What gives a fiat currency its initial value?

[jwest411]

what no one seems to be realizing in this forum is that fiat currency gets its "initial value" in the same way as any currency, and that regulation and taxation are neither necessary nor sufficient to explain its value. (Of course they aren't, if you put any stake in the idea that bitcoin has value!) There has been a lot of research on this subject for decades, and there are many different theories on what gives fiat it's value, including the state theory to the commodity theory. The commodity theory says that currency such as fiat which has no intrinsic value (this is actually the central concept behind the definition of a fiat currency), is valuable only as an intermediary between other goods, i.e. because it is expected to be tradeable for another asset in the future. Consider an economy of three people: A, B, and C. A has something B wants, B has something C wants, and C has something A wants, so that if they were to trade in a circle, the total utility of the economy would increase. However, assuming that all transactions in the economy must be pairwise (an exchange between two parties), there is no way to actually make the optimal trades in this economy, since there is no coincidence of wants. Now suppose we introduce a fiat currency into the market by giving it to one of the people. This extra degree of freedom allows for the 3 parties to complete their trades in pairwise exchanges, and increase the total utility of the economy. This increase in total utility is exactly the value of currency.

That is really the simplest answer to the OP's question. Of course, that oversimplified explanation has its problems. Most importantly, there is the built in assumption that the other people in the economy will accept the currency. It isn't rational to assume this, so it seems that the commodity theory of currency value, while sufficient to explain the VALUE of currency, is not sufficient to explain its existence, which I think is an important distinction to make. This is where the state theory comes into play.. the regulation and enforcement of this currency provides the requisite trust system that allows for the currency to take hold. However, this idea is also considered a vast oversimplification. There have been other ideas proposed that would allow us to get around this trust problem without the use of regulation and law enforcement.  You see, the main problem in the example with only three people is that after the first two trades have taken place, the third person will not be able to trade the worthless currency with anyone, everyone else has already received what they want, and no longer have interest in the new currency. This disadvantage for being the last guy "holding the bag" is precisely what destroys the viability of the currency, since there is no way of knowing if you will be last. A theory proposed by (Kovenock and De Vries, 2002) gets around this problem by making the number of players in the economy sufficiently large, though still finite.  This theory says that if the economy is large enough, there is a very low probability of being the last person holding the currency, and since you know that all of the other parties know that as well, your expected utility from using the currency outweighs the uncertainty about being the last person holding it. It has been proposed that this type of model is exactly what gives bitcoin currency value despite its lack of regulation or instrinsic value. Or said differently, the thing that gives a currency its "initial value" is simply the fundamental utility argument above, provided a sufficiently large core number of people trading said currency.

To sum up, I think it is kind of ridiculous that in a forum about bitcoins, where people assume that a currency can have aggregate value even if it is instrinsically worthless and has no regulation, almost no one has stopped to think that largely the same forces are at work in fiat currency. Yes, of course government can use force to make you pay your taxes, and that this kind of aggression can alter the value of the currency. But that is not what the OP asked. The OP didn't ask what forces us to use one currency over another (regulation/taxation), or what causes the value of currency to be stable (regulation), or what causes currencies to be homogeneous within a certain nation-state (taxation). As some posters have pointed out, there are many examples, such as the USD, of currencies that started out without strong legal enforcement, and there are countries without taxes, like somalia, which still use currencies. Does it really seem plausible that fiat currency and digital currency like bitcoin really derive their value in completely, fundamentally different ways? Of course not. Yes, bitcoin is radically different, but it is still a currency and the way it derives its value is fundamentally the same as fiat. All of the posters here who claim that the only reason fiat has value is because someone tells you at gunpoint that it does are really just fueling an "us and them" mentality while ignoring the hypocrisy of turning around and saying that bitcoin is valuable without regulation or taxation.

[aminorex]

personally, i think it is the pointing of guns which creates the "us and them" mentality.  as well it should.  otherwise, i found that post most excellent - thank you.

[LAMarcellus]

I didn't see the correct answer. I had to stop reading by page 3.

I think the correct answer to OPs question is direct convertibility.

