In today’s world of cryptocurrency, the internet is full of rage about fiat money being ‘unbacked’. Which means that you cannot go to a bank and redeem your paper money for gold (or whatever) – instead, you just have to accept it as legal tender.

And because we’re law-abiding citizens (or sheep), we do just accept it as money.

But is it really ‘unbacked’ though?

Having both lived through and academically-studied a hyperinflation first-hand (and hyperinflation is the full realisation of our fiat money fears), I think that fiat money is more ‘backed’ than you may think. Because here’s a thing: even when a currency’s value is being destroyed by money creation (like the bolivar in Venezuela), people continue to use it. 

And that can’t be because people are generally law-abiding. Hyperinflations are accompanied by price controls and restrictions on money exchange – and those same people who use the hyperinflating money will simultaneously (and happily) flout those laws.

So why?

What backs fiat money?

To answer this question, I’m going to start at a tangent and talk about how a company works.

How business does business

A company will have revenue, which will come from either selling a good or providing a service. And it will also have all the costs associated with generating that revenue: salaries, overheads, rentals, etc.

In most countries, companies are also appointed as tax collectors. They collect tax from:

• Their clients (usually in the form of Sales tax or VAT); and
• Their employees (payroll taxes).

They also pay tax themselves, in the form of:

• VAT (when they are purchasing goods and services from other ‘tax collector’ businesses);
• Income Tax (when they make a profit); and
• Customs Duties, levies, licence fees, permits and municipal rates (which vary according to the type of business).

Often, a business will also obtain some services and goods from parastatal companies. Depending on where you are in the world, these could include:

• Utilities (electricity, water, and telephone services);
• Fuel;
• Almost anything, really. There’s no limit to the variety of parastatals.

And when they’re not busy collecting tax or paying for other state-related stuff, most businesses are attending to their cash flow. Which involves banks, and credit cards, and overdraft facilities.

Why do I mention those activities?

Because those activities are all practically always payable in legal tender (until you hit the extremes of hyperinflation, by which point, everything is changing over anyway).

The point is: a government has to accept the tender that it, itself, has declared as legal*. And the banking sector also cannot refuse to accept ‘legal tender’ as a settlement of a debt – the Central Bank doing all the printing makes sure of it.
*To be honest, as mentioned above, the occasional government department may try to refuse the legal tender when the hyperinflation is extreme – especially those that have foreign currency obligations (for example, a parastatal fuel importer). But those examples really are isolated – the big ticket items (like tax payments) are always ‘settleable’ in domestic fiat money. 

What does this mean?

I guess what I’m trying to say is that the answer to the question of “What backs fiat money?” is:

“Taxation and credit”.

Those two systems are ultimate anchors for the value of a currency. As long as you can use a currency to pay taxes, and as long as you can use a currency to settle debts, there will be a demand for it.

Agreed, when tested, it’s a diminishing demand: because not all expenses *have* to be settled in legal tender.

But as a basis for a monetary standard, it’s how countries moved off the gold standard without too much fuss.

And also

On the other side of the equation, a government will always pay its bills in its own legal tender.

Which means that if companies want access:

• to the spending of civil servants;
• to the proceeds of government contracts; and/or
• to the spending of those companies and individuals that have already accepted that spending and those proceeds;

Then they too must accept settlement in legal tender.

Of course, they may have adjust their prices to reflect the settlement in that legal tender. But that’s not the same as refusing to accept payment in the legal tender at all.

The main conclusion

When the Bank of England writes on the 10 pound note “I promise to pay the bearer on demand the sum of 10 pounds”, we should read it as a note from the British Government saying:

“We promise to accept this note on request as settlement of a tax obligation with us for 10 pounds.”

That is: fiat money is backed by its government’s commitment to collect future taxes, and its banking sector’s commitment to accept future debt settlement.

I realise that’s hardly a comfort to those who dislike fiat money.

But perhaps there should be a difference between disliking how something is backed, and declaring it to be unbacked altogether?

Just a thought.

Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha. Also, check out the RA podcast on iTunes: The Story of Money.