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Fiat money is money declared by a government to be legal tender. The term derives from the Latin fiat, meaning "let it be done". Fiat money achieves value because a government demands it in payment of taxes and says it should be used within the country as a tender (offering) to pay all debts. In effect, this validates it to be used to buy and sell goods and services and mandates it to pay tax. Where fiat money is used as currency, the term fiat currency is used. Today, most national currencies, including the major reserve currencies, i.e. US dollar, euro, and pound sterling, are fiat currencies.

Overview

Historically, post-barter societies have relied on monetary systems where currency used in trade was either commodity money, composed of a physical commodity such as gold, or representative money, exchangeable for a predetermined amount of a named physical commodity ('specie'). The represented commodity could be a precious metal such as gold, silver, or copper, although some economies have had money that was redeemable for a fixed amount of other commodity items.

While specie-backed representative money entails the legal requirement that the bank of issue redeem it in fixed weights of specie, fiat money's value is unrelated to any physical quantity. Even a coin containing valuable metal may be considered fiat currency if its face value is higher than its market value as metal.

A feature of all fiat money is its (typically exclusive) acceptability to the government for payment of taxes and charges.

Fiat money is not essential for large countries, nor is it always used. An economy may function on credit money which is not fiat money, such as United States paper currency during periods prior to 1862, before the first United States Notes were created and declared by the government to be legal tender.

History

Early history

The Song Dynasty was the first in China to issue true paper money in 1023. Though technically not a fiat currency - as the notes were valued at a certain exchange rate for gold, silver, or silk - in practice conversion was never allowed. The notes were initially to be redeemed after three year's 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 support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

18th and 19th century

An early form of fiat currency were "bills of credit." Provincial governments produced notes which were fiat currency, with the promise to allow holders to pay taxes in those notes. The notes were issued to pay current obligations and could be called by levying taxes at a later time. Since the notes were denominated in the local unit of account, they were circulated from man to man in non-tax transactions. These types of notes were issued in the British colonies in Americamarker, particularly in Pennsylvaniamarker, Virginiamarker and Massachusettsmarker. Such money was sold at a discount of silver, which the government would then spend, and would expire at a fixed point in time later. Bills of credit were controversial when they were first issued, and have remained controversial to this day. Those who have wanted to highlight the dangers of inflation have focused on the colonies where the bills of credit depreciated most dramatically – New England and the Carolinas. Those who have wanted to defend the use of bills of credit in the colonies have focused on the middle colonies, where inflation was practically nonexistent.

Colonial powers consciously introduced fiat currencies backed by taxes, e.g. hut taxes or poll taxes, to mobilise economic resources in their new possessions, at least as a transitional arrangement.

The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to specie backed money. Examples include the “Continental” issued by the U.S. Congress before the constitution; paper versus gold ducats in Napoleonic era Viennamarker, where paper often traded at 100:1 against gold; the South Sea Bubble, which produced bank notes not backed by sufficient reserves; and the Mississippi Company scheme of John Law.

During the American Civil War, the Federal Government issued United States Notes, a form of paper fiat currency popularly known as 'greenbacks'. Their issue was limited by Congress at a little over $340 million. During the 1870s, withdrawal of the notes from circulation was opposed by the United States Greenback Party. The term 'fiat money' was used in the resolutions of an 1878 party convention.

20th century

By World War I most nations had a legalized government monopoly on bank notes and the legal tender status thereof. In theory, governments still promised to redeem notes in specie on demand. However, the costs of the war and the massive expansion afterward made governments suspend redemption in specie. Since there was no direct penalty for doing so, governments were not immediately responsible for the economic consequences of printing more money, which lead to hyperinflation – for example in Weimar Germanymarker.

Attempts were made to reassert currency stability by anchoring it to wholesale gold bullion rather than making it payable in specie. This money combined pure fiat currency, in that the currency was limited to central bank notes and token coins that were current only by government fiat, with a form of convertibility, via gold bullion exchange, or via exchange into US dollars which were convertible into gold bullion, under the 1945 Bretton Woods systemmarker.

Bretton Woods

The Bretton Woods system pegged the value of the United States dollar to 1/35th of a troy ounce (888.671 milligrams) of gold (the “gold standard”) and pegged other currencies to the U.S. dollar (as reserve currency) at fixed rates. The U.S. promised to redeem dollars in gold to other central banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fundmarker. This system collapsed when the United States government ended the convertibility of the US dollar for gold in 1971, in what became known as the Nixon Shock.

