Under a metallic standard, as discussed in Chapter 2, the monetary unit is conventionally or legally defined as a specified mass of a particular metal or alloy. For example, the Gold Standard Act of 1900 confirmed the previously established definition of the US dollar as “consisting of twenty-five and eight-tenths grains of gold nine-tenths fine,” in other words 23.22 grains of pure gold, and declared that “all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard.” (56th Congress, Session 1, Chapter 41, 1900). The dollar of defined gold content was the unit of account, and gold coins were the medium of redemption that dollar-denominated banknotes and bank accounts promised to pay. Dollar-denominated and standard-conforming gold coins were sometimes privately issued (while private issue was legal before 1864), and paper currency was predominantly privately issued.

In a fiat standard, by contrast, the monetary unit established by fiat (government decree) is merely one unit of itself. It is not defined in terms of, or redeemable for, any commodity that has non-monetary uses.Footnote ¹ Governments issue units of basic fiat money in the form of coins and central bank currency notes (e.g., Federal Reserve Notes or Bank of England notes) and as digital ledger entries on the balance sheets of central banks. A privately issued irredeemable medium of exchange like Bitcoin will not here be called “fiat money” because it is not established by government decree nor issued by government.

Coins under a fiat standard are tokens made of non-precious metal, valued for their interchangeability with paper notes or deposit dollars.Footnote ² Fiat currency notes carry the same name and may visually resemble formerly gold-redeemable notes, even bearing the same portraits, especially when a government has created a fiat currency by making its formerly gold-redeemable notes suddenly irredeemable. Checking account balances that the public holds at commercial banks are claims to fiat money, not themselves basic fiat money. Fiat money has thus been aptly described as “money consisting of mere tokens which can neither be employed for any industrial purpose nor convey a claim against anybody” (Mises Reference Mises and Greaves2007, vol. 2).

Some economists have confusingly departed from this terminology, even while recognizing it as the standard terminology. Milton Friedman (Reference Friedman1951, p. 210, n. 7) wrote: “I shall use the term ‘fiat’ to refer both to inconvertible government-issued currency (to which alone the dictionary restricts the term) and to other types of currency that have one essential feature in common with the former, namely, that they are evidences of debt rather than of the existence of specified physical amounts of the currency commodity.” Inconvertible currency is not evidence of debt, however. As the former central banker John Exter (Reference Exter1972) liked to say, since the Bretton Woods regime ended the fiat dollar is not an IOU but rather an IOU-nothing. Neither is it “fiduciary” (trust-based), another term that Friedman (Reference Friedman1960, p. 68) used for it, nor “debt-based.” Quite unlike the commercial bank as issuer of banknotes or checking account balances, the government as issuer of fiat money has no contractual obligation to repay the money-holder. Lumping government-issued irredeemable fiat money together with bank-issued redeemable debt leads to confusion rather than clarification. While the quantity of bank-issued money is limited by market forces, the quantity of fiat money is not.

A model of the supply and demand for money under a fiat standard necessarily differs from our model of a gold standard. Fiat money does not have a market-governed supply, or a standard upward-sloping supply curve indicating increasing marginal cost of production, since the supply is exclusive to government (apart from counterfeiting) and the marginal cost of production for nominal units is negligible. On the demand side, because fiat money units are neither composed of nor redeemable claims to any useful commodity, there is not any non-monetary demand. Monetary theorists accordingly say that a fiat money is “intrinsically useless” for non-monetary purposes.

4.1 How Fiat Standards Arose

Because it does not consist of a commodity or a claim to a commodity, fiat money could not have emerged in the same way that a commonly accepted commodity money emerged from indirect exchange. That is, pieces of fiat money could not have first proven suitable to a few traders for paying others who wanted to consume or wear them (as was the case with salt or silver or shells), their use as media of exchange then spreading as others observed the success of the first group and imitated them. Instead, fiat money was historically established by government intervention into the monetary system.

The typical historical path to the establishment of a fiat money came in three steps, beginning and ending with government policies.

1. 1. The central government gave a legal monopoly of note-issue to a single institution, which consequently became a central bank (Smith Reference Smith1936). In the UK, the Bank of England was chartered in 1694. Legislated restrictions on other banks (via the Acts of 1708, 1833, and 1844) gave the Bank of England a monopoly on note-issue in greater London, then in the entirety of England and Wales. The Federal Reserve, created by 1913 legislation, gained a note-issuing monopoly in the 1930s via additional legal restrictions that ended note-issuing by commercial banks.

2. 2. The liabilities of the central bank became so widely accepted that they displaced specie as the reserves for other banks. In the case of the Bank of England this development was unplanned, but was reinforced by law. In the later case of the Federal Reserve, it was part of the legislated plan.

3. 3. Government suspended the redemption of central bank liabilities permanently.Footnote ³ Central bank notes and deposits thereby became fiat money. Although the unit of account has been divorced from its specie definition, it continues to use its traditional married name (“Dollar”). Introductions of new fiat monies in recent decades have followed a similar pattern. Initially they are redeemable for a pre-existing money. Once they achieve wide circulation, redeemability can be ended, and they continue to circulate (Selgin 1994). In newly independent Lithuania, for example, the new central bank first introduced the Talonas in the form of notes and deposit balances redeemable for rubles, then ended redemption and floated it against the ruble.

In no known historical case has an irredeemable money standard resulted from a free-market-driven evolution of bank reserves from a positive fraction of liabilities down to zero, contrary to a scenario envisioned by the economist Kevin Dowd (Reference Dowd1996). The reasons are economic and legal. Economically, money-users understandably prefer bank-issued money with a fixed value in units of the standard money, where redeemability provides the fix, over bank-issued money with a floating nominal value. Imagine what would happen if a bank in a competitive system were to announce that it will be removing the option to redeem its notes and deposits after a specified future date, leaving its liabilities to float against standard money. Its note- and account-holders would want to cash out and move their funds to other non-floating banks before that date arrived. When money-users prefer par acceptance, and we have seen historically that most do, a switch to fiat money must be involuntary. Legally, only a bank that the government protects from ordinary contract enforcement has the immunity to unilaterally end its contractual obligation to “pay the bearer on demand” in basic money.Footnote ⁴

Economic theorists Joseph Ostroy and Ross Starr (1990) have proposed: “Since the opportunity cost of holding real goods in inventory will generally be non-negligible, there is an efficiency gain through the use of fiduciary (bank) or fiat money in place of commodity money.” In standard Paretian welfare economics, an “efficiency gain” means the capturing of additional mutual gains from voluntary trade (or, to be technical, gains on at least one side and no losses on the other). Bank-issued money issued competitively, without legal privileges, presumably provides an efficiency gain: If the bank or its customer considered bank-issued money inferior to available alternatives, they would choose not to issue or use it. But given that fiat money – money by decree – is involuntarily imposed, we cannot presume a Paretian efficiency gain. At least some customers historically objected when redeemable fiduciary money issued by the central bank became fiat money by the central bank unilaterally breaking the redemption contract on its notes.

Here is an example. In 1797, when the privileged Bank of England temporarily suspended gold redemption (not to be restored until 1819), it did so with the legislated permission of Parliament. When Bank of England notes depreciated against gold, it became clear that compulsion would be required to make creditors and landlords accept paper pounds at par for debt or rent payments contracted in pounds before the suspension. Lord King, a critic of the Bank of England’s expansionary behavior that drove the depreciation during the suspension period, notified his tenants in 1811 that they must now pay in gold coin or “by the payment in Bank notes of a sum sufficient to purchase the weight of standard gold requisite to discharge the rent” (quoted by Fetter Reference Fetter1950, p. 244). Parliament responded with legislation that effectively declared Bank of England notes a legal tender for old debts and rents, no matter the contractual terms.

