If money must arise as a commodity money, how can it become fiat money? It does so via the development of money substitutes (paper titles to commodity money)—but only fraudulently and only at the price of economic inefficiencies.
Under a commodity money standard such as the gold standard until 1914, money “circulated” on the one hand in the form of standardized bars of bullion and gold coins of various denominations trading against each other at essentially fixed ratios according to their weight and fineness. On the other hand, to economize on the cost of storing (safekeeping) and transacting (clearing) money, in a development similar to that of transferable property titles—including stock and bond certificates—as means of facilitating the spatial and temporal exchange of nonmoney goods, side by side with money proper also gold certificates—property titles (claims) to specified amounts of gold deposited at specified institutions (banks)—served as a medium of exchange.
This coexistence of money proper (gold) and money substitutes (claims to money) affects neither the total supply of money—for any certificate put into circulation an equivalent amount of gold is taken out of circulation (deposited)—nor the interpersonal income and wealth distribution. Yet without a doubt the coexistence of money and money substitutes and the possibility of holding money in either form and in variable combinations of such forms constitutes an added convenience to individual market participants. This is how intrinsically worthless pieces of paper can acquire purchasing power. If and insofar as they represent an unconditional claim to money and if and insofar as no doubt exists that they are valid and may indeed be redeemed at any time, paper tickets are bought and sold as if they are genuine money—they are traded against money at par. Once they have thus acquired purchasing power and are then deprived of their character as claims to money (by somehow suspending redeemability), they may continue functioning as money. As Mises writes:
Before an economic good begins to function as money it must already possess exchange-value based on some other cause than its monetary function. But money that already functions as such may remain valuable even when the original source of its exchange-value has ceased to exist. 9
However, would self-interested individuals want to deprive paper tickets of their character as titles to money? Would they want to suspend redeemability and adopt intrinsically worthless pieces of paper as money? Paper money champions like Milton Friedman claim this to be the case, and they typically cite a savings-motive as the reason for the substitution of fiat for commodity money: A gold standard involves social waste in requiring the mining and minting of gold. Considerable resources have to be devoted to the production of money. 10 With essentially costless paper money instead of gold, such waste would disappear, and resources would be freed up for the production of directly useful producer or consumer goods. It is thus a fiat money’s higher economic efficiency which explains the present world’s universal abandonment of commodity money. But is it so? Is the triumph of fiat money indeed the outcome of some innocuous saving? Is it even conceivable that it could be? Can self-interested individuals really want to save as fiat money champions assume that they do?
Somewhat closer scrutiny reveals that this is impossible, and that the institution of fiat money requires the assumption of a very different—not innocuous but sinister—motive: Assume a monetary economy with (at least) one bank and money proper (“outside money” in modern jargon) as well as money substitutes (“inside money”) in circulation. If market participants indeed wanted to save on the resource costs of a commodity money (with the ultimate goal of demonetizing gold and monetizing paper), one would expect that first—as an approximation to this goal—they would want to give up using any outside money (gold). All transactions would have to be carried out with inside money (paper), and all outside money would have to be deposited in a bank and thus taken out of circulation entirely (Otherwise, as long as genuine money was still in circulation, those individuals making use of gold coins would demonstrate unmistakably—through their very actions—that they did not want to save on the associated resource costs.)
However, is it possible that money substitutes can thus outcompete and displace genuine money as a medium of exchange? Even many hard money theoreticians have been too quick to admit such a possibility. The reason is that money substitutes are substitutes and have one permanent and decisive disadvantage as compared to money proper. Paper notes (claims to money) are redeemable at par only to the extent that a deposit fee has been paid to the depositing institution. Providing safeguarding and clearing services is a costly business, and a deposit fee is the price paid for guarded money. If paper notes are presented for redemption after the date up to which safeguarding fees were paid by the original or previous depositor, the depositing institution would have to impose a redemption charge and such notes would then trade at a discount against genuine money. The disadvantage of money substitutes is that they must be continuously redeposited and re-issued in order to maintain their character as money—their salability at par—and thus that they function as money only temporarily and discontinuously. Only money proper (gold coins) is permanently suited to perform the function as a medium of exchange. Accordingly, far from inside money ever displacing outside money, the use of money substitutes should be expected to be forever severely limited—restricted essentially to the transaction of very large sums of money and the dealings between regular commercial traders—while the overwhelming bulk of the population would employ money proper for most of their purchases or sales, thus demonstrating their preference for not wanting to save in the way fancied by Friedman.
