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There’s No Such Thing as Fiat Money

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There’s No Such Thing as Fiat Money

Michael F. Sproul


JEL Code: E50


I make the claim that fiat money does not exist, and that the money that is commonly called fiat money is actually backed by the assets of its issuer. I argue that convertibility is irrelevant to the value of paper money, and that fiat money would self-destruct by attracting rival moneys. Some implications for monetary policy are that the issue of money is not inflationary as long as the money is adequately backed, and that there is no justification for using tight money policies to control inflation.

I. Introduction

A considerable body of empirical work has suggested that the value of money is determined by the assets and liabilities of its issuer, and not by the principles of the quantity theory. This view has been supported by the work of Sargent (1982), Bomberger and Makinen (1983), Makinen (1984), Smith (1984; 1985a, b), Wicker (1985), White (1986), Imrohoroglu (1987), Calomiris (1988a, 1988b), Siklos (1990), and Cunningham (1992). Several defenses of the quantity theory have been offered, notably by McCallum (1992), Michener (1987, 1988), and Laidler (1987). Unfortunately, like the monetary debates of the 1800’s, the disputes “…have slumbered, rather from the exhaustion of the combatants than from the acknowledged defeat of either party.” (Farrer, 1898, p. 78.). This is largely due to the lack of a satisfactory explanation of the basic workings of backed money. My object in this essay is to provide such an explanation, and in doing so I come to the conclusion that all money is backed by the assets of its issuer. Once this is understood, economists might see that these empirical studies reflect much more than a simple wrinkle in the mainstream view of money. Instead, they point to the conclusion that fiat money is no more real than the phlogiston, ether, and caloric of early physical sciences, and that the value of money is determined by its backing, just like any other financial security.

II. Creation of Backed Money

The banker in figure 1 accepts 100 ounces of silver on deposit and issues 100 paper receipts (dollars) in exchange. This is shown in line (1) of figure 1. The paper dollars can be used as money, and assuming the banker maintains convertibility at one ounce per dollar, each dollar will have a market value of one ounce of silver. As long as additional dollars are only issued for one ounce of silver, and as long as convertibility is maintained at one ounce per dollar, any amount of dollars can be issued without causing inflation. It is also clear that it is immaterial whether the dollars are issued as printed pieces of paper or as bookkeeping entries transferable by check or other means.

In line (2), the bank lends $200 to a farmer. Assuming a market interest rate of 10%, the farmer might promise to repay $220—either in dollars or in goods of equivalent value—after one year. The banker could make the loan by printing and lending 200 paper dollars to the farmer. For his part, the farmer gives the banker his 1-year, $220 IOU, which is worth $200 today.

Figure 1

Assets Liabilities

(1) 100 oz. silver $100 paper

(2) Farmer’s IOU worth $200 $200 paper
The banker’s loan triples the supply of paper dollars. An economist trained in the quantity theory might expect the value of the dollar to fall—perhaps to one-third of an ounce of silver. This is incorrect. No matter how many dollars are issued, each dollar remains worth 1 ounce of silver as long as the bank only issues a dollar for a dollar’s worth (or ounce’s worth) of assets. This can be demonstrated by assuming that the contrary is true. Suppose, for example, that the tripling of the supply of dollars caused their market value to fall to something less than one ounce of silver. The bank has promised to redeem each dollar for one ounce of silver, so holders of dollars will present them at the bank and demand one ounce of silver for each dollar. Since there are 300 dollars outstanding and just 100 ounces of silver in the bank, it might seem that the bank is unable to redeem all of the dollars it has issued. But in fact the 300 dollars are fully backed by the silver plus the $200 IOU, and the bank is capable of redeeming every dollar at par. For example, the bank could sell the $200 IOU for 200 of its own paper dollars. It could then destroy the 200 paper dollars, and be left with 100 outstanding paper dollars laying claim to 100 ounces of silver in the bank. The bank could then redeem each of the remaining 100 dollars for 1 ounce of silver. At no point in this process would the value of the dollar fall below 1 ounce of silver.
III. The Real Bills Doctrine