As early as 1960, Belgianmarker-Americanmarker economist Robert Triffin predicted the inevitable failure of a system based on a gold standard with a reserve currency, in what became known as Triffin dilemma. This is the fundamental problem of the United States dollar's role as reserve currency in the Bretton Woods systemmarker, or more generally of a national currency as reserve currency. Briefly, the use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: to maintain all desired goals, dollars must both overall flow out of the United States, but must also flow in to the United States, which cannot both happen at once.

Fiat money and the concept of legal tender

One of the standard methods for creating fiat money has been for the government to declare the banknotes of particular government-backed banks to be "legal tender" (tender means "offering") for debts. For example, see United States Notes. Such laws typically require that the notes be legally offered as settlement for all debts, and if refused, the debt is not required to be paid with other kinds of money. Such laws force legal tender notes to function as money in many important situations in the economy. There are examples of credit money working without this legal protection, as in Scotland and Northern Ireland where no banknote is "legal tender", see Banknotes of the pound sterling

Fiat Money and tax liabilities

Chartalism is a monetary theory that states the initial demand for a fiat currency is generated by its unique ability to extinguish tax liabilities. Goods and services are traded for fiat money due to the need to pay taxes in the money.

Value when fiat money loses backing

Usually, a fiat-money currency loses value once the government which acts as the issuer refuses to further guarantee its value through taxation, but this need not necessarily occur. For example, the so-called Swiss dinar continued to retain value as a type of credit money in Kurdish Iraq even after its fiat-money status was officially completely withdrawn by the backing government, the central government of Iraqmarker.

Criticism

Fiat currency was anathema to American president Andrew Jackson. Jackson went so far as to pass the Specie Circular in 1836, which required all payment for government lands to be in gold or silver coin. The Austrian School of Economics has long held that no sound economy can long endure under fiat money, with prominent Austrian Economist Ludwig von Mises arguing in his book, Human Action, that, "What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The credit boom is built on the sands of banknotes and deposits. It must collapse."

Alan Greenspan, Federal Reserve Chairman from 1987 to 2006, was a critic of fiat money in his early career, arguing in his essay, Gold and Economic Freedom, that, This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

Fiat currency has also been criticized by some, such as G. Edward Griffin, Congressman Ron Paul, and Peter Schiff, the president of Euro-Pacific Capital Inc., for increasing the number and severity of boom-bust economic cycles, causing inflation, and allowing nations to initiate or prolong war.

Among many people who advocate for specie, such as gold, silver or a bimetallic standard, the term fiat money is often used as a pejorative term.

Fiat money in monetary economics

In monetary economics, fiat money is an intrinsically useless good used as a means of payment and a storable object. In some micro-founded models of money, fiat money arises endogenously as it makes some trades feasible that would not be feasible without it (because agents cannot write IOUs due to anonymity or physical constraints for example).

Determination of the purchasing power of a fiat currency

Fiat money requires a mechanism of ascertaining its value. In order for a business man to determine the prices to charge for produced goods, he must first know what he would be able to purchase with money collected, but this requires the knowledge of prices that other businesses charge for their goods.

Ludwig von Mises concluded that it was impossible for a fiat currency to establish itself without initially being based on some commodity to peg its value. The Mises regression theorem states, that when the backing is removed, the purchasing power of the currency can be deduced by tracing back in time to when the currency had backing.

See also



References

  1. Jones, Nick (2007). " Fiat Currency: Using the Past to See into the Future". The Daily Reckoning - Agora Financial.
  2. Michener, Ron (2003). " Money in the American Colonies". EH.Net Encyclopedia, edited by Robert Whaples.
  3. Human Action, P.559
  4. Text of "Gold and Economic Freedom".
  5. Ron Paul on Federal Reserve, banking and economy http://www.youtube.com/watch?v=ji_G0MqAqq8
  6. Peter Schiff was Right http://www.youtube.com/watch?v=2I0QN-FYkpw
  7. Nobuhiro Kiyotaki and Randall Wright (1989), "On Money as a Medium of Exchange," Journal of Political Economy 97(4), p p. 927-54.
  8. Ricardo Lagos and Randall Wright (2005). "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, 113(3], pp. 463-84 (press +).


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