I am a big fan of fiat money. In my view, it is the most underrated innovation in human history, innovation that has contributed tremendously to the prosperity and lifestyle we enjoy today. That’s because fiat money enables us not only to imagine the future but to also make it a reality. More importantly, fiat money does that better than any other type of money used in the past.
Unfortunately, fiat money has a bad rap. It has been under non-stop assault by gold bugs, inflationistas and bitcoin bros. Sadly, mainstream econ has failed to push back against such cranks, allowing misconceptions and conspiracies to thrive. The problem is that mainstream econ does not have an answer to the most basic question about fiat money. Why do we accept these “worthless” pieces of paper as payment for goods and services? Social convention, network effects, memory device, a bubble? All these answers are unsatisfactory, leaving the door wide open to misinformation and confusion.
The notion that fiat money does not have intrinsic value couldn’t be further from the truth. To see why, let’s consider how money is created. In the case of the US dollar, every single dollar in existence today was created in one of two ways: a private agent borrowed from a commercial bank or the Fed purchased bonds or extended loans to banks. This means that every single dollar represents either public or private debt. That debt is not without intrinsic value. Debt is a claim on someone’s future income. Such claims have value to savers who seek future income streams. It is these underlying claims that endow fiat money with its value. Rather than thinking of fiat money as a store of value, we should think of it as a claim on future value.
Furthermore, such claims come with extensive collateral. It is not a matter of belief or trust that someone else will accept your dollars in the future. Quite the opposite. Money represents tangible claims backed by powerful enforcement mechanisms. Fiat money is backed by the obligation of private borrowers to redeem their debts and the obligation of private citizens to pay taxes. Those obligations are enforced by the banking system, the legal system and last but not least, the taxing authority (the IRS, in the US).
Think for a moment what happens if you refuse to pay your monthly mortgage payment. You lose your home; you get kicked out; your credit is ruined. That’s why you gladly sell your labor for a paycheck in dollars. You need those dollars to pay your debts. Counterintuitive as it may seem, the greater the mountain of private debt, the stronger the demand for the fiat currency. By the same token, what happens if you refuse to pay your taxes? You go to jail, plain and simple. That is why the bigger the national income, the greater the tax base and the stronger the demand for the fiat currency. Because of the dollar demand by private borrowers and tax payers, you can rest assured that your dollars will continue to be accepted in the future.
What about inflation or hyperinflation, you ask, say the Weimar Republic, Zimbabwe or more recently, Venezuela? Why are fiat currencies at risk of losing their entire value? Because fiat money is debt. The value of the debt is as good as the credit of the issuer, and there are many bad credits out there. This is precisely why we used to have a gold standard, to keep currency issuers in check. However, over the last 50 years (since the gold exit by the Nixon administration), we have learned a lot. The necessary and sufficient condition for strong fiat money is an independent central bank dedicated to price stability. Think of the central bank as the cop who ensures that fiat money keeps its value consistent with expectations, benefiting neither buyers nor sellers, neither savers nor borrowers.
Lastly, I want to talk about why fiat money is the best money we’ve ever had. First, let’s consider the fundamental role money plays in the economy. Before any exchange of goods and services can occur, money must be created first. Where did that money come from? Borrowers borrowed from banks in anticipation of future incomes. For example, firms use credit lines to produce an inventory in anticipation of future revenue. Banks facilitate such borrowers by creating money. The money flows to workers in the form of wages, who now have the money to buy the goods and services they themselves produced. As a result, firms generate revenue that goes to pay down their credit lines, destroying the corresponding money balances in the process.
It is this cycle of money creation and destruction that allows a monetary economy to function. What initiates the cycle is the anticipation of future incomes. Borrowers must first imagine the world as it could be and then proceed to make it happen by borrowing newly-created money from banks. In other words, money is a memory of that possible future, a bridge, if you will, that we must cross to get to that future.
In terms of a formal model, this means that a monetary economy bootstraps whereby incomes must be anticipated ex-ante to be generated ex-post. Aggregate demand for each period is based on agents’ income expectations, plus desired borrowings, less desired savings. Banks finance this demand by creating money. As agents spend the money, the economy generates incomes that redeem the borrowings incurred at the beginning of the period.
