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Fiat Money –

by on 24/09/2013

As to fiat money, it is a dangerous game. After all you can’t seriously believe that when unlimited amount of money is thrown to the economy it will not cause degradation of the currency. The price of any marketable item is fixed by its relative scarcity (and not by its essence, enough to compare diamonds to food.). The same is with money, its value is relative to its relative scarcity. If abundant its value will decrease, or in other words the prices will go up. This means in economic jargon inflation. The process of Inflation usually starts with a general increase in prices, which after a while prompts the unions to complain that wages are ceasing to cover the daily expenses of employees. Then pensioners and the other sectors of society that live on social security payments start to protest. Last but not least the banks react, by increasing interest rates to keep them above the level of the price increase level.

…Then, as production costs rise, the exporters complain that their competitiveness against other producers from other countries has been damaged and they will have to lay off some of the workforce unless a compensatory adjustment is made. It is also common knowledge that without exports no foreign currency will be available to purchase the import commodities necessary for the economy. So the currency is devalued. But then all the imported goods that have to be bought for foreign currency become more expensive and the round of price increases starts all over again.

Because the different segments of the production chain have lost confidence in the stability of the price system, the new round of price increase will necessarily be higher than the previous one. As expectations of further price increase among the people mount, everybody wants to be compensated not only for the last price increase, but also for the expected next price increase, which they believe will be higher than the last one. To secure their position, all the participants in the society ask for exaggerated price and wage increases. By this stage the price increase is gathering extra momentum and is driven by expectations rather than by realities. And the expectations tend to be self-fulfilling.

And so as the spiral winds ever upwards, first the employers and the employees and last the institutions of social benefits like social security, pension funds etc., create a system of indexation based on an agreed anchor for prices, wages, tariffs, fees, charges, expenses, fares, premiums, rates, tolls, whatever…

At first the indexed raises occur every quarter, but then they happen every month and at the end every week. Theoretically everybody – the employees, the pensioners, the exporters and even the producers – should get proportionately the same progressive increases in income, but that does not happen in practice because it is impossible for people to keep their bearings in the avalanche of numbers. Those with a strong negotiating position get more and the others get less. Some economic entities even cease to exist, either because they lack the means to cope with the frequent price increase, or because they just don’t understand what is going on around them.

At a certain stage the prices start to rocket exponentially, and this stage is called Hyperinflation. In Hyperinflation the prices change daily until nobody has any remaining sense of the relative value of products, for Money has lost its major function as the supreme measurer of the value of Product price. During hyperinflation if you ask someone how much a loaf of bread costs he will probably just shrug, or if he is more polite he will tell you the price in a foreign currency. This is the stage at which the market starts looking for an anchor for measuring prices other than the local currency. Usually the anchor is a stable foreign currency, for example the dollar, or some other form of indexation.

pshakkottai Says:

Dear Eugen: Fiat money is not dangerous. It works like this.
My analysis: Fiat money is a token that changes hands to make transactions more convenient than barter.

Initial state of the economy: Idle capacity, available workers , available resources both inside and outside the nation. By work I mean all work, physical, academic, intellectual, artistic…

Final state: workers employed for many years, resources processed both inside and outside the nation. All workers paid, the bridge or dam or whatever built. USA has a new resource.

Money spent: project funded by fiat money has made prosperity possible and everybody gained including exporters to USA.

Who lost? Nobody. National debt is also fiat money that USA owes to itself and has to do nothing to pay it back. It is simply a record of all transactions.

In this example it is seen clearly that money is not wealth. You can’t do any of this in the Sahara desert because resources are scarce. You can do things if there are resources and humans willing to work. The nation should fund all infrastructure because the nation will be stronger.

Then how to we grow the economy starting from today?
Increase spending to set a reasonable deficit, say, Deficit1 =Net imports + 5% GDP
See how employment picks up
The deficit falls to Deficit2
Increase spending again
Wait another quarter to see if Deficit falls again
Repeat until full employment occurs
Now watch for inflation and if it picks increase interest rates.

  • EugenR Says:

    Dear Pshakkottai, i have do disappoint you, unlimited fiat money printing is solution for some problems in certain circumstances, but definitely not a solution for every problem in every circumstances. When all the resources are not fully utilized in the economy it can have positive effect, but only on the short term. It is enough that one essential resource (energy for example) out of many is limited and printing new fiat money will cause only damage and no economic growth. Then other problem is the long term problem. If for long term to much fiat money is distributed to the population, what way it can be done? It can’t be by investing indefinitely in new projects, because in certain stage the investments will be more damaging than useful with low or negative yield (white elephant projects). So the solution will probably be allowance payments without expecting any repayment back to the society. Such policy will have deep negative impact on functioning of the society. This is what is happening in some European countries. If in Greece and Spain you have 50% unemployment of the youth until age 25 it is not just because there are no jobs on the market. On the long run this phenomenon of unemployment is not just a economic phenomena, but also sociological. It destroys the feeling of duty towards society and towards personal needs of the individual.
    The other negative impact of fiat money is the necessary unregulated wealth allocation. Usually, the rich are getting richer and the poor are getting poorer at times of excessive fiat money printing and money value degradation that follows it. If fiat money printing becomes the major tool to finance government activities, as you suggest, it will be followed by government take over of bigger and bigger chalks of the economy. But it is well known the government is a very ineffective product and service supplier. Again the economy will go into waste of resources, and will stop to grow. This is what happened in USSR and other “socialistic” countries before it collapsed.

    I could continue so, pages and pages, but enough of it. All i have to say is that there is no magic wand in economy called Fiat Money, after all someone do have to produce the products, that the magic Fiat Money will be exchanged for it. But why would anybody work and produce if he can live from Fiat Money distributed freely? This i call a logical paradox.

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