I've talked about the Fed, and I've talked about gold, but now I want to talk about an assumption that I think is maybe a stretch. Specifically, the assumption that the money we use is Fiat, that its value is based only on the word of the bankers or the Fed.
I learned about the real bills doctrine in college; one of my main sources, here, is an article written by one of my UCLA professors, without whom I likely would not have graduated. So I may be biased. But I would like to talk about it anyway, because I think the real bills doctrine is important, even if many economists believe "The dead horses of economic theory have a habit of suddenly springing back to life again, which is why it is necessary to beat them even when they appear lifeless."
The basic tenent of the real bills doctrine is that, with or without gold, the Fiat money we use today actually does have backing; You can have money that is backed but inconvertable. The main result of this concept is that "money issued in exchange for sufficient security (usually short-term commercial bills) will not cause inflation."
Of course, this does not address the problem that inflation sometimes IS caused by central banks, but it is only because they issue it without sufficent security. The federal reserve actually does hold assets, just like other central banks, and it is against this that it issues federal reserve notes. The Feds balance sheets identifies them as "Collateral Held Against Federal Reseve Notes". So if the money is fiat, why the backing?
Money is not Fiat. The fed holds assets against the notes it issues, as backing, including but not restricted to gold. Money's value is not based on scarcity, or the word of the bankers. When banks fail to take a sufficient amount of assets in to back newly printed money, inflation results. This is not due to the fiat nature of modern money but due to the way it is backed; Under the gold standard or anything else, banks can print more money and cause inflation, the backing is irrelevant.
I do not wish to reproduce the whole paper here in my post. But I believe it is important for people to read it, as it is not particularly long.
There are other issues here though. As I've said before, the gold standard and money convertability does us no good, if convertibility can be suspended. If someone can suspend it for a weekend, they can spend it for a million years. The government has suspended convertibility before, and even if the gold standard was reinstated, it would do it again. The real bills doctrine admits that inflation is going to occur if money is issued without sufficent security. So, even if the real bills doctrine is true, and all money is backed but inconvertable, we still have to deal with danger that the fed isn't going to actually do it's job, or, in other countries, that the government is just going to go on a printing spree and stuff its pockets with the excess. Unfortunately, so long as there are governments, this risk exists. The gold standard doesn't protect us from eminent domain. It doesn't protect us from the goverment revaluing the dollar overnight, after they find a few billion dollars in their bedstands.
I'm getting off topic now (remember, money is backed!), but I imagine the only way that a gold-standard could be safe is if money was actually made of gold. Otherwise, there is nothing stopping governments from re-valuing their currency vs gold. Of course, then the alchemists would all become government employees. Or, amazingly, at the first sign of crisis the government would change the rules.
1. Is inflation inevitable, in the long run, due to human psychology? I know this isn't necessarily an economics question, but it's related. It seems to me that people want to make profit, and so they'll continually increase the value they put on what they own or sell. Individually this would be eliminated by unchanging demand levels, but if everyone in a system decides individually to knock up the cost of their goods by 1%-2% a year, then demand won't hold it in check, it doesn't seem.
2. I'm not sure what's wrong with the idea of fiat money. All governments are just groups of people that either represent their population (in which case their fiat is the "will of the people), or that oppress their population by force (in which case hey, they're using force, that's what's backing the money). The whole idea of fiat money seems like a myth to me.
From the paper by professor Sproul:
"
Depending on who is talking, we hear that fiat money has value because other people value it (Samuelson, 1980, p. 261), because the government accepts it for taxes (Wicksteed, 1910, p. 619), because it is useful for making exchanges and limited in supply (Marshall, 1922, p. 49), because the government requires banks to hold it (Fama, 1980, p. 56), or because it allows us to transfer wealth to our children (Wallace, 1980, p. 50). The trouble with these theories is that they fail to consider rival monies. Each theory begins by asserting that there is some force (e.g., liquidity services) that creates a demand for intrinsically worthless pieces of paper. They then assert that it would only be necessary to limit the supply of these pieces of paper in order to give them value. Of course, no one believes that such a thing would be possible for private, competitive banks. Furthermore, if a private bank could issue notes on which it paid no interest, while investing the proceeds at 5%, then competitors would issue rival notes until the interest spread just covered costs of printing, periodic redemption, controlling counterfeiting, etc. Given this, it is strange to see how easily economists accept the proposition that central banks earn seignorage on their note issue, and that note issue therefore gives a free lunch to the Federal Reserve, especially if the dollars go to foreign countries. Since most of us are trained to be suspicious of free lunches, this idea deserves some skepticism.
The only reason to believe that the Federal Reserve earns seignorage is that it has the power to suppress rival bank notes. But governments cannot suppress commodity money, credit, foreign bank notes, or barter. There are also traveller's checks, gift certificates, and scrip, all of which are bank notes issued by non-bank institutions. (In point of fact the only entities barred from issuing bank notes are banks themselves.) Given this rivalry, it is hard to believe that note issue could yield abnormal profits, even to government banks. Where countries are small, weak, and close together, it seems impossible.
But assume for the sake of argument that a country is strong enough to erect significant barriers to rival bank notes. The government notes will still face rivalry from derivative monies. (By 'derivative money', I mean money that is a claim to some other money, in the sense that a dollar in a checking account is a claim to a Federal Reserve note.) For example, a farmer might pledge $10,000 of wheat to a banker, and the banker in turn will lend the farmer $10,000 by crediting that amount to his checking account. By this exchange the banker will have effectively coined wheat into dollars. If we accept the assertion that the dollar has value because of the liquidity services it provides, then the creation of the new wheat-backed derivative dollars would reduce the demand for Federal Reserve dollars, and thus would reduce their value. If there were no constraint on the issue of derivative dollars, the value of Federal Reserve dollars would be driven to zero."
