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The Economics of Fiat Currency: A No Bullshit Explanation
Written by Matt Wolfe on Oct. 6th 2017

A Brief History (Latin, fiat. “let it be done” - a command, order, or decree by King)

From the beginning of recorded history human beings have interacted with, competed against, and (most importantly) cooperated with each other. We also tend to assign value to things. You might hear children trade toys, or candy. “I’ll give you one Babe Ruth card for your bicycle…” Edward O. Wilson; Pulitzer-Prize winning naturalist, goes into great detail about this trait in his book The Social Conquest of Earth. 

When groups of people organize and cooperate in a way that allows the exchange of things of value, the community gains and over time living standards go up for everyone. With cooperative, organised effort comes innovation and economic improvement. To make trade easier, instead of bartering items of value we can all agree to use shells, salt, or even pretty rocks that REPRESENT value. Currency is an evolutionary result of the human tendencies to assign value and group cooperation. 

It’s no stretch of the imagination to credit the global standard of living to the innovation of fiat money. (Now wait! Before you scream. I’m not here to argue about its shortcomings. I’m offering an unbiased, no bull-shit, explanation of the concept). What distinguishes fiat money’s value from gold or silver? Gold and silver have intrinsic value. Fiat attains its value merely by social construct - fiat money is completely worthless in and of itself. It's only real worth is the paper it's printed on and not a bit more. 

Naturally for a money system whose medium of exchange of this type to work, it requires universal cooperation. It makes no sense for several small groups of people to issue their own fiat money. Why would one clan accept the fiat from another clan? This is the very reason why fiat money finds its earliest use with sovereign powers (King, Government, State). A sovereign power can use force to organize cooperation.

Modern Monetary Economists will admit that fiat money ONLY “works” because a sovereign power declares 1) that it shall issue a sovereign fiat currency, 2) that a tax must be paid to the sovereign power by everyone in the group, and 3) the only acceptable payment of taxes is the fiat money which it issues. That in a nutshell is it - Fiat money can only really work by the “coerced” cooperation of a large group. 

The first recorded use of fiat currency was in 11th Century China. The Song Dynasty issued the Jiaozi, which were valued for exchange with gold, silver and silk. However, the practice was never allowed. The notes were returned after 3 years, and a 3% service charge applied before issuing new notes. Through time, use of fiat currency popped up in several places, including Europe, (where is now) Canada, and North America before becoming global during the 19th Century onwards. We will be publishing an article on the history of fiat soon; in it showing how Bitcoin was born out of giving a viable solution to the deficiencies of the fiat currency model.

Function of Fiat

Now that we know that it’s a government who issues fiat, that can use its force to compel cooperative effort from a large group; how does that government get those notes into the hands of the people who need it to pay their taxes? Well, the government could just give hand-outs (and we can see with social benefits programs). However, a more useful approach is for the government to SPEND the fiat currency it issues by purchasing goods and services from the people who will use the currency to pay taxes. “Government spending” then, accomplishes the goal of transferring the fiat money into the hands of the people—but it also has the benefit of creating goods and services the government might find useful. A commonly held fallacy: Government spending isn’t always valued by the community. Perception is that it serves as a transfer of wealth, not to actually add economic value. Once the people are paid in the fiat currency, they logically begin to use it to trade amongst themselves, being willing to take it as payment for goods or services because they know that every other “citizen-who-needs-to-pay-taxes” will be willing to take it as payment as well.

Now the question becomes, what is the government’s motivation to spend its fiat money? (Typically governments like to spend money on war. Again, that’s another topic altogether.) The government could only spend as much as it receives in taxes. Whatever the government spends its fiat on - more tanks, guns and soldiers; or roads, schools and hospitals, it is a consequence of this spending that the citizens come to hold the fiat currency as payment for their labor. Naturally the citizens will spend their fiat into the economy to buy the things they consume everyday but at the end of the year, all the fiat earned, is paid back to the government in taxation. The citizens are once again money-less but the government repeats the process again, spending that fiat back out into the economy through stimulus programs and the like. The government gets what it wants which is the labor and commercial energy of the citizens and the citizens get to use a fiat money system to pay their taxes. Who do you think gets the better end of that deal?

Now let me suggest that the function of fiat does change a little bit depending on the type of sovereign power we are talking about. In a monarchy the monarchy ultimately decides. In a democracy (it’s presumed anyway) the citizens get to vote on government spending. Another consideration is whether or not that fiat money can be redeemed on demand for something of intrinsic value like gold or silver. These two considerations play the biggest role in how a fiat money system looks in a society. If the government be a democracy then the government might choose one of form of spending (guns, tanks etc) and the citizens can vote to have a new school built or hospitals instead.

But what happens when the citizens realize they can vote for the government to spend its tax revenue for public services? Soon the citizens ask why can the government only spend the same amount it gets in taxes every year? Why should citizens vote to make themselves money-less every year come tax time? Why shouldn’t they vote instead to have the government issue MORE fiat currency than it is planning to collect in taxes? If that happened, the citizens would save more fiat currency each year and expand economic trade amongst themselves. It’s logical to see how a government can operate with a substantial “deficit”—the amount of fiat currency it spends over what it collects being exactly equal to the private wealth remaining in the hands of the “citizens.”

Fiat money and gold

Which brings us to our next consideration: Whether or not a government will redeem each fiat note for gold on-demand. Most people, in America anyway, wrongly believe that every Federal Reserve Note is redeemable for gold on-demand. Let’s imagine for a moment that the government did redeem each fiat note for its amount in gold. If a citizen were to present a fiat dollar to the government's reserve bank, that citizen would receive the specified amount of bullion. 

