Tuesday, March 27, 2018

More fiatsplainin': let's play fiat-or-not

The (Great) Tower of Babel, 1563, Bruegel the Elder. "Therefore is the name of it called Babel; because the Lord did there confound the language of all the earth"

People bandy the term fiat currency around a lot, but what exactly does it mean? None of us wants to live in a Babel where people use fiat to indicate twenty different thing. So let's try to zero in on what most people mean by playing a game called fiat-or-not. I will describe a monetary system as it evolves away from a pure commodity arrangement and you will tell me when it has slipped into being a fiat system. (The technique I am using in this post cribs from a classic Nick Rowe post).

So let's start the game.

1) An economy in which gold coins circulate as the medium of exchange.

Fiat or not? I think we can all agree that there is nothing fiat at all here. (For simplicity's sake let's assume for the duration of this post that taxes can be paid with anything, and that there is no legal tender.)

2) A government-owned central bank begins to issue banknotes that are redeemable into a fixed amount of gold. Owners of banknotes need only line up at the central bank's redemption window to convert their $1 notes into 1 gram of the yellow metal. The central bank ensures that its vaults contain 100% gold backing for its notes.

Fiat or not? Some people associate fiat with the invention of paper money or IOUs, but in general I don't think very many of us would say that these banknotes qualify as fiat.

3) The central bank sells off a chunk of its gold and invests in safe bearer bonds. Its banknotes are no longer 100% backed by gold coins, but are backed 70% bonds/30% gold. The central bank continues to redeem notes on demand with gold at a rate of $1 to 1 gram.

Say the public suddenly wants to hold more coins. A lineup develops at the central bank's redemption window and eventually the central bank uses up its coin reserves as it meets redemption requests. To continue meeting additional requests, it need only sell some of the low-risk bonds from its vault and use the proceeds to buy additional gold coins.  

Fiat or not? Since low-risk bonds have now become part of the backing for the banknote issue, a few readers may choose step 3 banknotes as the entry point for fiat money. But this would be unconventional, since most note-issuing central banks in the 1800s were running this sort of 70%/30% system, and we usually call the monetary system that prevailed in the 1800s a gold standard, not a fiat standard.

4) The central bank announces that it  will undergo extensive renovations. As a result, its redemption window will have to be shut for two months. People can no longer redeem their $1 for 1 gram of gold on demand, but will have to wait until the renovations are over.

Fiat or not? Two months is a long time. But it could be that the central bank already closes its doors on the weekends anyways, banknotes being inconvertible for 48-hours. I doubt many of us would describe the weekend as a fiat currency episode. Should we think of the renovation closure as an extended weekend, or is it long enough that it generates fiat money?

5) Unfortunately the central bank chose an incompetent construction company. Renovations will take another two years!

To make up for the inconvenience of the redemption window being closed for such a long time, the central bank promises to send agents to the local gold market who will ensure that the market rate stays fixed at $1/gram. These agents will buy & sell whatever amount of gold is necessary to maintain the peg (by selling and buying banknotes).

Fiat or not? Thanks to the strategy of buying and selling in the local gold market, the $1/gram price holds just as well as it did in steps 2 and 3. So the public notices no difference in the purchasing power of the money in their wallets. On the other hand, two years without a redemption window at the central bank may be long enough for many readers to tick the fiat money box.    

6) The central bank is still undergoing renovations, but instead of dispatching agents to the market to buy and sell gold to enforce the peg, they go with bonds in hand.

If the market price for gold threatens to rise from $1/gram to $1.01/gram, because there is too much money chasing too few goods, the agents sell bonds and withdraw banknotes, thus reducing pressure on the exchange rate and bringing it back to $1/gram. And when the exchange rate threatens to fall below $1/gram to $0.99/gram, because there is too little money chasing goods, agents buy bonds with banknotes.

Fiat or not? Not only are notes not redeemable in gold, but now the central bank no longer operates directly in the gold market. With this step we are getting a bit closer to modern central bank money. The Federal Reserve, the Bank of Canada, and other major central banks all regulate the purchasing power of money by purchases and sales of bonds. The $1/gram peg still holds thanks to bond purchases and sales, so step 6 money does almost everything that step 2 and 3 money does.

7) With the renovation dragging on, the central bank decides that it doesn't need a redemption window after all. So what was initially a temporary suspension of convertibility becomes permanent. But the central bank continues to send agents to the market to buy or sell whatever quantity of bonds are necessary to maintain the $1/gram peg.

Fiat or not? You tell me. Perhaps permanent inconvertibility is the very definition of fiat. However, if steps 2-6 didn't qualify as fiat money, because gold stayed at $1/gram, why would step 7 be any different?

8) The central bank decides that, rather than fixing the market price of gold at $1/gram, it will set the market price of a typical consumer basket of goods and services (i.e. meat, car repairs, school, etc). 

This is a bit trickier to think about than the other steps. So for example, say that the central bank is currently setting the price of gold at $1/gram. And people can buy a consumer basket for $1000. But the price of that basket starts to rise to $1010, $1020, and then $1030. To stop this inflation, the central bank will announce its intention to reduce the price of gold to $0.99/gram. It does this by selling bonds and withdrawing money from the system, so that there is less money chasing goods. It keeps repeating gold price decreases/money withdrawals until it has successfully reigned in the inflation and brought the consumer price basket back to $1000. The net effect is that consumers are always guaranteed that the money in their pocket has constant purchasing powe

Fiat or not? This is pretty much the monetary system we have now in the U.S. and Canada where central banks target inflation. Well, there are a few small differences. Instead of temporarily setting the price of gold in order to regulate the value of a consumer price basket, the Fed and Bank of Canada temporarily set the price of a very short-term debt instrument to hit their target for the basket. And rather than shooting for constant consumer goods and services prices, these central banks prefer one that shrinks by 2% a year.