The case of Bitcoin, a private irredeemable asset, will concern us in Chapter 5. Bitcoin has been irredeemable from the start, and its use is entirely voluntary (at least outside of the country of El Salvador, whose government has mandated its acceptance by retailers, although it does not seem to be actively enforcing the mandate).

Economics textbooks, much like Ostroy and Starr, have sometimes rationalized the switch from a gold standard to a fiat standard, or treated it as if voluntary on the public’s part, on the grounds that fiat money saves the public the real resources consumed by mining or storing gold for monetary use. We noted in Chapter 2 that economists have often severely exaggerated the resource cost of a gold standard. But even if many economists believed that a well-run fiat standard would have lower resource costs than a gold standard, a concern for social efficiency is inconsistent with governments’ behavior during and after the switch. Governments concerned with monetary efficiency would have wanted to avoid the inefficiencies caused by inflation, and so would not have gone on to produce the higher monetary expansion rates and correspondingly higher price inflation rates we have seen under fiat standards by contrast to commodity standards.

Further, a concern for reducing the resource cost of the monetary system does not explain the timing of the switch. Governments that left the gold standard during the First World War had something else in mind: Suspending gold redemption would allow them to print additional money, which would provide revenue to pay for soldiers and war materiel. The US federal government’s restrictions against private gold ownership beginning in 1933, and its final closing of the gold window in 1971, were motivated not by the desire to improve the efficiency of the monetary system but by macroeconomic and political concerns, the desire to loosen and finally escape the constraints that gold redeemability put on expansionary monetary policy. Economists Michael C. Keeley and Frederick T. Furlong (1986, p. 59) of the Federal Reserve Bank of San Francisco have rightly noted that governments have reasons to favor fiat money over a gold standard even if the switch brings no resource cost saving: “a fiat system does differ importantly from a commodity based system in that it makes the social control of money, prices and credit possible, and it provides a source of tax revenue.”

Compared to textbook accounts, the motive that actually produced the switch to fiat money has been better explained by humorist Dave Barry (Reference Barry2006, p. 10) in Dave Barry’s Money Secrets: “Over the years, all the governments in the world, having discovered that gold is, like, rare, decided that it would be more convenient to back their money with something that is easier to come by, namely: nothing.”

Accounts that identify governments’ political and fiscal motives for switching to fiat money have sometimes been ridiculed for supposedly depicting fiat money as a kind of “establishment conspiracy.” But President Richard Nixon and his advisors (indisputably “the establishment”) had then-secret discussions (a “conspiracy” if you like) between May and August 1971 about their options for dealing with dwindling US gold reserves, and the consequences for Nixon’s re-election of choosing to tighten monetary policy to stop the gold outflow, leading to his decision to end US dollar redemption for gold and thereby to establish a fiat currency. We know this because the discussions were taped, and transcripts are available (Abrams and Butkiewicz Reference Abrams and Butkiewicz2012). No country we know of switched to a fiat standard following an open public discussion of its benefits and costs.

4.2 Why Is a Fiat Money Valued?

Why do units of fiat money have a positive market value despite being intrinsically useless outside of a monetary role? At one level, the answer is simply supply and demand. Items (deposit balances and paper notes denominated in “dollars”) that are intrinsically useless for non-monetary purposes can be suitable for use as a medium of exchange (uniform, cheap to store, easy to transfer, and so on). If we assume that these items are held and used as money, we can plot the intersection of a money demand curve with the money-item’s supply curve to determine the purchasing power that clears the market for money balances. We can conduct thought experiments in which we shift one curve or the other, and find the new equilibrium intersection, to analyze the impact of events on its purchasing power. Supply–demand analysis of this sort is illustrated in the following text.

At a deeper level, however, it begs the question to begin the analysis with the assumption that an intrinsically useless good serves as money. It assumes what needs to be explained. It does not answer the question of how the convention arose of treating a particular intrinsically useless item as money.Footnote ⁵ Approaches to answering that question usually pursue one of the two lines of argument. The first line invokes sovereign powers: People value fiat dollars because the US government compels creditors to accept it in payment of debts (the government gives it legal tender status or debt-discharging power) or compels people to use it to pay taxes (gives it exclusive public receivability or tax-discharging power). The second and perhaps less obvious line is a path-dependency argument: The historical developments described earlier habituate people to accept redeemable paper money, with the result that, when redemption ends, they continue accepting it so long as it works, and it works (given moderate supply growth) so long as others follow the same strategy.

Some unusual evidence that sovereign powers are not strictly necessary for the continued circulation of fiat money at positive values comes from the case of the Somali shilling, a fiat money issued by the government of the nation of Somalia in northeast Africa. The Somali government collapsed during a civil war in 1991 and effectively disappeared. De facto control fell to “a variety of overlapping and fluid local authorities that included private militias, clan elders, and fundamentalist mosques” (Marshall and Jaggers 2008, p. 2). Somalia’s central bank was “destroyed and looted” (Mubarak Reference Mubarak1997, p. 2031). The central state no longer existed to enforce legal tender status or to collect tax payments. And yet the shilling continued to circulate. Given the shilling’s history of common acceptance, continuing to accept shillings was a self-fulfilling strategy: Everyone found it useful to continue accepting them as long as others did so and were expected to continue to do so. It was in no individual Somali’s interest to refuse shillings and insist on paying or being paid in some other money that his or her trading partners were not using (Luther and White Reference Luther and White2016). Sheer momentum thus appears to be enough to keep a fiat currency circulating once it has been successfully launched. Sovereign power might be necessary to launch a fiat money, but it is not necessary to keep it circulating at a positive value.

Self-reinforcing expectations of acceptance can be fragile, however. A negative shared expectation is also self-reinforcing. If the common expectation arises that most others will not accept an item as money, then its acceptance will indeed stop. Accordingly, there are two potential equilibria: The item that would be currency can have a positive value (acceptance) or a zero value (non-acceptance). Such fragility is presumably what commentators have in mind when they speak of money as a “shared illusion” or an “arbitrary social construct.” Popular author Yuval Noah Harari (Reference Harari2015, pp. 195–6) has written that “Money isn’t a material reality – it is a psychological construct.” People treat something as money “when they trust the figments of their collective imagination.” Such a view was parodied by The Onion (2016) with the headline “U.S. Economy Grinds to Halt as Nation Realizes Money Just a Symbolic, Mutually Shared Illusion.” That the gold coin or the fiat US dollar bill or any other specific material or non-material item has become the focus of a common expectation or “psychological construct” regarding its use as money, however, is the product of lived experience. It is not merely a figment of collective imagination. Its real properties and its history matter.

There is a germ of truth to the “shared illusion” view when applied to a fiat money or a cryptocurrency: The value of an “intrinsically useless” item would go to zero without a shared expectation of its future use as a medium of exchange. When the public abandons a fiat money in which prices are denominated, like the Confederate States dollar after 1864 or the Ecuadorian sucre in early 2000, the result is a high or hyper-inflation in which the price level rises even faster (the purchasing power and foreign exchange value of the money unit falls even faster) than its quantity grows. With rapid central-bank monetary expansion feeding rising inflation expectations, Ecuador’s sucre lost a quarter of its exchange value in US dollars during the first week of 2000 (Beckerman Reference Beckerman2001, p. 1). The purchasing power of the irredeemable Confederate dollar likewise collapsed as the Confederacy lost the US Civil War (Cutsinger and Ingber Reference Cutsinger and Ingber2019).