Backing a fiat currency by gold, as it were, clearly changes things. First and most obvious, the government is required to keep a large supply of gold to meet demands of citizens wanting to redeem their notes. Even if the government calculated that only a small percentage of the population would redeem their notes at any given time, and therefore only needed to keep a small amount in reserve, its spending would be limited by the amount of gold it had in reserve. Furthermore, and probably more important, for a government to spend fiat into the economy it must not, in effect, spend the gold bullion it has in its possession. Even though it has gold in its vaults, that gold is “promised” to the holders of those fiat notes. At some point, to continue spending, the government must obtain more gold by mining it out of the ground, stealing it from another government or collecting the “gold promises” back from its citizens BEFORE it can continue with its spending. In other words, it must collect taxes in order to have the fiat notes to spend. 

In order to protect the government’s gold supply from inflation the it only has one option: instead of printing new fiat that it may not have in gold reserves, it must borrow the extra fiat needed from the citizens. This is equivalent to selling a Treasury Bond. Here, the government will borrow your fiat and pay you some of the taxes it collects in interest.

When you think about it, this is quite an ingenious trick: It means that 1) the government is (apparently) prevented from issuing more fiat dollars than it has gold to back up, 2) the “citizens” get to exchange their saved fiat dollars for Treasury bonds that pay them interest, and 3) the “citizens” STILL get to benefit from the government spending MORE fiat dollars each year than it intends to collect back in taxes—enabling the “citizens” to continue to build up their wealth of fiat dollars and expand their private economy.

Shortcomings of gold as a standard

One notable problem with the above setup is that, over time the government will have “borrowed” a continuously growing amount of fiat dollars from the citizens. This, in turn, will have enabled it, year after year, to spend many more fiat dollars than it collected in taxes, adding more and more fiat dollars to the “citizens” savings and private economy. But eventually and inevitably, it will have surpassed the amount of gold in its vault to back up those fiat dollars.

This is exactly what happened in the U.S. in 1971. Nixon came up with the solution to abandon the gold standard and declare that the dollar would no longer be redeemable for anything other than another dollar. HOWEVER, what did not change was the system of selling Treasury Bonds. Put simply, gold is a scarce commodity and restricting the currency supply to something scarce in nature, inherently inhibits the government's ability to over spend. This restricts the currency in circulation and thus restricts economic growth. Getting rid of the gold standard allows the citizens to trade fiat for Treasury Bonds and continuously increase the government's deficit year after year.  

The dangers of fiat money and democracy

Although abandoning the gold standard wasn’t something we all voted on here in the U.S. It did obscure a problem that exists. As the government continues to sell Treasury bonds to “get” the fiat dollars it “needs”, the interest it will be paying the citizens holding the bonds will become a larger and larger component of spending. Requiring the government to sell even more Treasury bonds to make up the difference. The citizens will have become fabulously wealthy—but the government itself will appear to have fallen hopelessly into debt. 

(Now, I'd like to say reality is different. The citizens of the U.S. don’t actually hold those Treasury Bonds. International Creditors do. So it is in fact, them that have become fabulously wealthy). 

Debt, deficits and the cry for austerity

Let's assume, briefly, that the international Creditors don’t play a role in this discussion. It is possible that under these circumstances a group of well-meaning citizens could declare that the government’s debt is unsustainable and that the solution is to reduce spending. However, this cry for austerity is an irrational solution to a false problem.

Firstly, what is called the nation’s “deficit” is in reality, the balance the government would owe its citizens for borrowing their fiat to increase its spending. It is, basically, a savings account of the citizens that pays interest. Reducing the government’s “deficit” then will do nothing more that shrink the wealth of the citizens. This is why creditors that own the U.S. debt (Treasury Bonds) have no interest in shrinking the deficit.

Secondly, the nation’s “debt” was originally created as a strategy to prevent the government from issuing more fiat currency that it couldn’t back with gold. If the government’s currency is no longer redeemable in gold, this strategy is voided. The only reason a government would keep it “in place” is because the citizens demand to continue it. However, it is unlikely that the bonds will be owned “equally” amongst the citizens, but rather will be held by an elite group of financiers (bankers).

While the government, in fact, has the power to pay off the national debt at any time simply by converting those Treasury Bonds back into non-interest bearing fiat dollars, the Creditors (or financiers) might achieve enough power to take effective control over the democracy itself and prevent this from happening. This is a key point that I’ll discuss later. The Creditors are the parties that own the debt. The owners of a debt ultimately control.

It is clear that restricting government spending in an effort to reduce its debt, is irrational. As long as there is work to be done that provides real economic value to the community, and as long as the resources available are sustainable to accomplish this, then it is ridiculous to argue that the government cannot afford anything. A government that prints its own money CAN afford to provide work to its citizens. The only real constraint to fiat is the amount of physical resources available, our ability to cooperate, and our willingness to constrain any elite group that seeks to control our currency.

In conclusion

I hope now, that I have made a clear and easy to understand case FOR fiat currency. I wanted to give you a general and simplified explanation so that you can understand how fiat money systems are designed to work, without my subjective opinions. 
If you thought this blog was informative, do me a solid and hit that share button! ;)

About Author: Matt Wolfe 

Founder of, privacy advocate, entrepreneur, arm-chair economist, stand-up philosopher, cryptography enthusiast, free thinking Cypherpunk. 
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