Given that step 8 describes something close to modern money, and it is common practice to refer to modern money as fiat, then it would only make sense that many readers raise their hands at this point. Complicating matters is that step 8 money isn't really that different from steps 2 to 7. After all, the central bank is establishing a fixed price for banknotes, the only difference being that the fix has been adjusted from gold to a basket of consumer goods and services. 

9) The central bank donates all of its assets to charity, closes its doors and shuts down for good. But it leaves all its banknotes outstanding. Money floats around the economy without a tether to reality. Or as Stephen Williamson says, money is a bubble.

Fiat or not? By this stage, everyone will probably have ticked the fiat money box. 


Here is a collection of unconnected thoughts on the fiat-or-not game.

A) My guess it that readers will have chosen different stages as their preferred debut for fiat money. This is a bit tragic, since with no commonly-accepted definition for the term, most debates about fiat money have been and will continue to be meaningless.

B) We apply our definitions like cookie cutters to the real world. So if you chose step 7 (when banknotes became permanently irredeemable) as your flipping point, then 1971 would be a very important date in your scheme of the world since this is when the U.S. permanently removed gold convertibility.

But if you chose step 9 as your transition point to fiat, then the global monetary system is not currently on a fiat standard, since central banks have neither closed their doors nor donated their assets to charity. So 1971 really isn't an interesting date. I'm aware of only one country on a step 9 fiat standard: Somalia. Its central bank burned down yet Somali shilling banknotes continued to circulate. And ironically enough, if we choose to adopt a step 9 definition of fiat money, then bitcoin—which was designed to destroy central bank "fiat" money—is itself fiat, because it is unbacked, whereas most central bank money is not fiat.

What I've described is the Borges problem. Categories pre-digest the world for us. We get very different results depending on what definition we use and how we apply it to the world.

C) I think many readers associate fiat with hyperinflatable. For instance, here is Dror Golberg:

Readers who conflate fiat and hyperinflatable will probably have played the fiat-or-not game by gauging each step to see if it introduced (or removed) a set of features perceived to be conducive (inhibitory) to high inflation. They probably toggled the fiat button somewhere in the murk of temporary inconvertibility (step 4) and permanent inconvertibility (step 7). The thinking here is that convertibility into specie imposes a more imposing restriction on a central bank than a mere promise to hold gold's value at $1/gram by using open market operations (step 6). With the removal of convertibility, hyperinflatability is activated and thus money has become fiat.

There are certainly some good historical reasons for assuming that inconvertibility leads to hyperinflatability. Some of the most famous hyperinflations occurred after redemption was removed, including John Law's paper money scheme, the American Greenback episode, and the Wiemar inflation. But there is no inherent reason that these systems must lead to hyperinflation, or that step 1 (coin-based systems) and step 2 (fully convertible) systems aren't themselves hyperinflatable. In the case of coin-based systems, all that it takes is a rapid series of reductions in the silver content of coins to set off inflation, Henry VIII's consistent debasement of the English coinage being one example. And there is no reason that a fully convertible step 2 banknote system can't undergo a series of large devaluations leading to hyperinflation. 

D) Fiatness, fiatish? If we can't agree on what constitutes fiat-or-not, maybe we can agree that there might be a fiat scale, from pure fiat to not fiat at all, with most monetary systems existing somewhere in between. I am already on record advocating moneyness over money, so this fits with the general them of the blog. On the other hand, fiatness seems a bit of a cop-out.

E) We don't need gobbledygook like fiat. The term carries too much baggage. Let's select a more precise set of words, then apply them to the real world in order to understand what our monetary systems were like, how they are now, and where we are going. Until we settle on these words, let's avoid all conversations with the term fiat in them.

P.S. I have a recent post about the desirability of coin debasements at the Sound Money Project and another post on money as a measuring stick at Bullionstar. 


  1. Though I don't have a hard definition of fiat, I typically think of fiat money as being 1) government issued money (i.e. money by decree) that 2) has an exchange value significantly higher than its commodity value and 3) is nonconvertible. Clearly, the promise of future conversion muddies the waters, as you so well point out, hence why my definition is "soft."

    Re: Somalia, I believe the Somali shilling trades at the value of its production cost(See Will Luther's paper "The Monetary Mechanism of Stateless Somalia"), which suggests it would fall in the "commodity money" category.

    1. Agreed on Somalia. I think step 9 applies to the moment when the central bank is burned down, and before it has fallen to its production cost.

      "1) government issued money (i.e. money by decree)"

      Why government-issued? Private banks would often issue banknotes in the 1800s, and suspend conversion when they ran into difficulties, the notes turning into floating liabilities of the issuing bank. Would this not qualify as fiat?

    2. "Why government-issued? Private banks would often issue banknotes in the 1800s, and suspend conversion when they ran into difficulties, the notes turning into floating liabilities of the issuing bank. Would this not qualify as fiat?"

      The general definition of fiat includes the sense that it is a declaration by an authority with power (the government, religious leader, etc.). I wouldn't consider a private bank as being being an "authority." Moreover, when private banks suspended conversion, it was generally understood that it would be for a limited period of time. In contrast, I don't think anyone expects that at any time in the future they will be able to convert their Federal Reserve notes at the Federal Reserve for anything more than other Fed notes.

