Why Do We Accept Fiat Currency?

Most people have probably wondered, at one time or another, why national currencies gain wide acceptance. Why, for instance, do so many Americans choose to hold and transact in dollars rather than some other currency?

An instinctive answer might be that dollars just so happen to be what most Americans have accepted. If earlier Americans had decided to use a different currency, that would now be the one widely accepted.

On reflection, this answer is not very satisfying. It explains why we will accept a currency once everyone else has, but cannot explain why the first person or people ever to accept the currency chose to do so.

There is actually something solid behind the acceptance of a national currency. At base, we accept it because the government has imposed, and enforces, a tax obligation that can only be settled in that currency. Our need to pay taxes ensures that there is a willingness to obtain the national currency rather than just any currency.

Our willingness to accept the currency as payment for goods and services makes it possible for the government to spend its money into the economy. Some of us will be willing to work in the public sector to obtain it. Others will be willing to transact with public sector employees or the government to obtain it. Still others will be willing to transact with subsequent possessors of the currency. And so on.

Our willingness, at minimum, to use the fiat currency to cover our taxes is enough to ensure the government can transfer some labor services and real resources from the private to public sector.

In practice, of course, we are happy to use the national currency more widely than is needed merely to pay taxes. Not only do we mostly transact in the government’s unit of account but many of us also desire to save in it. The national currency is a secure form of saving provided it remains viable. And it remains viable so long as the government effectively enforces taxes and avoids issuing too much of its money.

This raises the question, how much currency issuance is “too much”?

When a unit of the currency – say a dollar – is issued, it will circulate around the domestic and global economies, changing from hand to hand as various transactions occur, until one of two things happens:

  • The dollar is used to pay tax
  • The dollar is saved.

In either case, the dollar is taken out of circulation. In the case of tax payments, the effect is permanent. The dollar is removed from the economy. In the case of saving, the effect can be temporary. If the saver chooses to spend the dollar at a later time, the dollar will re-enter circulation at that moment.

Whenever a dollar is withdrawn from circulation, it does not add to demand for goods and services, and so does not entice additional production nor put pressure on prices.

The implication for management of the currency depends on the state of the economy:

  • When the economy is at full employment and operating at full capacity, it is problematic for the government to issue still more currency without also increasing taxes. Otherwise, there will be “too much money chasing too few goods” and an inflationary episode.
  • When, as now, there is unemployment and excess capacity, there is room for additional non-inflationary currency issuance. Under present circumstances, extra demand for goods and services will chiefly encourage an expansion of production rather than price hikes as firms compete for the extra business.
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18 thoughts on “Why Do We Accept Fiat Currency?

  1. Another important point is that you don’t have to offset savings *now* in anticipation of some future event when it gets used. There is nothing to be gained by depressing the economy *now* because at some point in the future the saving might get spent.

    The time to deal with dissaving is when aggregate dissaving happens – which may be never.

    So for the most part you can treat savings in excess of investment as though it were tax paid.

  2. A thought on inflation: The common myth perpetuated, about government spending using created money, is that it will lead to hyperinflation. This is a false view, based upon a misunderstanding of how inflation works.

    However, perhaps there is a danger in adopting government use of money creation, because of the huge amount of savings among the wealthy (money that has been taken out of circulation, yet can be re-entered into circulation):
    Upon government beginning used of money creation for spending, an enormous increase in private spending could be engineered, sourced from the savings of the wealthy – and this could be used to deliberately create enormous inflation, in order to try and discredit government use of money creation.

    It would be the massive savings from the wealthy that would be pushing inflation, but it is an effective way of discrediting government use of money creation.

    Is this a real danger? If that happened, it’s the kind of thing that could put back public use of money creation, by up to a century, due to the lasting perception it would create.

  3. Hypothetically, I guess the wealthy could do that. For it to matter to the general population, though, the wealthy would have to be spending all that extra money on a broad range of what is actually being produced, which at the moment is to a substantial degree geared towards items of mass consumption. So, they would need to spend big on stuff they probably don’t want. And they would need to keep doing it. Not just for one period, which would cause a temporary spike in prices, but persistently and to an increasing degree, to achieve a continuous rise in the general price level. If, instead, they mostly wanted to purchase luxury items that are typically out of reach of the vast majority, they would mainly just be causing a sharp increase in the prices of the items they purchase.

    If the wealthy did do what was required to cause problematic inflation (just to imagine the scenario as a hypothetical exercise), there are probably various responses the government could take (assuming, perhaps optimistically, that the government opposed the behavior of the wealthy). One would be to introduce a new currency, let’s say “new dollars”, and then announce that new dollars are required to settle taxes and that the government will exchange new dollars for (old, regular) dollars at par up to some threshold that is sufficient to enable the general population to retain all its accumulated savings in old dollars, switched to new dollars, but in effect confiscates the wealth of the wealthy above the threshold. The excess old dollars of the wealthy that could not be exchanged for new dollars would become pretty much worthless, since they would now be unacceptable for tax payment. In effect, this would be a massive tax as retaliation for the destructive, inflationary behavior.

