Fiat Money: Advantages and Disadvantages

Fiat Money: Advantages and Disadvantages

Fiat money is a type of currency without intrinsic value. Unlike commodity money or repetitive money, it does not represent a commodity that has intrinsic value such as gold and silver, or even tobacco and livestock. Nonetheless, it derives its value from government assurance, as well as the relationship between supply and demand and the stability of the issuing government.

Most modern currencies such as the United States dollar, 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 made legal tender by 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. Hence, the central bank controls its production and circulation, thus 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.

Monetarists such as Milton Friedman have argued that variations in money supply have significant influences on price levels over long periods, as well as on economic output in the short run. Monetary policy is essentially a macroeconomic tool used by governments alongside a fiscal policy.

The Great Depression saw the justifications for using fiat money in addressing 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.

For example, in 1931, Great Britain and countries in Scandinavia recovered earlier than countries that remained on the standard much longer, such as France and Belgium. Countries such as China that did not follow the standard almost avoided the global economic crisis entirely.

Remember that fiat money can directly influence inflation and employment. During an economic recession, a government can stimulate the economy by creating jobs. However, employment requires payment. The workaround is to increase the money supply by printing more currency at the expense of high inflation rates.

Another specific 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 the growth of the population and increase in economic activity would require the expansion of money supply that in turn, would outpace the capacity of societies to mine precious metals.

It is also important to stress the fact that precious metals such as gold and silver are finite resources that are expensive to mine. While 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 become entirely worthless during hyperinflation for the simplest reason that it is not backed up by physical reserves, especially commodities such as gold and silver.

The hyperinflation experienced by Zimbabwe demonstrated the propensity of some governments to expand the money supply by overprinting money. Economists Mark. J. Ellyne and Michael R. Daily mentioned that aside from rapidly growing central bank reserves to lend to the government and state-owned enterprises, the Mugabe administration deliberately increased the money supply 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 circulation of this money naturally results in inflation.

Another argument against fiat money is that despite giving central banks the capacity to manage the economy through monetary policy, the mortgage crisis in the U.S. that resulted in the 2007 Financial Crisis exhibited otherwise. The event also showed that currency based on mere legal pronouncement could be unstable unlike a currency tied to gold.

German economist Thorsten Polleit also argued that government interventionism in the field of money product has lead to collective corruption. He noted that whenever a government increases the money supply and by extent, controls the interest rate to stir economic activities, it promotes public adherence to economically and socially destructive policies.

The system also promotes the boom-and-bust cycle in the economy. In his 1949 paper “Human Action,” Austrian economist and sociologist Ludwig von Mises asserted that currency not tied to commodity allows a government to expand the money supply. When used to stimulate the economy, expanding the money supply further and further would lead to an inevitable collapse of the monetary and economic system.

Printing money out of thin air is also a loose policy. In their paper for the Cato Institute, Kevin Down, Martin Hutchinson, and Gordon Kerr maintained that this loose policy that can artificially lower interest rates and provides incentives for taking excessive risks has also resulted to escalating solvency crisis characterized by damaging asset price bubbles, unrepayable debt levels, an insolvent financial system, and rising inflation.

Summary: The Pros and Cons of Printing Money Out of Thin Air

The following are 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

On the other hand, below 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