Sunday, August 29, 2010

What Is the Difference Between Commodity and Fiat Money

What Is the Difference Between Commodity and Fiat Money
Thomas Allen

Monetary systems can be divided into two major categories. One category is fiat money, which is sometimes called managed money, debt money, forced paper money, or irredeemable paper money. The other is commodity money, which is sometimes called full-bodied money, metallic money, specie, hard money, or precious metal money.

Commodity money is “that sort of money that is at the same time a commercial commodity.”[1] Gold and silver are the premier commodities used as money.

Fiat money “is a legal claim, since it derives all its properties from the law.”[2] It is simply a purchase voucher, whose purchasing power varies, that can be exchanged for goods and services. The settlement of debts is its only fixed right.

Webster’s New International Dictionary (second edition, unabridged) defines fiat money as “paper currency of government issue which is made legal tender by fiat or law, does not represent, or is not based upon, specie, and contains no promise of redemption.” The government or its central bank issues fiat money, and the government declares it to be legal tender. Currently, in the United States fiat money occurs as federal reserve notes.

Commodity money differs from fiat money in two important ways. First, under a commodity monetary system, the money supply adjusts automatically to 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. 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.

Johnson makes the following comparison between commodity money and fiat money: “(1) commodity money, or money made out of material of which the free use is permitted as money, so that its value is the product of two sets of utilities, namely its utility as money and its utilities as an ordinary commodity; (2) fiat money, or money the value of which has no relation to the value of the material out of which it is made, being the product solely of its utility as money.”[4]

Many people often confuse commodity money with fiat money when the fiat monetary system incorporates gold or silver. A money backed by gold is not necessarily commodity money. (Under the true gold standard, gold does not back the money. Gold is the money.) For example, legal tender federal reserve notes between 1933 and 1968 were legally required to be backed by gold. Yet it was not commodity money. No American citizen could redeem federal reserve notes for gold. The Federal Reserve decided how many federal reserve notes to issue instead of the markets. The value of gold backing them was much less than the monetary value of the notes. Hoppe makes this error.

Hoppe compares fiat money with commodity money as follows: “Fiat money is the term for a medium of exchange which is neither a commercial commodity, a consumer, or a producer good, nor title to any such commodity: i.e., irredeemable paper money. In contrast, commodity money refers to a medium of exchange which is either a commercial commodity or a title thereto.”[5] Hoppe’s description overlooks an important feature of fiat money, and, that is, the issuance of fiat money is arbitrary. Under Hoppe’s description, silver dollars issued in the 1880s and 1890s were commodity money as they contained a commercial commodity. They were money in their own right and were not directly redeemable in gold on demand. However, as Congress and the Secretary of the Treasury arbitrarily fixed the amount issued, they were fiat money. Moreover, the coin’s face or monetary value was greater than the value of its metal content.

Rist explains the difference between commodity money and fiat money as follows:
[I]t must be recognised that the belief in gold arises not from age old superstitions of a more or less magical character, but from age old experience. A claim on gold—a cheque or a banknote—is something clear and precise that everybody understands, just as everybody understands a mortgage on a piece of land or a house that he knows. Paper [fiat] money is a claim on something unknown, on a country or a government, whose political, social or financial escapades and arbitrary decisions nobody can be sure of beforehand.[6]
Vieira compares commodity money with fiat money as follows:
With commodity money, the actual commodity, the silver or the gold, is both the medium of exchange and the standard of value. The supply of commodity money is self-limited because of the costs of minting, refining, and coining the silver and gold. New supplies of commodity money will be coined only to the extent that coinage is economically profitable. The market will simply not produce more gold and silver coin than is necessary compared to all the other uses of that capital. . . . [F]iat money is composed of some intrinsically valueless substance which the issuer does not promise to redeem in a commodity or in a fiduciary money. Because fiat money has no legal connection to a commodity money, and, therefore, has no real economic cost in terms of production, the supply of fiat money is never self-limiting and is always largely a matter of public confidence in the economic or political stability of the issuer.[7]
Vieira description of commodity money and fiat money fails to account for silvers dollars of the 1880s and 1890s. They contained a valuable substance, silver, which seems to make them commodity money. However, the government decided the quantity to issue instead of the markets, which makes them fiat money.

