Why would anyone accept a ‘fiat’ currency?

By L. Randall Wray

(as originally posted at New Economic Perspectives)

Last week we introduced the concept of a sovereign currency. When I first started teaching, most students thought the US Dollar had gold backing—that it was valuable because Fort Knox was filled with gold, and if they drove to the Fort with a stash of cash, they could load up their car trunks with gold. (They were shocked to find out there had not been any gold backing since they were babies.) Today, very few students entertain such beliefs—they have all learned that our currency is “fiat”—it has “nothing” backing it up. Well, maybe “something”—but we don’t necessarily want to see what is behind Alan Greenspan’s “curtain”:

So, this week, let us take a peek behind the currency. Is there anything there, other than the Fed Chairman’s—how shall we put it—family jewels?

What “backs up” domestic currency? There is, and historically has been, some confusion surrounding sovereign currency. For example, many policy makers and economists have had trouble understanding why the private sector would accept currency issued by government as it makes purchases.

Some have argued that it is necessary to “back up” a currency with a precious metal in order to ensure acceptance in payment. Historically, governments have sometimes maintained a reserve of gold or silver (or both) against domestic currency. It was thought that if the population could always return currency to the government to obtain precious metal instead, then currency would be accepted because it would be thought to be “as good as gold”. Sometimes the currency, itself, would contain precious metal—as in the case of gold coins. In the US, the Treasury did maintain gold reserves, in an amount equal to 25% of the value of the issued currency, through the 1960s (interestingly, American citizens were not allowed to trade currency for gold; only foreign holders of US currency could do so).

However, the US and most nations have long since abandoned this practice. And even with no gold backing, the US currency is still in high demand all over the world, so the view that currency needs precious metal backing is erroneous. We have moved on to what is called “fiat currency”—one that is not backed by reserves of precious metals. While some countries do explicitly back their currencies with reserves of a foreign currency (for example, a currency board arrangement in which the domestic currency is converted on demand at a specified exchange rate for US Dollars or some other currency), most governments issue a currency that is not “backed by” foreign currencies. In any case, we need to explain why a currency like the US Dollar can circulate without such “backing”.

Legal tender laws. One explanation that has been offered to explain acceptability of government “fiat” currency (that has no explicit promise to convert to gold or foreign currency) is legal tender laws. Historically, sovereign governments have enacted legislation requiring their currencies to be accepted in domestic payments. Indeed, paper currency issued in the US proclaims “this note is legal tender for all debts, public and private”; Canadian notes say “this note is legal tender”; and Australian paper currency reads “This Australian note is legal tender throughout Australia and its territories.” By contrast, the paper currency of the UK simply says “I promise to pay the bearer on demand the sum of five pounds” (in the case of the five pound note). And the Euro paper currency makes no promises and has no legal tender laws requiring its use.

Further, throughout history there are many examples of governments that passed legal tender laws, but still could not create a demand for their currencies—which were not accepted in private payments, and sometimes even rejected in payment to government. (In some cases, the penalty for refusing to accept a king’s coin included the burning of a red hot coin into the forehead of the recalcitrant—indicating that without such extraordinary compulsion, the population refused to accept the sovereign’s currency.) Hence, there are currencies that readily circulate without any legal tender laws (such as the Euro) as well as currencies that were shunned even with legal tender laws. Further, as we know, the US Dollar circulates in a large number of countries in which it is not legal tender (and even in countries where its use is discouraged and perhaps even outlawed by the authorities). We conclude that legal tender laws, alone, cannot explain this.

If “modern money” is mostly not backed by foreign currency, and if it is accepted even without legal tender laws mandating its use, why is it accepted? It seems to be quite a puzzle. The typical answer provided in textbooks is that you will accept your national currency because you know others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an “infinite regress”: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will probably take it. What a thin reed on which to hang monetary theory!

Personally, I’d be embarrassed to write that in my own textbook, or to try to convince a sceptical student that the only thing backing money is the “greater fool” or “hot potato” theory of money: I accept a dollar bill because I think I can pass it along to some dupe or dope.

Now, that is certainly true of counterfeit currency: I would take it only on the expectation that I could surreptitiously pass it along.

But I’m certainly not going to try to convince readers of this Primer of such a silly theory. Next week: a more convincing argument. See if you can anticipate the answer.

Like a good Mexican soap opera, we need to leave you hanging. I know many readers already know the answer, and you’ve got your hands high in the air, saying “call on me, I know the Butler did it”.

But remember that this is a Primer and not all of your classmates know the answer (yet). So, please don’t give away the plot line. In the comments, let us stick to the “gold standard” vs “fiat money” or “legal tender” and “hot potato” theories of money. I am sure we’ve got at least a few “goldbugs” out there. You probably cheered when Ron Paul asked Bernanke whether gold was money. Is gold money? Can it be money? If gold no longer backs money, why does the Fed hold it? Could a currency be backed by nothing more than “trust”—the expectation that someone, somewhere, will take it?

Have fun pondering.

UPDATE: The next part in this modern money series can now be read here.