The claim that the bank can lend $200 to a farmer without causing inflation is reminiscent of the real bills doctrine:

...the decried doctrine of the old Bank Directors of 1810, “that so long as a bank issues its notes only in the discount of good bills, at not more than sixty days’ date, it cannot go wrong in issuing as many as the public will receive from it”. (Fullarton, 1845, p. 207)

The bank in figure 1 is acting in accordance with a loose interpretation of the real bills doctrine. The 200 paper dollars in line (2) were issued in the discount of a good bill in the sense that the $200 IOU is sufficiently valuable to adequately back the 200 paper dollars issued. But historically, the real bills doctrine has usually been interpreted as requiring that money be issued for productive purposes, and for short terms—the intent being to cause the quantity of money to move in step with the quantity of goods produced and sold. In this essay I advance a different view of the real bills doctrine: that the issue of adequately backed money does not cause inflation. While this view does resemble the real bills doctrine, there are important differences. What I will call the backing view of the real bills doctrine holds that the issue of money is not inflationary as long as the quantity of money moves in step with its backing. The traditional view of the real bills doctrine, in contrast, holds that the issue of money is not inflationary as long as the quantity of money moves in step with aggregate output of goods.

I interpret the real bills doctrine as requiring only that money be issued for assets of adequate value. Thus the bank could just as well lend the $200 to a gambler on his way to a casino, as long as the gambler offers collateral worth at least $200 as security for the loan. This view, incidentally, is surprisingly consistent with the views of prominent real-bills adherents (Bosanquet, 1810, Fullarton, 1845), as opposed to the views attributed to them by their critics. (Sproul (1998b)).

Even though the backing view of the real bills doctrine is not the same as the traditional one, it is close enough to be condemned by association. The real bills doctrine, after all, is “thoroughly discredited” (Mishkin, 1994, p. 503). And with few exceptions, I am forced to agree with Charles Calomiris’ (1997) assessment that “to my knowledge, the real bills doctrine has no current advocates.” The rejection of the real bills doctrine is the result of over two centuries of debates that have been as intense and voluminous as any in economics (Ashton and Sayers, 1953), and economists will naturally be skeptical of any theory resembling that doctrine. In the face of this skepticism, I had best begin by advancing claims that are modest enough not to admit of dispute. So far, I claim only that the issue of dollars by the bank in figure 1 is not inflationary, always understanding the following conditions: (1) that the bank maintains convertibility at 1 ounce per dollar, (2) that the bank’s assets are in fact adequate to back the dollars it has issued, and (3) that the issue of dollars is small enough to have no significant effects on the market value of silver.

Given these three conditions, one further claim can be made: The value of the dollar is not affected by the issue of derivative dollars. For example, suppose that a second bank opens for business and accepts 20 paper dollars (issued by the first bank) on deposit. In exchange, the second bank issues checking accounts containing $20. The second bank then lends 40 additional checking account dollars to a merchant who offers adequate collateral in exchange. Each checking account dollar is a derivative dollar in the sense that it entitles the bearer to demand one paper dollar from the second bank. We could also say that a checking account dollar is a call option on a paper dollar, with a striking price of zero and no expiration date. Just as the issue of call options or other derivative securities does not affect the value of the base security, the issue of derivative dollars does not affect the value of base dollars. The most direct way to see this is to note that the issue of dollars by the second bank has no effect on the assets or liabilities of the first bank, and therefore does not affect the value of the first bank’s dollars.
IV. What is Money?

Three kinds of money have been mentioned above: silver dollars, paper dollars, and checking account dollars. Suppose we were to ask ourselves which type of dollars should be counted as part of “the” money supply, and which should be downgraded to “money substitutes”? This question has hung fire for three centuries. In 1710, mainstream opinion was that the newly-popular paper money was not real money, since every paper bill must ultimately be paid in coin. (Harley [or rather, Simon Clement], 1710, pp. 7-8). By 1845, paper bills were finally considered to be real money, but checking accounts were not, since every check must ultimately be paid in coins or bills (Fullarton, 1845, pp. 32, 35, & 41). Even today, most economists deny that credit card dollars are part of the money supply, since every credit card dollar is ultimately paid with a check, bill, or coin. With each new kind of money, economists have taken the better part of a century to understand that there is always a permanent float of the new kind of money that is never really paid off.

