Fiat money

Often called paper money, fiat money is in a wider sense any money declared to be legal tender by government fiat (ie law). In a narrower sense, fiat money is an intrinsically useless good declared to be legal tender by government fiat. All modern paper currencies are fiat money.

"In no period of human history has paper money spontaneously emerged on the free market. In all known historical cases, paper money has come into existence through government-sponsored breach of contract and other violations of private-property rights."

Jörg Guido Hülsmann, Ethics of Money Production.

Properties
There are many reported advantages to fiat money as opposed to commodity-based money, among them:
 * much lower costs of production
 * the quantity can be easily modified to suit the needs of trade
 * the quantity can be easily modified to stabilize the value of the money unit.

The main risk of this money is the possibility of a complete loss of value. See also For and against paper money.

Legal Privilege
"Under a fiat money standard, governments (or their central banks) may obligate themselves to bail out, with increased issues of standard money, any bank or any major bank in distress. In the late nineteenth century, the principle became accepted that the central bank must act as the "lender of last resort", which will lend money freely to banks threatened with failure. Another recent American device to abolish the confidence limitation on bank credit is "deposit insurance", whereby the government guar­antees to furnish paper money to redeem the banks’ demand li­abilities. These and similar devices remove the market brakes on rampant credit expansion."

According to Hülsmann, there are four groups of legal privileges granted by the state (usually more than one is granted):
 * legalized counterfeiting - the promises of banks are allowed to be more "elastic". For example, a coin marked "an ounce of gold" will be allowed to have any amount of gold or none, and can have any meaning. Banknotes were named "promises to pay", but were obscure on the details.
 * monopoly - only some monetary products may be produced by law, like a specific metal; or only the banknotes or coins of a certain bank. This limits the freedom of choice of users of money and benefits the producers and first recipients at the detriment of others.
 * legal tender is a money, that must be accepted in exchanges under a predefined price. Some monies may be driven out of the market due to Gresham's Law.
 * legalized suspension of payments allows banks to avoid paying their obligations, while receiving payments from their debtors. If a bank is freed from contractual obligations to redeem its money and it is also legal tender, its banknotes become genuine paper money.

With legal privileges are the banks allowed to behave more irresponsibly, which increases moral hazard.

Origin
Money did not and never could begin by some arbitrary social contract, or by some government agency decreeing that everyone has to accept the tickets it issues. Even coercion could not force people and institutions to accept meaningless tickets that they had not heard of or that bore no relation to any other pre-existing money.

If anyone could produce paper money on their own, without backing by an underlying commodity, a hyperinflation would soon follow. Free entry into the note-production business must be restricted, and a money monopoly must be established. Fiat money can be only established via the development of money substitutes (paper titles to commodity money) - but only fraudulently and only at the price of economic inefficiencies. Hoppe speaks of the "devolution" of money.

Kuznetsov points out, that if a state forces its citizens to use the money and pay taxes with it, it becomes universally desirable because no one wants to be in prison. The fiat money can be exchanged for specific goods, such as the ability to escape aggressive violence.

Links

 * Is Our Money Based on Debt? by Robert P. Murphy, August 2010
 * Fiat Money and Collective Corruption (pdf) by Thorsten Polleit, 2011