The Strange Reality of Fiat Money

By J. D. Alt

It is time to come to terms with the fact that U.S. dollars are what economists call “fiat money”. Having acknowledged this—and it’s difficult not to accept it as true since the U.S. abandoned the gold-standard over forty years ago—it might be worthwhile to give some consideration to what “fiat money” actually is and the peculiarities of how it works.

A brief history

It may be useful to start with a short (and simplified) historical perspective. In his latest book, The Social Conquest of Earth, the Pulitzer-prize winning naturalist Edward O. Wilson goes to exquisite lengths to describe the unique evolution of human society—as compared to other eusocial species such as ants, termites and bees—which includes on the human side, above all else, the unprecedented specialization and division of labor homo-sapiens developed. This apparently was in response to the fact that early human groups had overlapping territories and were, as a result, constantly interacting, competing and cooperating with each other. Whatever the actual dynamics, it seems self-evident that what made this highly specialized division of labor really take off (to heights never imagined by Nature herself) was not just the invention of money and commerce, but specifically the invention of fiat money—exactly the kind of money discussed by the Modern Monetary economists of today. What is unique about fiat money is that, unlike gold or silver or some other easily carried “trade” commodity that has value in itself (and can, therefore, be traded for other things) printed fiat dollars, in themselves, are completely worthless. They attain their value only through a social contract.

It also seems self-evident that, from the beginning, fiat money required a large social group organized around a sovereign power.  This is because, as an invention, “small-group” fiat money doesn’t work. If every family-clan, for example, printed its own fiat dollars, each family-clan would have no incentive to accept any other family’s currency in exchange for specialized labor/resources—unless it planned ONLY to purchase something back from that one family-clan. So the “invention” of fiat money, as something which can be used in exchange for labor/resources from a large diversity of specialized producers, is not accomplished by small groups. In order for fiat money to work, it has to be shared by a very large group—like, for example, a nation.

The reason the very large group has to be organized around a sovereign power is suggested by Mancur Olson in his book The Logic of Collective Action. To summarize Olson’s argument (without going into details) it is fairly easy for small groups—say the size of an extended family—to work cooperatively together to produce something that benefits them all. In medium sized groups—large enough to prevent every individual from personally knowing every other individual— this becomes more difficult because no one person, by logic, has the incentive to make a personal sacrifice to a cooperative effort since it is clear that whatever personal effort or sacrifice they make will not be a deciding factor in whether or not the cooperative effort is achieved—while, at the same time, they realize that if the cooperative effort is achieved, they will benefit from its result whether they had personally sacrificed or not. Even though this “free-rider” logic make a cooperative goal difficult to achieve with medium sized groups, Olson explains several circumstances under which it can nevertheless be accomplished.

When you get to a very large group, however, Olson demonstrates that the logic of collective action makes it virtually impossible for cooperative goals to be voluntarily achieved—even though every single person in the group fully acknowledges the benefits that would ensue. The only way the collective goals of very large groups can be realized is through some form of coercion: the members of the group must be required to participate in the cooperative effort.

If we consider the widespread use of fiat money as being the result of a cooperative effort in a very large group, then, according to Olson, this can only have happened if the members of the group were somehow compelled to use the fiat money. And, indeed, this has been one of the mantras of Modern Monetary economists (especially L. Randall Wray): fiat money “works” because—and only because—a sovereign power declares (1) that it shall issue a sovereign fiat currency, (2) that a tax must be paid to the sovereign power, on a regular basis, by every member of the group (on pain of imprisonment), and (3) the only thing the sovereign will accept in payment of taxes is the fiat money which it issues. Voila! Modern fiat money comes into existence through a coerced cooperative effort—and the reality is it could not have come into existence in any other way.

Fiat money operations

The next step crucial to consider is HOW the sovereign power proceeds to transfer the fiat currency it creates into the hands of the “citizens” who will need to have it in order to pay taxes. The sovereign could accomplish this with direct hand-outs—and in some cases that may actually be necessary to prevent having to put lots of people in jail for not being able to pay taxes (a necessity that would cost the sovereign a lot of effort to build and run the jails!) A more obviously useful approach is for the sovereign power to SPEND the fiat currency it issues by purchasing goods and services from the “citizens” who need to get the currency to pay taxes. “Sovereign spending”, then, accomplishes the goal of transferring the fiat money into the hands of the “citizens”—but it also has the benefit of creating goods and services the sovereign might find useful.  Once they are paid in the fiat currency, the “citizens” logically begin to use it to trade amongst themselves, being willing to take it as payment for goods or services because they know that every other “citizen-who-needs-to-pay-taxes” will be willing to take it as payment as well.