This example shows that the “What is money?” question that bedevils quantity theorists is just a case of economists asking the wrong question. A better question would be “What backs the money?” The paper dollars mentioned above are backed by the assets of the first bank. The checking account dollars are backed by the assets of the second bank. If the second bank does not adequately back its checking account dollars, then those dollars will lose value, but the paper dollars issued by the first bank will be unaffected. If the first bank does not adequately back its paper dollars, then those dollars will lose value. But assuming the checking account dollars issued by the second bank are just claims to so many paper dollars, the checking account dollars issued by the second bank will lose value as well.

V. Physical Backing, Financial Backing, and Inflation

The 100 ounces of silver deposited with the banker can be called physical backing for the dollars, while the farmer’s IOU, being denominated in dollars, can be called financial backing. Define E as the exchange value of the dollar (oz./$). Since assets (100 oz. plus the $200 IOU) must equal liabilities (300 paper dollars), it must be true that 100+200E=300E, or E=1 oz./$. If the bank did not have adequate backing for its dollars, inflation would result. For example, if the bank were robbed of 20 oz. of its silver, then the above equation becomes 80+200E=300E, or E=0.8 oz./$. If the bank had backed its dollars with 300 ounces of silver and held no IOUs, then the loss of 20 ounces would yield the equation: 280=300E, or E=0.933 oz./$. Note that a higher level of physical backing (as opposed to financial backing) makes the value of the dollar less sensitive to changes in the bank’s assets.

It should be noted that convertibility cannot be maintained without sufficient backing. For example, if the bank loses 20 ounces of silver, (so that the dollar is really worth only 0.8 oz./$) and the bank tries to maintain convertibility at 1 oz./$, there will be a run on the bank. If, during the run, the bank redeems $50 for 50 ounces, so that all that is left of the bank’s assets is 30 ounces plus the $200 IOU, then the above equation becomes 30+200E=300E, or E=0.33 oz./$. If the bank continues paying out silver until all its silver is gone, then the result is E=0. The dollar will be worthless, the bank will be out of business, and the community will have to find another form of currency—or suffer a recession from the lack of a suitable medium of exchange. To avoid these troubles, the only practical choices for the bank are either to devalue the dollar to 0.8 oz/$, or to temporarily suspend convertibility, in which case market forces themselves will reduce the value of the dollar to 0.8 oz./$.

Inflation normally does not occur as long as the bank adequately backs its dollars. But one case where the creation of adequately backed paper dollars could cause inflation occurs when paper dollars displace silver money from circulation. People might initially demand silver both for decorative uses and for use as money. Given these two sources of demand, one ounce of silver might have a value equal to one loaf of bread. But if paper dollars displace silver as money, then the demand for silver will fall and the value of an ounce of silver might fall to only 0.9 loaves of bread. Once silver has been driven down to its “use value” of 0.9 loaves, the creation of additional paper dollars cannot reduce the value of silver any lower. The real bills doctrine (backing view) will then be fully correct: The issue of adequately backed dollars will not affect the value of the dollar in terms of silver, and neither will it affect the value of silver in terms of other goods.

Recall that the third condition for non-inflationary issue of dollars was that the quantity of dollars was small enough to have no significant effects on the market value of silver. This condition can now be dropped. In a modern economy, silver and other metals have long since disappeared from circulation, so any issue of paper dollars, no matter how large, cannot have any effect on the market value of silver (or gold) relative to other goods. Thus, the requirements for non-inflationary issue of dollars can be reduced to two conditions: (1) that the issuer maintains convertibility at 1 oz/$, and (2) that the issuer’s assets are adequate to back all dollars issued.

