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Fiat money vs. gold money and social acceptability


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The wise fact about money that it gains its power & value from social acceptance (in other words from PEOPLE) and not vice versa!

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Fiat money vs. gold money and social acceptability

  1. 1. Fiat Money and Gold Money The purpose of this paper to compare and contrast fiat and gold money on econ and social bases. 2013 Prepared by: Samer Abou Zaghla 10/30/2013
  2. 2. Fiat Money and Gold Money 1 I. Introduction  Purpose of the paper  Paper structure II. What is Money  Definition  Emergence of money  Function of money  Development of money and monetary systems over time III. Fiat Money Vs. Gold Money Comparisons  Pros and Cons of fiat money  Pros and Cons of gold money IV. Conclusion V. References and Bibliography
  3. 3. Fiat Money and Gold Money 2 I. Introduction Money is considered to be the most important invention by the man kind to carry out trading and exchanges of goods and services throughout history. The term Money has been used throughout history to call any object used as means of exchange including gems, commodities, gold, silver, sugar, food, animal skins, and even cigarettes. Before, inventing money people used Barter system (the exchange of one good or service for another) in exchange and trading, which always required what Edgeworth (1881) called a “double coincidence of wants”. The main problem of the Barter system that it is highly unlikely to always find two persons each have a good or service that the other demands, which is make it very difficult for any economy to achieve an efficient allocation of its scarce resources. Whereas, Money makes it easier and more feasible to trade, since the seller in any transaction will not be concerned whether the counterparty can produce a useful and precious commodity or service for him. He/she will be pleased to receive the Money, recognizing that it is acceptable by others in case he/she becomes a buyer in another transaction. (Wayne E. Baker) For example contended that “Modern money depersonalizes transactions and disembeds relations”. Money, in this sense, enables production and trading, and encourages people to work and do their best in the areas of their preferences, consequently, this will facilitate economic growth and enhances standards of living1 . In addition, money also endorses personal freedom as stated by (Wayne E. Baker) “Depersonalization permits new levels of individual freedom. Money, Parsons (1967) argued, grants four freedoms, you are free to buy what you want, from whom you want, and can accept or reject the conditions under which you 1 This was argued by Ibn Khuldoun before the advent of modern economics discipline (Khaldoun).
  4. 4. Fiat Money and Gold Money 3 buy”. The first part of this paper will discuss different types and functions of Money as well as the development of money and monetary systems over times. In the following part, the paper will focus on two types of money i.e. Gold and Fiat Money and will establish a comparison between both in terms of advantages and disadvantages from economic and social angles. II. What is Money 2.1 Definition of Money: Money can be defined as an asset that is commonly and socially accepted amongst people to pay for commodities, services and to pay back loans, “Money is an asset that is generally accepted as payment for goods and services or repayment of debt” (Cecchetti and Schoenholtz). In addition, (Mankiw) defined Money as “the set of assets in the economy that people regularly use to buy goods and services from other people”. Moreover, Money is considered to be a debt on the society, for example it is written on the dollar “This note is a legal tender for debts, public or private”, also on old Egyptian pounds it was written “This note is a debt on the State treasury” . 2.2 Emergence of Money – Introduction From reviewing the history of money, we can find out that many different objects have been used as money over times such as, gold, silver, wheat, dates, copper, animal skins, cigarettes, precious stones…etc. While a number of objects have been used as money, some have functioned in a superior way than others. Those objects that functioned well, tended to have
  5. 5. Fiat Money and Gold Money 4 five fundamental features: (i) durability; (ii) divisibility; (iii) liquidity; (iv) transportability; and (v) non-imitability. In fact, (Coleman) distinguished money into three types “Commodity money which contains its value; fiduciary money, which is a promise to pay, and fiat money, which is less than such a promise”. (Coleman) also suggested that the next stage of evolution will be ‘Cashless Societies’, where electronic clearing-houses will keep records on debits and credits rather than having cash exchanging hands. 2.2.1 Kinds of Money: Commodity Money Commodity money is money that takes the shape of a good and has an inherent value in itself ‘intrinsic value’ such as the six commodities mentioned in the Prophet’s Hadith (PBUH) on Riba Al-Fadl2 i.e. gold, silver, wheat, barley, dates and salt. Also, contemporary historical evidence shows that there are other types of commodities that were used as money like in the war camps of World War II prisoners used cigarettes as money to trade goods amongst each other3 . Likewise, cigarettes substituted currency in Moscow after “Perestroika” and the fall of the Soviet Union4 . (Mankiw) Pointed out that “In both cases, even nonsmokers were happy to accept cigarettes in an exchange, knowing that they could use the cigarettes to buy other goods and services”. It was also noted that commodity money has been lightly referred to in Aristotle’s books (350 B.C.) as he suggested that every object has two usages, the first being the original purpose for which the object was intended, and the second likelihood is to consider the object as an item to sell or barter. Nevertheless, it is noted that the most common 2 (Kahf, Riba As Described in the Qur'an and Sunnah) 3 (Mankiw) 4 (Mankiw)