    3. " I wouldn't consider a private bank as being being an "authority." Moreover, when private banks suspended conversion, it was generally understood that it would be for a limited period of time."

      Yep, good point.

  2. “Let's select a more precise set of words”

    ... fiat voluntas tua

    And - less academic categorization/ more real world description

    1. "...fiat voluntas tua"

      Had to look that one up.

  3. For modern money do away with discussing fiat and use monetary realism. This is that the money in the modern economy is commercial bank deposits created by the borrowers loan contracts and backed by the goods and services sold by the borrowers to deposits holders in honouring those loan contracts.

    1. "...the money in the modern economy is commercial bank deposits created by..."

      Ok, but what about banknotes issued by the central bank?

    2. The value of CB notes can have the same treatment. CB notes are backed by government bonds that represent an amount of commercial bank deposits because government bonds are serviced by paying taxes from holdings of commercial bank deposits.

    3. Ok, but what about banknotes issued by the central bank?

      Here I go again...

      Apart from the fact that there are less of them, they are only issued when commercial banks demand them for their customers. And for that to happen, they must borrow them from the central bank, pledging their own assets in return. So if you follow the money, in the end those notes point towards the goods and services being produced in the economy. Or, if you're looking for causation, it is the goods and services pledged that cause the notes to be borrowed / printed.

      If you think of a central bank that runs an overdraft system for its settlement balances, you can construct those in the same way. Same for government borrowing. It is bank money created in the name of the representative of the community (government), backed by the goods and services (e.g. horses) sold by the community (borrowers / tax payers) to the bond holders in honouring the communal contract, taxes being proof thereof.

  4. I question the extent to which the Federal Reserve can credibly commit to option #8 rather than option #7 above over the long term.

    Right now pegging the dollar to a basket of producer goods doesn't seem to be a problem, but imagine the dollar price of gold goes on a tear again like in the 1970s or the 2000s, tripling or quadrupling or octopling its dollar price for reasons that seem strongly supported by fundamentals (i.e. by the production price of gold rising, such that either the dollar-price of gold does not rise and gold production becomes unprofitable and falls, raising its price eventually through supply&demand, or the dollar-price of gold rises immediately in order to keep gold production going at its current rate).

    In this scenario, if I'm a creditor, do I even care that perhaps the CPI or PPE indices are going up by only about 2%? Hmmm...invest in a 3% dollar-denominated bond that will make me a 1% real return, or hoard gold and make a 200% real return? I wonder which one I'll choose...

    (And by the way, how could the production price of gold be going up many times, but the broader PPE index going up only 2%? Perhaps the inputs to gold mining are disproportionately going up in price for some reason compared to other producer inputs. Or perhaps gold mining just happens to witness less innovation, such that other industries require fewer and fewer inputs and become cheaper in raw real input terms, whereas gold production remains expensive in terms of raw materials and labor).

    My point is that any savvy creditor has to have at least one foot in goldbuggery at all times...not in the sense of being convinced that gold is ALWAYS the best investment, but simply in the sense of thinking of his/her financial returns in terms of "gold bond" returns as well as in terms of "real, inflation-adjusted" returns. A savvy creditor needs to make sure that both are always positive...or else he/she is losing out and would be better off just hoarding a basket of CPI goods or gold.

    For example, for the past several years gold has been hovering around $1300/oz. (Even if the Federal Reserve isn't trying to keep a new dollar/gold peg at around $1300/oz., they are certainly having some luck in doing so!) In this regime, a 3% dollar-bond is equivalent to a 3% gold-bond. It's still a good deal, even calculating one's profits in terms of gold. So, bravo Janet Yellen! You are keeping the bondholders happy!

    But then take the 1970s. Even if CPI or PPE inflation is 10%, it was not unusual for a creditor to be making 15% interest. But even at that point, with a 5% real return (which creditors would probably kill for nowadays), those creditors were still making something like a -50% return in terms of gold. They would have been so much better off investing in a 0% or even -5% gold bond, or just hoarding gold and incurring the ~1% storage costs.

    And it is my contention that this was an added source of both political and financial pressure from bondholders that helped bring about the Volker Shock. It is my contention that, even if CPI and PPE inflation had been at 2% in the 1970s, with the dollar-price of gold behaving as it was, the Fed would have STILL been under enormous pressure to tighten drastically as it did under Paul Volker...or else continue to face a "revolt of the bondholders" with creditors going on strike until they received higher and higher real returns (to compensate them for what they were, in fact, actually losing in terms of gold).

    In other words, I argue that the Fed must still keep one eye on the dollar-price of gold and not let it stray too quickly in the upward direction (regardless of what the CPI or PPE are doing), or else face the political and financial wrath of the bondholders and a credit crunch. In other words, the Fed has traded the golden chains of the *de jure* gold standard for the elastic straps of our modern, flexible, *de facto* gold standard.

    1. "In this scenario, if I'm a creditor, do I even care that perhaps the CPI or PPE indices are going up by only about 2%? Hmmm...invest in a 3% dollar-denominated bond that will make me a 1% real return, or hoard gold and make a 200% real return? I wonder which one I'll choose..."

