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Fiat currency

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Look up fiat in Wiktionary, the free dictionary.In economics, fiat currency or fiat money is money whose purchasing power derives from a declaratory fiat of the government issuing it. It is often associated with paper money unbacked by fixed assets, issued without the promise of redemption in some other form, and accepted by tradition or social convention. Fiat money is called fiduciary money in many languages.

The widespread acceptance of a fiat currency is enhanced by a central authority mandating its acceptance under penalty of law and demanding it in payment of taxes or tribute. Fiat money can be contrasted with alternative forms of currency such as commodity money and private currency.

Most currencies in the world have been fiat money since the end of the international gold standard of the Bretton Woods system in 1971. However, some of the major currencies today, despite being based essentially on arbitrary decree, have become so trusted that they are termed hard currency.

Contents [hide]

1 Debate over the term

2 Historical summary

2.1 Credit-based monetary systems

2.2 Critiques of credit money expansion

3 The importance of fiat money as a concept

4 See also

5 External links

[edit]

Debate over the term

What exactly is a “fiat” currency is a matter of some debate, with a spectrum of opinion that runs from those who declare as fiat any currency that is not in a gold standard, silver standard or fully backed by some other commodity, to a range of economic theories which hold that market dynamics enforce fiscal discipline, through to other heterodox schools of thought that reject the veil of money altogether, defining all monies other than the goods themselves to be fiat.

In general, libertarians define fiat money stringently, and an opposition to fiat money is coupled with an opposition to fractional reserve banking and governments having a central bank. There is disagreement among them as to whether representative money backed by specie is fiat money, with many conservative libertarians arguing that notes can have payment in specie suspended by law.

Advocates of “debt-free money” argue that money which requires the issuing of central bank debt is a burden on the public. In essence, just as there is a school of thought which opposes any money which is not linked to specific, countable, and measurable reserves, there is a school of thought which denies the value of any encumbrance on the government’s ability to issue notes at all.

The problems of maintaining a currency not linked to a fixed and redeemable asset dominate modern political economy, and are a feature of open currency macroeconomics. Nations whose currency is devalued or under attack (see financial crisis, capital flight and hyperinflation) are often encouraged or required to link their currency to an external currency or basket of currencies.

[edit]

Historical summary

Historically, specie-based money — generally gold and silver — was the unit of account that governments would accept as “legal tender”, and was struck into coins which were the “circulating medium”. That is, the government would accept it as payment, and would enforce others to accept gold and silver coins, usually at fixed rates. Notes backed directly by currency became used by private banks and holders of specie, which were used as “drafts” to move or lend money. This system of drafts has never completely disappeared, and there are today high tech equivalents of it that use fax machines in place of bank notes. However, such hard currencies were frequently in short supply, leading to alternate currencies based on a promise to pay, such as “notes of credit”, “bank notes” or stock in companies. These kinds of money become fiat money when the central government accepts, or requires others to accept, such notes as legal tender. Examples include stock in government monopolies and military scrip issued to soldiers. The general term “paper money” was used to cover such fiat money during the 18th and early 19th century, and its tendency to inflate led to hardened political opposition to any use of paper, even if backed by promise to pay, because such promises were easy to break, and hard to hold accountable.

The first historical example of fiat money was in China. Chinese governments would produce “notes of credit” which were valued as tender for limited periods of time, in order to prevent inflation. The Song Dynasty (960–1279), however, created unlimited legal tender paper money, good throughout their empire, as a way of centralizing financial control, and preventing external trade. This money, however, was only as stable as the mandarinate that enforced it, and only as safe as the rigidity and integrity of the people who created it. Since it was both easy to counterfeit, and communication was slow, the Song experiment with paper money collapsed, as individuals preferred doing business through bank drafts, or checks, which were backed with gold or silver.

In the 19th century, there was an increasing demand for international trade, which made monetary standards based on more than one kind of specie less and less stable, as individuals would take advantage of government determined exchange rates to buy silver where it was cheap, and then redeem it for gold where it was overvalued. This led to the gradual adoption of the gold standard among industrialized nations. While exact dates are often hard to fix, Britain’s adoption of the gold sovereign in 1816 began their move to a gold standard, and 1844 is generally dated as the establishment of the practical gold standard in the United Kingdom. Previously, silver had been the standard against which gold was measured, because Europe had had an influx of silver from mines in Germany and silver looted from the Inca and Aztec empires. The word “dollar” comes from the name “Thaler” for a silver coin from the mines near the town of Joachimsthal in Bohemia. These mines were the first significant discovery of silver in Europe since antiquity.

