Tuesday, June 23, 2009

Gold and Silver as Fiat Money

Gold and Silver as Fiat MoneyThomas Allen

Gold and silver can be used as fiat money and in fiat monetary regimes. How can this be? To understand how gold and silver can be used as fait money, one needs to understand what distinguishes fiat money from commodity money.

With commodity money, the value of the money equals the value of the material of which it is made. This equality of value can only be maintained with unrestricted importation and exportation of the monetary commodity and free coinage. With the true gold and silver standard, gold and silver are commodity money.

The true gold or silver standard requires free coinage. Under free coinage, any person can bring any quantity of gold or silver bullion to the mint and get it coined. Once the bullion is coined, the mint returns the coins to the presenter. The government does not buy the gold or silver with a check, certificate, or other paper money. The gold and silver remains the property of the person presenting it for coinage. Likewise, the minted coins are the property of the person who presents the metal. Furthermore, the government does not coin gold or silver on its own account.

With the true gold and silver standard, the market automatically determines the quantity of gold and silver coins. The people with each person acting in his individual capacity according to his economic contribution decides how much gold and silver to coin and how many gold and silver coins to melt for other uses. Thus, economics determines the quantity of money as gold and silver coins. The government’s monetary activity is limited to minting gold and silver coins and to certifying the weight and fineness of the metal content.
As Mises notes:

. . . it is the commodity in question that constitutes the money, and that the money is merely this commodity. The case of fiat money is quite different. Here the deciding factor is the stamp, and it is not the material bearing the stamp that constitutes the money, but the stamp itself. The nature of the material that bears the stamp is a matter of quite minor importance.[1]
With commodity money, the value of the currency equals the value of the material of which it is made or into which it is redeemable. The commodity makes the money. "The value of a coin has always been determined, not by the image and superscription it bears nor by the proclamation of the mint and market authorities, but by its metal content."[2] It derives its power from the material of which it is made.

With fiat money, the value of the currency equals what the government declares it to be. (Here value means nominal value and not purchasing power.) The stamp and force of government makes the money. Fiat money derives its power to make purchases and to pay debt solely from words printed on the currency, i.e., it derives its power from governmental fiat, the weapons of government.

Commodity money differs from fiat money in two important ways. First, under a commodity monetary system, the money supply adjusts automatically to meet monetary needs. "[T]he demand for, and supply of, money react simultaneously, through market prices for all goods and services and the monetary metal, to determine a given quantity of money."[3] The markets decide how much money to create and issue. They regulate the money supply. Under a fiat monetary system, the money supply is regulated artificially. The government or its central bank regulates the money supply. The government decides how much money to create and issue. Second, the value of commodity money is directly related to the material of which it is made. For fiat money, value is independent of its material and depends solely on the demand for and supply of money. Of these two differences, the most important lies in the method used to regulate the supply of money.

Thus, fiat money has two attributes that distinguishes it from commodity money. First and most important, the government or its agent, usually its central bank, arbitrarily determines the quantity of money. Second, the value of the material of which the money is made is usually less than its monetary value.

Commodity money is an economic currency. Needs of the economy determine its quantity. It is directly connected with the production of real goods and services.

Fiat money is a political currency. Needs of politics determine its quantity. It is directly connected with government debt even if the government issues the currency directly and interest free. (When the government issues a currency like U.S. notes, it is issuing interest free government debt that is used as money. Often such debt is never paid.) Politics and the fiscal needs of the government determines the quantity of fiat money. The quantity of money is independent of the market or economic needs or demand for money.

Three examples of gold and silver being used as fiat money or in connection with fiat money in the United States follow.

The first example involved the U.S. note or greenback. When President Lincoln first issued U.S. notes to finance his war to destroy the Constitution, they were pure paper fiat money.

U.S. notes were legal tender for public and private debts—except for the payment of tariffs. They could not be used to pay tariffs, which was a major source of revenue for the U.S. government.

The U.S. government did not fix the exchange rate between the U.S. note dollar and the gold dollar until 1879. In 1879, the U.S. government fixed the exchange rate of the U.S. note at 23.22 grains of pure gold per dollar. That is, a U.S. note dollar equaled a gold dollar. This exchange rate continued until President Roosevelt stole the people’s gold and ended the gold standard.

Obviously, U.S. notes were fiat money between 1862 and 1879 and after 1932. Congress arbitrarily fixed the quantity issued. Their monetary value far exceeded the material, paper, of which they were made.

Were they fiat money between 1879 and 1933 when Congress made them redeemable in gold at par? Yes. Congress decided the quantity issued. Also, as their gold backing was only about half or less[4] of the outstanding notes, they were not warehouse receipts like gold certificates. They represented at least twice as much gold as the gold backing them. Therefore, their monetary value was significantly more than their commodity value.