Moreover, even if one assumed for the sake of argument that only inside money is in circulation while all genuine money is stored in a bank, the difficulties for fiat money proponents do not end here. To be sure, in their view matters appear simple enough: All commodity money sits idle in the bank. Wouldn’t it be more efficient if all of this idle gold were used instead for purposes of consumption or production—for dentistry or jewelry—while the function of a medium of exchange were assumed by a less expensive—indeed, practically costless—fiat money? Not at all.
First, the envisioned demonetization of gold certainly cannot mean that a bank thereby assumes ownership of the entire money stock, while the public gets to keep the notes. No one except the bank owner would agree to that! No one would want such savings. In fact, this would not be savings at all but an expropriation of the public by and to the sole advantage of the bank. No one could possibly want to be expropriated by somebody else. (Yet the expropriation of privately owned commodity money through governments and their central banks is the only method by which commodity money has ever been replaced by fiat money.) Instead, each depositor would want to retain ownership of his deposits and get his gold back.
Then, however, an insurmountable problem arises: Regardless who—the bank or the public—now owns the notes, they represent nothing but irredeemable paper. Formerly, the cost associated with the production of such paper was by no means only that of printing paper tickets, but more importantly that of attracting gold depositors through the provision of safeguarding and clearing services. Now, with irredeemable paper there is nothing worth guarding anymore. The cost of money production falls close to zero, to mere printing costs. Previously, with paper representing claims to gold, the notes had acquired purchasing power. But how can the bank or the public get anyone to accept them now? Would they be bought and sold for nonmoney goods at the formerly established exchange ratios? Obviously not. At least not as long as no legal barriers to entry into the note-production business existed; for under competitive conditions of free entry, if the (nonmoney) price paid for paper notes exceeded their production costs, the production of notes would immediately be expanded to the point at which the price of money approached its cost of production. The result would be hyperinflation. No one would accept paper money anymore, and a flight into real values would set in. The monetary economy would break down completely and society would revert back to a primitive, highly inefficient barter economy. Out of barter then, once again a new (most likely a gold) commodity money would emerge (and the note producers once again, so as to gain acceptability for their notes, would begin backing them by this money). What a way of achieving savings!
If one is to succeed in replacing commodity money by fiat money, then, an additional requirement must be fulfilled: Free entry into the note-production business must be restricted, and a money monopoly must be established. A single paper money producer is also capable of causing hyperinflation and a monetary breakdown. However, insofar as he is legally shielded from competition, a monopolist can safely and knowingly restrict the production of his notes and thus assure that they retain their purchasing power. He then presumably would assume the task of redeeming old notes at par for new ones, as well as that of again providing safeguarding and clearing services in accepting note deposits in exchange for his issuance of substitutes of notes—demand deposit accounts and checkbook money—against a depositing fee.
Regarding this scenario, several related questions arise. Formerly, with commodity money every person was permitted to enter the gold mining and coining business freely—in accordance with the assumption of self-interested, wealth-maximizing actors. In contrast, in order for Friedman’s “fiat money dividend” to come into existence, competition in the field of money production would have to be outlawed and a monopoly erected. Yet how can the existence of a legal monopoly be reconciled with the assumption of self-interest? Is it conceivable that self-interested actors could agree on establishing a fiat money monopoly in the same way as they can naturally agree on participating in the division of labor and on using one and the same commodity as a medium of exchange? If not, does this not demonstrate that the cost associated with such a monopoly must be considered higher than all attending resource cost savings?