Similar effects can be seen when optimism about the future of a cryptocurrency evaporates. From a peak market cap of $175 million in December 2014, PayCoin (XPY) fell to under $1 million six months later as rosy expectations of its future faded. In February 2022, its market cap was under $100,000. Emercoin (EMC) dropped to $2 million from a peak above $300 million in 2018, and in February 2022 was worth about $2.5 million. The IOTA cryptocurrency was valued above $10 billion for five weeks in December 2017–January 2018, at which time it was the seventh-highest cryptocurrency in market cap, but by December 2018 it was valued below $700 million and ranked 28th. Its market cap recovered somewhat to reach $2.5 billion in February 2022. Many examples of other coins that have lost 99 percent of their peak value might be cited.Footnote ⁶

The shared-illusion view is less applicable to a commodity money. A commodity like gold, valued for its usefulness in jewelry and electronics, with additional units costly to produce, retains a positive value even when demonetized. Only part of the demand for it rests on its use or potential use as money. The World Gold Council estimates that about 40 percent of the above-ground gold stock is in the quasi-monetary forms of coins and bullion held by private investors or central banks. The rest is in jewelry and other forms like inventories for industrial use.

In a classic article, the economist John Hicks (Reference Hicks1935) asked why fiat currency notes are demanded despite their financial return (zero) being lower than that of risk-free bonds issued by the same governments. He offered a general answer: Money is more readily or conveniently transactable than bonds. Money overcomes “frictions” that impede paying with bonds or other financial assets. Researchers in monetary theory in recent decades have built a variety of interesting models based on specific assumptions about the relevant frictions (for a survey of the literature, see Lagos, Rocheteau, and Wright Reference Lagos, Rocheteau and Wright2016). A counterfactual implication of some models (e.g., Kiyotaki and Wright Reference Kiyotaki and Wright1991), however, is that an intrinsically useless money can prevail in equilibrium without reference to the economy first adopting a commodity money and then commodity-redeemable money. This cautions us against regarding such models as explanations of the historical path to fiat money.

4.3 Supply and Demand for Fiat Money

A central bank (like the Federal Reserve System, the ECB, or the Bank of England) controls the supply of a fiat money (dollars, euros, pounds sterling). Detailed accounts of the operating procedures of central banks can be found in many textbooks and central bank publications. In a nutshell, the central bank controls the quantity of basic fiat money (also known as the “monetary base,” on which bank deposits are “built”) by expanding or contracting its own balance sheet. The US monetary base is the sum of currency in circulation plus commercial bank reserve deposits at the Fed. Suppose that the Federal Reserve buys $5 million in bonds from the securities dealer Honest Joan by wiring $5 million into her account at Megabank. When the payment settles, Megabank has an additional $5 million in its reserve deposit at the Fed, matching the addition to Joan’s deposit balance at Megabank. The monetary base has grown by $5 million because no other bank has lost reserves. The Fed simply created $5 million in new claims against itself. Under a fiat standard, by contrast to a gold standard, the central bank can create as many claims against itself as it chooses, being unconstrained by any obligation to redeem its liabilities for an asset it cannot create. There is no built-in limit to amount of fiat money.

The stock of money held by the public, as measured by the M2 aggregate (roughly, the non-bank public’s holdings of currency plus all bank deposits plus checkable mutual fund balances), is a multiple of the monetary base. For example, in March 2022, M2 was $21.8 trillion while the monetary base was $6.1 trillion. When the Fed increases the monetary base by 1%, other things equal (the ratio of M2 to the base remaining the same), it causes M2 to expand by 1%. The mechanism for the expansion of M2 is that the commercial banks typically choose to hold less than 100% reserves against additional M2 deposits, enabling the banking system to make additional loans and securities purchases when it receives additional reserves, actions that expand the public’s holdings of deposits. So long as the Fed can predict the ratio of M2 to the monetary base (a ratio known as the “M2 money multiplier”), the Fed can control the size of M2 by controlling the size of the monetary base.

Since 2008, the Fed does more than try to predict the money multiplier: It strongly influences it by choosing the interest rate it pays on bank reserve deposits held on its books. Commercial banks’ desired holdings of reserves relative to other assets depend on the rate of interest on reserves (IOR) the Fed pays them relative to the rates that they can earn by lending or by holding bonds. A higher IOR rate, relative to these opportunity-cost rates, makes it more attractive at the margin for a bank to hold reserves rather than make loans, which shrinks the money multiplier and consequently M2 for a given monetary base. The Federal Reserve thus has two main tools for controlling the growth of the quantity of money held by the public: (1) The Fed can arbitrarily expand or contract the monetary base through bond purchases and sales, hence (for given money multiplier) can make M2 whatever size it wants; (2) the Fed can influence the money multiplier by setting the interest rate on reserves above or below other rates, hence (for a given monetary base) can vary the size of M2.

The central bank controls the supply side of the market for nominal money balances held by the public. Although the commercial banks can take actions that (unintentionally) change the money multiplier, the central bank can offset any such change.

As we did in the case of a gold standard, we can represent the determination of the quantity and purchasing power of a fiat money using supply and demand curves. As before, the horizontal axis of Figure 4.1 measures the nominal quantity of money, while the vertical axis measures the purchasing power of money (hereafter ppm, meaning bundles of goods per money unit, the inverse of the price level). The supply curve for fiat money is vertical, indicating that (by contrast to gold) no greater quantity of money automatically comes forth at a higher purchasing power per unit of money. Rather, the central bank chooses the quantity. Expansionary monetary policy shifts the vertical supply curve to the right. The vertical supply curve stands in contrast to the upward-sloping stock supply curves for monetary gold that we saw in Chapter 2.

Figure 4.1 Doubling the nominal fiat money supply halves the equilibrium purchasing power of money.

What about the demand curve? As in Chapter 2, we draw the money demand curve as a rectangular hyperbola. In a fiat system too, it makes sense for the level of nominal money balances that each individual wants to hold, and thus that the public as a whole wants to hold, to vary inversely and proportionally with the ppm. If prices are 10 percent higher, a money-holder will want to hold 10 percent more dollars to have the same amount of purchasing power. Alternatively put, if each dollar buys 10 percent less in goods and services, a money-holder will want to hold 10 percent more dollars. On the nominal money demand curve drawn, desired real money balances (M^D × ppm) are the same at every point on the curve.

From the property that desired real money balances are independent of the price level follows the proposition that when the central bank increases the nominal stock of money by Z percent, equilibrium between money supply and demand will not be restored until the general level of prices has risen by Z percent (or equivalently, the purchasing power of money has fallen to 100/(100+Z)). We illustrate this in Figure 4.1, which shows that a doubling of the nominal money stock results in a halving of the equilibrium ppm (or equivalently a doubling of the price level).

The implication of this analysis is that the central bank, because it is able to control the level of the money supply, is responsible for the price level. Because it can control the rate of growth of money supply, such a central bank can control the rate of growth of the price level, also known as the rate of inflation. Under a fiat standard, the central bank is responsible for the inflation rate. If the inflation rate is too high this year, it is because the central bank has been expanding the money supply too rapidly (given this year’s behavior of velocity and real income). As Scott Sumner (Reference Sumner2021, p. 43) puts it:

Before the Fed began in 2008 to pay interest on commercial banks’ deposits held at the Fed, there was a clear distinction between the monetary base and the interest-bearing debt of the federal government.Footnote ⁷ With banks not incentivized to hold excess reserves, higher base growth translated into higher growth in M2. Faster M2 growth in turn meant more units of money chasing each unit of goods and services, causing faster price level growth. Domestic money-holders bore the burden of a higher inflation tax.