Governments would often produce notes which were fiat currency, with the promise to allow holders to pay taxes in those notes, in effect, assuring at least one future trading partner for the note. These notes were also referred to as “debt-based” money, and included the issuance of notes in the British colonies in America, particularly in Virginia and Massachusetts. Such debt-based money was sold at a discount of silver, which the government would then spend, and would expire at a fixed point in time later. However, even this more restricted form of fiat money was prone to inflationary or deflationary cycles, as those entities which could tax in specie would do so, leaving the debt based money to be devalued as its expiration grew nearer.

The repeated cycle of deflationary hard money, followed by inflationary paper money continued through much of the 18th and 19th centuries. Often nations would have dual currencies, with paper trading at some discount to specie backed money. Examples include the “Continental” issued by the U.S. Congress before the constitution; paper versus gold ducats in Napoleonic era Vienna, where paper often traded at 100:1 against gold; the South Sea Bubble, which produced bank notes not backed by sufficient reserves; and the Mississippi Scheme of John Law. The abuse of paper money issued by banks led most industrialized nations to either outlaw private currency, or strictly regulate its printing, such as the United States National Banking Act of 1862.

Each cycle of inflation and panic would leave citizens vowing never to allow inflation again, until the next round of bone-crushing deflation caused business failure and squeezed borrowers who had to pay back in much harder money than they had borrowed. A good example being the abolition of the “Bank of the United States” by Andrew Jackson, where he declared paper money backed by the government “unconstitutional”. The two temptations — to create inflationary currencies and to allow reserves to drop from one-to-one to the expected rate of redemption of gold — repeatedly hobbled economic stability.

It was World War I which was the collision between specie currency and fiat money. By this point most nations had a legalized government monopoly on legal tender, and in theory governments promised to redeem notes in gold or silver on demand. However, the costs of the war and the massive expansion afterward made every currency effectively fiat money, since there was no reason for a government not to print as much money as it felt it could back with some fraction of its reserves. Since there was no direct penalty for doing so, governments were not responsible for the economic consequences of “running the printing presses”, and the 20th century found itself facing a new economic terror: hyperinflation.

The economic crisis led to attempts to reassert hard money with a new kind of currency: asset-based money. This money combined aspects of fiat currency, in that there was limited convertibility, fractional reserve banking and a unit of account set by the government, with commodity-based money, in that there were limits to the amount of money that could be put into circulation. However, many nations failed to create appropriate legal checks and balances, and they continued to suffer inflationary booms and deflationary busts as a result. One recent example was the Argentine bust which followed the unravelling of its “currency board”. Instead of being linked to gold, the peso was linked to the U.S. dollar, which served as the hard money basis. When an economic crisis hit, dollar reserves fled the country, causing the monetary basis to collapse.

[edit]

Credit-based monetary systems

After World War II, the Bretton Woods system was set up, which pegged the value of the United States dollar to 1/35 troy ounces (888.671 milligrams) of gold (the “gold standard”) and other currencies to the U.S. dollar. The U.S. promised to redeem dollars in gold to other central banks. Trade imbalances were corrected by gold reserve exchanges or by loans from the International Monetary Fund.

Global capitalism, wherein a currency is widely traded as a commodity in itself, is more likely to rely on credit money which can reflect both (commodity) supplies and protections of supplies (by states’ military fiats). It is not held stable by any one state but rather by tension between states, as investment migrates from currency to currency in an open “money market”. As long as there is an international feedback mechanism, such that states attempting to inflate their currency suffer a corresponding drop in international buying power, and an internal feedback mechanism, so that the government is liable for economic failures that stem from fiscal or monetary irresponsibility, the money system does not take on the characteristics of a fiat money system. However, to proponents of hard money such mechanisms are not to be trusted, and all money not directly based on specie redeemable on demand is “fiat money”.

This regime of asset-based money, or credit-based money — in which banks create currency as intermediaries and governments, in turn, back the banking system — produces a different series of problems. In no small part because it is not immediately easy to differentiate sound currencies from unsound ones, and it is possible to convert credit-based money into fiat money by a legal act or regulation. The question of confidence dominates credit-based money, the confidence that a particular central bank or government will not act in a manner contrary to its national interest by allowing the money supply to rise or fall too much. Part of the system of confidence includes holding of reserves to be able to support a currency if attacked, and the issuing of debt to regulate the supply of currency.

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Critiques of credit money expansion

Both Marxian economists and green economists view the evolution from fiat-centric to credit-centric regimes as fundamental to global capitalism, as direct imperialism and colonialism is replaced by more local intermediaries, and relations between rich and poor are defined more by debt.

