Professor Raymond Niles holds a Ph.D. in economics from George Mason University and an MBA in finance and economics from the Leonard N. Stern School of Business at New York University. He has taught economics at the university level and worked for fifteen years on Wall Street as a senior equity research analyst at several leading Wall Street firms, and as managing partner of a hedge fund. He is a senior fellow and columnist for the American Institute for Economic Research, a contributor to The Objective Standard, and has authored two book chapters.
Is fiat money real money? Isn’t gold real money?
The economist Carl Menger (founder of the Austrian school) defines money as the “universal good.” That is, it is the good that will always be accepted in trade. Gold today does not serve that function. (Incidentally, this is a principal reason why the dollar price of gold varies so much. It has less to do with changes in the purchasing power of the dollar and much more to do with changes in the demand for gold.)
Whether one likes it or not, our fiat dollar is money today. It is the universally accepted good in trade. It is the sole good universally accepted as a means of exchange. Specifically, our dollar is a fiat money, which is a specific type of money that is not convertible into a commodity like gold.
Of course, fiat money has all sorts of problems. Its chief problem is that our fiat money is issued by the government, which controls its supply. The government will readily issue new dollars (via the mechanism of deficit spending and “monetizing” the debt) in order to raise revenue. This has the principal problem of being inflationary; it reduces the value of the dollar. But it is also a “sneaky” way to raise revenue that does not require the explicit levying of taxes. Since it is politically so easy to raise revenue this way, it makes it too easy for governments to increase spending. We are witnessing the result of that ease of financing the government today where governments world-wide take and spend too much of our wealth.
Is there money in our economy? Or does our economy function without money?
If one thinks about that question, one realizes that there is money. It is the US Dollar. Yes, it is fiat money. It emerged out of the confiscation of gold in the 1930s. It is “backed” with government force via legal tender laws. Nevertheless, it is money.
And it certainly has the principal characteristic of money: it is universally accepted in exchange. All of us will accept US dollars in trade. Moreover, it is the only good that has that characteristic. There is nothing else in our economy — including gold — that functions as the universal medium of exchange.
Gold certainly isn’t money today. And that is why its value fluctuates so much. If it were money, its purchasing power would be highly stable, as it was when it was money, in particular under the “Classic Gold Standard” of the 1800s. During that time, its value actually grew at a fairly stable 1%-2% per year.
Even though fiat money is accepted as money, is it really money if that acceptance is forced on people by legal tender laws?
First, it is universally accepted. That is observably true. As for being forced on people, that is true on a fundamental level, but the context must be understood. Many voluntary choices still undergird our fiat money and make it valuable for the purpose of saving and trade. Let’s examine some history to understand this point.
At the time of our founding, the US dollar typically was convertible into gold (although states did issue fiat money during the revolutionary and early independence era). Gold was money and dollars represented a claim on gold. In the 1800s, a dollar was defined approximately as 1/20 ounce of gold. So, $20 = 1 oz. of gold. (The value was initially set at $19.75 and later set at $20.67. For simplicity, we will simply use the round number of $20.) Most of the circulating money was actually paper dollars, not gold coins, because people largely trusted that banks would honor the convertibility of gold. (This is despite occasional “runs on the bank.”) This meant that they believed that when they presented a banknote to a bank teller, the teller would give them the gold value of that banknote. Until the Civil War, essentially all banknotes were privately issued by the banks. This was truly private money that people voluntarily accepted.
However, even during the private banknote era, which lasted until the Civil War, money wasn’t completely free of government compulsion. For example, state governments, which chartered the banks, typically required that banks had to buy a certain quantity of state bonds to “back” their notes. In reality, this did not protect the notes against default. Rather, the requirement forced banks to become a major purchaser of state bonds, thereby providing a ready source of credit to state governments.
Then, during the Civil War the U.S. government dramatically stepped up its control of money by mandating that banks had to buy federal bonds, thereby helping to finance the war effort of the North. The government also forced banks to make their notes look very similar to each other, whereas during the earlier “Free Banking” era, individual banknotes were very different from each other, which facilitated individual banks establishing their own brand and reputation for creditworthiness.