There are at least two perspectives from which it is interesting to consider the unique dynamics of fiat money. The first is: What is the character of the “sovereign power” that issues it? Is it a monarchy (or military dictatorship)—or is it a democracy? The second perspective is whether or not the fiat money is “convertible-on-demand” to gold.

Fiat Money and a sovereign monarchy

Considering the first perspective, the question arises: what is the sovereign’s motivation to spend its fiat money? If the sovereign is a selfish king, he might want simply to keep the “citizens” employed to his benefit, with just enough benefit to themselves to stay strong and healthy enough to service the monarchy. In this case, the king may decide to levy taxes equal to his planned fiat spending, and then implement his royal plans by hiring the “citizens” to build his grand castles and estates, and to prepare and serve elaborate banquets. The “citizens”, after they are paid, use the fiat money to trade amongst themselves—but at the end of the year, when tax-time comes, all the fiat money earned is paid back to the sovereign king. The “citizens” become momentarily moneyless, but the sovereign commences the process again, issuing new fiat money, and hiring the “citizens” once more to build new rooms and additions on the castles and to prepare and serve even more lavish feasts, repeating the cycle. The king continually gets what he wants (bigger and bigger castles) while the “citizens” are able to continually sustain themselves—but without getting the uppity attitude they might develop if they weren’t rendered moneyless each year at tax-time.

In the course of human social development, some variation of the above model seems to have operated for many centuries and, in not a few cases, continues to operate today.

Fiat money and a sovereign democracy

What if, on the other hand, the sovereign power becomes a DEMOCRACY? (We do not need to imagine the arduous and painful process by which this might occur.) If such a transformation occurred, the model described above will only make partial sense. If a sovereign democracy pays the “citizens” fiat dollars to provide goods and services to the democracy—well, the democracy can vote to have things built and services provided that will benefit the “citizens” themselves. Instead of building royal castles, they can build roads and bridges and schools and hospitals. Instead of preparing royal banquets, they can provide police and fire protection services, and launch weather and GPS satellites.

That part makes sense. But the “citizens” might also ask: Why should the sovereign democracy only spend the same amount of sovereign currency as it plans to collect back in taxes? Why should the “citizens” vote to make themselves moneyless once a year at tax-time? Why shouldn’t they vote instead to have the sovereign democracy issue MORE fiat currency than it is planning to collect in taxes? If that happened, the “citizens” would be able to save some fiat currency each year, build up a reserve of it, and expand economic trade amongst themselves. It is logical, therefore, to imagine that a sovereign democracy will operate with a substantial sovereign “deficit”—the amount of fiat currency it spends over and above what it collects back in taxes being exactly equal to the private wealth remaining in the hands of the “citizens.”

Fiat money and gold

This brings us to the second consideration of fiat money: Whether or not the sovereign currency is “convertible-on-demand” to gold. This is important whether the sovereign is a monarchy or a democracy, but it is ultimately crucial to what appears to be America’s present “fiscal dillema”, so let’s continue with the “citizens” democracy just described. Let’s imagine that—for reasons we don’t want to get bogged down in at the moment—the sovereign democracy decided to make each of its fiat dollars “convertible” to a certain amount of gold. If a “citizen” wanted to, they could present a fiat dollar to one of the sovereign’s banks and receive, in exchange, the specified chunk of bullion. (L. Randall Wray, in his recent book Modern Money Theory, provides an excellent account of why, historically, sovereign powers may have been motivated to make their fiat currencies “convertible” to gold.)

Having fiat money that is “convertible-on-demand” to gold clearly changes the formula. First, and most obvious, the sovereign government is required to have a large supply of gold on hand with which to make the conversions. Even if it calculated that only a certain percentage of the “citizens” were likely to actually demand the converted gold at any given time—and, therefore, it only had to actually back up a certain percentage of the fiat dollars it issued—the sovereign government’s spending nevertheless would be constrained by the amount of gold it had in its vault. Furthermore, and perhaps most important, when the sovereign government spent fiat dollars to purchase goods and services from the “citizens”, it was in effect actually spending the gold bullion it had in its possession. Even though it kept that gold in its vault, it was “promised” to the holders of the fiat currency. At some point then, to continue spending, the sovereign had to either obtain more gold (by digging it out of the ground, for example) or it had to collect the “gold promises” back from the “citizens” BEFORE it could continue spending its fiat currency. In other words, it had to collect taxes in order to “pay” for spending.