  6. 6. Fiat Money and Gold Money 5 commodity that was used as money throughout history is Gold. Gold was always a key component in the international monetary systems throughout history. In fact, Money took the form of Gold for number of centuries. According to Herodotus, Gold money (gold coins) were initially introduced on the order of King Croesus of Lydia, in Asia Minor (currently Turkey) around (550 B.C.), from which it spread rapidly to Greece and then to the rest of the world5 . Since then Money was issued in the form of standardized coinage. Later the international monetary system operated under the gold standard, which established a direct tie between gold and paper money, with paper money being redeemable for gold on request. Fiat Money In contrast to commodity money, fiat money is a type of money that has no intrinsic value and not supported by gold reserves, but rather it gains its value from being ordered by the government and socially accepted by people. (Wayne E. Baker) argued that “Modern money derive their definitive bundle of traits from the socioeconomic organization of the societies in which they appear”. All currencies now (including paper, coins and digital accounts) are considered to be fiat money, and its worth is based on the issuing country economy’s strength. In fact, the term fiat is derived from the Latin term which means ‘so be it’ thus the literal meaning of Fiat Money is ‘so be it money’ or ‘money by order’. Some technical definitions of fiat money are listed hereunder: “A fiat is simply an order or decree, and fiat money is established as money by government decree i.e. money without intrinsic value that is used as money because of government decree” (Mankiw). “What is unique about fiat money is that, unlike gold or silver or some other easily carried “trade” commodity that has 5 (Davies)
  7. 7. Fiat Money and Gold Money 6 value in itself (and can, therefore, be traded for other things) printed fiat dollars, in themselves, are completely worthless. They attain their value only through a social contract” (Smith). According to Investopedia, fiat money is “Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Most of the world's paper money is fiat money. Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation's paper currency, the money will no longer hold any value”6 . 2.3 Functions of Money Money has three main functions in the economy namely: (i) Medium of exchange/Means of payment: money is used in this sense to facilitate buying and selling transactions, in the absence of money people would use the barter system. The main issue with the barter exchange, as highlighted earlier, that each transaction requires the double coincidence of wants, which has a minimal likelihood to exist and therefore ends up in an inefficient allocation of the Economy’s resources. Also, (Cecchetti and Schoenholtz) have argued that people would prefer Money over barter system since “Money is easier and finalizes payments so no further claims on buyers or sellers” (ii) Store of value: Money also is used as a store of value i.e. transferring the purchasing power between counterparties over different periods of time. Even though money is not 6
  8. 8. Fiat Money and Gold Money 7 the best asset to store value, as it depreciates over time in contrast to real estate for instance, money is the most liquid store-of-value-asset, “Money is the most liquid asset, but it is far from perfect as a store of value. When prices rise, the value of money falls” (Mankiw). (iii) Unit of account: Money also is used to measure the economic-value, determine the prices of goods and services, and record debts, “A unit of account is the yardstick people use to post prices and record debts” (Mankiw). Consequently this will enable market forces to interact efficiently and allocate resources effectively. It is worth mentioning here that Ibn Khaldoun has a pioneer contribution regarding the functions of Money theory, and as per many researchers, it is evident that Ibn Khaldoun put his theory of Value and Prices “Al-Qeima w Al-Athman” way before Adam Smith. According to the Khaldounian’s theory, Money is characterized by Monetary Stability “Al-Thabat Al-Naqdui”, which makes it suitable to act as means of exchange as well as store of value. In addition, Ibn Khaldoun argued that there is a direct relationship between welfare and prosperity, and the speed of circulation of Money, the higher the speed of circulation of Money the higher the standards of living and welfare of the community. 2.4 Development of Money and Monetary systems over time Money and monetary systems have dramatically developed and progressed over time. In this paper I will focus hereunder on three main stages of this development. First stage: Emergence of Money with an intrinsic value – Gold coins as an example. Second stage: Emergence of Paper Money backed by gold – The gold-standard. Third stage: Emergence of fiat Money not backed by Gold – Nixon Shock. First: Emergence of Money with an intrinsic value – Gold coins as an example