  4. Wow, it seems that if the wealthy did do that in a co-ordinated way (targetting everyday items, to create general problematic inflation), switching to a new currency would be a pretty drastic and disruptive measure – I wonder if there are other ways to tackle that.

    I can see how that would work though (would be a great solution for defaulting offshore accounts, even in the present) – but yes, maybe this kind of scenario (inflation-creating efforts, either through excess savings of the wealthy, or through private bank money creation – which there is historical precedent of I believe, in Guernsey, for discrediting money creation for public spending) – this kind of scenario should probably be considered, by MMT’ers and all other advocates of public use of money creation, as a significant potential threat, that they need to have a plan for dealing with.

    It’s my own personal (slightly cynical :)) view, that something like this should be considered as almost inevitable – as public use of money creation is (in a way) a huge attack on the de-facto power of the wealthy, and the money that the wealthy would lose in causing this inflation, is tiny compared to the power they would preserve, by killing/discrediting the idea of public use of money creation.

  5. But in practice, when does the government issue currency except with an offsetting debt obligation?

    But what I really want to understand is how it is that public sector spending & taxation constrains credit creation (since credit seems to be the predominant form of money)

  6. If people ramp up spending, in a country that has sales taxes or a value-added tax, the government would get a big slug of tax income. Plus, increased revenue would lead to increased income taxes.

    The government would move towards surplus, and dampen down the inflation.

    The end result would be a net destruction of wealth, as government debt would probably be retired as a result of the fiscal tightening.

  7. Why do we accept fiat currency? One reason (omitted in the above article I think) is the simple fact that currency / money is useful stuff, whatever form it takes – gold coins, fiat, you name it.

  8. Thanks for the comments, everyone.

    JohnB: Just to be clear, I find the scenario extremely farfetched. I was just considering it as a hypothetical since you brought it up. I doubt there would be much opposition to taxing away or confiscating excess wealth if this policy action was to occur in the context of the wealthy systematically buying up necessary items of consumption (preventing others from access to them) for no social purpose other than to cause disruption. By comparison, introduction of a new currency in the manner suggested would be less disruptive. It would have a fairly minor impact on people other than the wealthy. Savings, to the extent they were in deposits or conventional saving vehicles, could be converted easily and without issue up to the threshold, simply re-designated as being in the new currency. It would be possible, of course, to increase taxes on the wealthy instead, but such a tax would be easier to evade. Introduction of a new currency, as suggested, would take care of that problem automatically.

    In any case, before we got to all that, it would need to be explained why the wealthy would choose to spend persistently and to the degree necessary on a broad range of items when such an action, if they pulled it off, would be likely to antagonize a public that already thinks inequality is too extreme and is already probably quite disposed to the idea of taxing the wealthy more than at present. It seems like a plan, not to destabilize the currency, but to bring the wrath of the masses down upon their heads. They’d be smarter, I think, to keep a low profile, as most of them do, and hope no one notices the extent to which they already have things almost entirely their own way without needing to undermine the currency. They are doing very nicely under the present system with the existing currency.

    Jack: The issuance of public debt doesn’t really affect the situation. Whether additional financial wealth as a result of government spending net of taxes is held in the form of deposits or government securities, the holders of that additional financial wealth have greater capacity to spend.

    Bank money is widely accepted partly because it is convertible at par to government money, and government money is backed by taxes. The quantity of bank money expands and contracts endogenously through the credit creation process, largely independently of fiscal and monetary policy. Preventing the process from getting out of hand requires regulation. Demand-management policies on their own probably won’t do the trick, although they can be used to boost or constrain economic activity, and in that way have an effect on the demand for private credit.

    Ralph: One use of the national currency is central to the post. It is its usefulness in extinguishing the tax obligation. This ensures acceptance of the currency at least to a degree sufficient to conduct fiscal policy. The currency can of course be useful for other reasons too, as you point out, but those other reasons might not be enough to ensure wide acceptance of the national currency in the absence of an enforced tax.

    The question considered in the post is not simply why any currency is accepted, but why a particular currency is accepted rather than another one. In the US, for instance, why is the dollar widely accepted rather than some other currency.? And, also, how is it that the state is able to ensure acceptance of its currency rather than losing out to some other currency?

    Historically, there are really quite overt examples of authorities making use of taxation to compel acceptance of state currencies. There is also evidence that they understood what they were doing. For example, imposing a direct tax was one way colonialists compelled people to sell their labor power in exchange for the currency.

    Mathew Forstater — Taxation and Primitive Accumulation: The Case of Colonial Africa

  9. Why did Americans accept Continental Dollars? (More to the point, why did the states not give Congress taxation power, or accept Continentals in payment of state taxes? Benjamin Franklin advised them to do so.)

    Why did the French accept assignats and mandats? Why do people accept bitcoin?

  10. Other monies might be accepted. And a currency might be accepted without being backed by a tax. But “might” is not really good enough for the purposes of a national currency.