The other big intervention during the Civil War was that the US government itself began to issue irredeemable currency. These were the US “greenback” dollars. At the same time, the US government took the banking system off the gold standard. We were off the gold standard from the early 1860s until 1879, when we went back on it at its former parity of $20 = one ounce of gold. (Incidentally, this caused a rather large price deflation, which hurt borrowers, especially farmers, and fostered an intense hostility toward the gold standard and the banking system that persisted for decades.)
During the late 19th century, we were officially on a gold standard, the “classic gold standard,” but with a banking system hobbled by many rules, such as a ban on most interstate banking, and various other forms of federal and state government intervention in the banking system.
Then, if we fast forward, we get the formation of the US central bank in 1914, the Federal Reserve System. We were still on a gold standard then, but now there was a greater ability to begin to deviate from it. Then we had the Crash of 1929 and the Great Depression. FDR dramatically devalued the dollar, making 1 oz. of gold = $35. So, now the dollar was worth just a little more than half of what it was before, in terms of gold.
But, FDR went dramatically further and outlawed the private ownership of gold. Americans had to turn in their gold to the US government, who gave them depreciated fiat dollars in return. Technically, we were still on the gold standard, but only foreign governments could exchange dollars for gold. It was called a “gold exchange standard,” but really the gold standard was de facto mostly dead.
We fully and finally went off the gold standard in 1971 when President Nixon closed the “gold window.” That meant that the US government would no longer give gold to foreign governments who presented dollars to us. This happened because we were already massively inflating the money supply to pay for the Great Society welfare programs and the Vietnam War. The French central bank, in particular, took advantage of the situation by exchanging their depreciating dollars for more valuable gold. The U.S. almost ran out of gold. It was a run on the bank. More specifically, it was a run on the central bank! So, Nixon ended gold convertibility.
So, when you add it up, a long chain of force led to us using today’s fiat dollar. There is a hypothesis that the US fiat dollar would never have been accepted as money if it had simply been imposed on us all at once. Rather, because it had its roots in the voluntarily accepted private gold-backed banknotes, people simply continued using the dollars even as the government gradually stepped up its control over our money supply.
Economically, in terms of its function in our economy, our fiat dollar is money. But it is certainly not a desirable money. We should abolish every aspect of the government’s control over money and banking. That means repealing a lot of laws, as well as abolishing the central bank.
What would happen if these laws that keep the US dollar in its position as money were repealed?
I have no doubt that if these laws were repealed and appropriate laws recognizing other forms of money put into place, people would stop using the US dollar (maybe not immediately, but over some period of time).
Some of these laws include:
- Legal tender rule — By law, everyone must accept US dollars in payment for goods and services, even if another means of payment is specified in the contract.
- Capital gains taxes — These are a biggie. They are an insuperable obstacle against the emergence of a competing commodity money such as gold. The problem is that, for tax purposes, gold is treated as an asset, not as money. So, if the dollar value of gold appreciates, the holder must pay a capital gains tax on it. No money can emerge if changes in its value are taxed as capital gains.
- The Federal Reserve control over the banking system — This control is like an octopus. The Fed, with its many regulatory tentacles interfering with bank operations, can simply make it impossible for a bank to begin using some other medium as money. An example of the Fed’s power is seen in how it has made it extremely difficult for marijuana growers to use banks. The banks are petrified of the Fed’s power and the federal government’s hostility toward marijuana growers and sellers. So, they won’t offer bank accounts to them, even though it would be a new source of deposits and lending, and therefore profits. (Some banks do service the marijuana growers, but it is very difficult.)
Moreover, there is another potential major competitor to the US dollar that is not gold. It is Bitcoin. Our government and governments around the world have actively thwarted the acceptance of Bitcoin by closing down exchanges and taking other actions.
I have no doubt that if the government stopped thwarting competition, a competitive money and banking system based on that money would emerge, and the dollar would be kaput.
What are your thoughts on Matthew McConaughey’s monologue about money in The Wolf of Wall Street?
First, I worked on Wall Street for 15 years. I never met anyone like either character in the clip or any of the characters in The Wolf of Wall Street.
It was an entertaining movie, but largely false, based on my experience. Certainly, people like that exist, but then they end up as the Wolf did, or as Bernie Madoff did — in prison.