      Dunno, do creditors really care about the price of gold? Take Bank of America, a big lender. Was it watching gold rise from $350 to $2000 through the 2000s and early 2010s thinking... damn, if only we'd bought gold instead of lending to Jack and Jill. I'm not sure if I buy that scenario. You claim that people think in "gold bond" terms, but I don't think I've met many people who do this.

    2. If creditors don't care about the price of gold, then they are occasionally leaving money on the table, there is a free lunch for anyone who does care about calculating profits in terms of gold in addition to in terms of dollars.

      If creditors don't care about the price of gold, then that also means that the government can endlessly depreciate the dollar versus gold, and the government will never get punished for it by reluctant bondholders as long as that dollar devaluation vs. gold does not translate into a dollar devaluation vs. CPI or PPE goods. I find that hard to believe.

    3. Think of it this way:

      What happens when the Venezuelan peso starts to drastically devalue vs. the dollar? We will quickly have empirical testing of this scenario because it is happening as we speak.

      My prediction is, investors will increasingly have little interest doing business in Venezuela in order to earn meaningless V-peso paper profits (even if those profits appear high when calculated in terms of V-pesos), and creditors will increasingly have little interest in making V-Peso-denominated loans to Venezuela (except at absurd interest rates). So, you get capital flight. Creditors go on strike against loaning to Venezuela, and investors go on strike against investing in Venezuela, instead going mostly into dollar-denominated assets. And if the situation were reversed (i.e. the dollar was quickly depreciating versus the Venezuelan peso with no end in sight), wouldn't we expect capital flight in the opposite direction?

      Now, imagine that the same thing happens between the dollar and gold. The dollar starts to depreciate drastically versus gold, or what is the same thing, gold starts to drastically appreciate versus the dollar. Why won't investors flee dollar-denominated assets into gold-denominated assets? Are we seriously going to claim that the Fed only has to worry about the USD becoming devalued versus the Euro, the Venezuelan peso, the Yuan, CPI baskets, etc., but not versus gold? Why would gold behave so differently? Why doesn't the Fed have to worry about the exchange-rate between the dollar and gold when it has to worry about all of those other exchange rates?

    4. Matthew: "that also means that the government can endlessly depreciate the dollar versus gold, and the government will never get punished for it by reluctant bondholders as long as that dollar devaluation vs. gold does not translate into a dollar devaluation vs. CPI or PPE goods."

      The dollar:gold exchange rate can shift either because gold goes up in value, or because the dollar falls in value. If the first happens, then the dollar:CPI (and dollar:euro, etc.) rates will mostly stay the same, and the government/Fed shouldn't concern itself with gold appreciating. If the second happens, then the dollar:everything else rates will change, and monetary policy should respond appropriately.

      This distinction is important, because many economists blame the Great Depression on gold's value increasing and the major currencies following it up, up, causing awful deflation. In particular, they cite Gustav Cassel, who predicted imminent gold deflation from at least 1900 until 1930, when it apparently happened. Because France did something, and consequently the US economy crumbled, later followed by others.

      Personally, I think Smoot-Hawley and the resulting tariff war are the primary culprits. An obvious sign of this is that international trade fell much more (some 60%!) than GDPs (about 30%). And it's pretty easy to imagine that somewhat specialized economies would suddenly have a glut of unsellable goods in the export sector, with a shortage of imports. But the first is obvious, while the second is invisible. Thus it's easy to imagine that Keynes and others only noticed the first, going "hm, sold quantities and prices both decreased, so it's demand that must have fallen". Several countries also had significant tax hikes during the Depression. It's fairly obvious that such a move could push many companies from profitable to making a loss, consequently shutting down and firing workers.

      As an effect of such fiscal policy, the opportunities for profitable investment shrank. However, many people still had money to invest. The point where these meet, the interest rate, fell to very low levels. Unfortunately, a very low nominal interest rate looks like a deflation. Thus many economists concluded that the cause is a deflation; with a gold standard, that means an appreciation of gold. Why would that happen? Well, they went looking, and decided to blame France, as well as cite Cassel, who predicted something similar to what they were looking for.

      Back to the real economy. As factories closed and unemployment increased, wages decreased---again looking like a deflation. Because few people wanted to borrow in an economic meltdown (see falling interest rates), the quantity of bank deposits decreased significantly. M2 decreased, and by the quantity theory (and assuming that the demand for accumulated purchasing power was constant...) economists concluded that money must have appreciated.

      This is not to say that a deflation didn't happen, but that most of its symptoms are *also* created by a fiscal-policy-induced meltdown. Export goods, wages and nominal interest rates all decrease in both cases; the fact that they all decreased doesn't discriminate between the two explanations. Some possible observations that do discriminate:
      --volume of international trade falling significantly more than GDP: fiscal policy. Monetary deflation predicts mostly proportionate decrease in volume.
      --price of import goods increasing: fiscal policy. Deflation theory predicts the opposite. I don't have any data, so here's a falsifiable prediction!

    5. "The dollar:gold exchange rate can shift either because gold goes up in value, or because the dollar falls in value. If the first happens, then the dollar:CPI (and dollar:euro, etc.) rates will mostly stay the same, and the government/Fed shouldn't concern itself with gold appreciating."

      Surely you would agree that the Great Depression was a perfect test-case where gold was appreciating versus CPI goods, correct? So, in this circumstance you would assert that it's not a problem for investment, employment, and the willingness of creditors to loan money if investors' gold-profits are negative as long as they have positive "real" profits? I think the experience of late 1932/early 1933 suggests otherwise.