To raise these questions is to answer them. Monopoly and the pursuit of self-interest are incompatible. To be sure, a reason why someone might want to become the money monopolist exists. After all, by not having to store, guard and redeem a precious commodity, the production costs would be dramatically reduced and the monopolist could thus reap an extra profit. By being legally protected from all future competition, this monopoly profit would immediately become “capitalized” (reflected permanently in an upward valuation of his assets), and on top of his inflated asset values he then would be guaranteed a normal rate of return in the form of interest. Yet to say that such an arrangement would be advantageous to the monopolist is not to say that it would be advantageous to anybody else, and hence that it could arise naturally. In fact, there is no motive for anyone wanting anyone but himself to be this monopolist, and accordingly no agreement on the selection of any particular monopolist would be possible.
The position of a monopolist can only be arrogated—enforced against the will of all excluded nonmonopolists. By definition, a monopoly creates a distinction between two classes of individuals of different legal quality: between those—privileged—individuals who are permitted to produce money, and those—subordinate—ones who, to the exclusive advantage of the former, are prohibited from doing the same. Such an institution cannot be supported in the same voluntary way as the institutions of the division of labor and a commodity money. It is not, as they are, the “natural” result of mutually advantageous interactions, but that of an unilaterally advantageous act of expropriation (abrogation). Accordingly, instead of relying for its continued existence on voluntary support and cooperation, a monopoly requires the threat of physical violence.
Moreover, the incompatibility of self-interest and monopoly does not end once the monopoly has been established but continues as long as the monopoly remains in operation. It cannot but operate inefficiently and at the expense of the excluded nonmonopolists. First, under a regime of free competition (free entry), every single producer is under constant pressure to produce whatever he produces at minimum costs, for if he does not do so, he invites the risk of being outcompeted by new entrants who produce the product in question at lower costs. In contrast, a monopolist, shielded from competition, is under no such pressure. In fact, since the cost of money production includes the monopolist’s own salary as well as all of his nonmonetary rewards, a monopolist’s “natural” interest is to raise his costs. Hence, it should be expected that the cost of a monopolistically provided paper money would very soon, if not from the very outset, exceed those associated with a competitively provided commodity money.
Furthermore, it can be predicted that the price of monopolistically provided paper money will steadily increase and the purchasing power per unit money, and its quality will continuously fall. Protected from new entrants, every monopolist is always tempted to raise price and lower quality. Yet this is particularly true of a money monopolist. While other monopolists must consider the possibility that price increases (or quality decreases) due to an elastic demand for their product may actually lead to reduced revenues, a money monopolist can rest assured that the demand for his particular product—the common medium of exchange—will be highly inelastic. Indeed, short of a hyperinflation, when the demand for money disappears entirely, a money monopolist is practically always in a position in which he may assume that his revenue from the sale of money will increase even as he raises the price of money (reduces its purchasing power). Equipped with the exclusive right to produce money and under the assumption of self-interest the monopoly bank should be expected to engage in a steady increase of the money supply, for while an increased supply of paper money does not add anything to social wealth—the amount of directly useful consumer and producer goods in existence—but merely causes inflation (lowers the purchasing power of money), with each additional note brought into circulation the monopolist can increase his real income (at the expense of lowering that of the non-monopolistic public). He can print notes at practically zero cost and then turn around and purchase real assets (consumer or producer goods) or use them for the repayment of real debts. The real wealth of the non-bank public will be reduced—they own less goods and more money of lower purchasing power. However, the monopolist’s real wealth will increase—he owns more non-money goods (and he always has as much money as he wants). Who, in this situation, except angels, would not engage in a steady expansion of the money supply and hence in a continuous depreciation of the currency?
It may be instructive to contrast the theory of fiat money as outlined above to the views of Milton Friedman, as the outstanding modern champion of fiat money.
While the younger Friedman paid no systematic attention to the question of the origin of money the older Friedman recognizes that, as a matter of historical fact, all monies originated as commodity monies (and all money substitutes as warehouse claims to commodity money), and he is justly skeptical of the older Friedrich A. Hayek’s proposal of competitively issued fiat currencies. 13 However, misled by his positivist methodology Friedman fails to grasp that money (and money substitutes) cannot originate in any other way and accordingly that Hayek’s proposal must fail.