VI. The Real Bills Doctrine versus the Quantity Theory

Readers who are used to the quantity theory of money might wonder at the contradiction between the real bills doctrine and the quantity theory. How can more money be issued without its value being reduced? One way to answer this is with a stock market analogy: Economists all recognize that a corporation can increase its outstanding shares of stock by any amount, and as long as the new shares are adequately backed by new assets, the value of the stock will not change. For this reason nobody would claim that the quantity theory applies to corporate stock. The real bills doctrine claims that the same thing is true of money. When the bank in figure 1 issues paper money through open market operations, loans, or other normal means, every newly-issued paper dollar is backed by a dollar’s worth of bonds or other assets acquired by the bank, and so the value of the dollar is unaffected by the new issue of dollars. If quantity theorists object that an increase in the money supply relative to the quantity of goods must lead to inflation, the simplest answer is that if the new money displaces other forms of money, or if it replaces barter, or if it piles up in someone’s vault, then it need not be inflationary. More to the point, one could turn the objection around and ask the same question about corporate stock. The value of corporate stock, like any financial security, clearly depends on its backing, and not on the quantity of that stock relative to the community’s output of goods. Why shouldn’t the same thing be true of a financial security that happens to be used as money?

Critics of the real bills doctrine from Henry Thornton (1801) to Lloyd Mints (1947) have objected that the real bills rule puts no limit on the amount of money that banks might create. The answer to this objection is that no such limit is necessary or relevant as long as the bank’s assets rise and fall in step with its issue of money (Sproul, 1998b). A second objection against the real bills doctrine is that modern paper money is not convertible into any valuable commodity, and therefore has no backing. The answer to this objection is that there is a clear difference between money that is inconvertible and money that is unbacked. In fact, convertibility is irrelevant to the value of paper money, as I will explain below.

VII. The Irrelevance of Convertibility

The value of a convertible (“American”) call option is normally equal to the value of an inconvertible (“European”) call option. By the same reasoning, the value of a convertible dollar will normally be equal to the value of an inconvertible dollar.

Let C represent the cost (oz./$) of maintaining a dollar in circulation for one year. This cost would include costs of printing, controlling counterfeiting, periodic redemption, etc. Given this cost, and a market interest rate of R, absence of arbitrage requires that the supply of dollars is horizontal at 1/(1+R-C)n oz./$, for a dollar that will be convertible into 1 oz. after n years. Figure 2 assumes a 1-year time horizon, so supply is horizontal at 1/(1+R-C). For example, if R=5% and C=4%, then if a dollar promises 1.0 oz. at the end of one year, it must start the year worth 1/(1.05-.04)= .99 oz, and rise to 1.0 oz. over the year. If the dollar is convertible throughout the year, then the issuing bank must promise to redeem the dollar for .99 oz. at the start of the year, and gradually increase this rate to 1.0 oz. at the end of the year. If the dollar promises 1 oz. at year-end, but is inconvertible until the end of the year, then at the start of the year the public will value that dollar at .99 oz., in anticipation of its being convertible into 1.0 oz. at the end of the year. The value of the dollar is always the same, whether it is convertible or inconvertible.

Any other result would create either abnormal profit or abnormal loss for money-issuers. Suppose, in the above example, that the dollar started the year at .99 oz/$ and stayed at .99 oz./$ for the entire year. A banker who issued a dollar for .99 oz. of silver at the start of the year would lend the .99 oz. at 5% and get 1.04 ounces repaid at year-end. But the paper dollar he issued would have cost only .04 ounces to maintain in circulation for the year—a profit to the banker of .01 ounces for each dollar issued. Thus, if the dollar starts the year worth more than 1/(1+R-C), unlimited amounts will be issued. By similar reasoning, if the value of the dollar drops below 1/(1+R-C), no dollars will be issued.