Thats the best answer I can give to #2.
Ok, I'm not sure if I follow exactly how that applies, but what I'm getting from it is that all fiat money is backed by something, right? Wheat, gold, or force, maybe. In which case, there is no such thing as "unbacked" money.
I was just trying to say that force is likely not enough to back a currency. It will be driven to zero due to either rival currencies/barter or, in the event that rival currencies are all suppressed completely, then it will fail in the face of derivative currencies. It also seems you'd have a problem trading a currency backed by force with other nations, even if it worked internally.
Fiat money is money backed by promises or the word of the government/fed/banks, and not much else. It is "backed", but evey instance of the word "backing" in what I wrote means backed by something of physical value. You could make up a new word for money backed by force, but it would be functionally the same as Fiat if it had no actual backing.
Well, a currency can be completely unbacked. In the US, however, Sproul argues that the currency is backed vecause of how the fed increases the money supply.
In essence, the Fed increases or decreases the money supply by buying or selling bonds to federal banks.
To increase the money supply, the Fed buys securities (bonds) held by federal banks, injecting cash into the system. To decrease the money supply, the Fed sells securities to the banks.
So, all money issued by the Fed is issued in return for a negotiable security. Sproul argues that this makes the US currency backed by these securities.
Ok, that makes sense. I agree that force wouldn't be that effective in backing up money, and that money backed by mere force is basically what people mean by "fiat money".
I like what Dale says Sproul says. Essentially, creating "money" and a "bond" is like pulling vacuum apart into matter and anti-matter.
Well, you're close, but if I understand you right, you're thinking that the bonds are somehow created by the Fed.
In actuality, these are bonds issued by the Treasury Department, and the Fed buys them from the Treasury, then sells them to federal banks in turn. (Banks can also buy these bonds from the treasury, or in the secondary market from sources other than the Fed.)
So the bonds exist outside the Federal banking system, the Fed then buys them to use as the securitized backing for the currency.
So, it's not like creating matter and anti-matter from vacuum. It's more like separating the carbon and oxygen from carbon monoxide.
You can go here for another explanation of how the process works.
Interesting discussion. I just read the Sproul paper, and I hadn't consider all of these ideas before. A few points:
* Yes, US money is backed. It's an odd, circular arrangement. Essentially, as long as the US govt has credibility to make long-term payments on its debt in US dollars, then the dollars backed by this debt are backed by future dollars. It's a sort of Back to the Future situation. Dollars are backed by future dollars. Very odd, but it has the desired effect: To prevent politicians from raising the money supply every election cycle.
* Backing is not a yes-no proposition. You cannot say that a currency either is backed or isn't. All forms of backing carry risk. Even gold in the vault could be stolen while your back is turned, or (as pointed out repeatedly here) the convertibility could be suspended. Some forms of backing can be insured (e.g. mortgage insurance) but the insurance company itself could go under. The question is the degree of risk.
* The acceptable level of risk typically rises over time. Economists discount the risk of catastrophic failure of the economic system more and more as the years pass since the last catastrophe. Also, risk-takers make more money, so people gradually take more risks. It is an interesting phenomenon in human affairs.
* I used to favor the gold standard, but I've grown tired of arguing against the trend to higher risk. People only learn from their own mistakes. Now I think that, rather than a gold standard, what we need are continual, minor collapses to remind people of the risks, and to preclude catastrophe. Basically, we need the government to stop insuring everything. (Well, it's too late now. The next catastrophe will be the biggest in history.)
* There is such a thing as fiat money. It doesn't typically last long, so it's seldom seen outside wartime.
* There is a way for fiat money to be accepted by large numbers of people, at least for awhile: The pyramid scheme.
* Pyramid schemes are not restricted to fiat money. Such a scheme may also inflate the value of something which does have some intrinsic value. Pyramid schemes are common; e.g. Social Security, stocks which pay no dividends, Mary Kay, fractional reserve banking, etc. They can last a long time if there is some underlying value and if the creation of freebies is held in check; e.g. banks rarely reduce their fractional reserve requirement, and a growing population keeps Social Security stable. But eventually, the system ends, and somebody gets left out in the cold.
The circular-backing of money always seemed intuitive to me, and it was fun to read about.
Also, the "next catastrophe" is always the biggest ever. When it's smaller, it's not seen as a catastrophe :)
In reply to OBLIVION95
You're right that backing is not a yes-no proposition, but that's true of any stock or bond as well. There's always risk. The basic point of the real bills doctrine is that money is backed in the same sense that stock is backed. And nobody would deny that a corporation can double the amount of stock outstanding without affecting the stock price, PROVIDED they double their assets at the same time. By extension, ant bank can double its outstanding money without changing its value, as long as its assets double too.
About pyramid schemes: Yes; they happen. When they do they create free lunches for somebody, and competition acts to destroy that free lunch. I don't think that government-issued paper money is fiat money, because that creates a free lunch for the government, and given all the competing moneys out there, it's too much of a stretch to believe that competition from rival moneys wouldn't act to eliminate fiat money.
Other papers I wrote about money are available at
http://www.csun.edu/~hceco008/pricetheory.htm
(Or just do a google search for "Sproul real bills doctrine")
--Mike Sproul