Some groups (such as the anti-globalization movement or advocates of communism) characterize the shift as shallow and insincere. They argue that imperial or colonial powers (such as the United States or the United Kingdom) retain full control of the military power, especially naval power critical to control of commodity trade, and delegate only local enforcement to their former colonies (now their “allies”). They also argue that the credit regime is biased very heavily towards nation-states avowing capitalism, accepting policy from the International Monetary Fund, clearing their currencies via the Bank for International Settlements (BIS), and belonging to the World Trade Organization. These, they argue, simply extend the existing military fiat and its unfair advantages from colonialism, such as setting commodity prices artificially low.

Neoclassical economists respond that no nation is required to belong to any of these organizations, and that states such as Cuba and North Korea retain a strict military fiat and retain their own absolute control of currency, especially hard currency easily traded for goods on the Western markets. They point to the difficult economic position of these nations as evidence of the futility of maintaining fiat money regimes in a world run by mutual credit capitalism. Critics respond that the difficult economic position has been amplified by isolation, sanctions and boycott, and that these nations have suffered collateral damage due to their affiliation with the Soviet Union during the Cold War. This argument, however, is quite unconvincing to classical economists, who reply in turn that isolated economies are practicing not only fiat banking, but also protectionism — practices which protect incompetent local competitors from competent global competitors.

The relation of fiat money, usury, debt interest, and commodity money is complex and must usually be established in a political economy as a whole. Competing national economies and their relative advantages and stabilities are reflected on global currency markets. There are moves to make the BIS employ credit ratings for nation-states to render them equivalent to corporations or landowners for the purpose of required reserves. This would “hardwire the credit culture” in the words of Andrew Crocket, former head of the BIS. It would also render it difficult or impossible to truly distinguish fiat money from credit money, as both would then rely on the hegemony of global capitalism and the nation-states that practice it. In effect, all hard currency would rise and fall based on the agreements behind the BIS itself.

[edit]

The importance of fiat money as a concept

In a market economy, individuals should ideally make decisions based on the tradeoff between desires, particularly the tradeoff between having a good, service or license, and having the liquidity of money. When the role of the government in maintaining or backing the money supply is in question, the issue of credibility enters decisions. Economic actors begin making decisions they would otherwise not make for fear that the currency or money that they hold will change in value radically. This risk produces economic distortions: people convert money to other forms, increasing the demand for goods that are not meant to be used, but hoarded. Economic actors will shelter income in other currencies, or charge higher interest rates. There may be a depression as money which is percieved to be of more durable value leaves circulation, governments may stop striking metallic coins that are retained by individuals.

Fiat money then calls into question the veil of money: Money ceases to be a commodity like others, and begins to have special and peculiar properties. Instead of focusing on production, investment and consumption, economic actors begin to attempt to divine the actions of government. Since actors can have foreknowledge of government actions in a way they cannot have of a market, this leads to economic efforts to bribe, control or curry favor with the entities holding fiat power.

Fiat money is also closely tied to government borrowing for expenditures that do not have a clear social return, or which may have negative expectations, such as wars of conquest. Governments choose to pay for war in fiat money, rather than in hard currency or specie, on the belief that the returns of war will be sufficient to pay promised notes, and that during wartime shortage and austerity, goods are not available in any case. This has seldom proven to be the case in the absence of strong inflationary controls. Instead, the usual cycle is for the value of fiat notes to trade at a significant discount to portable and stable forms of exchange, specifically those that will be tender regardless of the winning side in the conflict.

Fiat money is also associated with attempts to control trade: If individuals possess notes which are not redeemable outside of the control of a government, the idea is that they will have to purchase preferentially within the boundaries of the nation, rather than importing (see Protectionism). It was David Hume who first argued that this merely leads to inflation by the quantity theory of money, even if the money is backed by specie.

Another aspect of fiat money is its relation to property rights. Many economists argue that since a government that has control over its territory can requisition, confiscate or otherwise ban the use of specie within its boundaries, or suspend promise payments — as has often happened in the past — the presence of fiat manipulation of money is seen as being a signal that a government is intent on abrogating property rights for other purposes.

The opposing view is that governments do not immediately intend to confiscate or ban the use of specie within its boundaries, nor reduce the property rights of its citizens. Instead, a government may be oblivious to the root cause of hyperinflation (excessive increase in the money supply). Worse still, a government may be aware of the cause, but choose to ignore the problem as it is not one that will come to light in its current political term.

Some political economists argue that there is no such thing as fiat money, that governments can create fiat currency, but that the amount of money is determined by the valuation of the market place, and that attempts to create fiat currency beyond the demand for money generate inflation. In the words of Keynes, “Money doesn’t matter,” meaning that control of the money supply beyond limited boundaries will be adjusted for in the marketplace (see IS-LM model).