In contrast to the views developed here, throughout his entire work Friedman maintains that a commodity money in turn would be “naturally” replaced by a—more efficient, resource cost saving—fiat money regime. Amazingly, however, he offers no argumentative support for this thesis, evades all theoretical problems, and whatever argument or empirical observation he does offer contradicts his very claim. There is, first off, no indication that Friedman is aware of the fundamental limitations of replacing outside money by inside money. Yet if outside money cannot disappear from circulation, how, except through an act of expropriation, can the link between paper and a money commodity be severed? The continued use of outside money in circulation demonstrates that it is not regarded as an inferior money; and the fact that expropriation is needed for the decommoditization of money would demonstrate that fiat money is not a natural phenomenon!
Interestingly, after evading the problem of explaining how the suspension of redeemability can possibly be considered natural or efficient, Friedman quite correctly recognizes that fiat money cannot, for the reasons given above, be provided competitively but requires a monopoly. From there he proceeds to assert that “the production of fiat currency is, as it were, a natural monopoly.” 14 However, from the fact that fiat money requires a monopoly, it does not follow that there is anything “natural” about such a monopoly and Friedman provides no argument whatsoever as to how any monopoly can possibly be considered the natural outcome of the interactions of self-interested individuals. Moreover, the younger Friedman in particular appears to be almost completely ignorant of classical political economy and its antimonopolistic arguments: the axiom that if you give someone a privilege he will make use of it, and hence the conclusion that every monopolistic producer will be inefficient (in terms of costs as well as of price and quality). In light of these arguments it has to be regarded as breathtakingly naive on Friedman’s part first to advocate the establishment of a governmental money monopoly and then to expect this monopolist not to use its power, but to operate at the lowest possible costs and to inflate the money supply only gently (at a rate of 3–5 percent per year). This would assume that, along with becoming a monopolist, a fundamental transformation in the self-interested nature of mankind would take place.
Having had extensive experience with his own ideal of a world of pure fiat currencies as it came into existence after 1971 and looking back on his own central resource cost savings argument for a monopolistically provided fiat money of nearly four decades earlier, it is not surprising that the older Friedman cannot but acknowledge that his predictions turned out blatantly false. 15 Since abolishing the last remnants of the gold commodity money standard, he realizes, inflationary tendencies have dramatically increased on a worldwide scale; the predictability of future price movements has sharply decreased; the market for long-term bonds (such as consols) has been largely wiped out; the number of investment and “hard money” advisors and the resources bound up in such businesses have drastically increased; money market funds and currency futures markets have developed and absorbed significant amounts of real resources which otherwise—without the increased inflation and unpredictability—would not have come into existence at all or at least would never have assumed the same importance that they now have; and finally it appears that even the direct resource costs devoted to the production of gold accumulated in private hoards as a hedge against inflation have increased. 16 But what conclusion does Friedman draw from this empirical evidence? In accordance with his own positivist methodology according to which science is prediction and false predictions falsify one’s theory, one should expect that Friedman would finally discard his theory as hopelessly wrong and advocate a return to commodity money. Not so. Rather, in a remarkable display of continued ignorance (or arrogance), he emphatically concludes that none of this evidence should be interpreted as “a plea for a return to a gold standard. On the contrary I regard a return to a gold standard as neither desirable nor feasible.” 17 Now as then he holds onto the view that the appeal of the gold standard is merely “nonrational, emotional,” and that only a fiat money is “technically efficient.” 18 According to Friedman, what needs to be done to overcome the obvious shortcomings of the current fiat money regime is find some anchor to provide long-term price predictability, some substitute for convertibility into a commodity or, alternatively some device that would make predictability unnecessary. Many possible anchors and devices have been suggested, from monetary growth rules to tabular standards to the separation of the medium of exchange from the unit of account. As yet, no consensus has been reached among them.