  9. 9. Fiat Money and Gold Money 8 In fact, gold has been used as the money of choice over time, until the emergence of paper money. The origination of gold coins as money can be traced back to early ages, precisely to the sixth century B.C. when gold money were initially introduced on the order of King Croesus of Lydia, as discussed above. Before further discussing the following two stages, it is worthwhile to review the emergence and development of Money throughout the Islamic History (from Prophet Muhammad PBUH until the fall of the Ottomans). The development of Money and currencies in the Islamic history reveals important aspects of Islamic communities’ development and cultural heritages as well as showing how Muslims, who used to be significantly illiterate people before Islam, have been elevated to a level of advancement and economic development no single civilized nation attained before in such a very short time. In fact, the pre-Islamic Arabs knew the money and used it in trading and exchange of goods and services. At the time, Gold and Silver coins were used as money, gold coin was called Dinar and silver coin was called Dirham, nevertheless, these coins’ source was the Roman Empire and was not struck by Arabs themselves. This currencies were the prevailing currencies during Prophet Muhammad’s PBUH time until the third year of Omar Ibn Al-Khatab’s tenure, when he introduced a newly struck silver Islamic Dirham and ordered to write on it “There is no God but Allah and Muhammad is His Messenger”. The biggest transformation in the Islamic Money development happened in Abdul Malik Ibn Marwan’s tenure. Abdul Malik Ibn Marwan ordered to mint new Islamic Money inside the country to replace the Romanian coins, following a dispute that happened between him and the Roman’s King. As a matter of fact, Abdul Malik Ibn Marwan, struck three types of currency namely, Dinar from Gold,
  10. 10. Fiat Money and Gold Money 9 Dirham from Silver and Fils from Copper. Islamic Money continued to take the form of gold and silver throughout Caliphates times until paper money was introduced. Second Stage: Emergence of Paper Money backed by gold – The gold-standard The emergence of Paper Money can be traced back to the eleventh century, when it was initially introduced by the Song Dynasty of China. The main reason of issuing Banknotes at the time is that merchants wanted to avoid carrying heavy weights of copper coinage in big transactions. However, paper money at the time didn’t replace coins, both of them were being used in parallel. Paper Money then spread and became known to the European continent around the thirteenth century, mainly by Marco Polo’s Travels Book7 . The first European paper money were issued by the Bank of Sweden (Stockholms Banco) during the second half of the 17th century. These issued banknotes replaced the metal coins at the time. However, this initiative didn’t succeed and the Bank of Sweden soon failed and stopped operations because the King of Sweden at the time ordered to print too much paper money to finance a war, and the bank ran out of the backing metal coins. On the other side of the European continent there was another initiative, in the United Kingdom this time. During the 18th century, the money metal coins were only issued by the Government, but British people preferred to keep their coins with goldsmiths for safety purposes. With the increase demand on safety by customers, those British goldsmiths become bankers rather than jewelers and started to issue bank-notes to their customers with the value of coins kept with them. If the customer demanded back their coins, they would present this paper note ‘bank-note’ to the bank to have back the 7 The Chapter about paper money called “How the Great Kaan Causeth the Bark of Trees, Made into Something Like Paper, to Pass for Money All over his Country”
  11. 11. Fiat Money and Gold Money 10 coins to spend them in the domestic markets. When shopkeepers in the local markets sold their goods and received the coins from customers, they would go to the goldsmiths to safe keep their coins with them and so on. Shopkeepers instead started to accept the banknotes, issued by trustworthy goldsmiths, directly from their customers to save the trip to the goldsmith. Over time, people got used to these bank notes and considered them a substitute for coins. Consequently, goldsmiths’ vaults became full of gold coins, obviously, goldsmiths were aware that this gives them a big opportunity for profits by lending these gold coins (or even lend newly issued bank notes backed by these coins) in return of interest. This new practice of Paper Money creation by private banks spread from the UK to other countries in Europe and eventually reached the United States. In the mid of the 18th century the gold-standard has emerged. According to the gold-standard rule any amount of paper money is redeemable for its value in gold by the government. This