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The Fiasco of Fiat Money

Tink123 2012/06/07 15:55:47

The Fiasco of Fiat Money


Mises Daily:
Thursday, June 07, 2012
by

I.


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
proper remedies.


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.


II.


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.


In The Mystery of Banking,
Murray N. Rothbard uncovers the fiat-money regime — with central
banking and fractional-reserve banking — as a form of embezzlement, a
scheme of thievery.[1]


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
institution.


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.[2]


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
production monopoly).


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.


The (admittedly rather lengthy) process through which government
obtains the monopoly of money production has been theoretically laid out
by Rothbard in What Has Government Done to Our Money?.[3]


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
receipts.


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
money.


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.
[4]



III.


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
starts declining.


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.[5]


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[6]: 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
bonds.


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
depression unfolds.


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.[7]







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
& Management.
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.
Send him mail. See Thorsten Polleit's article archives.


You can subscribe to future articles by Thorsten Polleit via this RSS feed.


Copyright © 2012 by the Ludwig von Mises Institute. Permission to
reprint in whole or in part is hereby granted, provided full credit is
given.

-- May we ever get out from underneath this beast?



Read More: http://mises.org/daily/6065/The-Fiasco-of-Fiat-Money

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Top Opinion

  • Cognito22 2012/06/07 16:23:26 (edited)
    Cognito22
    +3
    Government is allowed (by the people) to print money to represent existing wealth.
    As the wealth of a nation increases, more money needs to be printed to represent it.
    (Bill Gates is a dramatic example where the increase in wealth created by Microsoft needed to be represented by more printed money.)
    However, when the government sets policies that stifle conditions for wealth creation (as the current Administration does), it should be expected to curtail the amount of money printed.
    What we have now is a government printing money on the promise and faith that prosperity will increase. But that trust is beginning to surpass the capability of this country to create the wealth to match the worth of that promisary note (which causes inflation). And the burden to do so is being put on the shoulders of future generations and aggravated by government interference to fulfill that imposed burden.
    And worse yet, our government is borrowing money on that promise. Which puts a double burden on future generations.

    It's not In Government We Trust.

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  • FeedFwd ~POTL 2012/06/08 17:59:47
    FeedFwd ~POTL
    +1
    There is only one defense and it is nearly impractical. That would be to get off the US Dollar and switch to something else like gold. Problem is that nobody carries gold around with them or writes checks in gold or uses their credit card to debit their "gold account". So how can this be achieved. For some, who can price their goods and services on a daily basis, they can create a price list in say ounces of gold. One ounce for this, one-tenth of an ounce for that, etc. Then display the current conversion. So if you buy a suit today for half an ounce of gold and gold sells for $1,000/ounce, the suit can be bought for $500. (Obviously not off the rack at Sears! lol ) But if tomorrow, gold is $1,200/ounce, then the same suit will be priced at $600. Unfortunately, most of us can't go to our employer and ask to be paid in ounces of gold instead of dollars.
  • Tink123 FeedFwd... 2012/06/08 18:16:53
    Tink123
    +2
    Yes... we as a society are heavily dependent on the ease at which we can obtain something for nothing. True that.
  • Striker FeedFwd... 2012/06/11 19:00:59
    Striker
    +2
    Actually one CAN engage in the barter system. It's already here and growing. It's not all about gold, it's about anything of value.
  • FeedFwd... Striker 2012/06/11 19:20:49
    FeedFwd ~POTL
    +1
    That is true. The only problem with barter is that I can only barter with somebody who has what I want and wants what I have. Money creates liquidity in the market. That is really its purpose and so anything that makes money convenient to use and difficult to counterfeit can be used.
  • Striker FeedFwd... 2012/06/11 19:42:48
    Striker
    +2
    Money doesn't "create" liquidity, but does accommodate it.
    The fallacy of fiat money is that it is secured by nothing. The Debt sold by Gov is equally fiat. When this house of cards (fiat money) collapses, this entire PLANET will become a wild disaster.

    I strongly suggest that people NOT keep or save fiat money, because it is not a "store of value". The 1913 dollar is now worth less than 4 measly pennies!
    True, it's easy to stuff in one's pocket, so in that way it is "convenient".

    The people are masochists. Instead of getting rid of fiat, and central banking, and government controlling "money", they are opting for the abyss.