      Roosevelt's election in November of 1932, and the (accurate) rumors that Roosevelt was going to devalue the dollar versus gold sent depositors (i.e. a subset of creditors) scrambling to withdraw their banking deposits and redeem those deposits for gold before the devaluation occurred. Depositors could have left their money in the banks and continued to obtain positive "real" returns, if that is the only thing they cared about. But they correctly saw that they could obtain higher "real" returns by simply cashing out their deposits and redeeming their deposits for gold before the devaluation. If they left their deposits in the banks, they would be obtaining positive "real" returns but negative returns in terms of gold.

      (And they would have reaped those higher real returns if Roosevelt had not announced the unconstitutional Executive Order 6102 to confiscate private gold-holdings and redeem them at a below-market value; how could they have predicted that the U.S. govt. would do such an illiberal thing and get away with it?)

      The next time that we encounter a situation where gold is appreciating versus CPI goods, I predict that it will once again be problematic for the economy even if the Federal Reserve keeps the dollar more or less perfectly pegged to CPI goods. Was that not also the experience of the GFC? The Fed did a marvelous job of keeping the dollar pegged to CPI goods...and yet that did not prove to be a magical elixir for the economy.

    6. (And what's more, I also predict that, if gold should once again drastically appreciate versus CPI goods, it will be problematic for the economy even if the Federal Reserve adopts NGDPLT because even NGDPLT will not prevent the returns on investments and financial assets from turning negative in terms of gold; investors will still be tempted to increasingly go on strike and hoard gold rather than make dollar-loans or engage in production).

    7. "And they would have reaped those higher real returns if Roosevelt had not announced (gold confiscation)"

      Why, if they knew in advance that private gold storage would be outlawed, the price of gold would have not risen in the first place.

      "If gold should once again drastically appreciate versus CPI goods, [...] investors will still be tempted to increasingly go on strike and hoard gold rather than make dollar-loans or engage in production."

      If there is an actual reason why investing in "normal", productive assets is expected to give a worse return than zero, then investors will choose zero-yielding gold and drive up its price. But then the problems of the economy are *caused* by those reasons why productive investment yields less than zero. Gold rising is a symptom, not the cause. The way to fix the economy is not to do something about gold, but to set right the reasons why productive investment yields less than zero.

      On the other hand, if there is just a speculative bubble, then it's just a zero-sum game between gamblers, and nothing needs to be done.

    8. "The way to fix the economy is not to do something about gold, but to set right the reasons why productive investment yields less than zero."

      If productive investment is yielding less than zero in terms of gold, the only fix is to increase world gold production so that gold declines in relative value due to supply & demand. But world gold production cannot increase unless it is profitable to do so, which means that one way or another the golden prices of the inputs to gold production (how much gold it takes to buy those inputs to obtain a certain amount of gold on average) must fall, which can be accomplished in one of two ways. Either:
      1. The dollar-price of gold can rise while the dollar-prices of gold-mining inputs remain the same, which will correct the problem of gold underproduction in the long term only by intensifying the problem of productive investment yielding negative gold returns in the short run. This is how financial crises manifest themselves nowadays in the era of "fiat" money (what I would call an era of a de facto gold standard).

      2. The dollar-prices of gold-mining inputs fall while the dollar-price of gold remains the same. This is how financial crises manifested themselves in the era of the de jure gold standard.

      Whichever way the crisis manifests itself, it serves an essential role of correcting the disproportion between too little gold being produced and too many non-money commodities being produced.

      In order to avoid this disproportion from developing in the first place (and thus a corrective crisis becoming necessary for the world economy), one would have to prevent the golden prices of gold-mining inputs from rising so as to infringe on the profitability of gold production.

      What causes the golden prices of gold-mining inputs to rise to this level? It is the use of debt, which unsustainably raises apparent demand for non-money commodities in the short-run, thus raising their price-level in terms of gold, and thus raising the golden prices of the inputs to gold mining, making gold-mining unprofitable and causing a chronic deficiency in world gold production.

      To get rid of the cyclical phenomenon of crises of generalized overproduction of non-money commodities relative to the underproduction of the money-commodity gold, one must get rid of debt; legally mandate that all trades must be settled within a certain window of time with payment in either gold or a currency 100% backed by gold with no interest charge. Then every time commodity production threatens to outstrip the production of the money-commodity, the money-commodity will rise in relative value, causing capital to quickly flow into that sector, increase gold production (sending the relative value of gold back down and the price-level of commodities ever-so-gently back up), quickly correcting the disproportion before it can build up.

    9. If you tried to limit the quantity of liquidity to gold, it simply won't work. If it did work, the liquidity premium would go through the roof. And because its supply would be inelastic, if there were changes in demand, its price would fluctuate.

      My guess is that the economy would simply go in a different direction. Something that wasn't illegal, such as an ETF (100% equity, no debt), could well take over the role of providing liquidity and the unit of account.

    10. This comment has been removed by the author.

    11. If there is not enough liquidity, then there are two possible ways of addressing the problem: either interest rates can rise, or if interest is legally prohibited (as according to my proposal), the other solution is that the price-level can experience a one-time decrease. Simple. Problem solved.

      There is no such thing as too little gold if the gold-prices of commodities across the board fell to 1/10th or 1/100th of their current levels. Voila! Plenty of gold liquidity! This can either be achieved by the dollar-price of gold increasing by 10x-100x (and thus the gold-prices of dollars and commodities falling inversely), or by the dollar remaining pegged to gold and the dollar-prices (and thus gold-prices) of commodities declining by 10 or 100 times.

