To suggest that the economic problems presently facing the United States and Europe are challenging surely risks understating the state of affairs. Stubbornly high levels of unemployment, out-of-control deficits, ongoing declines in housing prices, and downward projections of economic growth are just some of the symptoms that suggest there is no immediate light at the end of the tunnel. Certainly, there are some bright spots, such as the efforts of David Cameron’s coalition government in Britain to use the crisis as an occasion to radically reform state finances. For the present, however, the overall outlook remains bleak.

But one of the Great Recession’s unexpected benefits is the manner in which it has reignited a range of economic debates that have needed attention for some time. One is a widespread questioning of the methods and priorities of mainstream economic science. Another discussion concerns the conduct of monetary policy. The decisions of the Federal Reserve and the European Central Bank, for instance, are now subject to micro-scrutiny by not only governments and the financial industry but also by increasing numbers of skeptics with serious reservations about the very manner in which modern central banks operate. Closely related to this are questions about the long-term viability of fiat money: the means of exchange that has dominated the world since the end of the gold standard.

As the Latin word fiat (“let it be done”) suggests, fiat money is a state-issued means of exchange which a government simply declares to be anything which, when presented as payment, extinguishes a debt owed to another. More specifically, as John Maynard Keynes stated in his Treatise on Money (1930), fiat money is “created and issued by the State, but is not convertible by law into anything other than itself, and has no fixed value in terms of an objective standard.” In short, it has no intrinsic value in itself inasmuch as fiat money is not representative of a fixed and known amount of a commodity such as gold or silver. Instead fiat money is ultimately backed, as the U.S. Treasury states, “by all the goods and services in the economy” as well as a confidence that the issuing government can ultimately pay its debts.

Here we should note that fiat money’s viability relies heavily upon the concept of legal tender. This expresses the legal obligation of individuals to accept payment of debt in terms of the currency issued by the state. Indeed, the ideas of legal tender and fiat money are inseparable inasmuch as legal tender provides fiat money with the legal force it needs if it is to be mandated as the means of extinguishing debt in a given jurisdiction.

Contemporary fiat money represents the end of a long process of development whereby governments have used their power of legal tender to use money to pursue various policy goals. Prior to the introduction of paper money, governments were more than willing to debase gold and silver coinage to artificially reduce their debts. Adam Smith pointed out in his Wealth of Nations (1776) that “when national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid.” Smith then added that “the liberation of the public revenue, if it has ever been brought about all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment.”

Smith was thinking of circumstances in which governments shirked their debts by debasing the currency, thereby evading formal bankruptcy while legally diminishing what they owed their creditors in real terms. The introduction of paper money made this process even easier, if only because printing more paper was less complicated than diluting the amount of gold or silver mixed into a given coin. As the economic historian Norbert Olszak writes in his Histoire des banques centrales (1998), the Bank of England’s first banknotes were described as “certificates of deposit.” They attested to the holder’s claim on a deposit of gold or silver held by the bank. By the mid-eighteenth century, however, the same documents were being formally described as “promissory notes.” The change in wording was deliberate: the purpose was to diminish in peoples’ minds and in the eyes of the law the strict link between the commodities and the paper that was supposed to redeem them.

For part of the nineteenth century and early twentieth century, the linkage of national currencies to the gold standard meant that the value of currencies as well as the amount of currency in circulation was somewhat stabilized by the fact that the paper monies issued by central banks such as the Bank of England were convertible into a fixed amount of gold. But after most countries left the gold standard in 1914 in order to fund unprecedented war expenditures, the prospect of fiat money became more real, despite the attempts of many politicians and economists to reestablish some link between gold and currencies in the inter-war years. Following World War II, the Bretton Woods agreements resulted in many nations setting their exchange rates relative to the American dollar, on the basis that the United States (which then held over half the world’s gold) would peg the dollar’s price to 1/35^th of a troy ounce of gold. The idea was that all currencies pegged to the U.S. dollar would therefore indirectly enjoy a fixed gold value. The tendency, however, of successive post-war American governments to issue more dollars than their holdings in gold could back in order to fund programs such as Lyndon Johnson’s Great Society, the Korean and Vietnam wars, and containment of an expansionist Soviet Union eventually made the system untenable and fiat money a reality in 1971.

This brief excursion into economic history hints at some of the deeper economic—not to mention moral—problems associated with fiat money. One is, as noted, the greater ease with which it permits governments to devalue currencies, thereby reducing the wealth of those with assets denominated in that currency. This surely constitutes an injustice to those individuals and businesses that have saved and behaved in a fiscally responsible manner while simultaneously letting the fiscally imprudent off the proverbial hook.

This underscores the second problem associated with fiat money: its facilitation of systemic moral hazard throughout entire economies. Moral hazard describes those situations whereby people are encouraged to take excessive risks because of the implied assurance that someone (usually the state) will bail them out if the enterprise or investment fails. From this standpoint, fiat money’s very existence arguably encourages the development of moral hazard throughout every sector of the economy. The high level of the U.S. federal government’s public deficit, for example, is at least partly premised on the unspoken supposition that the Fed (which is, after all, a government institution that operates within legal parameters set by Congress and whose members are nominated by the President) can simply print more money in paper or electronic form if creditors become worried that the U.S. government’s borrowings cannot be covered by anticipated taxation revenues, foreign borrowings, and its existing resources. This in turn encourages more people and governments to buy U.S. government debt in the form of bonds, which permits more deficit-spending, thereby encouraging a cycle of ever-spiraling public debt.

Thus, prior to the delinking of the American dollar from gold in 1971, the money supply between 1960 and 1970 grew by 47%, while the public debt grew by approximately 34%. In the decade after the dollar’s delinking from gold, however, a rapid acceleration occurred with the money supply growing by approximately 87% while the public debt increased by almost 139%. Between 1980 and 2005, the pace further accelerated at the respective ratios of 254% and 753%. The absence of some form of “golden brake” (even the pseudo-gold standard that existed between 1946 and 1971) is surely part of the reason for the accelerating increase in public debt.

A third and related problem of fiat money concerns the way that it encourages the illusion that governments and central banks can somehow “manage” multi-trillion dollar economies. The international obligations accepted by all countries adhering to the gold standard (even in its debased post-World War I forms) placed some limits on governments’ capacity to use their legal tender powers to pursue any number of macroeconomic objectives. With fiat money, however, any such restrictions are removed. Instead government and central bank officials can increase or decrease the money supply as they see fit in response to any number of economic phenomena. Sometimes it works (as in the case of Paul Volcker’s successful fight against inflation in the late-1970s and early-1980s), but it also often fails. A good example of this is the Fed’s easy money policies which sought to ease the effects of the dot-com bubble’s implosion in 2000, but which also played a major role in inflating America’s housing market between 2001 and 2007. In other words, the state’s efforts to manage fiat money means that monetary policy is far more dependent on the decisions of fallible human beings who cannot possibly know all the consequences of their choices, rather than the functioning of the rules of something like the gold standard, which, for all its imperfections, provided more predictability about the economy’s likely direction.

As a formal monetary institution, the contemporary system of fiat money is just thirty-nine years old. We are thus only at the beginning of this experiment. If, however, America and Europe’s economic tribulations continue to worsen and an endless cycle of devaluations, deficits and debts ensues, then the case for fiat money will become harder to sustain. That is what makes the articulation of alternatives to our present status quo even more urgent.


Samuel Gregg is Research Director at the Acton Institute. He has authored several books including On Ordered Liberty, his prize-winning The Commercial Society, and Wilhelm Röpke’s Political Economy.

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