was meant to increase the confidence of the newly introduced paper money since it is now linked to something valuable i.e. gold. Under the gold-standard rule almost all countries linked their money to a fixed amount of gold, or in some cases linked their money to the currency of country which did so. Most countries’ economies worked well with gold-standard until WWI 1914 – 1919, when some nations started to abandon the gold-standard and printed huge amounts of paper money not backed by gold, to finance their military forces. For instance Germany put the gold-standard on hold and printed too much money, which eventually led to hyperinflation to the extent that, the purchase power of 1 trillion marks in 1923 was equivalent to the purchase power of only 1 mark in 1914. However, the gold standard was restored back after the end of the war, realizing its benefit to a nations’ economy, until the great depression in 1929 when the US
  12. 12. Fiat Money and Gold Money 11 government had to abandon the gold-standard again due to the rush of people trading their dollars for gold. In 1933 US President Roosevelt instructed American people to return back their gold in return of US Dollars, and no longer allowed people to redeem the gold for dollars again, even though it was never officially announced that the US abandoned the gold-standard. The accumulation of gold by the Federal Reserve made the American government the largest in holding gold reserves (about ¾ of the world’s gold supply). Third stage: Emergence of fiat Money not backed by gold – Bretton Woods and Nixon Shock After the end of the WWII biggest countries including USA adopted another system replacing the classical gold standard – so called Bretton Woods system. In 1944 most of European countries and the USA signed an agreement in the Bretton Woods conference, whereby European countries had to fix their currencies against the US dollar (because USA was the largest holder of gold supply), and the US dollar was fixed against gold in a rate of 35 dollars to 1 ounce of gold ($35/oz). This system worked very well and the world economies grew steadily under what so-called the Keynesian policies, until 1971, when US president Nixon untied the link between the US dollar and gold. In the year of 1971 the Nixon-Shock announcement has broken the link between the US Dollar and gold and led to the collapse of the Bretton Woods system. Since this move, all the world’s important, if not all, currencies became pure fiat money including US Dollars, Sterling Pound, and Euro. When fiat money emerged and widely used some commentators started to argue that the Rabawi-money (money which is subject to Riba) is only the gold and silver money, based
  13. 13. Fiat Money and Gold Money 12 on the fact that both types have intrinsic value, whereas the fiat money doesn't have intrinsic value, and its purchasing power diminishes over time due to inflation. Nevertheless, large number of prominent Muslim Scholars have rejected this argument, for instance Sheikh Youssef Al-Qaradwi dismissed this argument in his book "Banks' Interests is the Forbidden Riba"8 and argued back that "Part of these argument is false and the other part is true but leads to false conclusion. The false part is to confine the Cash/liquidity (‫النقدية‬) and Precious/valuable (‫الثمنية‬) characteristics of money to only gold and silver, and not consider the fact that fiat money has currently become the means of exchange, the store of value (the most liquid store of value asset) and the tool of saving, regardless the material from which it is made. In fact, this argument will have a dangerous implications such as revoking Zakat, which is the 3rd pillar of Islam, and legalizing Riba, which is one of the biggest 7 sins (‫السبع‬ ‫الموبقات‬)." (‫)القرضاوي‬ III. Fiat Money versus Gold Money Comparison on Social and Economic basis 3.1 Pros and Cons of Fiat Money Fiat money is not a scarce resource as gold, therefore, the quantity of fiat money supply is not limited by scarcity like gold but can be controlled by central banks to serve the monetary system of a country. In fact, central banks through money supply can control the economy and effect the society. Also the production cost of fiat money is fractional in comparison to the production cost of gold money. Fiat money doesn’t have an intrinsic value, which is viewed as an advantage in some school of thoughts and disadvantage in other school of thoughts. At one end of the spectrum, some argue that this enables 8 (‫)القرضاوي‬
  14. 14. Fiat Money and Gold Money 13 government to print money with little effort and cost to distribute wealth amongst their citizens. At the other end, some argue that this may induce governments to print too much quantities of money which leads to hyperinflation and eventually to exacerbate poverty. However, this notion of ‘intrinsic value’ was criticized by some reporters on the grounds that value of commodities and money may differ from one person to the other, hence, nothing has an inherent value, neither commodities nor fiat money, “Paper money, such as the note above, is sometimes criticized by ‘commodity money’ theorists on the grounds that it has no intrinsic value. But is there really such thing as ‘intrinsic value’? I would say that people will value goods and services differently, depending upon each person’s character and