The idea that there is no such thing as fiat money is also consistent with the real bills doctrine. In this view, all paper and credit money is backed by the assets of the entity that issued it — usually by the gold and bonds of the central bank or the tax collecting ability of the government that issued it. Since all modern central banks do in fact maintain assets as collateral against the money they issue, one has to ask why these assets are universally held if, as quantity theorists claim, they are irrelevant to the value of the central bank’s money.

The real bills doctrine [1] says that economists have wrongly claimed that because a money is inconvertible, it must be unbacked. Most of the confusion centers around two meanings of convertibility:

Physical convertibility

A unit of paper or credit money (a “dollar”) can be presented to the issuing bank in exchange for a physical amount of gold, silver, or some other commodity.

Financial convertibility

A dollar can be returned to the issuing bank in exchange for a dollar’s worth of the bank’s assets.

The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold — for example, when the Christmas shopping season has ended. If the dollar is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted dollars to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper dollars. For example, if the community has $100 of unwanted paper money, and if people intend to redeem the unwanted $100 for silver at the bank, the bank could simply sell $100 worth of bonds or other assets in exchange for $100 of its own paper dollars. This will soak up the unwanted paper and head off peoples’ desire to redeem the $100 for silver.

Thus, by conducting this type of open market operation — selling bonds when there is excess currency and buying bonds when there is too little — the bank can maintain the value of the dollar at one ounce of silver without ever redeeming any paper dollars for silver. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued. Thus, it is an illusion that any physically inconvertible currency is necessarily also unbacked.

A further illustration of the irrelevance of physical convertibility can be seen by supposing that a bank issues two kinds of paper dollars: one redeemable for one ounce of silver throughout the year and another redeemable for the same amount of silver, but only at the end of a year. If the market interest rate is 5%, and if it is costless to issue paper dollars, then the inconvertible dollar must start the year worth about .95 ounces, rise to about .97 ounces at mid-year, and finish the year worth exactly 1 ounce. Any other values would result in arbitrage opportunities. For example, if the inconvertible dollar started the year worth .96 ounces, then each time the bank recieved .96 ounces of silver in exchange for a newly-issued dollar, it could lend the .96 ounces at 5% interest, be repaid 1.01 ounces at year-end, pay off the paper dollar with 1 ounce, and earn a free lunch of .01 ounces.

What is the value of the convertible dollar? A little reflection will convince the reader that it too must start the year at .95 ounces, reach .97 ounces at mid-year, and finish the year at exactly 1 ounce. That is, the issuing bank must actually raise the amount of silver it will pay for a dollar over the course of the year, or arbitrage opportunities will result. For example, suppose that at the start of the year, customers can deposit .95 ounces and get one paper dollar in exchange — a physically convertible dollar that can be returned to the bank for .95 ounces if the customer desires. If that dollar remained at .95 ounces over the whole year, then at the end of the year the bank will have received a free lunch of .05 ounces — a free lunch that will attract rival bankers willing to pay 5% interest to the holders of their dollars.

The result of these processes is that a convertible dollar will always be worth the same as an inconvertible dollar, so that if convertibility is suspended at any time, the value of the now inconvertible dollar will be unaffected — thus creating the illusion that the backing of the money was never relevant to begin with.

http://en.wikipedia.org/wiki/Fiat_money

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    • சமூகத்துக்கு பயனுடைய கல்விநிலை எது?

      பேராசிரியர் சோ. சந்திரசேகரன்

      இன்று நாட்டில் உள்ள கல்விமுறையையும் அதற்கு அப்பால் உள்ள கல்வி ஏற்பாடுகளையும் நோக்குமிடத்து, பல்வேறு கல்வி நிலைகளை இனங்காண முடியும். அவையாவன: ஆரம்பக்கல்வி, இடைநிலைக் கல்வி, பல்கலைக்கழகக் கல்வி உள்ளடங்கிய உயர் கல்வி, பாடசாலையில் வழங்கப்படும் (1-11 ஆம் வகுப்பு வரை) பொதுக்கல்வி, தொழில்நுட்பக்கல்வி, வளர்ந்தோர் கல்வி என்பன, இவை தவிர கருத்தாக்க ரீதியாக முறைசாராக் கல்வி, வாழ்க்கை நீடித்த கல்வி, தொடர்கல்வி எனப் பலவற்றை இனங்காண முடியும். இவற்றில் ஆரம்பக்கல்வி, இடைநிலைக்கல்வி, உயர்கல்வி என்னும் கல்வி நிலைகளே முறைசார்ந்த (Formal) கல்வியின் பிரதான நிலைகள் அல்லது கூறுகளாகும்.
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