Blogs > Liberty and Power > Questions on Mises V and VI: Two Questions on Fiat Money

Dec 12, 2006 10:05 pm

Questions on Mises V and VI: Two Questions on Fiat Money

Monetary self-education continues below the fold.

When Ludwig von Mises wrote The Theory of Money and Credit, it was unclear to him whether any country had ever employed a purely fiat currency -- that is, a currency that was neither a commodity nor a promise to pay a commodity. The year was 1912; virtually all monies were then either actual commodities (ie, coins made of real gold or silver) -- or they were credit money (ie, a promise to pay real gold or silver). Fiat currency existed for small change alone, while the gold standard predominated for everything else.

Today, however, I am fairly certain that there are no commodity currencies left, and that no major currency even entails a promise to pay a commodity. Fiat money is ubiquitous.

Now gold money is good both as a generic exchange commodity, or just as gold, which may be employed in art or industry. Paper money is good only as money; it is useful for very little else. How did we go from the one to the other, and what holds a system of fiat money up without a commodity support?

This is a difficult question: If I had a promissory note from you, under which you were obligated to pay me a kilogram of gold, then I should treat that note with almost precisely the same care that I would treat a kilogram of gold itself. Provided I knew that you would hold to your word, the two would be equivalent, except, of course, that the note would be more portable, which can often add to its convenience.

Yet if some court were to void the note, for example if it were found that you were not of a sound mental state when you issued it, then that note would be worthless to me. I might very well discard it, which I would never knowingly do to a kilogram of gold. Why do we not do the same to our paper money, when we know that it has ceased to be a promise of any commodity at all?

Using the scant data that he had, Mises answered the question of how a state might transition from commodity to fiat money by arguing that all monies must begin as commodities with an objective use value; without this value, there is no reason that anyone would come to use them as a commodity of exchange.

These monies may then proceed to become credit monies, as banks or governments issue promises to deliver a commodity which are printed on paper or on relatively valueless tokens which are then substituted for the commodity. Finally, at the end of the process, the promise to pay a commodity may be withdrawn, leaving a purely fiat money in the banks and pockets of the citizens.

But users of the money do not abandon it: The money retains its exchange value, even if its commodity value is nil.

At least in this volume, Mises seems to skip lightly over the question of what becomes of all of the gold that the state acquires in this transaction. Yet surely it must rank among the greatest of thefts ever perpetrated -- unless, that is, nearly all of the worth of gold resides in its exchange value, while almost none of it resides in its commodity value. This seems highly doubtful to me, as the price of gold is still quite dear. Was the commodity value of all the gold in the world's money supply stolen when the major nations abandoned the gold standard?

I am not sure, meanwhile, that exchange value makes any sense as an explanation for why fiat money is sufficient unto itself. Consider the following example:

"I'd like to buy this new car," I say.

"Certainly," answers the dealer."What can you pay me with?"

[Rummaging through pockets.]"Dryer lint! I'll pay you in dryer lint. And crumpled-up tissues!"

"You can't be serious," says the dealer.

"But I am," I answer."Don't you see that there's a value in just being able to trade stuff in the market, and that that this is what makes money so very valuable? Why, I'm doing you a favor by giving you this lint, because I am helping the economy to exchange goods and services."

"Sorry, I only take U.S. dollars," he answers.

So I produce from my pocket a quantity of plant fibers that are only somewhat different in their physical appearance, chemical composition, and origin. I hand them over and the sale is made.

One might object, perhaps, that lint is more easily manufactured than counterfeit money, that it is thus in greater supply than passable U.S. banknotes -- and therefore the exchange value will rapidly approach nil. Very well -- so we must choose something besides lint or old tissues, something harder to counterfeit and in limited supply. Let us use baseball cards, perhaps, at the following exchange rate: Any card manufactured prior to last year shall be equal to one dollar of U.S. money.

If"objective exchange value" were really what made fiat currency work, shouldn't this work just as well? (The so-called"Tinkerbell Effect," in which a legal institution only works because everyone believes it works, is not to be discounted here. But is it to be understood that this is a collective fantasy, and not a genuine source of value?)

I am inclined to think the real reason that a fiat money continues to work over the long term is one that Mises did not understand, as he did not live under a fiat money system: Fiat money works because, with almost every purchase we make, and with every dollar we earn, we are obliged to pay taxes. And these taxes must be paid in fiat money. If we consistently refuse to pay our taxes, or if we attempt to pay them with anything other than the fiat money, then large, surly men with guns will come along and put us in a small, unpleasant room for a very, very long time.

