Fiat Money#

When I first heard the term “fiat money,” I was in a civics class in middle school. The class was asked why money was valuable, what was the reason that people chased after it. One kid, fortunately not me, tried to look really smart by talking about how you could exchange money for gold, while I smugly smiled because I also “knew” this. But the teacher announced that this was false. I had been so confident in this “fact” that I was ready to object, but the teacher instead explained to us that that hadn’t been true since the 70’s, and that, since then, US dollars were “fiat” money, which meant that they were valuable because we all agreed it was valuable.

This was portrayed somewhat as a testament to the amazing power of community and social coherency, and it struck me as completely absurd and unreasonable. Perhaps money was instead valuable not because we all agreed it was valuable, but because the government insisted that it was – fiat, I knew, was Latin for “let there be/let it be,” used in the Bible when God speaks the universe into existence. Can a non-divine entity, even one as powerful as the federal government, similarly speak money into value? And, if it can and does, what words does it use?

This is important for today for two big reasons:

  • It distinguishes normal, fiat currency from cryptocurrencies, which don’t employ any of these mechanisms to maintain their value. This is a topic for another day, but it’s something to think about as you read this.
  • The explanation connects to fiscal and monetary policy, and the national debt, which is very much unlike any other form of debt, and is way less scary than people make it out to be.

Supply and Demand and Money#

My grandfather taught me the concept of supply and demand. He gave the example of a town where there was one book-seller. For some reason, in this example, it didn’t seem to matter which book each buyer wanted or whether it matched up with the particular books the seller had – we have to assume they were all the same, maybe that year’s World Almanic.

Now, if the book-seller had twenty books, and there were ten people who wanted books, the seller’d better make them cheaper so as to find more people who’d want to buy them. But if there were forty people who wanted the books, she should make the books more expensive, and make sure the books go to the people who really wanted them and were willing to pay more – and make sure she could get as much money out of it as she could. This seemed like reasonable behavior on the part of the book-seller, albeit maybe a bit Machiavellian.

My grandfather didn’t explain, however, that the same principle applied to money. If there was more money available, or rather more people with money, the price of the books would also be higher, as it would take more of a price increase to keep people from being able to afford the books. Alternatively, if you want to be clever about it, you can say that just like a larger supply of books makes the books worth less in terms of money, a larger supply of money makes the money worth less in terms of books. This is called “inflation,” and it can have dire consequences, like in “Hansel and Gretel” where a great “inflation” (German “Teuerung”) causes the parents to abandon their children because they can no longer afford food.

This is one among many reasons why everything in Manhattan is so expensive: all the rich people in the city drive the prices up by increasing the money supply. Even though we all use the US dollar, locally, there’s a lot of dollars here, and therefore, locally, we have a bit more inflation than the rest of the country. This is probably not a good thing, as the whole point of a national currency is to make money worth the same everywhere, but it does mean that when I visit home I feel super rich and people think I’m crazy for telling them about NYC’s Chase ATMs that dispense $100 bills.

So that’s money supply. But what’s the demand? Why does this book-seller want money for her books? Why not, say, small pieces of jewelry? Or farm fresh eggs or milk? Or, in general, something that she could actually use?

Well, as discussed, it is a “fiat” currency, which means the government is making it valuable by proclamation. And there are a few very big proclamations that the government makes where US dollars magically become valuable. One is: You have to pay your taxes in US dollars. Even if you get paid in eggs, you have to estimate how many dollars those eggs are worth, and pay your taxes on that dollar income in dollars.

If everyone needs dollars to pay their taxes, then that creates some reason for everyone to go out and get enough dollars each year that they’ll be able to make Uncle Sam happy. That’s enough to make them at least somewhat valuable.

Bank Money#

But that’s not the only place demand comes in for dollars. If you owe a bank money, you have to repay that loan in dollars. The thing is, though, that when the bank loans you the money, it effectively creates some of the money. And when you repay the loan, it destroys it.

This is easier to understand if we imagine that there’s only one bank. When the book-seller needs to buy a new building (because she’s discovered you can sell multiple different books), she goes to the bank and asks for a mortgage. The bank gets the right to take the building back and sell it if she doesn’t pay back the mortgage, and in exchange, the bank gives the money to the person she’s buying the house from.

But what does the seller do with the money? Take it all out as cash and run? Probably not – few enough people do that as to make very little difference. The seller keeps the money in his bank account. Perhaps he goes and buys another building with it, and the seller of that building keeps the money in her bank account. No matter – the vast majority of the money that the banks lend out as mortgages stay in bank accounts.

And, it turns out, the bank only has to have “cash” (or modern digital equivalents) for some percentage of the money in the bank accounts. The rest of the money in the bank account can be backed by debt, like mortgage debt, that is owed to the bank. That is to say that when the bank loans out the money in exchange for the mortgage, it is creating some percentage of the money out of thin air. This “bank money” is known as M1 for a checking account or M2 for a savings account, as opposed to the cash in our wallets, which is known as M0. The banks would be completely screwed if we took all the money into M0 – they’re banking on us not doing that.

