Home > Macro/Monetary Theory > “Fiat Money” or “I’m Back Baby”

“Fiat Money” or “I’m Back Baby”

If you are a regular reader of this blog, then hi mom!….(how do you type a rimshot?)  Ok if you’re a regular reader of this blog you’ve probably noticed that I haven’t been blogging for a while.  I’m trying to get back in the habit so I’m going to restart with the most important thing I have to say.  Even though I’ve sort of been over this ground before, it is a difficult concept and I don’t think I’ve nailed it yet so I’m just going to keep trying until I do.

Among libertarians, there is a lot of uneasiness about our system of fiat money.  For that matter, among leftists there is a lot of uneasiness about our system of fiat money (although they would usually like to replace it with a more centralized fiat money system rather than a decentralized hard money system).   However, I don’t think many people on my side really grasp the true nature of the system we have now.  If they did they would be even more horrified by it than they already are.

The misunderstanding centers on the idea that the currency is not backed by anything.  This is not correct, and it leads to the notion that the government/Federal Reserve can endlessly debase the currency imposing a stealth tax on us and potentially leading to hyperinflation.  While the first part of this is true to some extent, it is not hyperinflation that we should be concerned about it is precisely the opposite phenomenon.  To understand this we must first understand the fundamental difference between the monetary/banking system with a gold standard vs. without.

In both systems money represents debt.  When you have a gold standard and a fractional reserve banking system, you take 100 oz. of  gold to the bank and the bank hands you a piece of paper signifying a debt from the bank to you for 100 oz of gold.  This paper can then be traded as though it were gold because anyone can take it to the bank at any time and exchange it for gold.  When they do this the Bank’s balance sheet will look like this (assuming no additional fees or interest in either direction):

Assets                                         Liabilities

Gold:   100                                Accounts Payable (cash outstanding):  100

Banks can inflate economic bubbles in this case.  When an investor comes in asking for a loan, the bank can write an IOU for 100 oz. of gold without receiving the gold up front.  In this case the bank trades debt for debt.  They give an IOU for gold payable at any time and receive an IOU for gold payable at some specific time in the future.  If they charge interest, the debt they receive will be larger than the one they give up.  The bank’s  balance sheet will then look like this:

Assets                                                   Liabilities

Gold:                               100              Accounts Payable (cash outstanding)    200

Accounts receivable     100

By doing this the bank has doubled the amount of cash supported by the original 100 oz. of gold.  In the process they have made a profit of 10 oz.  However, because of the difference in maturity of their assets and liabilities they have made themselves technically insolvent.  As long as the cash, representing their promise to pay gold at any time, continues to circulate in the economy rather than being redeemed for gold until their loan becomes due they will be fine.  However, if the people holding this cash show up demanding gold before that 110 oz. comes in from the repayment of the loan to the investor, then they will not have enough gold to pay their debts and they will go bankrupt.  This is the dreaded bank run.  I have already discussed how a bank run could be managed in a free market economy so I won’t get into that here but the key point is that the bank goes bankrupt in the event of a bank run.  This is because the debt which backs the currency is a debt from the bank to the public.  This is convenient because the bank is the one determining how much to inflate the money supply and they destroy themself if they inflate it too much (the more money they create in this way, the more incentive there is for people to exchange it for gold).  In other words there is a natural incentive for banks not to get too carried away with the creation of money.

Now consider a central bank with fiat money.  Here I will speak of a central bank which represents the banking system as a whole.  This should not be confused with an individual bank within that system which is confronted by different issues.  The distinction is very important.  Money no longer represents a debt payable by the bank in the form of gold to the bearer of the money.  This leads many smart people to proclaim that our money is not backed by anything.  However, this is not the case.  The money is in fact backed by real assets and this distinction is the key to understanding the system.  The money is backed by the goods that collateralize the debt which calls it into existence.  To see what I mean, consider a homeowner who takes out a mortgage.  When this happens the bank “prints” (though the actual printing is largely circumvented these days) money and gives it to the homeowner.  The homeowner promises to pay the money back at some time in the future and if he is unable to, the bank gets the house.

The homeowner takes the money and uses it to buy the house from a builder.  Now the builder has the money.  But the builder cannot redeem the money for anything at the bank.  It is no longer backed by gold.  This eliminates the potential for a bank run.  So why does the builder want the money?  Because he can exchange it for other goods and services of course.  But why is he able to do this?  Most people seem to think this is just some kind of magic or “animal spirits,” driving people to always keep accepting something that is ultimately guaranteed by no real assets in the hope that someone else will accept it in the future.   The real reason is that it is contractually guaranteed to be redeemable for real assets.  To see how consider the homeowner again.

When we talk about a mortgage we typically say that the homeowner takes out a loan and buys the house and then must pay back the loan or the bank takes the house.  Another way of saying the same thing is that the bank buys the house (and lets the borrower live there) and promises to sell the house to the homeowner at a later date for a specified amount of money.  Either way, the homeowner must pay dollars back to the bank in the future to keep the house.  The dollars are guaranteed by the house!  The homeowner we considered can borrow freshly printed dollars to buy a house because the builder can use those dollars to buy groceries because the grocer has a mortgage which he must pay with those dollars in order to keep his house.

In this system, the amount of money the borrower promises to pay in the future is larger than the amount created when he takes out the loan.  This means that in order for him to be able to pay off his loan, even more money will have to be created in the future.  Every dollar created requires more than a dollar to be destroyed (paid back to the bank) in the future.  This means that in the future more money will have to be created to replace the money coming out, otherwise there will not be enough money for everyone to pay their debts and they will scramble to get the existing dollars to avoid losing their homes and other collateralized property.  This will cause the value of the dollar to rise (price deflation)!  It will also cause a wave of defaults.  As people default on their loans, real property is accumulated by the central bank and money leaks out into the economy (the money not used to pay back the loan).  This process will continue until enough money has leaked out to stabilize the system.  Sound familiar?

So here is the difference.  With a gold standard, if the banks inflate the money supply too much, they cause a bubble.  When the bubble collapses they go bankrupt and the real wealth remains in the hands of the people (though there is likely to be some “collateral damage”…I really have to figure out that rimshot thing).  With fiat money, when the central bank inflates the money supply it causes a bubble.  When the bubble bursts we go bankrupt and the property ends up in the hands of the bank (remember this is not your local savings and loan we’re talking about, they go bankrupt too and their property goes to the Fed.)  This is because when there is a gold standard money is created by a debt from the bank to the public.  With fiat money, money is created by a debt from the public to the bank.

So now the important question is this:  Why in the world would we think that going from a system in which the banks lose from blowing up monetary bubbles to one with a single centralized bank which gains from this process will result in fewer monetary bubbles?  Maybe more fundamentally, how can we claim to love liberty and fear tyrants when we grant a group of private bankers the right to buy whatever of our property they wish just by printing money and literally print laws requiring us to indebt ourselves to these men?  How is it that we find the idea of free money more frightening than this scenario?


  1. February 4, 2013 at 10:10 pm

    Honor is a value that people see in you and that you live abtulosely in the world. You cannot have honor, but earning it is itself honor. You cannot attain honor but trying is what is honorable.

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