circumstances. Gold may in fact be quite value-less to the producer of goods. Value is always subjective, never ‘intrinsic’. When people make market exchanges, each gives the other something they value less at the time in exchange for something they value more. Gesell argues it is solely its utility in the act of exchange that should give money its value and that attempting instead to give money an ‘intrinsic value’ is attempting to conjure a phantom”. (Jones) On the other hand, many economists argue that the biggest disadvantage of fiat money is its exposure to devaluation (the decrease in its purchasing power). Many commentators also argue that fiat money under today’s fractional reserve banking system, induces banks to create more money, which could lead eventually to inflating the money supply within an economy. Consequently, this economy will suffer from price bubbles, which always results in financial and economic crisis. 3.2 Pros and Cons of Gold Money
  15. 15. Fiat Money and Gold Money 14 Since gold is a scarce resource then its supply is limited to its scarcity and cannot be fully controlled by central banks to serve the monetary system of a country, which may have negative implication on the economic growth. Gold money is not cost-efficient since it requires a long and expensive production process from mining to coinage, with the involvement of several production resources such as capital, labor, land…etc. Also, one of the most important disadvantages of gold money for governments, the restriction it imposes on their ability of issuing public debt as well as the limitations on credit lines extension, since a 100% reserve is required in case of gold money. On the other hand, some commentators suggested that the main advantage of the gold standard its ability to maintain lower levels of inflation. Nevertheless, it was argued by some commentators that on the long term this is a disadvantage rather than an advantage. “When money does not rust, those with money have a store of value immune to deterioration, while those holding goods do not. Hence those with money will have superior bargaining power to those with goods. They can wield this advantage in every market exchange, exploiting it to accumulate more and more money for themselves. Over time then, the “gold-bug utopia” goes bad – almost all the gold coins end up in the possession of a few people (the 1% you might call them!), who can then exploit their gold monopoly to trap everyone else into peonage. Producers still require a temporary means of exchange, but this has been monopolized by the holders of gold to serve as their incorruptible store of ever accumulating value. So gold must be borrowed at almost any rate of interest demanded by its lenders. Ironically enough, the Gold Standard advocated by Austrian economist Friedrich Hayek can itself be “the road to serfdom”!” (Jones). Therefore, it was contended by the advocates of this argument, that fiat money is more advantageous in
  16. 16. Fiat Money and Gold Money 15 comparison to gold money since it devalues over time, which leads to striking balance between money and the commodities it can buy, and consequently facilitates wealth distribution amongst different social classes. IV. Conclusion Generally speaking, we can conclude that it is proved that money, throughout history, has increased economic growth, social welfare and standard of living when compared to barter exchange. In addition, it is noted from historical evidence that barter system was used in relatively uncivilized simple communities since it required a double coincidence of wants, while when the man-kind started to become more civilized and transactions became more complicated, monetary exchange started to be used, whether in a commodity form (like gold) or in fiat form. It was also observed that money and monetary systems have been evolved dramatically over time from commodity money to fiat money. In fact, this evolvement had number of implications on man-kind from both social and economic standpoints as highlighted earlier. Fiat currency now can be viewed as a social custom supported by government rather than economic relationship.
  17. 17. Fiat Money and Gold Money 16 Bibliography Cecchetti, Stephen G. and Kermit L. Schoenholtz. Money, Banking and Financial Markets. McGrew- Hill/Irwin, 2010. Coleman, James S. Foundations of Social Theory. Cambridge: Harvard University Press, 1990. Davies, Glyn. A History of Money from Ancient Times to the Present Day, 3rd ed. Cardiff: University of Wales Press, 2002. Jones, David A. "Positive Money." 14 March 2012. Positive Money Web Site. Document. 1 October 2013. Josh Ryan-Collins, Tony Greenham, Richard Werner, Andrew Jackson. "Chapter 3. The nature and history of money and banking." Josh Ryan-Collins, Tony Greenham, Richard Werner, Andrew Jackson. Where Does Money Come From? London: New economics foundation, 2011. Kahf, Monzer. "Islamic Finance: Business as Usual." 25 September 2006. —. "Riba As Described in the Qur'an and Sunnah." 1997. Khaldoun, Ibn. Muqademat Ibn Khaldoun. 1377. Mankiw, N. Gregory. Principles of Economics. 2009. Smith, Devin. "The strange reality of fiat money." (2013). Wayne E. Baker, Jason B. Jimerson. "The Sociology of Money." The American Behavioral July/August 1992: 678. Document. ‫,القرضاوي‬ ‫يوسف‬ ‫.الشيخ‬ ‫المحرم‬ ‫الربا‬ ‫هي‬ ‫البنوك‬ ‫فوائد‬. ‫,الدوحة‬ n.d.