The movie also makes a basic, but endemic, mistake about financial assets, including money. That mistake is that they serve no useful role in the economy and have no value in themselves. This is a Marxist perspective which, unfortunately, stems from Aristotle. Aristotle thought that making money from money (i.e., interest from lending, or profits from speculating) was sterile. It created no value.
Aristotle and Marx were wrong.
But, it is easy to make that mistake because money and financial instruments, and banking, are all difficult to understand properly. The reason is that finance is very abstract. Concretizing it is difficult.
The best description of the origins of money, and its fundamental nature as the “most saleable good,” which became the “universal good” in trade, is the Austrian economist Carl Menger and his 1892 article “The Origins of Money.” Although it is abstract and somewhat difficult reading, you could read sections III and VIII and perhaps a few more that seem relevant to get a sense of his thesis. It is generally accepted by most economists.
His basic idea is that a good that is widely (but not yet universally) desired, say gold and silver jewelry, becomes money (a universally desired good for trade) if it also has certain useful characteristics, such as durability, divisibility, portability (a high value to volume or size ratio), etc. Menger lays it all out in his pamphlet.
To understand how money emerged it is helpful to think of the emergence of money in other societies. An interesting example is the POW camps in Germany during World War II where cigarettes became money. The American, British, and other prisoners began using cigarettes as money. It had the desired useful characteristics. It was divisible, portable, and reasonably durable. It was also a widely valued good since most people were smokers. But not all people were smokers. Nevertheless, when the non-smokers realized that most people would accept cigarettes in exchange for other goods, they, too, began desiring cigarettes for trade. At that point, the cigarettes became money. In a similar manner, gold made the jump from being desired as jewelry to being desired as money. In fact, the first modern-style bankers were goldsmiths. They were called goldsmith bankers.
It is pretty generally accepted among economists that money does not need to be “backed” by anything in order to be money. It simply must be universally valued in trade. So, fiat money can and does exist. However, I don’t know whether any fiat money has actually been created de novo by fiat (despite its name). Instead, the typical pattern, which was the pattern of the US dollar, is that the dollar started off as a privately-issued certificate exchangeable for gold. That exchangeability is what gave it its value and made people willing to accept the paper banknotes as money for trade.
Gradually, over a series of steps (as I outlined above), the exchangeability into gold was at first attenuated and then eliminated altogether. But by that point, people simply continued using the paper notes as money. As long as the issuer (the government) does not issue too many notes, they retain their value, despite no longer having any relationship with gold. (Note that the government does put golden-colored imagery on today’s notes to maintain the fictional tie-in with gold. Look at one of your bills.)
As for private money, and this may surprise you, nearly all money is actually created by the private actions of banks and their borrowers. The Federal Reserve largely does not directly create any money. So, you could say that most money is privately created today. What do I mean by this? Well, most money exists in the form of bank deposits, not as paper currency. New deposits are created every time a bank makes a loan. Economists call this “bank money.” It is real money. Every time you write a check, you are paying someone in privately-created bank money.
Now you must be really confused! It would take some time to explain this point, but I would be glad to do so, time permitting.
Is a store of value the essential aspect of money?
The ability to save with it is not the defining aspect of money. It is one of the most important economic uses of money, but it is not the distinctive quality that defines it.
One can save in many forms, such as land, iron ore, or nails. All of these substances have durability (which is also a necessary characteristic of money). But they are lousy ways to save. How do I pay a baker with land or nails, if he doesn’t want any?
Money is the ideal way to save because it is universally desired in trade. Everyone is willing to accept it. That characteristic makes it the best form of saving wealth. That characteristic is what makes it money.
Ayn Rand, in her quote on money, is correct about the economic and philosophic importance of saving using money. Incidentally, the characteristics she cites that make gold a good form of money — durability, portability, steady value, etc. – were (as far as I know) first enunciated by Carl Menger, the father of Austrian economics. I am guessing that Ayn Rand probably learned these characteristics from reading the later Austrian economist Ludwig von Mises.
How do governments change the money supply?
Most people think that the government expands the money supply by printing banknotes. It certainly does print banknotes, but that is incidental to the creation of money. In the United States and any modern country, the money supply is not changed through the creation of banknotes. (However, in some countries it has happened this way, for example in Zimbabwe. There, hyperinflation was caused in large part by the direct printing of notes. The dictator, Robert Mugabe would order the central bank to print more banknotes that he would then use to pay his cronies.)