At the start of the year, the demand for dollars for liquidity purposes is given by D, but if the price of dollars fell below 1/(1+R), the demand for dollars as an investment would become infinite, so overall demand would be horizontal at 1/(1+R), to the right of Q*. (The industry is assumed to contain 1000 competitive banks identical to the bank in figure 1, hence Q*=300,000.) To the left of Q*, demand depends on the liquidity services yielded by paper dollars, and on the availability of substitute moneys such as checks, credit cards, foreign currencies, etc. In the limiting case where other moneys are issued costlessly and are perfect substitutes for paper dollars, demand would be horizontal throughout at a height of 1/(1+R), and no paper dollars would be issued. If few substitute moneys were available, demand would have a negative slope to the left of Q*, reflecting peoples’ willingness to pay a premium for the liquidity afforded by paper dollars.

In the case where C=R, the cost of issuing and circulating a paper dollar is just equal to the interest the bank earns on the assets it received for the dollar, so a dollar that was convertible into 1 ounce of silver at the start of the year will still be convertible into 1 ounce at year-end or, for that matter, after any number of years. If convertibility were suspended in any year, the value of the dollar would remain at 1 oz./$.

It is a short step to recall that prior to 1933, the Federal Reserve issued paper dollars that were convertible on demand into 1/35 oz. of gold. If C=R, the Federal Reserve could maintain convertibility at 1/35 oz./$ indefinitely. In 1933 the Federal Reserve suspended

convertibility for an indefinite number of years n, and the value of the dollar remained at

1______ = 1/35 oz./$


The value of the dollar was unaffected by the 1933 suspension of convertibility1. It would be an understandable mistake if quantity theorists were to claim (as every textbook does) that since people could no longer redeem dollars for gold, the dollar was unbacked. If a real-bills adherent were to point out that the Federal Reserve still had the same assets as before, still recognized those assets as “Collateral Held Against Federal Reserve Notes”, and stood ready to use those assets to buy back the dollars it had issued, then quantity theorists could answer that those assets were only an archaic relic of the gold standard, with no real significance.

If a real-bills adherent pointed out that truly unbacked fiat money creates arbitrage opportunities for the issuers of rival moneys, then I do not believe that a quantity theorist could give a convincing reply. People who believe the dollar is unbacked will usually claim that dollars have value because of supply and demand. The government limits the supply of dollars, while people demand dollars because of their usefulness for making trades, paying taxes, etc. If this were true then the Federal Reserve could issue paper dollars for (say) one ounce of silver each, then suspend convertibility and spend the silver like the free lunch that it is. As long as the Federal Reserve did not issue any more dollars, the dollars would remain worth 1 oz./$--held up only by the forces of supply and demand.

This free lunch would attract rival moneys, and it is competition from these rival moneys that forces the value of money to be equal to its backing. For example, the Mexican central bank might issue paper pesos that were initially convertible into 1 ounce of silver, and those paper pesos might circulate as money. If the quantity theory were correct, then the Mexican central bank could eventually suspend convertibility and throw away its silver. As long as the quantity of paper pesos was not increased, the quantity theory implies that their value would be maintained by the forces of supply and demand.

The profit earned by the Mexican central bank would attract rival banks, including the American central bank. That bank, by assumption, is also capable of earning a free lunch by the issue of paper money, so the American central bank would make every effort to circulate its paper dollars in Mexico. As the dollars invade Mexico, the demand for paper pesos would fall and, on quantity theory principles, the paper pesos would lose value. As the peso lost value, the resulting loss of public confidence in pesos would cause the demand for pesos to fall still further, so the value of the peso would continue to fall with no stable solution short of zero value.

In the face of this rivalry, how does the peso manage to have any value at all? One answer is that the demand for pesos can be maintained by government edict or force of habit. A better answer is that the value of the peso is not determined on quantity theory principles. The peso’s value, like that of every other paper currency, is equal to its backing. No matter how many paper pesos are displaced from circulation by dollars or other rival moneys, the value of the peso will always be determined by the assets and liabilities of the Mexican central bank.