What is the objective use value of fiat money? It's the ability to keep the tax collectors at bay. It is interesting, if a little revolting, to contemplate that our shared commodity of exchange is not gold or silver or even cowrie shells, but rather in steps from the prison cell door. And this leads me to my question: If, under a regime of fiat money, the obligations of the citizens to the government were somehow reduced to zero, would the value of the currency collapse?

Certainly its objective use value would drop to nothing. (Or would it? You could not defer indefinitely a promise to pay a given sum of fiat money, or the men with guns would arrive and lock you up for a different offense.) But at any rate, one very significant use of the fiat currency would disappear, and it is hard to see how this could fail to have an effect on the supply of money. Would it retain its exchange value? Or would it go the way of baseball cards and pocket lint? And if the latter, what would replace it?

(I will turn to some considerations on commodity money in my next post in this series, but in the meantime I would like to hear others' thoughts on the system of fiat money, and particularly on my questions above. Bear in mind that I am still learning about monetary history, and that there is a good deal I do not know in this area.)

[Crossposted at Positive Liberty.]

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Sudha Shenoy - 12/13/2006

See Menger's unrivalled discussion of the range of commodities which served the monetary function in various peasant societies round the world, in his 'Principles'.

Sudha Shenoy - 12/13/2006

1. Mises lived through the great Austrian hyperinflation after WWI & also observed the German hyperinflation, _almost_ contemporaneous. He also lived till 1973, so he had ample opportunity to observe & experience fiat-money standards. In the preface to the 2nd ed of TMC he says there is no need for long historical discursions on inflation since people have just experienced it in the most awful way.
2. Gold coins were withdrawn during WWI, as an 'economy' measure to 'help pay for the war.' Paper money had already been circulation alongside gold since the 18th century, so people were accustomed to both. 'Patriotism' led people to accept the loss of gold coins. Post-1918, the situation was so confused & unlike that before 1914, that people spent their time adjusting to these strange new circumstances. On the Continent, there were tremendous _political_ changes as well. Thus paper money continued to circulate.

3. When paper money was introduced, as a 'money-substitute', legal tender legislation also had to come in, to allow private debts to be paid in paper, as an alternative to gold. Until WWI, in any case, the paper circulation had never been _that_ large, relative to gold. Legal tender legislation continues, needless to say.

Andrew D. Todd - 12/13/2006

Well, there is a certain amount of anthropological literature pertaining to poll taxes in West Africa, and the so-called "Journalero" [day laborer] system in Central America (I cannot recall whether it was Nicaragua or Guatemala). The basic thing you have to understand is that peasant cultivators do not want to be in the market. They prefer to "provision the household," that is, to produce things which they can consume directly. So the government has to find some means of forcing them into the market. In the land-scarce regions of the world, such as most of Asia and the Middle East, the government collects taxes on land, or monopolizes the irrigation water supply (Wittvogel's "hydraulic despotism"). Landlordism is generally a fossilized form of tax collection, and indeed, in some cases, eg. the Zamindar system of India, it is impossible to make a distinction between the two. In the areas where land is abundant (Africa. Latin America), this system of collecting taxes on land does not work. People simply escape into the remote jungle. The most common solution was some form of slavery or serfdom, eg. the Spanish colonial "encomienda." But there were other systems. West Africans were obliged to work for wages on plantations, or make cash crops, in order to get the money to pay the poll tax. In the case of the Journalero system in Central America, peasants owning less than a stipulated amount of land were required to work for wages a certain number of days, and to collect a receipt to that effect from their employer, to show to the officials. With pre-industrial technology, market transaction costs tend to outweigh efficiencies of scale, etc. Under premodern/early modern conditions, there was an emphasis on "customshouse taxation," that is, the government used its limited power to collect taxes at a port, or a bridge, or the gates of a city, rather than trying to control the hinterland, and compensated for its limited power by levying a draconian rate on the goods thus taxed. Thus, it simply did not make sense to produce things for sale until one had exhausted the possibilities of self-consumption.

You might also find it interesting to read the eighteenth-century military theoretician, Marshal de Saxe, on the subject of "requisitioning." His system, in occupied territory, involved requiring village notables to come in to headquarters and buy "Protections." A raiding party would then go out and check if villages had "Protections." The raiding party would move stealthily, and arrive in a given village without warning. If the village did not have a Protection, the raiding party would burn down a house, without any further discussion or negotiation, and then leave, fast, before an ambush could materialize.

Reveries on the art of war [by] Marshal Maurice de Saxe,translated and edited by Brig. General Thomas R. Phillips., Harrisburg, Pa., The Military service publishing company, 1944.