Indeed, this sounds logical and very familiar to us right now. Furthermore, to protect the sovereign gold supply from the over-issuing of fiat currency, the next logical step the democracy might take would be to ensure that whenfor whatever reason—the sovereign government decides to spend more fiat dollars than it collects in taxes, then it shall do this by BORROWING the extra fiat dollars needed from the “citizen’s” savings, rather than by issuing additional “new” fiat dollars which might exceed the back-up gold supply. When you think about it, this is quite an ingenious trick: It means that (1) the sovereign government is (apparently) prevented from issuing more fiat dollars than it has gold to back up, (2) the “citizens” get to exchange their saved fiat dollars for sovereign Treasury bonds that pay them interest, and (3) the “citizens” STILL get to benefit from the sovereign government spending MORE fiat dollars each year than it intends to collect back in taxes—enabling the “citizens” to continue to build up their wealth of fiat dollars and expand their private economy.

The limits of gold

The only problem with the set up described above is that, if you do the math, over time the sovereign government will have “borrowed” a great—and continuously growing—amount of fiat dollars from the “citizens”. This, in turn, will have enabled it, year after year, to spend many more fiat dollars than it collected in taxes, adding more and more fiat dollars to the “citizens” savings and private economy—but eventually and inevitably, it will have surpassed the amount of gold in its vault to back up those fiat dollars.

This is essentially the problem the U.S. confronted in 1971. The solution was quite simple, and President Richard Nixon implemented it in that year: the U.S. abandoned the gold standard and declared the U.S. dollar would no longer be “convertible” to anything other than itself. The U.S. dollar returned to the original “pure” fiat money with which we began this discussion.

What DID NOT change, however, was the system that had been set up to protect the back-up gold supply: By law, the U.S. sovereign government continued to sell Treasury bonds to “citizens” in order to “get” the fiat dollars it “needed” in order to spend MORE each year than it collected in taxes. And the “citizens” continued to benefit from this ingenious bargain: they continued to exchange their saved fiat dollars for sovereign Treasury bonds that paid interest. And they continued to add to their savings—and build their private economy—as the sovereign government continued to spend MORE each year than it collected in taxes.

The dangers of fiat money and democracy

The fact that the democracy did not vote to change the law when the gold-standard was abandoned has created today the confused perception that a great problem exists for which there is no reasonable solution. The problem is this: As the sovereign government continues to sell Treasury bonds to “get” the fiat dollars it “needs” to spend MORE than it collects in taxes, the interest it will be paying the “citizens” holding the bonds will become a larger and larger component of annual sovereign spending—requiring the sovereign government to sell even more Treasury bonds to make up the difference. The “citizens” (or at least those who are successfully operating in the expanding private economy, and those who own the Treasury bonds) will have become fabulously wealthy—but the sovereign government itself will appear to have fallen hopelessly into debt.

Debt, deficits and the cry for austerity

It is possible under these circumstances that a group of well-meaning “citizens” could arise declaring that the nation’s debt and deficits are unsustainable and that the only solution is to dramatically REDUCE sovereign spending. But if this discussion accurately depicts the way fiat money functions, this cry for austerity is an irrational solution to a false problem.

First of all, it is clear that what is called the nation’s “deficit” is, in actuality, a balance-sheet account of the fiat money the sovereign has spent into the private economy but not collected back in taxes—it is, in other words, the savings the “citizens” have managed to keep and use to grow their own business and commerce. Reducing the sovereign “deficit” will do nothing more that shrink the private wealth of the “citizens.”

Second, it is clear that the nation’s “debt” was originally created as a strategy to prevent the sovereign from issuing more fiat currency that it could back-up with gold. If the sovereign currency is no longer convertible to gold, this strategy is no longer needed, and the only reason a sovereign democracy would keep it “in place” is because the “citizens”, in fact, want to continue exchanging their saved fiat dollars for Treasury bonds that pay interest. To be more specific, it is unlikely that the bonds will be owned “equally” amongst the “citizens”, but rather will be held by an elite group of financiers. While the sovereign government, in fact, has the power to “pay off” all the “national debt”at any time (by converting the bonds back into non-interest bearing fiat dollars) the financiers might well achieve the power to take effective control of the democracy to prevent this from happening.

Finally, it is clear that constricting sovereign spending—in a confused effort to reduce the sovereign “deficit”—would be the height of irrational behavior on the part of a democracy. As long as there is work that can be done to improve the lives and well-being of the “citizens,” and as long as the labor and sustainable resources are available to accomplish that work in exchange for sovereign fiat dollars, it is a perverse logic that argues the sovereign cannot afford to have the work accomplished.

A sovereign nation with its own fiat currency CAN afford to accomplish that work! The strange reality of fiat money tells us the only limitations we actually have are the physical resources available, our ability to cooperate, and our willingness to confront and constrain any elite group that seeks to take control of, and manipulate, sovereign spending and taxing for the purpose of self-enrichment and power.

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