Nigel Farage gives a pretty good account of fiat currencies in his book The Ascent of Money

Notes, currency, were first circulated as "warehouse receipts", circa 1600's if i remember correctly.
People wanted to safely store their gold and silver. The warehouse aka "bank" gave them a receipt.
Rather than go claim their precious metals before every purchase, people found it more convenient to just hand over the receipt itself. They handed over the ownership claim to an amount of metals stored in the warehouse. This is how paper money was born. (ignoring chinas story that goes back earlier but is unrelated)

Unfortunately unsavory characters realized that they could create more receipts than there was metal backing for and then lend the receipts out at interest. This process is inherently risky and precious metal bankers are truly skilled people at matching lenders with borrowers. Unfortunately, like most humans, greed won out and the warehouse operators realized they could apply usury with receipts to defraud their customers. There bankers used paper receipts to match lenders and borrowers.
Fractional reserve banking was born. By which characters of what descent is for you to learn about. When one factors in that bankers harmed millions of people... well it changed my understanding of history.

Certain families grew wealthy thru this form of fraud.
Others didn't manage their receipt creation so well and were subjected to warehouse runs.

The founding fathers of the American colonies knew the evils of paper money. It was first introduced 200 years before their time. This was plenty of time to see multiple warehouse runs, booms and busts (tulips for example as people wanted to get a return on their inflationary paper)

The United States has had three central banks.
The first is hardly known to us today unless one is a avid student of history. The first note circulated was called "the continental" which gave birth to the phrase, "not worth a continental", https://en.wikipedia.org/wiki/Early_American_currency

The 2nd central bank was shut down by President Andrew Jackson. The famous quote this central bank gave birth to is "You are a den of vipers and thieves. I have determined to rout you out and, by the Eternal, I will rout you out!"
Also something along the lines of "you bankers tell me that if I shut down the central bank 100 families will starve and it will be on me, but if I dont shut down the bank, 10,000 families will starve, and that will be on you." Then he went on to call them snakes.

Finally in 1913 we have a secret meeting on Jekyll Island between Senator Aldrich and other cronies.
The result of this meeting was a plan to again give a private bank a government sanctioned monopoly over money creation.

If i remember correctly, prior to 1913, there were state banks and private banks acting as "warehouses". They each issued their own notes. This led to problems of acceptability outside of a certain range, also this led to multiple "wildcat banks".
They open up, take peoples real metal money, they issued receipt notes, created notes without metal backing, lent these notes, people exchanged for metals and the last ones to arrive found the warehouse empty, and the warehouse bank went bust leaving everyone holding the bag with useless notes. Mt.Gox is a modern day wild-cat bank!!!. The warehouses were the very first exchanges. Literally exchange the receipt note for real money. They stored real money and gave out receipts. Then they defrauded their customers by issuing more receipts at interest for which there was no metal backing.

There was no limit to the amount of receipts printable.

Even if US citizens were aware of this... As many posters before me said....  once 1913 hit.. it was the barrel of a gun that forced acceptance of the warehouse notes.

[byronbb]

The US dollar was originally backed by physical assets. Then once people were psychologically conditioned to use  paper as currency, they left the gold/silver standard and just went on printing. This will one day be understood to be the biggest scam in the history of the world.

[bgmc]

There is only one thing that gives any currency (include fiat) its value, and that is: public acceptance of the currency as means for payment to buy crap. If, for example, Americans all of sudden decided that they will not accept the USD as payment for stuff, then the USD would be worthless.

Therefore, the real question is: how do you convince the population to accept a currency as payment?

[twiifm]

There is only one thing that gives any currency (include fiat) its value, and that is: public acceptance of the currency as means for payment to buy crap. If, for example, Americans all of sudden decided that they will not accept the USD as payment for stuff, then the USD would be worthless.

Therefore, the real question is: how do you convince the population to accept a currency as payment?

You force them to pay their taxes in USD. 

[ArticMine]

There is one little problem with the payment of taxes as an argument for giving fiat currency its initial value. Tax authorities have taken all sorts of things over the centuries for non payment of taxes. Here is just a small sample from the US Government. http://www.treasury.gov/auctions/IRS/index.html. My favourite example is brothels https://en.wikipedia.org/wiki/Mustang_Ranch. Are brothels a form of fiat currency in the United States because the IRS seized one?

[counter]

Well in the case of the almighty dollar I'd say it was gold and silver, now however not so much. 

[zolace]

I believe having  healthy circulation system and the cap is also another important role in that too

[twiifm]

There is one little problem with the payment of taxes as an argument for giving fiat currency its initial value. Tax authorities have taken all sorts of things over the centuries for non payment of taxes. Here is just a small sample from the US Government. http://www.treasury.gov/auctions/IRS/index.html. My favourite example is brothels https://en.wikipedia.org/wiki/Mustang_Ranch. Are brothels a form of fiat currency in the United States because the IRS seized one?

