The term fiat money is used to mean:

• any money declared by a government to be legal tender.^[1]
• state-issued money which is neither legally convertible to any other thing, nor fixed in value in terms of any objective standard.^[2]

The term derives from the Latin fiat, meaning "let it be done". Where fiat money is used as currency, the term fiat currency is used. Today, most national currencies are fiat currencies, including the US dollar, the euro, and all other reserve currencies.

Contents 1 Overview 2 History 2.1 Early history 2.2 18th and 19th century 2.3 20th century 2.4 Bretton Woods 3 Chartalism 4 Loss of backing 5 Criticism 6 Monetary economics 7 Purchasing power 8 See also 9 References

[edit] Overview

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.

[edit] History

[edit] Early history

The Song Dynasty in China was the first to issue true paper money, Jiaozi, around the 10th century A.D. 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 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.^[3]

[edit] 18th and 19th century

An early form of fiat currency were "bills of credit."^[4] 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 America, particularly in Pennsylvania, Virginia and Massachusetts. 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.^[4]

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 Vienna, 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.^[5]

[edit] 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 Germany.

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 system.

[edit] Bretton Woods

The Bretton Woods system pegged the value of the United States dollar to 1/35th of a troy ounce of gold. Other currencies were pegged to the U.S. dollar 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 Fund. 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.

[edit] Chartalism

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.

[edit] Loss of backing

Usually, a fiat-money currency loses value once the issuing government 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 in Kurdish Iraq even after its legal tender status was withdrawn by its issuer, Iraq's central government.^[6][7]

[edit] 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^{[citation needed]}, 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."^[8]

[edit] Monetary economics

In monetary economics, fiat money is an intrinsically useless good used as a means of payment.^[9] In some micro-founded models of money, fiat money arises endogenously as it makes feasible trades that would not otherwise be possible, either because agents may not anonymously write IOUs, or because of physical constraints.^[10][11]

[edit] Purchasing power

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.^[12] 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.

[edit] See also

[edit] References