Everything is a 'fiat' currency

There seems to be a lot of interest in currency regimes with the failings in EMU and concerns about what might happen there next. The US and the dollar have become part of this dialogue as the dollar has over the years lost value and gold bugs are quick to propose gold as an alternative that would be better at preserving capital. I don’t think there is really much doubt about that. On a gold standard a country commits itself to fix its currency value to a certain price of gold. But such a link has its costs as a peg to gold eliminates flexibility. And, I know that to many that is a great benefit or even the point of having a gold-based system. But even a gold-based system uses currency, as we did under Bretton Woods. Gold cannot be the coin of the realm. It may back the coin of the realm but gold is not used in transactions. When gold and other precious metal coins did circulate as ‘money’ there was always someone making an attempt to undermine the integrity of the circulating coin. Some people would shave them others might clip them, depriving them of intrinsic value. In today’s world we have heard of gold bars that are filled with titanium, another form of debasement. Gresham’s Law describes the result of these sorts of antics on a precious metal circulating coin: ‘bad money drives out the good’. This is the earliest statement that I know of that referred to a phenomenon we have come to be call ‘adverse selection’. When you can’t know the value of something you are transacting for (or with) markets tend to drive the price down to its worst-case value. So even with gold there can be problems. Gold does not circulate well. In light of this I would like to re-open the notion of what fiat currency means to make these sorts of risk more apparent. Economists refer to paper currency unbacked by a pledge to link it to another asset’s value as a fiat currency. A Fiat currency is backed by the law of the land and has no intrinsic value. This is supposed to be different from a gold backed currency or a silver backed currency and so on. But is it? In looking at the expression I would like to focus on the fact that the fiat aspect relates to all currencies however they may be backed. Since a dollar put on the gold standard only has the implied value of gold as long as the governments stick to the gold standard gold also has a fiat element to it. . Essentially I think all currencies except those that actually circulate coinage made of precious metals are fiat currencies. Gold bugs like to point out the fragility of the fiat currency system by pointing out that in history no fiat currency has survived (so far). I take their point. Maybe they should also take mine. It is that while many nations have been on gold standards no one in the history of the world has pegged to gold and stayed with it. No one? So does gold have any better record? Adopting a gold backing for your currency is doing the one thing that you can be just about sure of that will come to an end. Gold standards are not flexible and they put government in straitjackets that they refuse to stay buckled into. Gold standards fail. And as much as a gold bug might say that is why we need it, I will assert, again, the fact that its inflexibility is why it is impractical and why it is eventually rejected. All currencies are fiat currencies in the sense that the value a currency has stems from the decision of a government to imbue that currency with certain features (a link to gold or not, for example). A nation’s money needs to fulfill the role of being a store of value, satisfying speculative demands and transaction demands. Modern fiat currencies are able to do those things. I would urge anyone who is truly a gold bug to get off their high horse and realize that government is not in the preservation of value business. You will not replace the capriciousness of government by linking your currency to gold. When the government adopts a currency people in that country are free to invest as they like in the stocks and bonds of domestic companies that will be denominated in the currency or in the financial paper of foreign economies that will be denominated in another sort of paper. Or investors can invest in hard assets or gold. In the end it is not a question of whether a country has preserved the value of its currency. It is whether the currency has helped to promote the business within that country. Business is the objective not the preservation of value. A currency that is sufficiently elastic for business may not hold its value relative to gold. That does not make it a bad currency. Indeed, I see one of the big problems with EMU as being that countries are undergoing all sorts of pain to preserve a currency while that currency is doing nothing for them but causing them pain. EMU has it backwards. Setting an economy up on gold might preserve the currency values but might do it at a cost of growth and higher unemployment. On balance I think gold bugs take the arguments that are beneficial to them too quickly. No fiat currency system has lasted in the history of the world and that includes a system in which government fiat decreed that it would peg its currency value to gold. The international community has become very fluid with new nations emerging and some ‘old ones’ running very high rates of growth. It would be hard to sustain a system like this with everyone stuck to gold. Gold is oversold by its advocates who are uninterested in looking the problems that gold standards have faced over the years. The problems are so great that they have caused every single country that adopted gold ultimately to reject it. Gold is no panacea. It might fix one problem you don’t like today but it would introduce many constraints that would impede us in the future. Better to have a fiat currency system and to let investors know that they have to manage their own risks to preserve their capital because that is true even in a gold-based system, it’s just that everyone assumes a gold-based system will not break down so that when it does everyone is completely unprepared. Is that really better?


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