Since gaining authority to pay IOR in 2008, by contrast, the Fed has raised the interest rate it pays on excess reserves as necessary to persuade commercial banks to hold them rather than to create additional deposits by “lending out” the excess reserves, and thus was able to keep M2 growth from rising along with the higher base money growth during 2008–2015 (White Reference White2016). The dramatic base growth 2008–2015 consequently did not raise the inflation rate. Instead, insofar as the Fed acquired Treasury rather than private securities, and paid banks the full Treasury yield rate on their depository reserves, growth in the monetary base has been merely a fiscally pointless swap of one interest-bearing government liability in the hand of the public (interest-bearing commercial bank deposits on the Fed’s books) for another (interest-bearing Treasuries held outside the Fed).

Interest on the reserves that the Fed issues to buy Treasuries means that Fed purchases of Treasuries no longer in effect retire them. That is, Fed acquisition of Treasuries no longer reduces the consolidated Fed-Treasury burden of debt service to the public. The Treasuries held by the Fed are now properly counted as federal debt held by the public. Rising Fed holdings of Treasury debt, financed by interest-bearing reserves, are part of the rising ratio of federal debt to GDP.

In 2020–2021, the Fed chose not to raise IOR as it dramatically expanded the monetary base, and thus let M2 grow dramatically, to offset a temporary sharp rise in the demand to hold money accompanying the uncertainties of the COVID-19 pandemic. Failing to moderate the expansion of M2 promptly enough as money demand returned to normal, the Fed fueled a rise in the CPI inflation rate to 9 percent, June 2022 over one year earlier, the highest inflation rate in forty years.

4.4 The Quantity-of-Money Theory of the Price Level

The “quantity theory of money” (QTM) proposition that the price level is proportional to the quantity of money, other things equal, applies to a fiat standard. (A clearer label would be “the quantity-of-money theory of the price level.”) Expositions of the QTM explain how the price level P is linked to the quantity of money M by using an accounting identity known as “the equation of exchange”: MV = Py. (It is an identity because we define V such that V = Py/M.) The equation says that the economy’s nominal income, decomposed one way into the product of M time V, equals the economy’s nominal income decomposed another way into the product of P times y.

In the equation of exchange, M can represent a narrow monetary aggregate (M0) or a broader measure of money held by the public (M1 or M2). V is the “income velocity of money,” meaning how many times per year the average dollar of M is spent in transactions that generate final income or GDP, so that MV equals nominal GDP. (“Final” indicates sales of newly produced goods and services to final users, excluding such intermediate transactions as an oil extractor selling crude oil to a refinery.) M is measured in dollars, and V in times per year, so the product MV is in dollars per year. The price level P is an index of dollars per basket of newly produced final goods, such as the consumer price index or the GDP deflator, while y measures real final income or real GDP, measured in index baskets per year. The product Py is thus also in dollars per year.

From MV = Py it follows mathematically that holding V and y constant, P must be proportional to M. This truism alone cannot establish, however, that in a particular real-world monetary system M varies exogenously, real-world V and y are unchanging parameters, and only real-world P changes as a result. The QTM, therefore, has to go beyond the accounting identity of the Equation of Exchange. It requires three key conditions to justify running the thought experiment in which a fiat-issuing central bank varies M, any resulting changes in V or y are only transitory, and only P changes in the long run. Namely, it assumes that (1) a monetary authority can exogenously vary the nominal quantity of money M held by the system; (2) the public’s desired ratio of money balances to income (desired M/Py, or, stood on its head, “desired V”) is determined by real factors, independent of the nominal quantity of money (except for transitory effects following changes in M), and in the long run, the actual ratio converges to the desired ratio; and (3) real income y is determined by real factors (such as labor and capital supplies, technology, institutions) that are independent of the nominal quantity of money M in the long run (any supply effects following changes in M are transitory).

All three conditions are reasonable for a fiat money regime, and the last two are reasonable for any monetary regime. The first condition, however, excludes the changes in M that come about endogenously under a commodity money standard, namely regional gold inflows driven by the price-specie-flow mechanism and new gold production induced by a growing global demand for money. Thus the quantity theory is not generally applicable to the operation of a commodity money regime. The first condition does apply, however, when a sovereign exogenously debases (reduces the metallic content of) the local monetary unit. Raising the dollar value of a given mass of coined silver will raise the dollar prices of goods proportionally.Footnote ⁸

The equation of exchange provides a framework for understanding the inflation rate in a fiat money economy, meaning the growth rate of the price level.Footnote ⁹ Converting the equation of exchange expressed in levels to a “dynamic” equation of exchange expressed in growth rates, we get gM + gV ≈ gP + gy, where gM is the growth rate of the money stock and so on.Footnote ¹⁰ Holding velocity growth gV and real income growth gy constant, the new equation says that the inflation rate must rise by one percentage point with each percentage point increase in the growth rate of the money stock. A central bank accordingly can control the inflation rate by varying the fiat money growth rate. Overly expansionary central banks are to blame for cases of persistently high inflation.

We can use the dynamic equation of exchange to dig beneath the surface of Milton Friedman’s (Reference Friedman1970, p. 24) famous statement that “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The statement says that gP > 0 can only occur when gM > gy. The equation gM + gV ≈ gP + gy does not exactly tell us that. It rather says that gP > 0 reflects the combined influences of positive money growth gM plus positive velocity growth gV, together in excess of positive real income growth gy. Friedman’s statement mentions the growth rates of the price level, money stock, and real output, but makes no mention of the growth rate of velocity. It remains a logical possibility that a particular period’s positive inflation rate could be produced without “a more rapid increase in the quantity of money than in output” provided there is high enough velocity growth gV. Hence Friedman’s “can be produced only” is not strictly correct.

Here it should be noted that Friedman used “inflation” to mean a sustained period of positive price level growth, not just one year’s upward blip. The predominance of money growth in accounting for inflation is then an empirical matter: It rests on money growth being larger and more persistent in practice than velocity growth or shrinkage in real income. In US postwar history, recession periods with negative real income growth have been short and relatively few (there have been only ten such years since 1948, and two consecutive years of negative real GDP growth only in 1974–1975). The trend in velocity has been downward in every decade except for the 1950s and 1990s. In only one postwar case has velocity growth been positive for four or more consecutive years and high enough to create positive inflation despite money growth being less rapid than output growth, namely 1992–1995.Footnote ¹¹

These sorts of exceptions noted, Friedman’s statement is by and large an accurate summary of the historical record of fiat monies. A central bank that issues a fiat money can make the nominal money stock grow persistently at an arbitrarily high rate, while velocity growth and real income growth are determined by technological change and other real forces. They may be cyclically disturbed by monetary policy, but overall, their changes make relatively modest contributions to explaining changes in the inflation rate.Footnote ¹² Countries with persistently high inflation are almost always countries with persistently high fiat money growth (rather than persistently high-velocity growth or real output shrinkage, because those are rare). In any single country, high inflation decades are almost always decades with high money growth.

4.5 How Fiat Standards Have Performed on Inflation

15 August 2021 marked the fiftieth anniversary of President Richard Nixon closing the “gold window,” formally ending the US commitment to redeem dollars held by foreign central banks for gold at $35 per ounce. Nixon’s action ushered in a floating fiat money regime. The closing of the gold window followed a period of rising inflation rates after 1965. During successive five-year periods beginning August 1961, the US Urban Consumer Price Index rose at average annual rates of 1.62 percent, 4.35 percent, 7.1 percent, and 10.0 percent. The Federal Reserve had loosened monetary policy to reduce unemployment rather than maintaining moderate money growth to keep inflation close to zero and thereby consistent with continuing redemption of dollars at $35 per ounce. The Fed could not both produce a rapidly rising price level, reducing the purchasing power of the dollar relative to that of gold, and sustain a constant redemption rate of the dollar for gold. Redemptions by foreign central banks, over-supplied with US dollars of diminishing purchasing power, progressively drained gold from the US Treasury. The loss of gold reserves forced Nixon to choose between tightening monetary policy and shutting the gold window. He chose the latter.

