The Confidence Trick of Fiat Currency

Earlier today, I re-posted on Naked Capitalism, the article “If the U.S. stopped issuing treasuries, would it go broke?”, which I wrote in November 2009. I said that at the time wrote the original piece, I was getting to grip with how the government designed constraints in order to prevent deficit spending. What was and still is clear to me is that while different types of federal government obligation served different operational purposes, they all are identical in that they are a promise to pay the holder of that obligation a specific sum of the money unit of account.

In a world in which government is the creator of that currency and in which the currency has no tether to a physical product like gold, this promise has no tangible financial support other than the full faith and credit of the issuing government supported by its monopoly power to tax in its jurisdiction of control. Put more simply, there is nothing supporting fiat currency besides the coercive power of the state to impose tax and to entrench its obligations’ circulation as legal tender.

When thinking about the debt ceiling debate, the reality then is that the debt ceiling is a purely artificial constraint; Treasury notes or bonds are substantively the same as every other US government obligation. It is interesting that no other major developed economy has such a constraint. [Correction: at least Denmark and Australia have this constraint as well. There may be others.] I would be interested in readers’ with knowledge of the debt ceiling history explaining why this is so.

In any event, some economists recognize that the US government obligations are all substantively identical promises to repay a specific amount of the currency unit of account backed by nothing but taxing authority. As a result, there has been a lot of chatter about ways of circumventing the debt ceiling by issuing other forms of US government obligations and swapping those with outstanding Treasuries to diminish the number of Treasuries outstanding. Some of these proposals are fairly inventive. See Scott Fullwiler’s here for instance.

I doubt Secretary Geithner would implement any of these schemes, of course. But the larger question I have goes to the reason the debt ceiling exists at all: all deficit spending must be accompanied by the issuance of an equivalent unit of currency amount of Treasuries. Mentally, this ties the deficit spending and the treasuries together so that the layman thinks the Treasuries ‘fund’ the deficit spending. But, I just told you that all government obligations are promises to repay the currency unit of account backed by nothing but taxing authority. It’s as if you go to the government with your paper IOU with $100 printed on it to claim your money and the government hands you another paper IOU with the exact same amount printed on it. That’s pretty much how fiat money works. So, Treasuries don’t ‘fund’ anything. The US government issues Treasuries only because it is forced to do so to create the artificial tie between Treasuries and deficits and the mental connection we make as a result.

Now, with a default looming, we are seeing that as artificial as this constraint is, it has real world implications.

That’s all I said in the NC version of this before adding the original column. But let me add a few more words here.

In my view, fiat currency is a confidence trick. The key to confidence in a fiat currency is the belief of citizens that the government issuing the currency will manage its finances in a way that promotes general “life, liberty and prosperity”. If confidence erodes, tax evasion will rise, citizens will begin surreptitiously using other media of exchange to transact and inflation and currency depreciation will spiral out of control.

The question we are asking right now about the debt ceiling in the US goes to the existence of and need for artificial constraints in maintaining this confidence trick. As I demonstrated above, the need to issue treasury bonds to match any government deficit spending and the debt ceiling that emanates from that tie are artificial constraints meant to tie government’s hand in diverting real resources to the few who can line their pockets at the expense of the life, liberty and prosperity of the greater many.

This is a debate I often have with some of my blogging colleagues. Your answer depends crucially on your view of what the public purpose of government is. If you believe government’s core public purpose is to maintain the value of currency and permit the private sector freedom to deal with distributional issues of equity and general prosperity issues of efficiency then you will answer one way. On the other hand, if you believe the government’s public purpose is to maintain full employment in pursuit of life, liberty and prosperity, you will answer another way.

Personally, I like having some artificial constraints and am not enamoured with fiat money for that reason. When I made a vague reference to counterfeiting, that was my subtle way of indicating this. I like gold but I don’t think a return to the gold standard is practical or desirable since the gold standard has its own problems with limiting fiscal space and precipitating a deflationary spiral as we saw during the Great Depression. But I am trying to look at this neutrally.

Supporters of fiat money like it because it gives government fiscal space to deal with the consequences of crises. And we see what that means with the lack of fiscal space affecting the euro zone sovereign debt crisis. On the other hand, fiscal space also allows the few well-connected to be favoured at the expense of the many, which is neither fair nor efficient.

Ultimately, this is a political philosophy question. This debate, then, is not an objective one. And that makes it emotional, intractable, and potentially violent in the same ways political philosophy did during the American Revolution, the Civil War and the Great Depression.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.