Taxes didn't give USD its initial value. But in the present day, taxes insures a demand for USD

[waldox]

pizzas!

[hikedoon]

Magic words give every fiat currency it's initial value.
"I ....... promise to pay the bearer on demand ........."
If enough people believe it then its game on.
 

 

[Robert Paulson]

the dollar started as a receipt for gold thus its value was the same as the value of gold you could get for it.
over time to finance public works and war the government started printing more dollars and eventually had to give less and less gold per dollar in existence (they couldn't print gold to back up the paper).
eventually in 1971 the government had so little gold and so much paper in circulation that it had to stop redeeming paper for gold altogether.
since then more and more paper was printed the the purchasing power is declining ever since.

[Dr.Zaius]

the dollar started as a receipt for gold thus its value was the same as the value of gold you could get for it.
over time to finance public works and war the government started printing more dollars and eventually had to give less and less gold per dollar in existence (they couldn't print gold to back up the paper).
eventually in 1971 the government had so little gold and so much paper in circulation that it had to stop redeeming paper for gold altogether.
since then more and more paper was printed the the purchasing power is declining ever since.

No it didn't. The dollar was merely a weight of silver. Later on they fixed a specific silver to gold ratio, which led to redefining the dollar in terms of gold. The government has always fucked around with what money was, namely in the interests of the usury(capitalist) class centered in New York. Gold was replaced with the government bond as a "risk free asset". Essentially the Fed and the Treasury began engaging in check kiting in the 1920's. By the 70's this scheme was fully accepted.

"Fiat" is not really fiat. It is in places like Zimbabwe, however in the US it is credit money. Every single credit dollar in existence is backed by collateral. The federal reserve asset column consists of mainly US government bonds. What are US government bonds? These are future claims on the sweat equity of 310 million Americans. So every dollar the fed lends into existence is collateralized by the future productivity of American's which will be extracted via taxation. Now ask yourself, does future productivity have "intrinsic value"? Of course it does.

Do you understand this concept? It is not  by decree. It is not by coercion. It is by DEBT. The collateral "backing" the credit(dollars) gives them value. If the collateral is of poor or dubious quality the value of the dollars decreases(inflation). Total debt + interest also exceeds available dollar credits in existence, this places an almost perpetual BID for them. Someone in the economy is constantly in need of dollars to repay old debts.

Commercial banks essentially produce dollar derivatives. They lend out claims to federal reserve dollars, every-time you get a loan for XYZ. What are those claims backed by? The collateral you post(house, car) and your sweat equity(income). When these institutions engage in counterfeiting of credit you get inflation.

For this system to work it requires perpetual economic growth, as new wealth must act as collateral for new loans. Hence the obsession with constant GDP expansion. Obviously, this is impossible. The economy never grows as fast as the rate of interest. This places a certain class of people(usury) to essentially rent seek. When the economy can no longer produce new wealth fast enough they simply begin recollateralizing existing assets. Ie homes, stocks, education, sweat equity gets revalued(hence inflation occurs). Anything that can be borrowed against must rise in price in perpetuity to expand the total debt pool. When this system begins breaking down 2008 happens.

Hyperdeflation will occur before hyperinflation.

The end game is when you cannot trade a US government bond for gold. Meaning there is no exchange rate between Gold and US treasuries. No bid. That is when the credit dollar system implodes. We are still far away from this scenario, and it does not have to happen. Also since the majority of global fiat currencies are pyramided off of the dollar, the USD will be the LAST to fail. So betting on the US dollar to collapse, you won't survive the journey.

Bitcoin will also be next to worthless under this scenario. Why? Because bitcoin requires a sophisticated civilized society to function. It requires electricity, high bandwith, communication, smart phone networks. Under a fiat collapse trade essentially grinds to a halt, multilateral trade turns into bilateral trade ie BARTER. The last thing people will be concerned about will be some virtual units on the internet that have no value outside of their exchange. All of you hoping on a fiat collapse, are essentially cheering on your own misery.

 

[Robert Paulson]

the dollar started as a receipt for gold thus its value was the same as the value of gold you could get for it.
over time to finance public works and war the government started printing more dollars and eventually had to give less and less gold per dollar in existence (they couldn't print gold to back up the paper).
eventually in 1971 the government had so little gold and so much paper in circulation that it had to stop redeeming paper for gold altogether.
since then more and more paper was printed the the purchasing power is declining ever since.

