknotes were used first during the 13th century in China. Fiat money started to predominate during the 20th century. Since US President Richard Nixon's decision to suspend US dollar convertibility to gold in 1971, a system of national fiat currencies has been used globally.
Fiat money can be:
- Money declared by a person, institution or government to be legal tender, meaning that it must be accepted in payment of a debt in specific circumstances.
- State-issued money which is neither convertible through a central bank to anything else nor fixed in value in terms of any objective standard.
- Money used because of government decree.
- An otherwise non-valuable object that serves as a medium of exchange.
Treatment in economics
In monetary economics, fiat money is an intrinsically valueless object or record that is accepted widely as a means of payment. Accordingly, the value of fiat money is greater than the value of its metal or paper content.One justification for fiat money comes from a micro-founded model. In most economic models, agents are intrinsically happier when they have more money. In a model by Lagos and Wright, fiat money does not have an intrinsic worth but agents get more of the goods they want when they trade assuming fiat money is valuable. Fiat money's value is created internally by the community and, at equilibrium, makes otherwise infeasible trades possible.
Objections to fiat money can be traced back to at least the 1700s. In 1787, George Washington wrote to Jabez Bowen, regarding the Rhode Island pound: "Paper money has had the effect in your State that it ever will have, to ruin commerce—oppress the honest, and open a door to every species of fraud and injustice."
In the Grundrisse, Karl Marx considered the modern economic ramifications of a historical switch to fiat money from the gold or silver-commodity. Marx writes:
"Suppose that the Bank of France did not rest on a metallic base, and that other countries were willing to accept the French currency or its capital in any form, not only in the specific form of the precious metals. Would the bank not have been equally forced to raise the terms of its discounting precisely at the moment when its "public" clamoured most eagerly for its services? The notes with which it discounts the bills of exchange of this public are at present nothing more than drafts on gold and silver. In our hypothetical case, they would be drafts on the nation's stock of products and on its directly employable labour force: the former is limited, the latter can be increased only within very positive limits, and in certain amounts of time. The printing press, on the other hand, is inexhaustible and works like a stroke of magic."Commenting on the passage, Marxist economist and geographer David Harvey writes that "he consequence, as Marx saw it, would be that "the directly exchangeable wealth of the nation" would be 'absolutely diminished' alongside of 'an unlimited increase of bank drafts' with the direct consequence of 'increase in the price of products, raw materials and labour' alongside a 'decrease in price of bank drafts'." Harvey notes the accuracy of the modern economy in this way, save for "...the rising prices of labor and means of production." The latter point can be explained by the private exportation of debt, labour, and figurative and/or literal waste to the global periphery, a concept related to metabolic and carbon rift.
Another mathematical model that explains the value of fiat money comes from game theory. In a game where agents produce and trade objects, there can be multiple Nash equilibria where agents settle on stable behavior. In a model by Kiyotaki and Wright, an object with no intrinsic worth can have value during trade in one of the Nash equilibria.
History
China
China has a long history with paper money, beginning in the 7th century CE. During the 11th century, the government established a monopoly on its issuance, and about the end of the 12th century, convertibility was suspended. The use of such money became widespread during the subsequent Yuan and Ming dynasties.The Song dynasty in China was the first to issue paper money, jiaozi, about the 10th century CE. Although the notes were valued at a certain exchange rate for gold, silver, or silk, conversion was never allowed in practice. The notes were initially to be redeemed after three years' service, to be replaced by new notes for a 3% service charge, but, as more of them were printed without notes being retired, inflation became evident. The government made several attempts to maintain the value of the paper money by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes became disfavored.
The succeeding Yuan dynasty was the first dynasty of China to use paper currency as the predominant circulating medium. The founder of the Yuan dynasty, Kublai Khan, issued paper money known as Jiaochao during his reign. The original notes during the Yuan dynasty were restricted in area and duration as in the Song dynasty.
During the 13th century, Marco Polo described the fiat money of the Yuan dynasty in his book ''The Travels of Marco Polo:''
Europe
According to a travelogue of a visit to Prague in 960 by Ibrahim ibn Yaqub, small pieces of cloth were used as a means of trade, with these cloths having a set exchange rate versus silver.Around 1150, the Knights Templar would issue notes to pilgrims. Pilgrims would deposit valuables with a local Templar preceptory before embarking for the Holy Land and receive a document indicating the value of their deposit. They would then use that document upon arrival in the Holy Land to receive funds from the treasury of equal value.
Washington Irving records an emergency use of paper money by the Spanish for a siege during the Conquest of Granada. In 1661, Johan Palmstruch issued the first regular paper money in the West, by royal charter from the Kingdom of Sweden, through a new institution, the Bank of Stockholm. While this private paper currency was largely a failure, the Swedish parliament eventually assumed control of the issue of paper money in the country. By 1745, its paper money was inconvertible to specie, but acceptance was mandated by the government. This fiat currency depreciated so rapidly that by 1776 it was returned to a silver standard. Fiat money also has other beginnings in 17th-century Europe, having been introduced by the Bank of Amsterdam in 1683.
New France 1685–1770
In 17th century New France, now part of Canada, the universally accepted medium of exchange was the beaver pelt. As the colony expanded, coins from France came to be used widely, but there was usually a shortage of French coins. In 1685, the colonial authorities in New France found themselves seriously short of money. A military expedition against the Iroquois had gone badly and tax revenues were down, reducing government money reserves. Typically, when short of funds, the government would simply delay paying merchants for purchases, but it was not safe to delay payment to soldiers due to the risk of mutiny.Jacques de Meulles, the Intendant of Finance, conceived an ingenious ad hoc solution – the temporary issuance of paper money to pay the soldiers, in the form of playing cards. He confiscated all the playing cards in the colony, had them cut into pieces, wrote denominations on the pieces, signed them, and issued them to the soldiers as pay in lieu of gold and silver. Because of the chronic shortages of money of all types in the colonies, these cards were accepted readily by merchants and the public and circulated freely at face value. It was intended to be purely a temporary expedient, and it was not until years later that its role as a medium of exchange was recognized. The first issue of playing card money occurred during June 1685 and was redeemed three months later. However, the shortages of coinage reoccurred and more issues of card money were made during subsequent years. Because of their wide acceptance as money and the general shortage of money in the colony, many of the playing cards were not redeemed but continued to circulate, acting as a useful substitute for scarce gold and silver coins from France. Eventually, the Governor of New France acknowledged their useful role as a circulating medium of exchange.
As the finances of the French government deteriorated because of European wars, it reduced its financial assistance to its colonies, so the colonial authorities in Canada relied more and more on card money. By 1757, the government had discontinued all payments in coin and payments were made in paper instead. In an application of Gresham's Law – bad money drives out good – people hoarded gold and silver, and used paper money instead. The costs of the Seven Years' War resulted in rapid inflation in New France. After the British conquest in 1760, the paper money became almost worthless, but business did not end because gold and silver that had been hoarded came back into circulation. By the Treaty of Paris, the French government agreed to convert the outstanding card money into debentures, but with the French government essentially bankrupt, these bonds were defaulted and by 1771 they were worthless.
The Royal Canadian Mint still issues Playing Card Money in commemoration of its history, but now in 92.5% silver form with gold plate on the edge. It therefore has an intrinsic value which considerably exceeds its fiat value. The Bank of Canada and Canadian economists often use this early form of paper currency to illustrate the true nature of money for Canadians.