Published: Mon 04 March 2019
Money Politics Policy 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
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
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.
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
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
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?