When Keynes talks about animal spirits and self-fulfilling prophecies, he is basically saying that a monetary economy bootstraps. Bootstrapping means that money-financed demand comes first and creates its own nominal supply with prices, output and employment being the unknown residuals. Money plays a critical role. It is the bridge that connects the present to the future, a bridge that we must extend day-in and day-out in order to cross over to tomorrow.
With this context in mind, we can now tackle the question why fiat money is the best money we’ve ever had. Two reasons:
- Under a fiat money system, banks are much more resilient.
Strong banks are critical to a monetary economy. They are the flux-capacitors that enable the economy to bootstrap. To illustrate, I collapse the economy into two markets (chart below). The spot market for labor-time represents physical markets where we trade goods and services (think of goods and services as encapsulations of labor-time). The futures market for labor-time represents financial markets where we issue and trade claims against our future income.
You can think of a borrower as someone who sells labor-time in the futures market in order to buy labor-time in the spot market. By the same token, a saver is someone who sells labor-time in the spot market in order to buy labor-time in the futures market.
As I describe above, before we can trade in the spot market, we must first create money by trading in the futures market. The futures market for labor-time can be further split into capital markets and money markets.
There is always a perfect match between buyers and sellers in capital markets, so there is no net new money creation. In other words, capital markets simply circulate existing money. Therefore, capital markets cannot bootstrap the economy.
It is in money markets where new money is created because banks act as a market maker. In other words, banks do not intermediate between borrowers and savers but stand ready to facilitate borrowers by creating new money (i.e., issuing demand deposit liabilities). This is exactly how banks enable the economy to bootstrap.
This only works if banks are trusted third parties. Otherwise, bank deposits will not be perceived as money and the economy will grind to a halt. That’s where reserves come into play. Bank reserves act as collateral that ensures banks are creditworthy.
During the gold standard, gold acted as reserve. Gold was a highly inadequate reserve because of the fixed supply (or rather I should say, its exogenous supply that was unrelated to the needs of the economy). Bank runs and financial crises were common. This caused huge disruptions in the real economy as banks were unable to bootstrap the economy (think of the self-fulfilling prophecies of doom). On a side note, the whole talk of price stability under the gold standard should be taken with a grain of salt. Yes, in the long-run prices were stable, but in the short-run prices fluctuated widely, subject to continuous bouts of inflation and deflation that closely followed the business cycle.
Under fiat money, the central bank steps in to replace gold with reserves that it can issue at will. Reserves are central bank liabilities convertible into cash. There is absolute certainty that the central bank can meet its obligation to convert reserves into cash and, therefore, it can withstand any bank run. The central bank is the ultimate trusted party. Fiat money, in the form of central bank reserves, is the rock-solid foundation that supports the banking system and the entire economy. To illustrate, the Fed prevented two depressions in the last 10 years (GFC and the pandemic) by aggressively expanding its balance sheet and issuing reserves.
2. Full Employment
Bootstrapping has another profound implication. A monetary economy does not self-correct to full employment. To illustrate, unemployed agents do not bootstrap their demand as they do not anticipate incomes that they can borrow against. As a result, aggregate demand is insufficient to provide them with jobs (unless someone else bootstraps on their behalf). This is the catch 22 of a monetary economy. Unemployment is not a bug, but a feature.
In the absence of self-equilibrating mechanism toward full employment, economic activity and employment are determined by self-fulfilling animal spirits. This boom and bust cycle was the dominant feature of gold standard economies. Also, booms and busts are just as prevalent in emerging and developing markets today, where people prefer FX for reserves. In such economies, the business cycle is largely driven by FX capital flows.
However, under a fiat regime, a central bank that has credibility with respect to its price stability mandate, can lean against animal spirits by expanding and contracting its balance sheet, effectively smoothing out the business cycle and bootstrapping the economy toward full employment.
Fiat money is not, by any means, perfect. It has only been around for 50 years. There have been many ups and downs. But we have learned a lot. The state of the art of central banking and fiat money has advanced appreciably under the leadership of giants such as Volker, Bernanke, Draghi and now, Powell. If only mainstream econ and the public at large could catch up and embrace this tremendous innovation. Fiat money raises the prospect of full employment with steady prices and no booms and busts, the holy grail of economics. This is the memory of a full-employment future that fiat money makes possible. We have not crossed that bridge just yet, but we definitely have a chance to get there with fiat money.
If you would like to read more about my thoughts on money, I will refer you to these posts:
Endogenous Money, A Reconsideration.