VIII. A Case Where Convertibility Matters

There is a qualification to the contention that convertibility does not affect the value of the dollar: The issuing bank must still conduct open-market operations to maintain the dollar’s value. Suppose that figure 2 shows a monopolistic central bank that has issued $300,000 and holds assets of 100,000 ounces of silver, plus bonds worth $200,000. Each dollar is worth 1 ounce of silver, and the dollar is inconvertible until the end of one year. If the public’s demand for dollars fell slightly, and if the bank were willing to restore convertibility, then people might present (say) $1000 to the central bank, demanding 1000 ounces of silver in exchange. But the central bank could head off this demand by making an open-market sale of $1000 worth of bonds. This would take the unwanted $1000 off the public’s hands, and no one would care if the bank had not paid out silver for its dollars. As long as the bank uses open market operations in this way, convertibility is irrelevant.

But if the public’s demand for dollars fell drastically, the central bank might be forced to sell all $200,000 of its bonds in order to maintain the dollar’s value. This would leave the bank with 100,000 ounces of silver backing $100,000 in circulation. If the public’s demand for dollars fell slightly more, so that people presented another $1000 to the bank and demanded 1000 ounces of silver, then convertibility would matter. If the bank resumed convertibility at 1 oz./$, then the value of the dollar would be maintained at 1 oz./$ even if the entire $100,000 were redeemed for silver. But if the bank insisted that the dollar would remain inconvertible until the end of the year, then the value of the dollar would fall to 1/(1+R). In effect, a bank that maintains convertibility at 1 oz./$ will have a supply curve of dollars equal to the line EHS in figure 2. A bank that refuses convertibility for a year, but still conducts open-market operations with its bonds, will have a supply curve of dollars equal to FGHS.

This example makes it clear that there are two kinds of convertibility: (1) physical convertibility, where the dollar is convertible into a given physical amount of silver or other assets, and (2) financial convertibility, where the dollar is convertible into a dollar’s worth of the issuing bank’s assets. The modern paper dollar, mislabeled as fiat money, is not physically convertible, but it is financially convertible as long as the Federal Reserve conducts open market operations. When the public finds itself with excess currency (after the Christmas shopping season, for example), the Federal Reserve normally sells bonds to soak up the excess currency. This action heads off any public desire to redeem dollars for gold. Thus the Federal Reserve’s maintenance of financial convertibility makes its refusal of physical convertibility irrelevant. If the day ever comes that the Federal Reserve has sold off all of its bonds for its own dollars, and the public still holds unwanted dollars, then it will matter whether or not the Federal Reserve chooses to resume physical convertibility. Since that day shows no prospect of coming soon, there is no need for economists to puzzle over why people value dollars even though they are not physically convertible.

There is still a question of the rate at which a bank will maintain financial convertibility. In the case of the bank in figure 2, where the dollar is inconvertible for 1 year, the bank could potentially use open market operations to keep the value of the dollar anywhere in the range from 1/(1+R) to 1/(1+R-C). In the case where C=R=5%, the value of the dollar can range from 0.95 oz./$ to 1.0 oz./$. For example, at the start of the year, customers might have each deposited 1 ounce of silver, expecting that the dollar received in exchange would remain worth 1.0 oz. for the entire year. But suppose that soon after the bank issues the $300,000 shown in figure 2, the demand for dollars falls enough that the equilibrium quantity of dollars drops from $300,000 to $250,000. A conscientious banker would respond by selling $50,000 worth of bonds, thus keeping the value of the dollar at 1 oz./$. But an unscrupulous banker might respond by insisting that the dollar would remain inconvertible, both physically and financially, until the end of one year. This would cause the value of the dollar to fall to 0.95 oz./$ at the start of the year, and it would gradually rise to 1.0 oz./$ by year-end. If convertibility were extended for a longer period, then the lower bound of the dollar’s value would be reduced. For example, if the dollar were declared inconvertible for 10 years, its initial value could fall as low as 1/1.0510=.614 oz./$.

The wide potential range for the value of the dollar creates empirical problems for economists trying to test the validity of the real bills view. The most obvious empirical test of the real bills doctrine would be to observe whether the value of the dollar is better explained by the assets and liabilities of the issuing bank (as implied by the real bills doctrine) or by the quantity of money relative to the community’s output of goods (as implied by the quantity theory). But the real bills doctrine only implies a maximum value for the dollar. The minimum value can be as low as zero in the case of a bank that chooses to conduct open market operations at that rate.