The formal end of redemption at $35 per ounce in August 1971 – the adoption of a fully fiat monetary standard – enabled still greater monetary expansion, driving inflation rates still higher. Year-over-year inflation rate peaks were reached at 12.2 percent (November 1974) and 14.6 percent (March 1980). In subsequent decades the Fed moderated money growth, and the inflation rate fell. Over the fifty years after August 1971, the Consumer Price Index for All Urban Consumers (CPI-U) rose a cumulative 569 percent, for an average annual inflation rate of 3.9 percent.Footnote ¹³ The average annual US CPI inflation rate during the period of the classical gold standard (1879–1913), by contrast, was 0.13 percent.Footnote ¹⁴

Fiat money regimes have resulted in even higher inflation rates in most other countries. For the UK, average inflation since 1971 has been 5.2 percent per year, with peak year-over-year rates of 26.9 percent (August 1975) and 21.9 percent (May 1980). For Mexico, inflation has averaged 19.9 percent per year, with year-over-year peaks of 117 percent (April 1983), 180 percent (February 1988), and 52 percent (December 1995).Footnote ¹⁵

In mid-2021, according to the IMF, the three countries with the highest annual inflation rates were Venezuela at 5,500 percent, Sudan at 197 percent, and Zimbabwe at 99.3 percent. Six more countries had inflation rates above 20 percent per year, and another ten had inflation rates above 10 percent. Of 169 countries with reported inflation rates, only 9 had inflation rates below the classical gold standard benchmark of 0.13 percent.Footnote ¹⁶

A cross-country study by Arthur J. Rolnick and Warren E. Weber (Reference Rolnick and Weber1997) provides systematic historical evidence. The authors computed inflation rates for fifteen countries, contrasting the rates experienced while those countries were under commodity standards (silver, gold, or bimetallic) with the rates experienced while they were under fiat standards. During the commodity-standard periods in their sample, the average annual inflation rate was 1.75 percent, while during fiat-standard episodes the average was 9.17 percent (excluding the one hyperinflation in the sample). Every country in the sample had higher inflation under fiat money than it had under commodity money.

4.6 Inflation Is Burdensome Even When the Inflation Rate Is Correctly Anticipated

A monetary regime that produces a higher average inflation rate, as fiat standards historically have relative to commodity standards, imposes at least four burdens on money-holders. First, it erodes the purchasing power of money balances and thereby transfers wealth from money’s holders to its issuers. Second, in response to the tax, households and firms adopt costly strategies for keeping real currency balances at a lower level. Third, higher inflation enlarges economic deadweight losses where higher effective tax rates result from the tax system not being fully indexed to the price level. (In the United States, capital gains taxes are not indexed, although income tax brackets are.) Fourth, a higher average inflation rate is associated with a more variable inflation rate, increasing noise in the price system and thereby reducing the efficiency with which the price system allocates resources. The following paragraphs say a little more about each of these effects.

1. 1. The transfer from public to government. As noted above, ongoing price inflation is normally due to ongoing expansion in the quantity of money. Under a fiat standard, government can produce new money units at practically zero cost. Introducing new units dilutes the value of existing units. The process transfers wealth from money-holders to the government. Government undertakes more spending with newly introduced money, or retires debt, at the expense of money-holders who see the purchasing power of their existing balances diminished. (The technical name for the government’s profit from money creation is “seigniorage.”) The government buys up a larger share of the economy’s output, leaving less for households and firms in the private sector.Footnote ¹⁷

2. 2. The deadweight burden on money-holders. By increasing a distorting tax on money-holding, a higher inflation rate makes it worthwhile for the public to expend the time and effort necessary to accomplish any given amount of spending with smaller average money balances. Households lose benefits (“consumer surplus”) and business firms lose net income by operating with smaller real money balances. At a higher inflation rate, a household or firm is more heavily penalized for holding those types of money (currency and some deposits) that do not pay interest (or more generally, do not pay an after-tax interest rate that rises one-for-one with the inflation rate).

3. 3. Unindexed taxes. In the presence of taxes that are not fully indexed to remove the effects of inflation, higher inflation can significantly increase effective tax rates and amplify the distortive effects of those taxes. In the present-day US tax system, nominal capital gains are taxed. This means that if an asset’s dollar price rises only just enough to keep up with inflation, so that there is no gain in real terms, taxes are nonetheless due on the purely nominal gain. The asset owner receives a negative after-tax return in real terms. The higher the inflation rate, the greater the real tax burden, and the greater the discouragement to investment and capital formation. A lower inflation rate in such a tax system conversely lowers the cost of capital and thereby encourages capital formation, leading to higher real output per capita. The United States and many other countries also tax merely nominal interest income, which means that a higher inflation rate lowers the after-tax real return to owning bonds and interest-bearing savings accounts, and makes the after-tax real return negative when the nominal return just matches inflation.

Because savers and investors care about after-tax real returns, if two countries have the same tax rates on nominal capital gains, or the same tax rates on nominal interest income, the country with the higher inflation rate will have lower after-tax returns. It will become poorer as savers and investors respond by moving their financial and real capital to the country with lower inflation and correspondingly higher after-tax returns. An empirical study by Tamim Bayoumi and Joseph Gagnon (Reference Bayoumi and Gagnon1996) found that this effect – capital flight prompted by higher inflation – is large. Countries with chronically higher inflation rates have noticeably less capital per head – fewer machines per worker – and therefore lower real incomes.

1. 4. Ragged price adjustments. Lower inflation rates are associated with less “raggedness” in price adjustments (some prices rising early in the process and others catching up later) and thereby less “noise” in relative prices. By increasing the reliability of observed relative prices, a low inflation environment permits more accurate savings and investment decisions (Leijonhufvud Reference Leijonhufvud1981, pp. 227–269; Heymann and Leijonhufvud Reference Heymann and Leijonhufvud1995, pp. 84–108; Horwitz Reference Horwitz2003, pp. 71–95).

4.7 Unanticipated Inflation Is Even Worse than Anticipated Inflation

Inflation harms the public in the four ways listed earlier even when the public correctly anticipates the inflation rate. Additional harms are added when the inflation rate is surprisingly high. A well-known harm arises from the effects of unanticipated inflation on the real burden of debt: When inflation over the course of the loan contract is higher than anticipated, reducing the value of dollars repaid below what was reckoned, it harms the creditor (and benefits the debtor). When inflation is lower than anticipated, increasing the real value of the debt, it harms the debtor (and benefits the creditor, if the debtor is still able to pay). A more variable inflation rate, imposing a greater risk that the inflation rate will be significantly higher or lower than its anticipated average, deters both borrowers and lenders.

Risk surrounding the inflation rate means that the lenders and borrowers face an inflation risk in addition to a default risk. The greater the risk about the future value of the dollars to be repaid, when some lenders and borrowers are risk-averse, the smaller the number of willing lenders and borrowers. Financial markets shrink, harming both potential borrowers and potential lenders. Looking across countries, it is evident that countries with higher and more variable inflation have shallower financial markets (Rousseau and Wachtel Reference Rousseau, Wachtel, Negishi, Ramachandran and Mino2001; Boyd, Levine, and Smith Reference Boyd, Levine and Smith2001; Berentsen, Breu, and Shi Reference Berentsen, Breu and Shi2012).

