Fiat money is a type of currency without intrinsic value. Specifically, unlike commodity money or repetitive money, it does not represent a commodity that has intrinsic value like gold and silver or even tobacco and livestock. Nonetheless, it derives its value from government assurance, the relationship between supply and demand, and the stability of the issuing government.
The prevalence of fiat money also forms part of the contemporary history of money. Most modern currencies, such as the United States dollar, the renminbi of China, the euro of the European Union, the Japanese yen, and the sterling pound of the United Kingdom, are fiat money. It is also important to highlight the fact that this type of currency is legal tender through a government decree.
Advantages: The Arguments And Justifications For Fiat Money
A primary advantage of fiat money is that it gives the government control over the economy through its central bank. Remember that this type of currency is a government-backed legal tender. The central bank is primarily responsible for controlling its production and circulation. This further translates to controlling the money supply and the banking system.
Take note that one of the ways the government manages the economy is through a monetary policy that includes controlling the money supply to address inflation and influence aggregate demand and economic activity. The central bank sets monetary policy using various tools at its disposal. These include setting policy rates and open market operations.
Monetarists like Milton Friedman have argued that variations in money supply have a significant influence on price levels over long periods. The amount of money in circulation also influences economic output in the short run. Monetary policy is essentially a macroeconomic tool used by governments alongside fiscal policy to either expand or contract the economy.
The Great Depression saw a strong case for using fiat money to address persistent macroeconomic problems. Results of the analysis by economists Ben S. Bernanke and Harold James showed that the speed at which countries abandoned the gold standard predicted their economic recovery. This comes from the fact that fiat money gave them monetary freedom.
For example, in 1931, Great Britain and countries in Scandinavia recovered earlier than countries that remained on the gold standard much longer, such as France and Belgium. Adopting fiat enabled them to expand the money supply in their economies. Countries like China that did not follow the standard almost avoided the global economic crisis entirely.
Remember that fiat money can directly influence inflation and employment. Hence, during an economic recession, a government can stimulate the economy or pursue an expansionary policy by creating jobs. Moreover, since employment requires payment, the workaround is to increase the money supply by printing more currency at the expense of high inflation rates.
Another advantage of fiat money is that it is more practical than commodity money. Most monetarists argue that linking money with precious metals is impractical because population growth and economic expansion would require the further expansion of the money supply that would later outpace the capacity of societies to mine precious metals.
It is also important to underscore that precious metals like gold and silver are finite resources that are not only limited but also expensive to mine. Moreover, although a currency based on a gold or silver standard has the advantage of preventing inflation, it essentially has no mechanism for counteracting deflation due to an increasing need for money in circulation.
Disadvantages: The Arguments Or Criticisms Against Fiat Money
A primary disadvantage of fiat money is that it risks losing its value due to inflation or becoming entirely worthless during hyperinflation for the simplest reason that it is not backed by physical and tangible assets or commodities such as gold and silver. Remember that the legitimacy and acceptability of fiat money hinge on the issuing government and the trust of the public.
The hyperinflation in Zimbabwe showed the consequences of overprinting money to expand the money supply. The Mugabe administration, according to economists Mark. J. Ellyne and Michael R. Daily, deliberately increasing the money supply not only to lend to the government and state-owned enterprises but also to win the favors of different political allies.
It is also important to highlight the fact that fiat money derives its value from this particular principle: money can be created without gold or more specifically, out of thin air at the expense of inflation. Increasing the supply of money in circulation naturally results in inflation because there would be more money chasing the same amounts of goods and services.
Another argument against fiat money is anchored on the mortgage crisis in the U.S. that resulted in the 2007 Financial Crisis. This crisis affected also other countries like the European Union. The event demonstrated that the central banks have limited capacity to manage the economy and that currency based on mere legal pronouncement can be unstable.
German economist Thorsten Polleit argued that government intervention in money production has restless in collective corruption. Moreover, whenever a government increases the money supply and controls the interest rate to stir economic activities, he noted that it promotes public adherence to economically and socially destructive policies.
The system also promotes the boom-and-bust cycle in the economy. Austrian economist and sociologist Ludwig von Mises, in his 1949 paper “Human Action,” asserted that currency not tied to commodity allows a government to expand the money supply. Expanding this supply further and further would lead to an inevitable collapse of the economic system.
Printing money out of thin air is also a loose policy. Kevin Down, Martin Hutchinson, and Gordon Kerr maintained that this loose policy, which can artificially lower interest rates and provide incentives for taking excessive risks, has also resulted in an escalating solvency crisis characterized by asset price bubbles, unrepayable debts, an insolvent financial system, and rising inflation rate.
Summary: The Pros and Cons of Printing Money Out of Thin Air
The following is the summary of the advantages and arguments for fiat money:
• Provides the government with the capacity to exert considerable control over the economy through the monetary policy of the central bank
• The Great Depression demonstrated how abandoning commodity money to print money out of thin air could effectively stimulate the economy
• Fiat money is more practical than money tied to gold or silver because it does not depend on a finite resource that requires costly production
• Population growth and increased economic activity would outpace the capacity of societies to mine precious metals
The following are the disadvantages and counterarguments or criticisms:
• It can lose its value due to inflation or become worthless during hyperinflation for the simplest reason that it is not backed up by physical reserves
• History shows that some governments can have the propensity to over pint money, thus artificially increasing the money supply
• Money is essentially created infinitely without intrinsically valuable commodity or more specifically, out of thin air at the expense of inflation
• It artificially lowers interest rates and provides incentives for taking excessive risks, thus leading to an escalating solvency crisis
FURTHER READINGS AND REFERENCES
- Bernanke, B. S. with James, H. 2000. “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison.” In B. S. Bernanke, Essays on the Great Depression. New Jersey: Princeton University Press. ISBN: 0-691-01698-4
- Down, K., Hutchinson, M, and Kerr, G. 2012. “The Coming Fiat Money Cataclysm and the Case for Gold.” Cato Journal, 32(2): 363-388. Available via PDF
- Ellyne, M. J. and Daly, M. R. 2016. “Zimbabwe Monetary Policy: From Hyperinflation to Dollarization.” In eds. G. Kararach and R. O. Otieno, Economic Management in a Hyperinflationary Environment: The Political Economy of Zimbabwe, 1980-2008. Oxford: Oxford University Press. ISBN: 978-0-19-874750-5
- Polleit, T. 2011. “Fiat Money and Collective Corruption.” The Quarterly Journal of Austrian Economics. 14(4): 397-415. Available online
- Mises, L. V. 1949. Human Action. New Haven, Connecticut: Yale University Press. ISBN: 9780865976313