IX. Tax Backing

There have been many historical cases of paper currencies being issued by governments that appeared to have no assets at all backing their currency. American colonial currencies, for example, were often issued by nearly bankrupt governments, and were not convertible into metallic currency. How can such currencies be said to be backed?

The answer is that the American colonies did have assets—principally their ability to collect taxes. The colonies would typically rate the value of their paper currency in terms of coins, metal, or some other commodity. For example, the colony of New York declared in 1709 that its paper shillings were equal in value to silver shilling coins, and made them acceptable for taxes at that rate. Thus a colonist with a tax liability of 8 silver shillings could pay that tax either with 8 silver shillings or with 8 paper shillings. In this case the paper shillings were backed not by New York’s (questionable) ability to pay out silver shillings on demand, but by New York’s ability to take away silver shillings as taxes. If New York lost the ability to collect taxes, then its paper shillings would fall just as in the case of a bank that loses the ability to pay out silver for the paper dollars it has issued. This view is in substantial agreement with the evidence presented by Smith (1985) and Sargent (1982), among others.2
When colonial currencies were carefully backed by future governmental surpluses, they held their value remarkably well. When such backing was not carefully provided, depreciation was the rule. The quantity of bills issued, on the other hand, bears little relation to currency values, or to colonial price levels. (Smith, 1985a, p. 156.)
Figure 3: A Money-Issuing Colony

1) 100,000 shillings 100,000 shillings

taxes receivable net worth


2) +20,000 paper shillings

-20,000 shillings net worth


3) Building worth +10,000 paper shillings

10,000 shillings


4) -8,000 shillings -8,000 paper shillings

taxes receivable


In line (1) of figure 3, it is assumed that a colony’s only asset is 100,000 shillings of taxes receivable. If the colony has no claims against it, then its net worth at this point is 100,000 shillings.

Line (2) shows the effects of the colony printing 20,000 paper shillings and, let us suppose, giving them away. The effect is to reduce the colony’s net worth by

20,000 shillings. But the shillings are more than adequately backed by the 100,000 shillings of taxes receivable, so every paper shilling will still be worth 1 silver shilling. It

is evident that the colony can safely issue in this fashion up to 100,000 paper shillings without causing inflation, but if it exceeded that amount, then inflation would result as the colony’s issue of currency outran its assets.

The colony is unlikely to simply give the paper shillings away. Normally the colony would spend the shillings acquiring new assets, such as buildings, roads, etc. In this case the colony could avoid inflation by following the real bills doctrine and taking care to spend shillings only on assets worth at least as much as the shillings paid for them. For example, in line (3), the colony prints and spends 10,000 new paper shillings on a building worth 10,000 shillings. Since assets rise as much as liabilities, there is no tendency to inflation.

Line (4) shows the effects of a tax collection. As the colony receives and retires 8,000 paper shillings, it simultaneously reduces taxes receivable by 8,000 shillings. Most colonies issued paper shillings on the condition that those shillings would gradually be retired as they were collected in taxes. On real bills principles the retirement of 8,000 shillings would not affect their value, since the quantity of paper shillings falls in step with their backing. But we should not be surprised to find that such a reduction in the

quantity of money depressed trade.

 “The retirement of a large proportion of the circulating medium through annual taxation, regularly produced a stringency from which the legislature sought relief through postponement of the retirements. If the bills were not called in according to the terms of the acts of issue, public faith in them would lessen; if called in there would be a disturbance of the currency. On these points there was a permanent disagreement between the governor and the representatives, discussions concerning which reveal themselves in 1715 and traces of which are frequently found after that date.” (Davis, 1910.)
The central controversy of monetary theory thus emerged at an early date. On one side of the controversy, ‘tight money’ advocates feared inflation. On the other side, ‘easy money’ advocates feared recession. Unfortunately, both sides accepted the idea of fiat money, and neither side seems to have understood the role of backing. Friedrich Hayek, in his comments on an English credit rationing episode, exemplified quantity theorists’

confusion over this issue:

This recourse to a rationing of credit caused renewed stringency in the money market in the spring of 1796 and evoked loud protests from the City (London). It is not easy to reconcile these complaints about the continued scarcity of money during this period with the no less insistent complaints about high prices, and with the continued unfavorable course of the exchanges." (Hayek, 1933, p. 40)

From a real bills perspective, it is easy to reconcile the two sets of complaints. High prices would have been the result of the pound having inadequate backing, while monetary stringency would have been the result of the Bank’s refusal to issue money to those offering adequate security in exchange. On real bills principles there is no reason to think that these two things could not happen together. Only on quantity theory principles would mere scarcity of money be expected to relieve inflation. In fact, complaints of scarcity of money are often dismissed out of hand by quantity theorists, since their models imply that scarcity of money would increase the value of money, thus relieving the scarcity.

One practical lesson of the real bills doctrine is that inflation can be ended without causing a recession. On the real bills view, inflation can be stopped even as the money supply is increased, provided that the newly-issued money is adequately backed. The European hyperinflations of the 1920’s were ended because European governments began to adequately back their money, even as the money supply increased and trade was stimulated (Sargent, 1982). Unfortunately, this lesson was not learned well enough, and to this day, misguided central bankers still resort to various “shock therapies” aimed at restricting the money supply to reduce inflation, but at the cost of a recession.
X. Conclusion

Available evidence suggests that the value of money is determined by its backing, and not by its quantity. The best explanation for this finding is that all money is backed, and that there is no such thing as fiat money. This is the case whether the money is issued privately or by a government, whether it is convertible or inconvertible, whether the issuer holds physical backing or financial backing, and whether the money exists as printed pieces of paper or as transferable bookkeeping entries. If any money ever did have value in excess of its backing, there would be profit opportunities for the issuers of rival moneys. Competition from rival moneys thus keeps the value of any money in line with its backing.

Is there any such thing as unbacked money? Is there anything that can with propriety be called fiat money? The answer to both questions is negative. Whenever any alleged fiat money is examined carefully, it becomes clear that it is actually backed. The U.S. dollar, for example, is always issued in exchange for equal-valued assets, which are explicitly recognized as collateral held against Federal Reserve notes. The only justification ever given for calling the dollar fiat money is that it is not physically convertible into gold. This justification falls apart when we recognize that: (1) Physical convertibility is irrelevant as long as the Federal Reserve maintains financial convertibility through its use of open-market operations, and (2) an inconvertible dollar is normally equal in value to a convertible dollar, just as a European call option is normally equal in value to an American call option.

Once we recognize that a currency like the dollar is backed, two things become clear: (1) Governmental issue of dollars in exchange for assets of adequate value is not inflationary, and (2) the issue of derivative dollars such as checking accounts and credit cards has no effect on the value of governmentally-issued ‘base’ dollars. Furthermore, given that adequately backed money does not cause inflation, there is no justification for using tight money policies to control inflation. Inflation is best avoided by assuring that money is adequately backed, and recessions are best avoided by allowing unrestricted issuance of money whenever assets of adequate value are offered in exchange.

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1One of the most prominent examples of the advantages of suspending convertibility is the Bank of England’s suspension on February 26, 1797. “Looking back from the safety of 1798, ‘A Proprietor of Bank Stock’ thus summarized the transition: ‘In this desponding state, when all men dreaded, with the utmost anxiety, the event that was seen to be inevitable, and not far distant, and which it was supposed would involve the kingdom in general bankruptcy and intire ruin, the 26th February, 1797, was the crisis that gave the happy turn, and almost instantly dismissed all the horrors and fears that surrounded us; restored complete confidence…’” (Horsefield, 1944, quoted in Ashton and Sayers, 1953, p. 19).

2 The Smith-Sargent view produced a number of replies (e.g., McCallum (1992), Michener (1987, 1988), Laidler(1987)). My reasons for favoring the Smith-Sargent view are discussed in Sproul (1998a).

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