The money supply in the US is changed through a more complicated and indirect process. It is a two-step process. First, the Fed can create new bank reserves. Every bank keeps a bank account — called a reserve account — with the central bank. (Note: This was also true before there was a Fed, except that the central reserve depository was a private corporation, the New York Clearing House.)
The reserve account is used by the banks to settle balances owed to each other. These balances arise as the banks’ customers write checks or otherwise make payments to each other. Imagine that Citibank’s customers wrote more checks to Chase’s customers than the other way around. At the end of each day (or whatever time period — the clearing process keeps getting faster and faster), the net balance that Citibank would have to send to Chase is settled through a payment from its reserve account.
Banks need reserves in proportion to the transaction volume of their customers. As customers transact more, a bank needs more reserves to handle the net payment imbalances that arise. A major cause of transaction volume is bank lending. Whenever a bank lends money, it creates a checking account for its customer. When the customer spends this money, the bank must have a certain quantity of reserves to handle the transaction balances that arise with other banks.
The Fed’s influence on the banking system is that it can directly create new bank reserves. This, in turn, can enable banks to increase their lending. If new transactions arising from that lending expand at a faster rate than the rate of growth in goods and services, there will be price inflation.
But here is the rub. The Fed can only influence the quantity of reserves. It has surprisingly little influence over the rate of bank lending. But, it is only an increase in bank lending and related financial transactions that can lead to price inflation.
After the 2007 financial crisis, the Fed massively increased bank reserves, but the banks did not massively increase their lending. The result was basically no price inflation.
So, to summarize, the Fed’s influence over the money supply is indirect. Banks directly control the money supply through their lending activities. The Fed can influence that volume of lending by directly changing the reserve balances that banks hold at the Fed, but any change in reserves does not automatically cause a change in lending. This is why we have seen apparent quandaries such as the huge creation of new reserves by the Fed following the 2007 financial crisis, which did not result in massive new lending or price inflation.
So how does gold prevent such price inflation?
As to why a gold standard prevents price inflation, recall that bank reserves under a gold standard are gold bullion. That cannot be created out of thin air. Rather, it must be mined, which is a difficult and costly process. New bank reserves due to the mining of new gold was never more than a few percent a year. In contrast, since bank reserves under a fiat system are simply electronic balances on a computer at the Fed, those reserve balances can be created more or less costlessly in any amount.
*How* the Fed changes those reserve balances is another story. It is a detail in the process, but it also has its own larger significance. The key point is that today the Fed can change those reserve balances more or less at will.
Is the U.S. dollar backed solely by force?
There is a good quote from the philosopher Ayn Rand on this topic. She said in her essay, “The Meaning of Money”:
“Money rests on the axiom that every man is the owner of his mind and his effort. Money allows no power to prescribe the value of your effort except the voluntary choice of the man who is willing to trade you his effort in return. Money permits you to obtain for your goods and your labor that which they are worth to the men who buy them, but no more. Money permits no deals except those to mutual benefit by the unforced judgment of the traders. …”
“So long as men live together on earth and need means to deal with one another—their only substitute, if they abandon money, is the muzzle of a gun.” [For the New Intellectual]
We are forced to use the US dollar in transactions, but on a fundamental level, the US dollar is not backed *only* by force. No money would be successful if its only virtue was that you would avoid jail or fines if you used it. Consider some examples where authoritarian rulers attempted to make people use a certain money through force alone.
- In Zimbabwe, the dollar collapsed — people stopped using it — despite all the force Robert Mugabe could employ to make people use it.
- In Ancient Rome, even the death penalty could not make people transact with debased coins at the nominal value dictated by the emperor.
- In the Soviet Union, no gulag could make the ruble desirable or preferable to dollars. People did everything they could to get out of rubles and into dollars and other valuable Western currencies.
The US dollar is not solely backed by force. For the most part, what gives it value is what makes any money worth holding: production. It is the production of abundant goods and services that makes the US dollar worth holding.
Just like we have a mixed economy of freedom and controls, I think of the US dollar in similar terms. Its value is determined by the productivity of Americans (and many people around the world who also use the US dollar in trade). The fact that we use the US dollar and not a potential superior money, like gold or Bitcoin, is because the government compels us to use this particular money through various forceful means such as legal tender laws, discriminatory capital gains taxes, etc.
