The Fiasco of Fiat Money
The Fiasco of Fiat Money
Thursday, June 07, 2012
by Thorsten Polleit
Today's worldwide paper-, or "fiat-," money regime is an economically
and socially destructive scheme — with far-reaching and seriously
harmful economic and societal consequences, effects that extend beyond
what most people would imagine.
Fiat money is inflationary; it benefits a few at the expense of many
others; it causes boom-and-bust cycles; it leads to overindebtedness; it
corrupts society's morals; and it will ultimately end in a depression
on a grand scale.
All these insights, however, which have been put forward by the
scholars of the Austrian School of economics years ago, hardly play any
role among the efforts of mainstream economists, central banks,
politicians, or bureaucrats in identifying the root cause of the current
financial and economic crisis and, against this backdrop, formulating
This should not come as a surprise, though. For the (intentional or
unintentional) purpose of policy makers and their influential "experts" —
who serve as opinion molders — is to keep the fiat-money regime going,
whatever it takes.
The fiat-money regime essentially rests on central banking — meaning
that a government-sponsored central bank holds the money-production
monopoly — and fractional-reserve banking, denoting banks issuing money
created out of thin air, or ex nihilo.
Rothbard's conclusion might need some explanation, given that
mainstream economists consider the concept of fiat money as an
economically and politically desirable, acceptable, and state-of-the-art
An understanding of the nature and consequences of a fiat-money
regime must start with an appreciation of what money actually is and
what it does in a monetary exchange economy.
Money is the universally accepted means of exchange. Ludwig
von Mises emphasized that money has just one function: the
means-of-exchange function; all other functions typically ascribed to
money are simply subfunctions of money's exchange function.
With money being the medium of exchange, a rise in the money stock
does not, and cannot, confer a social benefit. All it does is reduce,
and necessarily so, the purchasing power of a money unit — compared to a
situation in which the money stock had remained unchanged.
What is more, an increase in the money stock can never be "neutral."
It will necessarily benefit early receivers of the new money at the
expense of the late receivers, or those who do not receive anything of
the new money stock — an insight known as the "Cantillon effect."
Because a rise in the money stock benefits the money producer
most — as he obtains the newly created money first — any rational
individual would like to be the among the money producers; or even
better: to be the sole money producer.
Those who are willing to disrespect the principles of the free market
(that is, the unconditional respect of private property) will want to
obtain full control over money production (that is, holding the money
Once people have been made to think that the state (the territorial
monopolist of ultimate decision making with the right to tax) is a
well-meaning and indispensible agent, money production will sooner or
later be monopolized by the state.
Having obtained the monopoly of money production, government will
replace commodity money (in the form of, say, gold and silver) with fiat
money, and the regime of legalized counterfeiting gets started.
Commercial banks will press for fractional-reserve banking, meaning that they should be legally allowed to issue new money (fiduciary media)
through credit extension in excess of the reserves they obtain from
their clients. Fractional-reserve banking is a rather attractive
profit-making scheme for lenders; and it provides government with cheap
credit for financing its handouts (well) in excess of regular tax
Fiat money will be injected through bank-circulation credit:
banks extend credit and issue new money balances which are not backed by
real savings. Economically speaking, this is worse than counterfeiting
Fiat money is not only inflationary, thereby causing all the economic
and societal evils of eroding the purchasing power of money and leading
to a non-free-market related redistribution of income and wealth among
the people; banks' circulation credit expansion also artificially lowers
the market interest rate to below the rate that would prevail had the
credit and fiat-money supply not been artificially lowered, thereby
making debt financing unduly attractive, especially for government.
It is the artificial lowering of the market interest rate that also
induces an artificial boom, which leads to overconsumption and
malinvestment, and which must ultimately end in a bust. Mises put it succinctly:
The boom cannot continue indefinitely. There are two
alternatives. Either the banks continue the credit expansion without
restriction and thus cause constantly mounting price increases and an
ever-growing orgy of speculation, which, as in all other cases of
unlimited inflation, ends in a "crack-up boom" and in a collapse of the
money and credit system. Or the banks stop before this point is reached,
voluntarily renounce further credit expansion and thus bring about the
crisis. The depression follows in both instances.
A fiat-money regime depends essentially on the demand for money.
As long as people are willingly holding fiat money (and
fiat-money-denominated government, bank, and corporate bonds, for that
matter), the fiat-money regime can be run quite smoothly, for then
people raise their demand for fiat money as its supply increases.