    12. What I wanted to say is that the gold prices of other commodities would fall, too. M2 is some 14*10^12 dollars, while gold has a market cap of 8*10^12 dollars. (Numbers from quick Googling.) If you wanted to provide the liquidity of M2+gold with gold only, the combined 22*10^12 dollars' worth of liquidity would mean that gold would have to ~triple in price relative to commodities. That's bad enough in itself.

      In practice, doing this is simply impossible; and even if it were possible, it wouldn't be desirable. The quantity of liquidity the economy needs is variable, i.e. there are irregular, unpredictable demand shocks. If the face value supply (the quantity of aboveground gold) is inelastic, then its price would go up and down.

      And it is simply impossible. Older articles on this blog describe how e.g. the stock market has provided increasingly more liquidity over the past decades. If you prohibited leverage/lending/debt/bonds/interest, people will just come up with ways to substitute equity.

      Instead of a central bank, there would be a central closed-end fund (doing open-market operations to increase or decrease the quantity of its shares outstanding, i.e. the money base). Instead of commercial banks, there would be MMFs. Instead of personal lending, people would register a sole proprietorship company, take a job as a contract between the employer and their company, and sell/lease/whatever shares to the lender. People could reinvent the "living gage", as distinct from the "mort gage", for home loans.

    13. You don't need to strenuously prohibit anything. You simply refrain from enforcing debt contracts, and if people try to enforce arrangements between themselves with mafia-like violence, you prosecute them like any mafia.

  5. I use my own definition.
    A fiat bank will asynchronously apply a sufficient interest charge to borrowers, at the moment that the imbalance between lender and borrowers exceeds the pre-defined error band.
    So I take fiat to be the simplest of all currency issuers, it is a spreadsheet function that auto prices between buyer and seller.

    Fiat is the one step currency issuer, that is the definition of fiat. If there were a simpler currency issuing function, then that would have to be called fiat. One step is the key definition.

    1. "I use my own definition."

      I think that proves my point.

    2. The direct denotation of fiat. I have the point proved the other way, we have generally twisted the meaning of fiat when it comes to banking. By direct command, why change meanings?

      But I am willing to call the direct issuance as credit money.

  6. Fiat still suggests backing of some form, something 9 could only aspire to, so there should be a less than fiat category which bitcoins would fall into, like confederate money with less collectability.

  7. An excellent set of questions. I never cease to be amazed at how rarely economists ever ask those questions, and how easily they fall into the trap of saying inconvertible=unbacked.

    1. Thanks Mike. I was thinking about your paper on the different channels for reflux while writing it. (Not sure if you ever uploaded it to the internet?)

    2. The reflux paper is here:

      (But I think a better version is the one you posted on your blog!)

      For what it's worth, I went through all nine of your scenarios.
      without clicking the "fiat" box.

      A fly in the ointment: If money is backed by its issuer's assets, then then if the issuer tries to raise the value of the dollar from 1.0 grams to 1.01 grams, then the issuer would lose .01 grams in the process. The dollar would have less backing and its value would fall, not rise. Of course, this only happens when the issuer's net worth is zero or less. If net worth is positive,then there's some wiggle room and you could get the results you described.

    3. "For what it's worth, I went through all nine of your scenarios without clicking the "fiat" box. "

      Even step 9?

    4. In step 9 there's no government decree determining value, so I didn't click "fiat".

  8. Although it doesn't resolve all the ambiguities, von Mises' distinction between "credit" money and "fiat" money, both of which are distinct from readily redeemable paper "money substitutes," is very helpful, as it at least does away with the strict and inadequate fiat/convertible dichotomy. The difference between these is that a "credit" money is _eventually_ supposed to become redeemable again in some underlying standard money. Greenbacks and the British Paper Pound are important examples. The difference matters for all sorts of reasons, because a credit money is still valued as an IOU, albeit with redemption prospects that may fluctuate over time. Hence Greenbacks' value varied with the Union's changing war fortunes. That would be surprising for a fiat money; not so for a credit money.

    In the cases you list,(6) is clearly credit money, according to this understanding, while (7) is clearly fiat. IMHO, (8) is fiat as well, for there's still no convertibility offer of any sort. In (9), the money is a (paper) commodity, assuming it commands any value at all.

    1. Thanks for that, George. I read them ages ago but I forgot about Mises' categorizations.

      You make an interesting point about why the fiat-or-not distinction matters. i.e. the value of fiat money (7) might be different from credit money (4), say due to changing war fortunes.

      I suppose I could have introduced a (7b), where the government says that it will temporarily stop sending agents to the market to buy/sell bonds to enforce the $1/gram price, while promising to restart this practice when the war is won. In that case step 7 money would show the same sorts of fluctuations as a step 4 credit money (which would presumably become fully convertible after the war). So I guess I am still struggling to understand why the switch from credit to fiat money necessarily matters.

    2. All of the examples include: 'The central bank decides'.

      Central bank money is always converted into government services via tax. Central bank fiat obtained a special definition unrelated to the strict definition of fiat. Why are we afraid of asking, first, what a private fiat issuer looks like, then we skip the deceptive jargon. There are plenty of private systems that issue units of account via fiat.