My observation is that people have, in fact, continued to use fiat notes. There is no moral implication that this is somehow justified. Because they continued to use the notes, the notes continued to perform the role of money.
As to what degree this was the result of force, I would argue that it was only partially forced on people. As I pointed out, force alone cannot make people use a fiat money. The fact that they had been using a commodity-backed money before the gold standard was suspended made it tenable to continue using it. Moreover, people were willing to accept US dollars because of the productivity of the American economy. There was an abundance of goods and services that could be bought with the money. (The money was “backed” by those goods and services).
So, in part people continued using US dollars out of habit, as they always did, even when it was no longer convertible into gold. And, in part, they continued using it because of the various laws that made competing money illegal or very difficult to implement.
I don’t see the point in trying to say that the US dollar is not money. It serves as the universal medium of exchange. That is the defining characteristic of money. This remains true even if its continued use as money is partially due to force.
The fact of the US dollar being money is an economic “fact on the ground,” to paraphrase an Israeli leader (I can’t remember who) who described Israel’s claim for legitimacy. Fiat money is money. It would be defining money by a non-essential characteristic to say that only gold-backed money is money. There have been too many other varieties of money to belie that definition.
Gold-backed money may be the best money, but fiat money is also money.
If economists stopped thinking of the US dollar as money, there would be no way to understand how banking works, and there would be no way to understand a whole variety of monetary issues, such as inflation, the effect of central bank policy on economic performance, etc.
Can credit grow faster than the rate of gold production under a gold standard?
I am going to “shoot from the hip” a little bit and respond to this without my data in hand (my apologies). I recall observing, but don’t have the data handy now, that credit volumes rose rapidly throughout the 19th century when the United States was on a gold standard. Even though the supply of gold grew moderately (1%-2% per year), aggregate output grew at a much higher rate. Importantly, credit grew at a rate that actually exceeded that growth in real output. How is this possible?
I contend that it is possible because the banking system grew in scope and importance during this time. As the scale of industry grew, its need for financial capital grew to finance it. Banking and new credit grew at a faster rate than the growth in production of real goods and services. And it certainly grew at a faster rate than the growth in gold production.
What does this mean? This meant that the banking system created new credit — and new “bank money” — on top of the existing supply of gold. Banks create money all the time, back then and today, simply by extending credit. When a bank extends a loan, it simultaneously creates a bank account for the borrower to draw on. That is newly-created “bank money” (“inside money” in today’s parlance, or what Ludwig von Mises called “fiduciary media”).
As the economy grew in scale, scope, and sophistication in the 19th century, the need for banking — for aggregating and allocating capital — grew at a very fast rate. As banking grew in sophistication, it was able to create fiduciary media at a faster rate than the growth rate in gold and the growth rate in production of goods and services.
This would mean that equity indices could go up — and they did — in real terms, under a near laissez-faire economy and the “classic” gold standard, as it existed in the 19th century.
I would summarize the point this way. The “financialization” of the economy grew in the 19th century. Credit grew faster than gold. This would allow the money values of companies and capital to grow, even in real terms.
The key to understanding this is to think about why gold is part of a (free) banking system. Gold is the only true money in a free banking system. However, maintaining that stock of gold is costly. It is costly to store gold in vaults and move it around (it can be stolen, etc.). Moreover, a holder of gold receives no interest for it since it is not debt. (Interest is not paid on money, which is simply a means of payment.)
Under a gold standard, as we had in the 1800s, banks hold gold as reserves. Why do banks need to maintain reserves? They need it when depositors withdraw their deposits in the form of gold (which depositors rarely do, it turns out; usually, they are happy to withdraw their money in banknotes — i.e., bank-created money, redeemable in gold). They also need it to settle adverse check clearing balances with other banks (i.e., when banks present checks to the issuing bank for redemption).
So, gold reserves are costly. Because of this, banks have figured out ways to economize on reserves. For example, prior to the mid-1800s, banks used to settle net clearing balances by shipping bags of gold coins to each other. This was costly. This required a lot of gold, and it encouraged theft. Then the banks developed the idea of a clearinghouse (the New York Clearing House). All of their notes and checks could be netted against each other, and only the net balance had to be settled in gold. Moreover, the gold never had to leave the clearinghouse vault. Thus, the banks kept a portion of their gold reserves at the central clearinghouse.
