All Commentary
Wednesday, January 7, 2015

Let There Be Money

The free market has its own brand of fiat

For more than a century, skeptics of government power have rightly focused on the damage caused by interventions in money. As the market’s classic commodity moneys have been displaced by unbacked State-issued paper, libertarians — particularly those versed in Austrian economics — have disparaged fiat currencies and championed commodity-based money, especially gold and silver.

Unfortunately, the complaints against State fiat money can be imprecise at times, leading libertarians to form a faulty understanding of how money works. “Fiat money” is not unique to a coercive State. Neither does the State have the power to force its citizens to use something as money. In other words, it takes more than guns and cages. Until we’re clear on the market’s role in establishing the commonly accepted medium of exchange — that is, until we understand how the community of buyers and sellers gets to decide what counts as money — we will continue to muddy the waters with talk of fiat versus free-market money.

First, we should define our terms. In his 1912 classic The Theory of Money and Credit, Ludwig von Mises distinguished between commodity and fiat money in this way:

There are two sorts of thing that may be used as money: on the one hand, physical commodities as such, like the metal gold or the metal silver; and, on the other hand, objects that do not differ technologically from other objects that are not money, the factor that decides whether they are money being not a physical but a legal characteristic. A piece of paper that is specially characterized as money by the imprint of some authority is in no way different, technologically considered, from another piece of paper that has received a similar imprint from an unauthorized person, just as a genuine five-franc piece does not differ technologically from a “genuine replica.” The only difference lies in the law that regulates the manufacture of such coins and makes it impossible without authority…. We may give the name of commodity money to that sort of money that is at the same time a commercial commodity; and that of fiat money to money that comprises things with a special legal qualification.

Thus for Mises, the crucial distinction between commodity and fiat money was not one involving persuasion versus coercion. Rather, the difference (for Mises) is that an item is a commodity money simply by virtue of its being a unit of that commodity, whereas a fiat money only qualifies if it possesses certain characteristics as established by some authority that are arbitrary and only serve to artificially restrict the quantity of money.

We can make Mises’s distinction clear by contrasting the role of “minting” additional units of a commodity money versus a fiat money. Before making this contrast, we need to clarify what it means for two objects to qualify as units of the same commodity. Using modern subjective value theory, an economist would classify an “ounce of gold” as a hunk of metal that is close enough to any other “ounce of gold” so as to be interchangeable, from gold users’ point of view. In reality, no two hunks of metal are going to possess the same number of atoms, and hence neither will be a canonical “one ounce of gold.” Nonetheless, we can operationally define a unit of gold — picking ounces as our unit, if we choose — as one that can satisfy physically the possible applications people have for gold.

The above discussion doesn’t mean that every ounce of gold has the same subjective value; a person will value the 15th ounce of gold less than the 14th ounce of gold (because of diminishing marginal utility) even though the particular hunks of metal could be interchanged as far as the person is concerned. Keeping in mind these subtleties, we can understand the sense in which both physical reality and subjective valuation interact in order to meaningfully distinguish “an ounce of gold” from “an ounce of Swiss cheese.”

When gold was embraced the world over as the market’s money, an ounce of gold was an ounce of gold. A private (or State) mint could take an ounce of the yellow metal and stamp it into a coin of a certain shape and with certain markings. But the function of such minting was merely to reassure the public that the object really was an ounce of gold. The stamping process per se did not turn it into money.

In contrast, when a State printing press takes paper and ink and creates new currency notes, those particular pieces of paper (covered with ink) become additional units of money because of the minting process. It’s not that a “genuine” $20 bill can provide services physically that a counterfeit $20 bill cannot. No, the only difference is that one piece of green paper satisfies the (arbitrary) rules for authenticity promulgated by the US government.

With Mises’s distinction in mind, we observe that privately issued, voluntary fiat monies are theoretically possible. Friedrich Hayek imagined private-sector financial institutions issuing competing currencies. I would also argue that bitcoin is a private-sector fiat currency (though in my view it is not a “money” yet).

Finally, we should guard against a mistake that is all too common in libertarian discussions of money. The term “fiat money” sometimes leads critics to declare that the State can turn something into money “by fiat.” At first glance, this assertion seems to follow naturally enough from Mises’s definition of fiat money. But accompanying his definition in The Theory of Money and Credit, Mises also wrote:

In order to avoid every possible misunderstanding, let it be expressly stated that all that the law can do is to regulate the issue of the coins and that it is beyond the power of the State to ensure in addition that they actually shall become money, that is, that they actually shall be employed as a common medium of exchange. All that the State can do by means of its official stamp is to single out certain pieces of metal or paper from all the other things of the same kind so that they can be subjected to a process of valuation independent of that of the rest…. These commodities can never become money just because the State commands it; money can be created only by the usage of those who take part in commercial transactions. (emphasis added)

To illustrate Mises’s point we can use the modern case of the US dollar. The US government can announce rules telling Americans which pieces of paper are and are not authentic US dollars. For example, there are rules (that the tellers at banks know very well) governing how much of a paper dollar can be ripped off, and periodically the dollars are redesigned to stay ahead of counterfeiters.

Even though the US government can tell Americans which pieces of paper are dollars, it cannot tell Americans that dollars are the money that they will use economically. The existence of legal-tender laws and other regulations complicates the issue, but nonetheless it is possible that next Tuesday, nobody will want to hold US dollars anymore and so their purchasing power will collapse, with prices quoted in US dollars skyrocketing upward without limit. This has happened with various fiat currencies throughout history, and these episodes did not occur because the State in question repealed a regulation that had previously ensured its currency would be the money of the region. Instead, the people using that currency simply abandoned it in spite of the government’s desires, resorting either to barter or adopting an alternative money.

In summary, the historical association of private money with commodities and State money with fiat currency does not perfectly line up with economic theory; we can at least imagine privately issued fiat money. (If cryptocurrencies such as bitcoin ever become widely accepted and thus a true money, then they would qualify as such.) Even though a State that issues fiat money has the power to designate particular items as units of it, the unbacked currency in question is not money merely because of the State’s decrees: there must have been a more complex history through which the community embraced the currency as a commonly accepted medium of exchange.

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.