It also fails to account for U.S. notes between 1879 and 1933. U.S. notes were redeemable in gold on demand during in those years. However, Congress decided the quantity to issue. Also, the gold backing them varied between about one-third and one-half. Thus, they were not genuine warehouse receipts as were gold certificates, which were required to be fully backed by gold.

Mises describes the difference between commodity money and fiat money as follows:
. . . 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.[8]
Mises’ description accounts for silver dollars of the 1880s and 1890s The stamp instead of the metal content gave these silver dollars their value. His description also accounts for U.S. notes between 1879 and 1933. The stamp and not the metal backing gave them their value as they were not fully backed by gold.

With commodity money, 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.”[9] With fiat money, the stamp and force of government make 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.

Fekete notes that commodity money is “tied to a positive value: the value of a well-defined quantity of a good of well-defined quality.”[10] Fiat money is “tied not to positive but to negative value—the value of debt instruments.”[11]

Commodity money is the only form of money that is a present good. All paper money, including certificates and fiat money, is a promise to pay; it is a future obligation. With fiat money the payment is never made; it is only discharged. Payment with commodity money completes the transactions; payment with fiat money is an extension of credit. (In this respect a gold certificate is like fiat currency. The gold certificate is credit, a promise to pay in gold and the transaction is not completed and the debt retired until the certificate is redeemed in gold.) With irredeemable fiat currency, the transaction can never be completed because the currency is irredeemable. The transaction is discharged by a transfer of credit.

Under a fiat monetary system, debt, promise, or obligation is used as money and as final payment. Fiat money is basically paper money and its electronic equivalent representing nothing but a promise or an obligation. Under a fiat monetary system, a final payment can never really occur as one is always paid with debt, promise, or obligation, a representation that something else is owed. Thus, fiat money can only discharge debt; it can never retire debt.

Under a pure commodity monetary system, final payment is always in the commodity being used as money in the transaction. The commodity can function as final payment because it is no one’s obligation. Receipt of the commodity in payment ends all further obligations. Thus, it retires debt.

In fiat monetary systems, the monetary unit is a nebulous abstraction, a legal fiction. Fiat money is not tangible, lacks definition, and has no defined unit of measure. It is an illusion with no connection to reality.

In commodity money systems, the monetary unit is tangible and measurable. It is a specific and definable weight of a particular commodity, usually gold or silver. Unlike fiat money, commodity money has value in and of itself independent of its monetary use.

Under a commodity monetary system like the gold or silver standard, the quantity of money is not subject to governmental manipulation. With fiat money, the government maintains control of the money and can change the money supply to suit political considerations.

With a commodity monetary system like the gold standard, market forces determine the quantity of gold coined. The people decide how many gold coins that they need by the quantity of gold brought to the mint for coinage and by the quantity of gold coins melted for other usages. Thus, a commodity monetary system uses the knowledge and wisdom of all the people in regulating the money supply.

With a fiat monetary system, a definite governmental monetary policy is needed to regulate the quantity of the fiat money. Development of this policy requires the opinions of “experts” on the desirable goals. Thus, this policy is nothing more than the personal value judgment of these experts. Once they have selected a policy, the force of government is needed to carry it out. Neither the experts who develop the policy nor the governmental agents who impose it can accurately foresee the long-term effects of the policy. Adolph Miller, a member of the Federal Reserve Board, in his testimony before Congress, summed up this major problem with fiat money: “Up to this day it has never yet been demonstrated that any agency can be invented to which power to govern the currency could be entrusted without ultimately disastrous consequences.”[12]

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.)