  9. If the self-imposed rules say that racing must be done by hopping in a sack, does that mean humans are not bipedal? Does that mean humans cannot run a 4-minute mile? We should be asking what fiat monies allow us to accomplish for public purpose if we had the understanding and political will. See "The Big Three" at ifhttp://neweconomicperspectives.org/2018/03/the-big-three.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+neweconomicperspectives%2FyMfv+%28New+Economic+Perspectives%29

  10. The term fiat, latin for 'let there be!', implies that such money has a positive value based on decree. Personally, I feel that cannot ever be the case and so the term should be scrapped altogether. Bitcoins might be viewed as an attempt at fiat since there is no real world counterpart which can explain its value, but then I would say that attempt has so far failed, at least in the sense that its value isn't stable enough for it to function as money.

    I personally would distinguish between barter and credit. That line I would probably draw betwen 2 and 3 (has anything like 2 ever existed?). Starting form 3, there is an element of trust involved in explaining the value of money. Credit, from credere: to believe.

    1. "The term fiat, latin for 'let there be!', implies that such money has a positive value based on decree. "

      Nice, another definition!

  11. Brilliant post JP as always. I always wonder why these nuances are never taught/discussed in economics courses. If I could have it, I will ask people to stop reading economics textbooks and just read blogs like yours. There is so much to learn and figure. Please collect your several ideas and put them together in a book haha...

  12. The meaning of the word fiat is probably more meaningful than the meaning of the term fiat currency - this maybe being an example of widespread diminishment of language in economics.

    Merriam Webster on the word:

    1. a command or act of will that creates something without or as if without further effort According to the Bible, the world was created by fiat.
    2. an authoritative determination : dictate a fiat of conscience
    3. an authoritative or arbitrary order : decree government by fiat

    Perhaps this suggests a broader application of the meaning in the case of currency - fiat should pertain to the origin of the authority who creates or establishes the currency. If the authority is a government, then whether the currency is convertible into gold or anything else shouldn’t be the issue for the meaning of fiat. It’s the determination of the currency approved and legislated for general use in some way that should matter. Whether the government declares the currency is convertible into gold or whether it insists that it be used to pay taxes may matter less than the government’s insistence that it be used for commerce in some more generally applicable way. That might even allow very budget conscious governments to finance their expenditures entirely through bonds without any taxes (or the Chartalist magic that goes along with taxes) – with the popular knowledge that the bond accumulation can be converted into the same quantity of fiat money used more generally in the economy, where inflation is controlled in some way by the authority.

    If the authority is Crypto Mad Max, then maybe it also works if you believe in the authority of demagogues and cult leaders to spin stories of crypto currency magic.

    1. "...may matter less than the government’s insistence that it be used for commerce in some more generally applicable way."

      Interesting. I guess by that definition gold and silver coins were fiat, since the monarch insisted in their use in commerce?

  13. I think we come full circle, 1 and 9 being identical. Those are the only two where the money is not listed as a liability on any issuer's books. These are the two that work according to the quantity theory, their values being ~100% pure liquidity premium.

    I think 8 is very different from 1-7. If any two note-issuing banks independently maintain a fixed exchange rate to gold (or to the same third currency, as in the Bretton Woods system), then the exchange rate between their respective currencies will stay within a very narrow band. On the other hand, if two central banks each maintain a fixed (or 2% inflation) exchange rate to their respective countries' CPI, then the exchange rate between their currencies will float widely, and can very well diverge over time.

    This is not so much because there isn't a CPI security (6-7 demonstrates that is not a problem), but because the hard-to-move components of CPI (real estate, healthcare, &c) have no law of one price operating on them. Whereas under 1-7 easy-to-move gold provided common ground, under 8 an economy rapidly gaining in per capita productivity will see a high CPI growth, causing the CPI-targeting central bank to create deflation. At least, as compared to the central bank of the country experiencing slow productivity growth.

    If the above sounds suspiciously like what NGDP targeting would cause, that's because real GDP per capita, i.e. per-person productivity is linked to many, highly labor-intensive and immobile components of the CPI. For example, if my company wants to hire someone to clean the toilets, it needs to offer a (... adjusted) wage that exceeds the next-best offer.

    Of course, this would not be a problem if the central banks targeted the same CPI measure—but that would be a weird thing to do. Why would the Someland National Bank target Differentland's CPI? Especially given that they could simply target the latter's money.

    1. Yes, 1 and 9 are identical. At least, they are after a sufficient amount of time has passed, and banknotes have fallen to their commodity (ie paper) value like they did in Somalia. Before that moment, 9 is unique in that it has no genuine backing.

      "I think 8 is very different from 1-7. If any two...then the exchange rate between their currencies will float widely, and can very well diverge over time."

      I wasn't really thinking along that dimension when I set up the sequence of steps, but that's probably right.

    2. CPI divergence: the case is much the same as if some countries were on a gold standard and others were on a silver standard. This is not a theoretical difference, though, just a practical one.

      "Before that moment, 9 is unique in that it has no genuine backing."
      I agree, and I would add that just like "ideal gold", it doesn't have any fundamental backing---but does enjoy liquidity, and that is value enough. I blew my own mind over the past few hours by realizing that the modern central bank mostly ... levers liquidity even for its assets' fundamental value. I'm at a loss for concise words, because I still find it a little bizarre.

      With that, I think I just came up with my own answer to what I mean by fiat money. This kicks in at step 6: "but instead of dispatching agents to the market to buy and sell gold to enforce the peg, they go with bonds in hand."

      My question was: given that bonds are denominated in dollars, rather than gold, why would buying and selling them affect the price of the dollar? After all, whether the dollar goes up or down, the bond moves in sync. And by the same token, if the bank no longer held gold (it doesn't really need any, since it only transacts in bonds), why would the price of dollars be anything particular?