The price level under fiat standards has not only risen at a faster average rate than under the classical gold standard, it has been less predictable at medium to long horizons. Conversely, the classical gold standard era had lower price level uncertainty. Whereas fiat standard price levels drift with no tendency to return to a predictable underlying trend, deviations of the gold standard price level were followed by a return to the flat trend established by the flat long-run supply curve for gold. Higher price level uncertainty under fiat money means that savers and financial intermediaries are less able to predict what a dollar will be worth in ten to fifty years.Footnote ¹⁸ They are accordingly less eager to buy ten- to fifty-year bonds, as shown by the fact that corporate bonds issued since 1971 have a much shorter average maturity than bonds issued during the classical gold standard era. Butler, Gao, and Uzmanoglu (Reference Butler, Gao and Uzmanoglu2021, p. 1) report: “From 1975 to 2015, the average maturity of new corporate bond issues in the U.S. declined from 20 years to 10 years.” Fifty-year bonds, commonly issued by railroads during the classical gold standard era, have practically disappeared. Under a less predictable regime, a borrowing firm must pay a larger purchasing-power-risk premium when it issues medium- to long-term bonds, so entrepreneurs find it more costly to finance medium- to long-term investment projects. It is hard to put a number on the size of the effect, but it stands to reason that by raising a barrier to long-term investments the reduced predictability of the price level over medium to long terms has harmed economic growth.

4.8 Fiscal Discipline under Fiat Money

Under a gold standard, government bonds are nearly free of inflation risk but not of default risk. Under a fiat standard, the reverse is true.

Under a gold standard, government borrowing creates an obligation to repay in gold, a medium that the borrowing government cannot simply print into existence. There is consequently always a danger of default. The amount the government can borrow at reasonable rates (with a low default risk premium) is limited to the amount that the government can credibly commit to repay by raising more tax revenue than it spends on things other than debt service. (This is also known as running primary budget surpluses. We assume that there is no prospect of the government’s bondholders being bailed out by some multinational entity.) A reduction in the credibility of the government’s repayment plan forces upward the yields it must offer when rolling over its debt and when issuing new debt. Accordingly, as the economist Joseph Schumpeter (Reference Schumpeter1954, pp 405–406) commented: “An ‘automatic’ gold currency … is extremely sensitive to government expenditure … . This is the reason why gold is so unpopular now and also why it was so popular in a bourgeois era. It imposes restrictions on governments or bureaucracies.”

The credibility constraint is much the same for a government that has to borrow in a fiat currency that it does not issue (and that likewise has no likelihood of being bailed out). Such a country might be one that issues its own fiat money, for example, Argentina, but because the devaluation risk is so great, the global bond market makes borrowing in US dollars cheaper in real terms. Or it might be a country that does not issue its own currency, for example, Greece using the euro issued by the ECB, or Panama using the US dollar.

The effectiveness of the default risk premium at limiting over-borrowing is weakened if creditors to a government think that they are likely to be bailed out by some supernational agency. Greece in recent decades provides an object lesson. Before Greece joined the Eurozone in 2001, the bond market imposed a 500 basis-point (5 percentage-point) default risk premium on Greek sovereign two-year bonds, measured by the spread over the yield on two-year German bonds. After joining, the premium fell to only about 40 basis points (4/10 of one percentage point) and stayed there until 2008 (Gibson, Hall, and Tavlas Reference Gibson, Hall and Tavlas2014). There had been no fiscal reform in Greece. Buyers of sovereign Greek bonds evidently placed a high probability on being bailed out, should the Greek government be unable to pay, by some combination of the ECB, the European Union, and the IMF. When the cost and unpopularity of a full bailout became clear to other ECB and EU member nations in 2011, however, the limited bailout actually provided was too little to prevent a Greek default. Commercial banks that held Greek sovereign debt lost €100 billion.

A government that borrows in its own currency, like the federal government of the United States, can issue sovereign debt that is free of nominal default risk. Meaning, it can always issue as many new dollars as it needs to pay what it has promised as principal and interest on its bonds. Such a government’s debt is not free of inflation risk, however. A monetary expansion that enables the government to repay the number of dollars owed, but that causes the dollar to decline in purchasing power by 10 percent, is equivalent in real terms to repaying creditors only 90 percent of the debt owed. With higher inflation comes devaluation against foreign currencies (holding their inflation rates constant), so devaluation risk accompanies inflation risk. It is thus a mistake to call US Treasury debt denominated in fiat dollars “risk-free.”

4.9 Business Cycles Have Not Been Milder under Fiat Money Regimes

It has often been claimed that a fiat standard valuably enables a central bank to conduct a counter-cyclical monetary policy that dampens business cycles (reduces the volatility of real output or the average level of unemployment). Under the influence of Keynesian macroeconomic thinking, the Bretton Woods conference did not reinstate the classical gold standard, but promised to give central banks more leeway to practice counter-cyclical policies. The Keynesian approach calls for a data-driven central bank to vary its monetary policy as needed to stimulate an economy that is operating below its sustainable full-employment output path, or to dampen an economy that is operating above it. In theory, by appropriately tailoring policy to changing conditions in a timely manner, the central bank will dampen business cycles.

Greater macroeconomic stability is not evident in the historical record of fiat standards, however. For the United States, volatility in real output and unemployment have been nearly the same in the post–Second World War period as they were during the classical gold standard period (Selgin, Lastraptes, and White Reference White2012). Postwar output volatility through 2009 (measured as percent standard deviation of real GDP from its trend using Christina Romer’s GDP estimates) is insignificantly different from pre-1913 output volatility (2.6 percent vs. 2.7 percent). This despite the postwar US economy having a more diversified mix of agriculture, industry, and services, and thus smaller real supply shocks, which by itself should have produced improvement without any change in the monetary regime.

Stated in terms of the dynamic equation of exchange, stabilization policy could actually dampen cyclical swings in the economy if it could alter gM in a timely manner to offset changes in gV just as they occur, thus stabilizing growth in aggregate demand MV, and thereby keeping real output y near its full-employment or natural rate y_n. (Note that such a monetary policy cannot keep y from changing when y_n changes, for example, when there are real productivity shocks like the shrinkage of output by the COVID-19 pandemic and policy responses to it. No monetary policy can.) Such a stabilization of aggregate demand would be desirable if it could be achieved. But achievement requires timely and well-measured application, shifting M to offset changes in V, thus avoiding changes in aggregate demand that would otherwise occur. Alternatively put, when people want to hold larger money balances relative to income, and M remains constant, they have to cut spending to build up money balances. The aggregate demand for goods falls, and a recession with unsold inventories and unhired labor ensues in a world of sticky prices and wages. If the Fed provides enough extra money (as in 2020), aggregate demand for goods does not have to fall. But the Fed, to keep stabilzing, has to withdraw the extra M when people start spending off the money balances they have built up and V rises. Failure to tighten monetary policy promptly (as in 2021) brings about a higher rate of inflation (as in 2021–2022).

Central banks in practice, whether due to political pressure from elected officials or due to bureaucratic inertia, tend to err on the side of tightening policy too late rather than too soon.Footnote ¹⁹ At the very onset of the fiat money era, the French economist Jacque Rueff (Reference Rueff1972, p. 42) warned: “I do not believe, as a matter of fact, that the monetary authorities, however courageous and well-informed they may be, can deliberately bring about those contractions in the money supply that the mere mechanism of the gold standard would have generated automatically.”