    Left free, the free market can quickly provide secured money. End of the problem, and end of TheFed, all in one fell swoop. Opt for Liberty!
  • FeedFwd... Striker 2012/06/11 20:56:53
    FeedFwd ~POTL
    +2
    Ahhh yes, you are right. Real money has among its desirable characteristics, intrinsic value. Gold has intrinsic value as does silver and oil. Oil is not very convenient. Sometimes silver is more convenient and sometimes gold is, but gold tends to be less volatile than silver. Real money, paper if it is backed with hard assets, gold or silver coins, etc provide liquidity by serving as a medium of exchange. Not sure how else you define liquidity. Maybe we are simply arguing semantics at this point. Anyway, I agree with the rest of your post.
  • Striker FeedFwd... 2012/06/11 21:30:51
    Striker
    +2
    Yes, carting a barrel of oil to the market would be impossibly inconvenient! This is the reason for SECURED currency. Oil is decent security, and the currency is easily exchangeable for any other thing of value. Liquidity is generally considered currency, but many other things can be liquidated quickly, common example is stocks and bonds. They don't work well at the cash register, tho LOL
  • FeedFwd... Striker 2012/06/12 12:17:05
    FeedFwd ~POTL
    +2
    Yes, there are 2 components to liquidity. Ease of exchange and volume of exchange. Without volume, there will be a tendency to see an increasingly large gap between the buyer's and seller's price. In a commodity, which by definition is heavily traded, the gap disappears, demonstrating that prices are neither good nor bad, just information about the value of things. Paper money that is backed with something has the benefit of being both convenient and having intrinsic value, namely the value of the underlying currency. I think we are in agreement.
  • Striker 2012/06/08 05:24:39
    Striker
    +1
    Every comment thus far has thrown some valid points into the mix. I am too tired at this hour to attempt a full contribution to this, but suffice it to say that the problem is both fiat money and the amazing fiat debt supported only by payment of more fiat dollars.

    This entire and MOST important issue can be thrown onto supply/demand graphs. While the history is interesting, it's unnecessary to defining the problem. The solution is in quite simple logic and turning the "control" over to the free market. That does require that Gov and TheFed withdraw from control and manipulation.

    I hope be back in the morning with my head more awake. We CAN do this, and hopefully those who have already been participated will return to assist!
  • Kiosk Kid 2012/06/07 18:03:06
    Kiosk Kid
    +1
    There is no problem with fiat money. The problem is government spending and borrowing. Once the government borrows too much money, the Markets refuse to lend the government more money.

    The Federal Reserve has bought 2.5 trillion dollars of Obamadebt to keep interest rates low. They bought it by printing money. Sooner or latter, the bond markets are going to shut Obama’s credit off.

    When that happens, this country is going to be in for a very rough time. However, it wasn’t caused by fiat money. Like Greece and Spain, it was caused by Government policies of buying votes with welfare programs.

    Socialism is a philosophy of failure, the creed of ignorance, and the gospel of envy. Its inherent virtue is the equal sharing of miseries. – Winston Churchill.

    The problem is not with fiat money, the US has had fiat money since 1791. The problem is with socialism.
  • TheCouc... Kiosk Kid 2012/06/07 20:38:48 (edited)
    TheCouchF*cker
    +1
    There have been instances of fiat currencies issued, including the Continental of the late 1700s and the Greenbacks of the mid-1800s. The Continental was such a failure due to runaway inflation that they included the gold and silver clauses and banned bills of credit("fiat money") on a state level. Too bad they didn't apply the same logic to the federal government(not that it would've mattered). The Greenback got started during the American Civil War to provide quick money to fund the Federal Army without making the cost directly felt to taxpayers by increasing taxes. Only when Richard Nixon abolished the Gold Standard in 1971 has the country been using solely fiat currency.

    Clearly you haven't read my reply below to Cognito22, so allow me to reiterate it. Fiat currency is the tool governments use to disguise the true costs of their spending from taxpayers and encourages the kind of limitless vision that not only results in buying votes with promises of social welfare programs, but big business bailouts and undeclared foreign wars. George W. Bush was a big fan of those, too, in case you forgot.

    Government is the problem, not who's in charge of it.
  • Kiosk Kid TheCouc... 2012/06/07 20:57:08
    Kiosk Kid
    +1
    Before, 1791 there was a problem with fiat money that was issued by states. You said; "There have been instances of fiat currencies issued, including the Continental of the late 1700s and the Greenbacks of the mid-1800s."

    Fiat money was issued by the confederate states in the mid 1800’s which were worthless.