When you add a second bank to the mix, it gets more complicated, but the principle is the same. Banks will lend to each other and have accounts at each other to balance all the flows out, so that they can still create money when they issue mortgages. Yes, that’s complicated to figure out, but all that detail is part of why banks cost money to run. For the rest of this essay, though, we’ll pretend that Chase is the only bank, because that’s where I have my checking account.

Money Supply and Debt#

So how does this affect the money supply? Well, if I get a million dollar mortgage to buy a house from Joe Shmoe, Chase gives him a million dollars in his bank account. This increases the money supply by a million dollars. Meanwhile, I’m going to owe Chase a total of almost two million dollars over the next 30 years. This increases the demand by almost two million dollars. I’m going to have to get all that money back from Joe (or probably actually someone else), and then some – almost twice as much!

Well, this means that I’m going to have demand for money besides just paying my taxes. I’m going to have a mortgage. And for every dollar that goes into the economy because of a mortgage, there’s more that’s going to be demanded out of it later. In fact, it seems unfair, because if everyone has a million dollar mortgage, and owes Chase two million dollars over the next 30 years, where’s that money going to come from? Will it have to come from new mortgages when we resell the houses for two million years to the next guy? Or is Chase going to use some of the interest to pay people with so they can pay their mortgages? Is it enough? Will the total amount of money just have to keep growing for everyone to be able to pay?

This is something I think about when I pay my Chase credit card from my Chase checking account. Chase tells me I owe it X dollars, so I go to my checking account, where Chase owes me Y dollars (because that’s what a checking account is), and I tell Chase to use the money they owe me to pay the money I owe them, and they… adjust some numbers in a computer and their balance sheet shrinks.

Government Money and Inflation#

So we have taxes and loan repayments creating demand, and loans creating supply. For loans at least, we have a guarantee that the demand will always be greater than the supply, making sure that for every dollar out there, there’s someone who wants it. What about the other side of taxes?

The other side of taxes is government spending. The government creates demand for money by taxing, and it creates a supply of money by spending. The government owns the presses where the money is printed – they could simply print more if they wanted to, and that would be a very direct way to increase the money supply. As long as they made sure that that money was balanced out by taxes later – not by taxes now, necessarily, but by taxes later – the demand would exist to counterbalance the supply. A promise of taxes later would help prevent inflation in the land, and keep Hansel and Gretel away from cannabalistic witches.

The way we promise taxes later in exchange for spending now is by structuring taxes like a loan. It works for mortgages, so why not use it for the government? The government takes out a loan, and when it takes out from private citizens or foreign governments, it works like a normal loan. But if the government were to take a loan out from a bank, which it does at least some of the time, that basically is creating money.

The Federal Reserve Bank is a special bank, and it gets to create cash. All the cash in the country is like a portable, anonymous checking account with the Federal Reserve, an IOU from them. They won’t give you gold for it, but if you owed them money, they’d accept it as payment, and it would effectively be cancelled out. And, like any bank or corporation, it has to have assets on the other side to balance out these debts that are our cash. And some of those assets are treasury notes, loans to the government. So, all together, the money you’ve got in your pocket is very literally backed by a promise to accept it later as taxes – or, more cynically, the fact that it will be demanded later as taxes.

Because, from a certain perspective, saying that the Federal Reserve has treasury notes is just an accounting way of saying that the government promises to collect taxes later for the money it’s spent. And, in this case, the reason it’s going to do that isn’t because the Federal Reserve is going to bang down the door and demand the money – they’ll lend the US more to pay it, if it comes to that, which it really hasn’t yet. The danger is that people will stop believing the taxes will be collected later, and the confidence in the demand for money will go away, and there’ll be inflation.

Now, not all the national debt is owed to the Fed. Much of it is owed to private investors. But if private investors were to lose interest, the Fed would be forced to pick up the slack. So it’s all connected.

The big danger of a budget deficit is causing inflation. Now, you might be thinking of how your grandmother, if she’s like mine, worked for $12 a week out of high school (plus lunch) and thought this was a fine deal, whereas today that’s enough to buy you one nice drink at a bar. But that’s actually a very tame amount of inflation. The types of inflation that we’re talking about are the kinds that might actually make Hansel and Gretel have to go into the wilderness, where last month’s reasonable week’s salary is now barely enough to buy a nice loaf of bread.

But we’re nowhere near that. We only have been getting 2% per year recently, which is extremely modest, in spite of our huge national debt. Now, it could be, the economy will suddenly notice that we have this huge national debt, and panic, and cause some major inflation, but it seems kind of unlikely where I’m standing, and I don’t see many people earnestly worried about that. More, I see people worried about the national debt because it bothers them, or because they know that it’s a good talking point to bother other people with.

So, all in all, the national debt is not a particularly strong reason to object to tax cuts or government spending. It won’t be a problem if it keeps growing indefinitely, as long as we tax enough to prevent inflation. Given that, with loans alone, the amount of money has to keep going up so that everyone can afford their interest, a little bit of extra money in the economy can be a good thing, so that we don’t get deflation, where everyone scrambles for an insufficient number of dollars, or credit crunches, where all the banks are scared to loan out money. And if we really did manage to pay the debt off, where would there be enough money to pay off those loans, each requiring more in payback than there was money created to issue it?