4.10 Seigniorage: The Profit from Issuing Fiat Money

As noted earlier, a national fiat money offers a national government a quick and easy way to fund its spending: merely issue new units of money. Because an obligation to redeem on demand in gold coin constrained money-creation, it is not a coincidence that the European combatant nations suspended redeemability into gold with the onset of the First World War. Outbursts of irredeemable money and high inflation followed. Nor is it a coincidence that the gold standard was suspended only later by initially non-combatant nations such as Switzerland and the United States (Selgin and White Reference White1999).

Unlike the cumbersome medieval process of generating seigniorage revenue by calling in the existing silver coins and reminting them into a larger number of coins with less silver in each coin, enlarging the stock of fiat money is easy. A central bank can expand the nominal stock to whatever extent it desires, with practically zero production cost, if it is prepared to accept the resulting rise in the price level.

Under modern arrangements, the fiscal authority (the Treasury or Finance Ministry) is distinct from the central bank. Spending in excess of tax revenues is seldom directly financed by paying government employees or suppliers or transfer recipients with newly created money.Footnote ²⁰ The process is indirect: The Treasury finances deficit spending by borrowing, selling new IOUs in the bond market. To the extent that the central bank subsequently buys bonds from the market with newly created money, the two transactions add up to the same result: Deficit spending is financed by seigniorage, the profit from money creation.

Hyperinflations in history have all happened under fiat regimes. Peter Bernholz (Reference Bernholz2014) lists thirty hyperinflations, using the definition of a hyperinflation as an episode in which the inflation rate reaches 50 percent per month. Only one episode (the hyperinflation of the French Revolution’s paper assignat) preceded the twentieth century. (Monthly inflation rates of the paper continental during the American Revolution peaked at 47 percent.) To Bernholz’s list may be added Venezuela in 2018, which had a December inflation rate of 142 percent.

A hyperinflation requires a hyper-rapid expansion of the money supply. Such rapid monetary expansion has usually been driven by the deliberate use of money-creation to finance deficit spending (Bernholz Reference Bernholz2003; Sargent Reference Sargent and Hall1982). Hyperinflating nations, and more broadly nations with triple-digit annual inflation rates, are nations in desperate fiscal conditions, effectively unable to borrow, such that enormous money-creation is the only way left to fund their enormous budget deficits. Triple-digit and higher inflation rates are almost never fully anticipated in financial contracts. Citizens who enter a triple-digit inflation holding government bonds paying nominal returns only in single digits or low double-digits see the real value of their bonds wiped out. In the Weimar hyperinflation, Hall and Sargent (Reference Hall, Sargent and Dabla-Norris2019, p. 39) note, the 1923 price level in papiermarks rose “to approximately 12 orders of magnitude of the 1913 price level (that is, 10¹² in scientific notation),” by which means the German government effectively wiped out its domestic debt denominated in papiermarks. (Much of its foreign debt was denominated in gold.)

The good news is that fiat monetary expansions rapid enough to generate triple-digit inflation rates have been relatively rare. At least in higher-income countries, national governments rely almost entirely on other taxes and borrowing to finance their spending. Money-creation typically supplies only a small amount of their revenue, for example, only 1 to 2 percent of US federal expenditure. When budget deficits grow, however, and correspondingly the ratio of public debt to GDP rises, there is an increasing danger that budget deficits will be covered by printing money, leading to higher inflation.

4.11 The Danger of Fiscal Dominance over Monetary Policy

The danger of “fiscal dominance” over monetary policy, whereby chronically high budget deficits compel an inflationary monetary policy, has been famously analyzed by Thomas Sargent and Neil Wallace (1981) under the label of “unpleasant monetarist arithmetic.” To summarize their analysis, we begin with a government budget constraint:

$\text{G}-\text{T}=\Delta \text{D}+\Delta \text{M},$ (1)

where G is government expenditure, T is ordinary tax revenue, ΔD is the change in government debt held by the public, and ΔM is the change in government-issued money. The stock of government debt in the hands of the public, D, is the accumulation of all previous years’ budget deficits (net of any years’ surpluses). The constraint says that a budget deficit requires financing from some combination of bond finance (borrowing) and seigniorage finance (money creation). Equation (1) implicitly rules out financing government spending by receiving gifts from multinational agencies or by selling off government assets.

We can modify the budget constraint by expressing G, T, ΔD, and ΔM as fractions of national income, and defining ΔD as borrowing proceeds net of debt service (thus moving debt service out of G). Then:

$\text{G}-\text{T}=(\delta -\text{r})\text{D}+\mu \text{M},$ (2)

where δ is the growth rate of government debt ratio, r is real after-tax interest rate on government debt, and μ is growth rate of fiat money. Equation (2) says that a primary deficit (net of debt service) must be financed by some combination of the net proceeds from bond issue plus money creation. The net proceeds from bond issue become zero when a government so saturates the market for its debt that the interest rate on its debt rises to match the growth rate of the government debt ratio. Issuing new debt yields no net revenue because it raises the interest rate in equal measure. With (δ – r) falling to zero, only money-creation remains as a way to finance the stream of budget deficits. The government is reduced to defaulting outright or defaulting in real terms by producing an inflationary rate of monetary expansion.

Is there any relevance to this scenario in which fiscal deficits compel money creation? It follows simply from the market demand curve for debt sloping downward (like all other demand curves) Such that issuing more government debt (relative to the ability to repay in real terms) will lower the market price of that debt relative to its promised payouts, and thereby will raise the market yield (r) on that debt. Put another way, as the debt ratio grows, the marginal buyers will be increasingly reluctant investors who will not buy without a higher yield, because they attach a higher probability to default or to equivalent depreciation of the currency. The idea that bond finance “maxes out” at some high ratio of debt to GDP (where GDP indicates the ability to repay) follows from remaining potential lenders beyond some point being increasingly reluctant, and the rate that the marginal buyers require having to be paid to all bond-holders as bonds are rolled over.

Of course, it does not follow from the theoretical existence of a point beyond which no more bond revenue can be had that a particular government is currently near to that point. But the real-world relevance of the scenario in which a government saturates the market for its debt became plain at the peak of European sovereign debt crisis. In November 2011, the Washington Post ran the headline, “Jump in European borrowing costs adds to debt crisis” (Schneider and Faiola Reference Schneider and Faiola2011). The story noted that “Spain’s sale of short-term, one-year bonds fell short of its target, and the interest rate jumped to 5 percent, compared with 3.6 percent in a similar sale last month.” Spain’s ratio of sovereign debt to GDP had nearly doubled in the previous four years during the global financial crisis, to 70 percent from 36 percent.

The ratio of US total federal debt to GDP also rose during the recession of 2007–2009. In the first quarter of 2011, it stood at 93 percent, well above Spain’s contemporary 70 percent debt ratio.Footnote ²¹ During the subsequent period of economic recovery, the US debt ratio did not shrink (as used to be common during recovery periods) but continued to rise due to chronic budget deficits. In 2020 Q1, it reached 108 percent. Then came unprecedented peacetime budget deficits associated with the COVID-19 pandemic. In 2021 Q3, the US debt-to-GDP ratio stood at 123 percent, up by 15 percentage points in less than two years. The dramatic rise in US federal debt has not, however, brought much of a rise in its sovereign bond yields yet. In fact, the real yields on ten-year US Treasury bonds have been lower over the last twenty over than they were over the previous twenty years, suggesting that demand has grown (presumably because Treasuries are considered safer than other assets in turbulent times) even more than supply, so that the international market for US Treasuries has not yet begun to become saturated.