The second example is the silver dollar between 1873 and 1900. In 1873, Congress ended the silver standard, and by that action it ended the constitutional dollar. To appease the pro silver forces, Congress authorized the minting of silver dollars. However, it did not open the mint to the free coinage of silver. The U.S. government bought silver on its own account and coined it. Thus, Congress and the Secretary of the Treasury arbitrarily decided the quantity of silver dollars to mint and issue.

Furthermore, Congress declared the silver dollar to be money in its own right. It fixed the value of a silver dollar to equal the value of a gold dollar. Silver dollars could not be directly redeemed in gold on demand; therefore, it was not a subsidiary coin for gold as were silver halves, quarters, and dimes. Moreover, the value of silver in a silver dollar was worth less than a dollar. It varied between 40 cents and 97 cents in gold.[5] In 1900, Congress made the silver dollar a subsidiary coin for gold and by that ended its status as fiat money.

The third example is the federal reserve note after Roosevelt stole the people’s gold in 1933. Before his thief, federal reserve notes were not legal tender and were redeemable in gold on demand. They were not fiat money. They were merely a form of credit money.

After Roosevelt’s thief, American citizens could no longer redeem federal reserve notes in gold. Congress declared federal reserve notes to be legal tender for all public and private debts. Thus, federal reserve notes became fiat money. The Federal Reserve arbitrarily regulated the quantity of notes issued. The monetary value of a note far exceeded the value of the material of which it was made.

Nevertheless, Congress required a 40-percent-gold backing for federal reserve notes. It changed this requirement to 25 percent in 1945 and eliminated the backing entirely in 1968.

In summary, the United States has had fiat money redeemable in precious metal, fiat money made of precious metal, and fiat money backed by precious metal.

Another fiat monetary system using gold has been promoted by some economists. This system requires the Federal Reserve to expand and contract the money supply and credit to keep the price of gold within a specific range. It is a fiat monetary system where the price of gold becomes the index by which to adjust the money supply. This system has not been officially used in the United States.[6]

As shown above, fiat money is not necessarily paper money or its electronic equivalent although it usually is. Moreover, paper money is not necessarily fiat money. If the government, its central bank, or some other entity decides the quantity of paper money issued and regulates its supply, that money is fiat money. If the people with each person acting in his individual capacity decides how much
of their metallic money or commercial money[7] to convert to privately printed paper money, that paper money is not fiat money—especially if it can be converted back to gold or silver on demand.

The classical gold standard is an utter failure at accommodating the welfare-warfare state. It can accommodate world trade and commerce many times over, but it cannot support the welfare-warfare state. (One of the first casualties of war of any significant is the gold standard.) For this reason, governments hate the gold standard and seek ways to abandon it. They often replace it with a fiat monetary system that incorporates gold. Thus, they control the gold instead of the people or the markets. Whenever even this highly controlled gold begins to impede the welfare-warfare state, governments abandon it in favor of pure paper fiat money.

Because the quantity of gold and silver is limited, the quantity of fiat money using them is limited much more than fiat money using solely paper and electrons. For this reason, gold and silver seldom appear in fiat monetary regimes except as a ruse. The exception has been silver in subsidiary coins. However, even this silver must eventually be removed as the value of the silver in the coin approaches the value of the coin.

In summary, two types of monetary systems exists. One uses commodity money. The other uses fiat money. Using a commodity for the money does not make it commodity money. After all, paper is a commodity, and most fiat money is paper. What distinguish commodity money from fiat money is how the money is created and issued and how its quantity is regulated.

For a more detailed discussion of fiat money, commodity money, and the true gold and silver standard, see the author’s book Reconstruction of America’s Monetary and Banking System: A Return to Constitutional Money.

1. Ludwig von Mises, Theory of Money and Credit (new edition, 1971) p. 62.

2. Ibid., p. 65.

3. Richard H. Timberlake, "Gold Standards and the Real Bills Doctrine in U.S. Monetary Policy," Econ Journal Watch, II (August 2005), 199.

4. In 1932, the U.S. Treasury held $156 million in gold to back $289 million in U.S. notes (Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1914-1941, pp. 409, 506.) In 1879, it held $133 million in gold (H. White, Money and Banking, p. 196) to back $347 million in U.S. notes (J. Johnson, Money and Currency, p. 283).

5. Joseph F. Johnson, Money and Currency (revised edition, 1905), p. 251.

6. A variant of this system has been unofficially tried in recent years. Instead of adjusting the supply of dollars to maintain the price of gold within a specific range, the Federal Reserve and the U.S. government in collaboration with other central banks and governments have attempted to adjust the gold supply to maintain its price below a certain level.

7. Commercial money is a real bill of exchange. A real bill of exchange is created when a supplier or manufacturer enters into a agreement with a retailer to allow the retailer time, 90 days or less, to sell the merchandise to collect money from the final consumer to pay the bill. The supplier can use the bill of exchange to pay his creditors or sell it to a bank. When a bank buys a real bill of exchange, it converts it to bank money (bank notes or checkbook money).

Copyright © 2009 by Thomas Coley Allen.

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