MMT Fundamentals: A Fiat Currency - What Is It and Why Is It Important?
Modern Monetary Theory (MMT) - Key Ideas and Concepts: Fiat Currency
A Fiat currency is a currency whose value is wholly derived from trust in the issuer of that currency. For example, the UK Government issues the UK Pound, the UK Government has declared it to be the legal tender and, therefore, it is accepted in exchange for goods or services wherever the UK Government has jurisdiction.
A fiat currency is not backed by a physical commodity like gold or silver. It has no intrinsic value. For example, if you have a gold watch, you could visit a pawn shop and exchange it for British Pound notes (assuming you are in the UK). You would expect the pawn broker to evaluate the worth of your watch and give you what he or she thinks it is worth. A gold watch has intrinsic value.
You could give the pawn broker a £10 note to weigh on their scales and then find out the price of the plastic used: but, of course, you both know that its value is not derived from the cost of the plastic. The note itself has no intrinsic value. Its value is determined by the fact that the UK Government has backed it as legal tender. Both you and the pawn broker implicitly trust that you can spend its value on goods and services.
So, a fiat currency is a common, trusted means of exchange, backed by the government, used to simplify the trade of goods and services.
Who issues and controls the fiat currency?
The issuance, destruction and management of a fiat currency is controlled by a central authority, for example, a central bank (on instruction from the central government). In the UK, the central bank manages monetary policies, such as setting the interest rate, with a goal of engendering economic stability.
Do all countries have fiat currencies?
No, but most countries have fiat currencies. However, it should be noted that within the Eurozone, only the European Central Bank (ECB) could be characterized as having a fiat currency - the countries using the Euro do not. Eurozone countries are currency users not currency issuers. As such they do not have complete control over their own monetary policy or indeed full control over their own spending plans. For example, the ECB sets deficit limits: i.e., there is a limit to the amount they are allowed to spend over what they bring in - in taxes and other income.
Other countries that do not have fiat currencies, include those countries who peg their local currency to another country’s currency - such as Bahraini Dinar which is pegged to the US Dollar
And there are countries that use another country’s currency. For example both Ecuador and El Salvador use the US Dollar and Panama uses the US Dollar alongside the Panamanian Balboa. The Panamanian Balboa is pegged to the US Dollar.
When did fiat currencies become common?
There is evidence of fiat currencies being used in ancient China (Tang Dynasty, 618–907 AD) and in medieval times, both English and Scottish kings used tally sticks for financial record-keeping and as credit instruments. Tally sticks are a form of fiat currency as they were given value and managed by a central authority, in this case, the king.
However, the development of modern fiat currency was a response to the limitations of a commodity-based money supply at the start of the 20th century. Prior to the introduction of fiat money, governments could only create an amount of money that matched the gold they held, which was called the gold standard.
The road toward abandoning the gold standard started during the Great Depression and World War Two as it was viewed as an impediment to economic growth and stability. Fiat money provided greater flexibility to manage economic shocks, control inflation, and implement government policies.
From 1944 through to the early 1970s, countries operated under the Bretton Woods Agreement. The Bretton Woods Agreement pegged currencies to the US dollar, which in turn was convertible to gold at a fixed rate. The idea was to provide stability and prevent currency devaluations, which were common during the interwar period.
Richard Nixon ended the convertibility of the dollar in 1971 to deal with issues related to the US economy, and by 1973 the fixed exchange rate system was abandoned. From that point on, currencies were allowed to float freely against each other.
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Fiat currencies and MMT
MMT emphasises the power of currency-issuing governments over currency-using governments. The assumption is that currency-issuing governments, with monetary sovereignty, have full control over their own currency, giving them infinitely greater policy options. MMT arguments are dependent on the existence of a fiat currency system, as any money system that is dependent on the value of something else—whether gold, silver, or another currency—will be similarly constrained as with the previous gold standard.
As a result of fiat currencies MMT is able to point out that Monetary sovereign governments are not financially constrained. They can pay all debts in their own currency and fund all spending plans and programs. A monetary sovereign government can pursue its policies, whether those policies are related to full employment, the development of a wellbeing economy, renewable energy projects to combat global warming, or tackling child poverty. This doesn't mean there are no limits. The limits are primarily tied to the finite resources of the economy (people, factories, knowledge, raw materials, and so on) and inflation, not solvency.
MMT demonstrates that the constraints on development are a country’s finite resources, not its finances. This means they can pursue policies to achieve full employment, economic stability, and other societal goals without being overly concerned about traditional budget deficits as long as inflation is kept in check.
A fiat currency is key to MMT's policy recommendations
So, the development of the fiat currency system is a foundational concept for MMT. It forms the basis for MMT's understanding of government spending, taxation, and economic policy. MMT argues that governments with their own fiat currencies have more flexibility in managing their economies than is often assumed by traditional economic thinking. This understanding of currency sovereignty is a key driver of MMT's policy recommendations.
Do you agree? Do you disagree? I welcome your comments either way. Please comment below.
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