But an approach to saturation must eventually come if the federal government continues on its current fiscal path. Budget deficits that continually exceed real GDP growth (both as shares of GDP) means that debt outgrows GDP. In the last twenty years, the US federal budget deficit has never been in surplus, and has only twice come in below 1.94 percent of GDP, which has been the compound average annual growth rate of GDP during the same period. Nominal debt growing faster than nominal gross domestic product means an ever-rising ratio of debt to GDP, as seen in the numbers of the previous paragraph. To avoid the inflationary “solution” to mounting US federal debt, dollar-holders must somehow lower the path of the ratio of debt to GDP, or somehow credibly constrain the Federal Reserve such that it cannot create money to cover fiscal deficits even the should Treasury begin to saturate the market for its debt.

4.12 The Case for a Fiat Standard

Given the checkered history of fiat monies, why do so many economists defend fiat standards? Mostly they defend an ideal version of how a fiat standard could perform, not how the typical fiat standard has performed in practice. In principle, appropriate management of the quantity of fiat money can achieve whatever nominal target the economist thinks best for the macroeconomy. Leading proposals call for a stable price level, a stable growth path of the price level, a stable level of nominal income, or a stable growth path of nominal income. The most widely discussed proposal in the pure theory of fiat monetary policy is Milton Friedman’s “optimum quantity of money” proposition (Friedman Reference Friedman1969) that efficiency calls for a negative inflation rate to bring the nominal interest rate on Treasury bills down to the zero nominal rate paid on Federal Reserve Notes.Footnote ²² Under a gold standard or a Bitcoin standard, by contrast, the supply of money is governed by market forces or by a program, and its behavior does not guarantee the achievement of any of these policy targets.Footnote ²³

4.13 Can Fiat Central Banks Be Credibly Constrained?

But will a central bank in practice successfully pursue the nominal target assigned to it? The problem is not technical; it has the ability. A large technical literature in macroeconomics spells out models and empirical coefficients that can be used to manage monetary policy to hit various nominal targets.

The problem is getting the central bank to stick to its assigned task rather than neglecting it while pursuing other goals. Many central banks have been assigned – or like the Federal Reserve System have assigned themselves – the goal of keeping the annual rate of inflation close to a target rate, typically 2 percent. In January to March 2022, the Federal Reserve’s preferred measure of the inflation rate, the year-over-year percentage change in the Personal Consumption Expenditures deflator, was above 6 percent and rising, while the Fed’s inflation target was 2 percent. (The more commonly reported CPI-U rose above 8 percent during the same period.) In mid-March 2022, the Fed’s monetary policy committee (the Federal Open Market Committee, FOMC) released a Summary of Economic ProjectionsFootnote ²⁴ indicating that the FOMC’s own PCE (Personal Consumption Expenditure) inflation-rate forecast for 2022 had risen to 4.3 percent. The Fed did not expect to tighten monetary policy during 2022 by enough to produce a 2 percent inflation rate by the end of the year. Or even by the middle of the following year, given that its projections for 2023 and 2024 were, respectively, 2.7 and 2.3 percent. Clearly, the Fed’s inflation target did not closely constrain monetary policy in practice in the sense that even an inflation rate 4+ percentage points above target did not prompt timely corrective action.

In the Eurozone, the March 2022 inflation rate hit 7.4 percent, well above the ECB’s formal target of 2 percent. In the United Kingdom, the inflation rate was 7.0 percent, despite the Bank of England’s target of 2 percent. All three currencies – US dollar, euro, and UK pound – saw their inflation rates rise rather than fall between March and the end of 2022.

The Fed adopted its inflation target at its own initiative. The target is not embodied in any binding legislated mandate. There is no penalty for the Fed missing its target. Accordingly, the Fed can suspend or modify its target at its own initiative, as it did by announcing in August 2020 that it was switching from “not above 2 percent” to “2 percent on average.” The Fed calls its modified approach “flexible average inflation targeting,” where “flexible” indicates that “the Federal Reserve will seek an inflation rate that averages 2% over a time frame that is not formally defined” (McCracken and Amburgey Reference McCracken and Amburgey2021). The speed of returning to the preferred average rate following an overshoot is unspecified, leaving market participants to guess. Fed Chair Jerome Powell at first declared the overshooting of the inflation rate in fall 2021 to be “transitory,” but later withdrew the description. His use of “transitory” was transitory.

The Bank of England’s Monetary Policy Committee is slightly more specific, explaining that “[t]he Committee’s approach is to set monetary policy so that inflation returns sustainably to its target at a conventional horizon of around two years.”Footnote ²⁵ Its target was assigned to the bank by legislation.

Even a legislated inflation target (rather than one self-adopted by the central bank) seems a weak bar against fiscal or financial pressures on the central bank. The Congress or Parliament that imposed the inflation target on its central bank can suspend or neglect the target whenever the legislature finds that issuing new money is a faster and easier way to finance spending beyond its current tax revenue than enacting and collecting new taxes. Consider the limiting case of a national government with a legislated inflation target that has saturated the global financial market for its debt. That government has a stark problem: If it adheres to the rate of money creation consistent with keeping the price inflation rate to 2 percent, it will have to default on its sovereign debt, because it cannot borrow more and there is not enough ordinary tax revenue to service the debt. It seems likely that a government in such circumstances would consider it the lesser evil to abandon its inflation-rate target.Footnote ²⁶

The ECB initially had something that was supposed to be even stronger than a legislated inflation target: It had a written constitution that made price stability its sole target. The ECB board declared that price stability meant that inflation rate was not to exceed 2 percent. This experiment might be considered the last great hope for constitutionally constrained fiat money. It has not kept Eurozone inflation from exceeding 10 percent in 2022.Footnote ²⁷

When it was first advanced in the 1980s, the “fiscal policy dominance” scenario of Sargent and Wallace (in which rising debt saturates the market and thereby compels inflationary money creation) seemed empirically irrelevant to contemporary monetary policy, at least for nations like the United States that can borrow as much as they want at low real interest rates (Darby Reference Darby1984). In a review of a book by Sargent, Milton Friedman (Reference Friedman1987) wrote:

Needless to say, government budget deficits were not brought under control. The ratio of total debt to GDP rose from 41 percent in 1985 to 65 percent in 1995. Today it is triple 41 percent, at 123 percent. If the United States is not yet into the “serious problems” zone where real interest rates on sovereign debt are rising, it must at least be closer to that zone.

Situations of fiscal dominance driving rapid money creation are more common in lower-income countries, where money-printing often finances a much larger share of government expenditure. A table compiled by Reid Click (Reference Click1998) shows that thirty-four nations relied on money creation to finance more than 10 percent of their expenditure during 1971–1990. Ten of those nations financed more than 20 percent of expenditure with seigniorage. Argentina and Yugoslavia were the most seigniorage reliant, and both had hyperinflations at the end of the period. In nations with seigniorage-dependent governments, the convenience of revenue from money-creation makes high inflation a serious danger to money-holders. Money-creation levies a tax on holders of currency and any other form of money that pays a return that does not fully compensate for inflation. The tax burden is felt as a shrinkage in the purchasing power of a household’s money balances.

4.14 Is a Private Fiat-Like Money Feasible?

Monetary theorists at one time imagined systems where private irredeemable monies would promise a competitive interest return (Klein Reference Klein1974) or stable purchasing power (Hayek Reference Hayek1976). But no such projects have been successfully launched. In addition to legal restrictions, such monies might lack credibility because the private issuer would be tempted – absent a contractual buy-back commitment – by the profit from unexpected monetary expansion (for a detailed discussion, see White Reference White1999, ch. 11). Instead, we have seen the launching of Bitcoin, followed by other cryptocurrencies, which directly constrains expansion in the number of units and – at least before widespread monetary use – leaves their purchasing power unstable.