With fiat money, the government gains a monopoly over money. Using its monopolistic control of money, it can inflate until the money becomes completely worthless. With legal tender laws, it can force people to accept ever depreciating money.

Under a commodity monetary system, the value of the monetary commodity comes from its production. Under a fiat monetary system, the value of money comes from its legal obligation.

With fiat money, people trust politicians, bureaucrats, and bankers. They trust paper and promises. With commodity money, people trust gold and silver. They trust that which is no one’s obligation or promise.

Fiat money is totally dependent on commodity money, at least initially, for its value. Greaves describes this dependency as follows:
The original value of any money was the use value that commodity had in its other uses before it was first used as a medium of exchange. It then had an objective exchange value based on some other use or uses. This historical link is absolutely necessary, not only for commodity money, but also for every legally sanctioned credit or fiat money. No fiat money ever came into use without first satisfying this requirement. It is absolutely impossible to start a new money without an historical use value, or without its being related to some previous money or commodity with a prior use value. Before an economic good or a “paper money” begins to function as money, it must possess, or be given, an exchange value based on some use or good other than its own monetary value.[13]
“Money cannot originate as a new fiat name, either by government edict or by some form of social compact.”[14] Fiat money grows out of commodity money. “Money must emerge as a commodity money because something can be demanded as a medium of exchange only if it has a pre-existing barter demand. . . .”[15]

Unlike commodity money, fiat money does not come into use spontaneously. Conversion from commodity money to fiat money requires coercion. People do not naturally and freely abandon commodity money for fiat money.

Fiat money rests upon the premise that the power of government is enough to give value to a piece of paper that has no intrinsic value. Fiat money adherents firmly believe that a government can create value by simply proclaiming that a piece of paper has value. Evidence of this is seen in the federal reserve note. Originally, the note promised to pay in gold. Now it just declares itself to be so many dollars. It went from being a legitimate substitute for real money, gold, to being fiat money.

Gold and silver protect the people. Fiat money enslaves them. Frederick von Hayek remarks:
With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people. What is dangerous and ought to be eliminated is not the government's right to issue money, but its exclusive right to do so and its power to force people to accept that money at a particular rate.[16]
Commodity money limits the power of government.

Gold and sliver money limits the size of government by restraining its growth. Fiat money allows government to expand almost without limits.

1. Ludwig von Mises,. The Theory of Money and Credit (New edition. Translator H.E. Batson. Irvington-on-Hudson, New York: The Foundation for Economic Education, Inc., 1971), p. 61.

2. Charles Rist, History of Monetary and Credit Theory from John Law to the Present Day (1940; reprint. Translator Jane Degras. New York, New York: Augustus M. Kelly, 1966), p. 337.

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

4. Joseph French Johnson, Money and Currency: In Relation to Industry, Prices, and the Rate of Interest (Revised edition. Boston, Massachusetts: Ginn and Company, 1905), p. 32.

5. Hans-Hermann Hoppe, “How is Fiat Money Possible?—or, The Devolution of Money and Credit,” The Review of Austrian Economics, VII (1994), 49.

6. Rist, p. 434.

7. Edwin Vieira, Jr., “Restoring the Dollar,” Vieira_Restoring_the_Dollar.html, Apr. 23, 2008.

8. Mises, p. 62.

9. Mises, p. 62.

10. Antal E. Fekete, “Whither Gold?”, Oct. 29, 1996,, Sept. 13, 2007.

11. Ibid.

12. Percy L. Greaves, Jr., Understanding the Dollar Crisis (Belmont, Massachusetts: Western Islands, 1973), p. 231.

13. Ibid., p. 157.

14. Murray N. Rothbard, The Case for a 100 Percent Gold Dollar (Washington, D.C.: Libertarian Press, 1974), p. 10.

15. Hoppe, p. 51.

16. Antony C. Sutton, War on Gold (Seal Beach, California: ‘76 Press, 1977), p. 65.

Copyright © 2010 by Thomas Coley Allen.

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