    An enforced tax obligation is a sufficient (not necessary) condition for acceptance of a currency. This point has been discussed in previous posts and threads. See, for instance:

    Randall Wray on Tax Driven Money

  11. Well I would not say that the reason that I accept a USD is because “there is a guy at the door with a gun….”

    I accept it because its the state currency of my country… rsp

  12. Surely it’s not just that taxes must be paid in it but more that the State has decreed it to be legal tender. In other words sufficient to settle any obligation and not just taxes.

  13. Chartalism focuses on taxation as a sufficient condition to drive a state-issued currency.

    However, that is not the end of the story, of course. What we call money is embedded in the complex legal institutions that underly a society and its economy

    See Christine Desan, Making Money: Coin, Currency, and the Coming of Capitalism.

    • An exciting new theory of the history of the modern monetary system, describing its origins and the eventual development of capitalism

    • Examines the constitutional influences of currency and the impact of government on money throughout history

    • Focuses on the added value of money as more than a simple commodity

    Money travels the modern world in disguise. It looks like a convention of human exchange – a commodity like gold or a medium like language. But its history reveals that money is a very different matter. It is an institution engineered by political communities to mark and mobilize resources. As societies change the way they create money, they change the market itself – along with the rules that structure it, the politics and ideas that shape it, and the benefits that flow from it.

    One particularly dramatic transformation in money’s design brought capitalism to England. For centuries, the English government monopolized money’s creation. The Crown sold people coin for a fee in exchange for silver and gold. ‘Commodity money’ was a fragile and difficult medium; the first half of the book considers the kinds of exchange and credit it invited, as well as the politics it engendered. Capitalism arrived when the English reinvented money at the end of the 17th century. When it established the Bank of England, the government shared its monopoly over money creation for the first time with private investors, institutionalizing their self-interest as the pump that would produce the money supply. The second half of the book considers the monetary revolution that brought unprecedented possibilities and problems. The invention of circulating public debt, the breakdown of commodity money, the rise of commercial bank currency, and the coalescence of ideological commitments that came to be identified with the Gold Standard – all contributed to the abundant and unstable medium that is modern money. All flowed as well from a collision between the individual incentives and public claims at the heart of the system. The drama had constitutional dimension: money, as its history reveals, is a mode of governance in a material world. That character undermines claims in economics about money’s neutrality. The monetary design innovated in England would later spread, producing the global architecture of modern money.

    Readership: Legal historians and constitutional theorists, economists and economic historians

    Money is primarily legal rather than economic. The simple version of money as a neutral medium of exchange that developed out of barter is simplistic and undercuts most of contemporary economics as a false assumption that has misled research.

  14. Tom
    Thanks for that. I’m currently looking into the history of the Bank of England and that rings true. It’s a very interesting and enlightening journey.

    Hasn’t Paul Davidson been saying something similar for a long time regarding the legal and contractual aspects of money ?

  15. Yes. Davidson makes the point that money as a legal institution was the basis for Keynes’s critique of neoclassical economics based on the difference between a monetary production economy in which money is non-neutral and a barter economy in which money is neutral. For Keynes, investment is the driver of a capitalist economy and demand is the signal to invest. Decisions to invest are chiefly driven by expectations, which necessitates forward commitments, and that requires contractual obligations that are enforceable. Markets in a monetary production economy are based on money being a legal institution. See, for instance, “Real World Macroeconomics: Financial Markets, Liquidity, And Money Contract Obligations”

    p. 7 For decisions that involved potential large spending outflows or possible large income inflows that span a significant length of time, people “know” that they do not know what the future will be. They do know that for these important decisions, making a mistake about the future can be very costly and therefore sometimes putting off a commitment today maybe the most judicious decision possible. Our modern capitalist society has attempted to create an arrangement that will provide people with some control over their uncertain economic destinies. In capitalist economies the use of money and legally binding money contracts to organize production, sales and purchases of goods and services permits individuals to have some control over their cash inflows and outflows and therefore some control of their monetary economic future. For example, households enter into contracts where they agree to pay rent, and contracts to pay for electric, gas, and telephone utility companies for providing services over time. These contracts provide the households with some cost control over major aspects of their cost of living today and for months and perhaps years to come. It also provides the other parties (business firms) to these money contracts with the legal promise of future current and future cash inflows sufficient to meet the business firms’ costs of production and generate a profit for providing the rental of the dwelling unit, and the utility services provided.

  16. Mentioned above were comments about “government putting money into the economy” but as long as the bean counter rule is enforced, federal spending = taxes collected + treasuries sold, then the federal government is constrained from either adding to or subtracting from the money supply. The government can only move money around in the economy by taxing and spending. Nor can commercial banks add to the money supply as long as they insist on charging a positive interest on all loans which removes money from the economy. The only mechanism for placing additional money into the economy is the central bank buying government debt and the minimum they must buy is the net amount of interest collected by commercial banks and that maintains a stable money supply. To grow or inflate the money supply the central bank must buy more national debt.

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