"Fiat" is not really fiat. It is in places like Zimbabwe, however in the US it is credit money. Every single credit dollar in existence is backed by collateral. The federal reserve asset column consists of mainly US government bonds. What are US government bonds? These are future claims on the sweat equity of 310 million Americans. So every dollar the fed lends into existence is collateralized by the future productivity of American's which will be extracted via taxation. Now ask yourself, does future productivity have "intrinsic value"? Of course it does.

this is not true, the dollar has no collateral backing it, not even government bonds (who are nothing but papers as well anyway), commercial banks are allowed to create as much currency as they want they don't need any government bonds to back that currency.

[twiifm]

the dollar started as a receipt for gold thus its value was the same as the value of gold you could get for it.
over time to finance public works and war the government started printing more dollars and eventually had to give less and less gold per dollar in existence (they couldn't print gold to back up the paper).
eventually in 1971 the government had so little gold and so much paper in circulation that it had to stop redeeming paper for gold altogether.
since then more and more paper was printed the the purchasing power is declining ever since.

No it didn't. The dollar was merely a weight of silver. Later on they fixed a specific silver to gold ratio, which led to redefining the dollar in terms of gold. The government has always fucked around with what money was, namely in the interests of the usury(capitalist) class centered in New York. Gold was replaced with the government bond as a "risk free asset". Essentially the Fed and the Treasury began engaging in check kiting in the 1920's. By the 70's this scheme was fully accepted.

"Fiat" is not really fiat. It is in places like Zimbabwe, however in the US it is credit money. Every single credit dollar in existence is backed by collateral. The federal reserve asset column consists of mainly US government bonds. What are US government bonds? These are future claims on the sweat equity of 310 million Americans. So every dollar the fed lends into existence is collateralized by the future productivity of American's which will be extracted via taxation. Now ask yourself, does future productivity have "intrinsic value"? Of course it does.

Do you understand this concept? It is not  by decree. It is not by coercion. It is by DEBT. The collateral "backing" the credit(dollars) gives them value. If the collateral is of poor or dubious quality the value of the dollars decreases(inflation). Total debt + interest also exceeds available dollar credits in existence, this places an almost perpetual BID for them. Someone in the economy is constantly in need of dollars to repay old debts.

Commercial banks essentially produce dollar derivatives. They lend out claims to federal reserve dollars, every-time you get a loan for XYZ. What are those claims backed by? The collateral you post(house, car) and your sweat equity(income). When these institutions engage in counterfeiting of credit you get inflation.

For this system to work it requires perpetual economic growth, as new wealth must act as collateral for new loans. Hence the obsession with constant GDP expansion. Obviously, this is impossible. The economy never grows as fast as the rate of interest. This places a certain class of people(usury) to essentially rent seek. When the economy can no longer produce new wealth fast enough they simply begin recollateralizing existing assets. Ie homes, stocks, education, sweat equity gets revalued(hence inflation occurs). Anything that can be borrowed against must rise in price in perpetuity to expand the total debt pool. When this system begins breaking down 2008 happens.

Hyperdeflation will occur before hyperinflation.

The end game is when you cannot trade a US government bond for gold. Meaning there is no exchange rate between Gold and US treasuries. No bid. That is when the credit dollar system implodes. We are still far away from this scenario, and it does not have to happen. Also since the majority of global fiat currencies are pyramided off of the dollar, the USD will be the LAST to fail. So betting on the US dollar to collapse, you won't survive the journey.

Bitcoin will also be next to worthless under this scenario. Why? Because bitcoin requires a sophisticated civilized society to function. It requires electricity, high bandwith, communication, smart phone networks. Under a fiat collapse trade essentially grinds to a halt, multilateral trade turns into bilateral trade ie BARTER. The last thing people will be concerned about will be some virtual units on the internet that have no value outside of their exchange. All of you hoping on a fiat collapse, are essentially cheering on your own misery.

 

+1 great post!

[billysweird]

A generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within an economy. Used as a medium of exchange for goods and services, currency is the basis for trade.

Generally speaking, each country has its own currency. For example, Switzerland's official currency is the Swiss franc, and Japan's official currency is the yen. An exception would be the euro, which is used as the currency for several European countries.

Investors often trade currency on the foreign exchange market, which is one of the most heavily traded markets in the world.