Fiat dollars explained
October 26, 2015 § 46 Comments
The king has legitimate authority to levy taxes. As with all human authorities this particular authority is inherently limited. (We’ve discussed some possible moral limitations on the sovereign’s authority to tax before).
Suppose that initially the king decides to levy taxes in gold. Gold is a useful industrial commodity and is relatively portable, which makes it convenient, and people are already using it for marketplace exchanges for those reasons. So when a citizen comes to the king to pay his taxes, that citizen has to first get some gold. Perhaps the farmer sells some of his wheat in the marketplace for gold, and he brings some of that gold to the publican to pay his tax liability.
The king has many things that he has to pay for himself. For example he has to pay wages to his soldiers. He pays them with gold, which he acquires in all sorts of different ways, only one of which is through taxation.
But dealing directly in gold is rather unwieldy, for a variety of reasons. The problems of physical transfer and security can be mitigated by keeping the gold stockpiled and, instead of physically transferring gold around, using a system of ‘banking’ to transfer title to gold around. We call these titles-to-gold ‘dollars’, and everything proceeds as before except that now we don’t have to take unnecessary risks and waste resources moving lots of physical gold around.
(This ‘banking’ system will later develop into a system of fractional reserve lending, which I’ll probably discuss again in a later post. For the time being and for the purposes of the present post the banks simply hold the gold for us and transfer title – ‘dollars’ – around, for a fee which we pay. It is worth it to ‘depositors’ to pay the banker’s fees, because using the ‘bank’ is both more convenient and more secure. Taking care of real property always and without exception carries risks and costs).
However, the king notices that using gold and titles to gold (‘dollars’) in this way for transactions creates market distortions. Some people in niche markets still value gold for its usefulness as an industrial commodity, of course, but most people also value it as a means for settling tax liabilities and as a general currency for buying and selling in the marketplace. The settlement of public and private debts via gold and gold-titles however is itself distorted by the gold-qua-gold niche market: most people as it turns out have a lot more use for food, clothes, shelter, land, tools, etc than they do for gold, but a shortage (or overabundance) of gold can still cause all sorts of problems for a town or city or region when fluctuations occur. Large numbers of people whose lives objectively depend not a bit on this one niche industrial commodity nevertheless find their flourishing has become slave to this one narrow market: the use of gold as universal currency distorts both the gold market qua industrial commodity and the markets in all sorts of other things.
So the king decides to issue tax vouchers, entirely independent of gold or other industrial commodities, which he pledges to accept from citizens to settle their tax liabilities. Just to be confusing he calls these tax vouchers ‘dollars’, the same label which was previously given to gold-titles. These fiat dollars have value, not because they entitle the bearer to some quantity of gold, but because they entitle the bearer to settlement of tax liability in the denominated amount. These tax vouchers (fiat dollars) then replace the use of gold titles (so-called ‘hard currency’) as a convenient marketplace currency, precisely because using them to temporarily store and carry value is very convenient. People are of course welcome to use whatever currency they like in private transactions, but when tax liabilities arise they must be valued in fiat dollars and settled by giving the king back the vouchers that he issued.
Because these tax vouchers have intrinsic value to the bearer, the king himself can use them to pay for things — the wages of soldiers, for example. And like a corporation with theoretically plenary power to issue capital stock, the king has theoretically plenary power to issue more vouchers whenever he chooses. However this power is, like the aforesaid corporation, limited by numerous practical and moral considerations. If he issues too many at once (for example) then they become worth less, and his outstanding tax claims against citizens become correspondingly worth less. In general the stability of the king’s fiat currency will reflect the supply of his tax vouchers (‘dollars’) in the marketplace and the public’s faith in his long term viability as a tax authority.