This development alone reduced the need for gold, which is equivalent to saying that banks could extend a greater volume of loans against a given supply of gold. This is also equivalent to saying that the reserve ratio of the banks declined throughout the 19th century, and could do so safely because of the clearinghouse innovation.
Because reserves are costly, banks constantly looked for ways to minimize their need for them. Over time, this has allowed credit balances to grow at a faster rate than gold.
Other innovations were the development of robust markets for lending reserves between banks, and the use of clearinghouse certificates, or loans from the clearinghouse to settle reserve imbalances. Another innovation was the acceptance of high-quality bank-created money as reserves. For example, a small regional bank in the 19th century might have held notes from a well-respected New York City bank as reserves, which it knew it could quickly convert into gold if it needed it.
The bottom line is that there is no fixed relationship between the volume of gold and credit in the economy. It is a loose relationship. There are limits at the high and low ends. If a bank lends too much to deadbeat borrowers, there will be defaults and people will want to redeem the bank’s notes for gold. At the extreme, this can cause a “run on the bank.” At the other end of the spectrum, if a bank keeps too much gold reserves, it is actually lending *too little* and forgoing profits it could be earning. A bank can only make money by lending.
As an example of how credit and paper bank-issued money can dominate a financial system even when it is based on gold, my understanding is that circulating gold coins constituted only 2% or 3% of outstanding money circulation in Scotland during its free banking era in the late 18th and early 19th centuries (h/t Lawrence H. White, the leading scholar on free banking). The rest was bank money or banknotes. People trusted banknotes. They trusted the banks to redeem the notes on demand in gold (although they did not do it in all cases). And because of that, they did not need to do it. That meant banks could keep very small gold reserves in relation to their outstanding loans.
Is fiat money moral?
No. I hope that is clear. Fiat money is the result of government coercion – confiscation of gold, abrogation of contracts, interference with banking operations, nationalization of the banks’ private clearinghouse, etc.
However, the moral status of fiat money does not change its economic status. It is money.
And it must be remembered that to a great degree, the continued value of fiat money is the result of voluntary choices. Those are the voluntary choices of the producers of goods and services that underlie its value. And in the choice (albeit influenced by coercive government policies) of people who continue to use the US dollar.
The government does not have total control over the fiat dollar. They cannot — through force — make it valuable. They can preserve its value by restraining the use of force, specifically by not over-inflating the issuance of the dollars, and by not overly interfering in the production of goods and services that underlie its value.
When governments did use extreme force along these dimensions, people stopped using the fiat currency, as they did in Zimbabwe and Venezuela, for example.
Any business today is hobbled by regulations, taxes, and subsidies, but is it still a business? Yes. Our fiat money — understanding its full context — is also such a hybrid creature. But, just as we call a company today a business, judging it by its essential nature, we have to use the same standard to say that fiat money is money since it displays the central characteristic of money: a universal medium of exchange.
Where can we learn more about money?
I will cover money and banking in a live, interactive, online course I am teaching next year, among other topics. The course is called “Henry Hazlitt Meets Ayn Rand: Economics and Objectivism, United for Freedom” and begins on January 5th, 2020, and lasts for 8 weeks.
Issues I cover will include:
- Why production and trade are fundamentally driven by reason and self-interest—and why grasping this principle is essential to making the moral case for capitalism;
- How supply and demand jointly determine market prices, and why establishing and maintaining freedom for this “pricing mechanism” to work is in everyone’s self-interest;
- Why coercive policies, such as wage controls and tariffs, harm all parties involved—employers and employees, job-holders and job-seekers, businesses and customers, exporters and importers;
- What free-market banking is, why it is in everyone’s self-interest, and why government intervention in banking is morally and economically disastrous;
- Why free markets result in better and safer health care, food, travel, education, etc.
and course the role of money and banking in a capitalist society.
The goal of the course is to integrate the basic principles of economics with those of Objectivism to help students become an intellectual powerhouse in the fight for freedom and capitalism.
Capitalism Magazine readers can learn more about the course here.