    However, the problem hasn't been fiat money. The problem is government welfare, buying votes with borrowed money.

    BTW, George Bush created 2.4 trillion dollars of public debt in 8 years. The spending machine created 4.3 trillion dollars of public debt in just 3 years.

    http://www.whitehouse.gov/omb...
    Table 7.1
  • TheCouc... Kiosk Kid 2012/06/07 21:04:22 (edited)
    TheCouchF*cker
    +2
    The Confederacy were not a part of the US government, so by omission, they don't count, but you're right, they did make the same stupid mistake even after they banned bills of credit and "internal improvements"(the 19th century name for corporate/social welfare) in their own Constitution after being singled out for taxation to fund it.

    And your argument is because it was done to a lesser degree during Bush's administration that he's off the hook? That's like calling Hitler an "OK guy" because he's responsible for 54 million fewer deaths than Stalin.

    *Government* is the problem, not who's in charge of it.
  • Kiosk Kid TheCouc... 2012/06/07 21:07:19
    Kiosk Kid
    You said; "There have been instances of fiat currencies issued, including the Continental of the late 1700s and the Greenbacks of the mid-1800s."

    Provide facts but you can't. Come on slam me with facts but you can't!
  • TheCouc... Kiosk Kid 2012/06/07 21:31:51
  • Striker Kiosk Kid 2012/06/08 15:07:02
    Striker
    +1
    Objection! Argumentative and serving no purpose.
  • Kiosk Kid Striker 2012/06/08 15:30:45
    Kiosk Kid
    +1
    What asking for facts serves no purpose?
  • Striker Kiosk Kid 2012/06/08 15:38:15
    Striker
    +2
    Look, friend, this is a great post, with which we can actually do better than just attacking and arguing. For once we have a post which can lead to some worthwhile action, and so I merely ask that you hang in here and contribute your savvy to solutions.
  • Kiosk Kid Striker 2012/06/08 17:06:48 (edited)
    Kiosk Kid
    I don't know what you want. I don't think I have any problem with proving that fiat money isn't the problem. The problem is spending. There are only two countries in the world that do not have a Central bank.

    I don't know of any countries in the world that don't use fiat money. Look at credit cards which is only backed up by a persons credit rating.

    The idea of getting rid of Fiat money is rediculous. Everyone is using fiat money some countries don't have a problem and some do. The ones that do is always a result of government spending.

    Government debt ended many world powers throughout history. The Roman Empire, the British empire, and the Ottoman empire all ended primarly because of government debt.

    Obama is spending and the Federal Reserve is printing money to buy Obamabond. That is the road to disaster every time it has been tired.
  • Tink123 Striker 2012/06/08 17:20:31
    Tink123
    +1
    Haaa! Oh man, you had me hooting on this one Striker. Thank you Sir, I needed a good laugh.
  • Cognito22 2012/06/07 16:23:26 (edited)
    Cognito22
    +3
    Government is allowed (by the people) to print money to represent existing wealth.
    As the wealth of a nation increases, more money needs to be printed to represent it.
    (Bill Gates is a dramatic example where the increase in wealth created by Microsoft needed to be represented by more printed money.)
    However, when the government sets policies that stifle conditions for wealth creation (as the current Administration does), it should be expected to curtail the amount of money printed.
    What we have now is a government printing money on the promise and faith that prosperity will increase. But that trust is beginning to surpass the capability of this country to create the wealth to match the worth of that promisary note (which causes inflation). And the burden to do so is being put on the shoulders of future generations and aggravated by government interference to fulfill that imposed burden.
    And worse yet, our government is borrowing money on that promise. Which puts a double burden on future generations.

    It's not In Government We Trust.
  • Tink123 Cognito22 2012/06/07 17:25:08
    Tink123
    +1
    The problem is, the only commodity backing this money is... people. The money itself is backed by debt, the debt is backed by people - according to 13th Amendment, we've no legal recourse to even question the validity of said debt AND we've inadequate representation. Pretty sure there's a word for that... Slavery.
  • TheCouc... Tink123 2012/06/07 17:35:03 (edited)
    TheCouchF*cker
    +3
    That's because it is. As far as the government is concerned, we're serfs and party doesn't matter. Dropping your opinions in a suggestion box doesn't make you free.
  • Tink123 TheCouc... 2012/06/07 17:37:23
    Tink123
    +1
    Precisely, well said.
  • TheCouc... Cognito22 2012/06/07 17:28:47

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