      My answer is that exactly because there *isn't* any at-will redemption window between money and CB assets (I can't just go up to the bank, hand over a T-bill and get money), money can have a liquidity premium over the backing assets. And through regulating the quantity of money, the CB can adjust this liquidity premium.

    3. Hold onto your hair. This liquidity premium is essentially an unbacked, scarce commodity with an infinitely elastic supply, if the CB can manage it perfectly. And when I said that this liquidity premium is "levered" into the fundamental value of the backing assets, I meant that they have value because, due to this premium, the unit they are denominated in has value. Phrased somewhat differently, the bonds are valuable because they are less liquid than the money they are backing. ("Wait, what?")

      This is the Baron Münchhausen fiat money system. As long as the central bank has a central position the liquidity creation business, it doesn't need any gold or other assets that aren't denominated in its own money. Because it can synthesize an infinitely elastic supply in theory, demand shocks don't have to cause variations in the price of money. And best of all, money once more works by the quantity theory, and in the long run, money is neutral.

      Just for comparison: putting the whole world from 1-2 to 3 would create a ridiculous inflation. (Rather than a deflation as Gustav Cassel predicted.) Due to free redemption, gold and "paper gold" would necessarily trade at the same value. But the issue of money would dilute the liquidity premium so far enjoyed by gold. In the limit case of ~0% required backing (but still with redemption), there would be a negligible liquidity premium, and the fundamental, industrial commodity value of gold would determine money's value. (And that wouldn't work by quantity theory.)

      Unfortunately, the Münchhausen system has an Achilles' heel. If the central bank loses its place as regulator of the liquidity premium, the whole system can (and probably would) collapse to zero. At least, as far as the central bank has no assets denominated in other units, the backing equation returns a big fat zero as soon as the central bank has less than zero capital on its balance sheet. Of course, if the central bank just closes its doors and orphans any outstanding liabilities, there will be only a finite amount of them and they will behave as 1&9, inelastic-supply liquid commodities, with positive value. This still implies a sharp hyperinflation, though. And because the starting assumption was some outside force displacing the central bank from its position as #1 liquidity provider, naturally that would also displace the orphaned banknotes, truly sending the system to zero.

  14. Good post.

    I would say step 9. Steps 2 to 8 are all variants on convertible money. Whether it's convertible into gold or some other good (or bundle of goods) makes zero difference.

    Whether convertibility is direct or indirect is just a minor change in the central bank's operating procedures (instrument rule vs target rule) that doesn't affect the results much.

    Convertibility with a lag makes a difference, with the size of that difference depending on the length of the lag. (If the lag is short/long, an exogenous increase in the stock supply of M will have a small/large effect on the value of M in terms of that underlying commodity, depending also on the elasticity of demand for money with respect to the rate of return differential between money and other assets.

    I would think of step 9 (fiat) as the limiting case as the convertibility lag goes to infinity. That's where we can talk usefully about fiat being a matter of degree.

    1. So Bitcoin is very close to pure fiat, except for limited one-way convertibility of electricity and computer services into money?

    2. Thanks, Nick. I sometimes use step 9 as my definition for fiat too (and sometimes step 7 as well). My guess is that when step 7 people (like George Selgin above) and step 9ers like yourself get into debates over fiat money, a lot of confusion results if definitions are not made explicit at the outset of the debate.

      I hadn't thought of bitcoin as having one-way convertibility, but I suppose you could think that way. In the case of banknotes, people know ahead of time what the rate is (i.e. one gram to $1 note) but there is no fixed rule for how many dollars worth of electricity can be converted into bitcoins.

  15. FWIW, Nozick uses that same rhetorical technique in Anarchy, State, & Utopia to explore the line between a free man and a slave as you step through various formats of governance.

  16. Nick Rowe’s analysis makes sense.

    But it implies that the current use of the term in economics is ridiculous and useless – unless you want to invent categories for Somalia and Bitcoin to the exclusion of all practically functioning monetary systems. And it means that the term as currently used is just a redundant variation on the idea of convertibility – whether the currency is directly convertible by the central bank as an intervening counterparty, or indirectly convertible with the central bank as a guiding force behind the convertible market value of the currency (in terms of gold, CPI, or some other target).

    1. i.e. the term as currently used amounts to non-convertible in that broader sense of convertibility (either direct or indirect)

    2. And functioning monetary systems always include convertibility in that broader sense - and also in the context of Nick's excellent linked post on gold/CPI, where he said:

      "But other than making the basket much more representative and sensible, which matters massively in practical terms, did it really change things theoretically?"

    3. ... and so I revert to the definition implied by my earlier comment, in which fiat would be better thought of as the authority and instruction that determines the nature of the convertibility - direct or indirect - in a functioning monetary system - which is actually the polar opposite of Nick's conclusion, because it would imply that number 9 is the only system that is not fiat. And of course it is completely out of sorts with any normal definition that might be actually be found in economics today. Different use of language and meaning.

    4. Great points. If step 9 is the definition for fiat, then fiat doesn't really apply to many functioning monetary systems, as you point out, so why bother using it. And adopting step 7 means that you must find some fundamental difference between indirect and direct convertibility, as you point out. But does either of these forms of convertibility "really change things?" as NR asked in his gold/CPI post? We can also adopt a non-standard definition like yours (which might include gold and silver coins?) or just abandon the whole fiat money thing (my preference) since it has become a Babel.