As a result, the rise in the money stock does not show up in a change
in overall prices of goods and services (while it goes unnoticed that
prices would have declined had there be no fiat-money expansion).
If, however, people's demand for fiat money declines relative to the
supply of fiat money, the system gets into trouble, for then a rise in
the fiat-money supply will show up in price increases — be it consumer
or asset prices.
Rising prices, in turn, especially when it comes to accelerating
prices increases, bring fiat money's hitherto rather subtle
redistribution of income and wealth to the surface. Once people start
realizing that fiat money is inflationary, the demand for fiat money
If people expect ever-greater increases in the fiat-money supply
going forward (without any limit, so to speak), the demand for fiat
money falls (drastically) or even collapses altogether. This is what
triggers a crack-up boom, as Mises called it.
People desperately exchange fiat money against other vendible items,
bidding up the money prices of goods and services, thereby setting into
motion a downward spiral, leading to ever-greater losses of the
purchasing power of fiat money.
In such an extreme scenario, fiat money can actually become completely destroyed. This is what occurred in the 1923 German hyperinflation, when government issued ever-greater amounts of money, and eventually no one accepted the Reichsmark as money any longer.
To keep the fiat-money regime going, therefore, people must keep
their confidence in the value of fiat money. This, in turn, explains the
critical role of government-sponsored opinion molders in keeping the
fiat-money regime going.
Especially in the field of monetary economics, government-favoring
economists take great effort to convince people of the advantages of the
fiat-money regime, painting the fiat-money regime — and thus central
banking and fractional-reserve banking — in the brightest colors.
What is more, people must be made to think that they benefit from
fiat money, that there is actually no alternative to a
government-sponsored fiat-money regime, and that abandoning fiat money
and replacing it with commodity money would be economically disastrous.
There is an additional and no-less-important factor that works toward
upholding the fiat-money regime. It is what can rightly be termed as collective corruption: sooner or later an ever-greater number of people will develop a vital interest in keeping the fiat-money regime going.
This is because a fiat-money regime allows government to expand
strongly, thereby corrupting an ever-greater number of people: people
seek (allegedly prestigious) jobs, generous handouts, and business
opportunities offered by government. People increasingly team up with
government, making their personal career and business success dependent
on an expanding government apparatus. And many people even start
investing their lifetime savings in fiat-denominated "secure" government
As a result, sooner or later a government default becomes a no-go. In
times of crisis, the printing of ever-greater amounts of money for
shoring up government finances (and the finances of government
beneficiaries) will be cast as the policy of the least evil.
To the great number of those who have become dependent on the
government apparatus, printing money to finance government's empty
coffers will be seen as preferable to letting financially overstretched
public sectors and banks go bankrupt.
The incentive structure provoked by fiat money therefore works toward
pushing the system beyond its limit. In other words, fiat money will go
through high inflation — even hyperinflation — first before a
A fiat-money regime cannot be upheld indefinitely, though, because it
erodes — via ever-greater government interventionism — the very pillar
on which the free market system rests: private property.
Mises put it as follows:
It would be a mistake to assume that the modern organization of
exchange is bound to continue to exist. It carries within itself the
germ of its own destruction; the development of the fiduciary medium
must necessarily lead to its breakdown.
The erosion of the free-market system, in turn, entails a decline of
the economy's production capacity, thereby making it increasingly
impossible for debtors to service their liabilities, thereby increasing
the incentive for running the printing press.
As the Austrian economists have shown, however, there is no escape
from the disastrous economic consequences caused by fiat money; high
inflation, or hyperinflation, wouldn't do the "trick." In fact, it would
make ensuing depression even worse.
The sooner the fiat-money boom is brought to a halt, the lower will
be the costs of the ensuing depression — a reasoning already expressed
by the Prussian philosopher Immanuel Kant (1724–1804), who noted in his Prolegomena
(1783), "It is never too late to become wise; but if the change comes
late, there is always more difficulty in starting a reform."
Thorsten Polleit is chief economist of the precious-metals firm
Degussa Goldhandel GmbH.
He is also an honorary professor at the Frankfurt School of Finance
He is an adjunct scholar of the Ludwig von Mises Institute and was
awarded the 2012 O.P. Alford III Prize in Libertarian Scholarship.
His website is www.Thorsten-Polleit.com.
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Copyright © 2012 by the Ludwig von Mises Institute. Permission to
reprint in whole or in part is hereby granted, provided full credit is
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