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Fiat System


Fiat Money

Today's money in almost all economies is fiat currency or fiat money. Fiat money consists of coins and notes that have little intrinsic value and nor to they represent anything of intrinsic value as representative money does. Its value results from a government's order in law (fiat) that it can be used in settlement of a debt and that it will be demanded as payment for taxes. Any court of the economy will consider a debt paid if paid in the fiat currency.

This gives the coins and notes of the fiat currency a general use value to the population subjected to the taxes, and so an exchange value amongst them, making it suitable as money.

One of the advantages of a fiat currency is that it does not require tying up of valuable commodities when the objective is to store value.



The function of issuing of the fiat currency was initially the responsibility of government the government also having the power to collect tax. The government could issue money by spending it on public works. However issuing money necessarily leads to a devaluation. To avoid the governments recklessly issuing money the responsibility to issue money is given to an independent institution the central bank while the government must pay for public works by raising taxes. Thus the government cannot devalue the money.

Narrow Money

A central bank accepts certain types of asset and in exchange it provides a note or notes. At some later time the notes can be used to redeem the assets that were deposited with the central bank. In the beginnings of banking the assets were often precious metals and the notes represented a specific amount of gold for example. This was the gold standard.

These notes can be used as money, indeed the notes issued by the central bank, of an economy, are known as "the narrow money supply".

Nowadays the central bank assets can be commodities, foreign currencies, equity and debt collectively called financial assets. Further to this the central bank notes are no longer tied to specific amounts of anything. When a central bank bids to buy an asset it bids on the open market and buys at the market price. Similarly when it offers to sell an asset it offers on the open market and sells at the market price. These are called open market operations. The financial assets held by the central bank at any time are called its reserves.

The central bank can also borrow and lend its currency to other banks at the base rates which it determines. Central bank lending and borrowing and therefore the interest paid in both directions should balance in the long run so that the narrow money supply does not expand or contract.

The central bank has no limits on the notes it may issue or absorb, however it is responsible for maintaining financial stability in the economy based on those notes and so it should not be reckless in how it issues or absorbs them.

It must be responsible in terms of the prices it buys and sells assets at and the rate it borrows and lends at.

Theoretically its books should balance i.e. central bank assets should equal its liabilities. The notes it has issued, are of course, a liability. All the issued notes, i.e. the narrow money supply, should be just sufficient to buy all the assets held by the central bank. Of course if the central bank is forced to buy junk assets in "Quantitative Easing" operations then the books may no longer balance!


Over lending by the central bank can effectively implode the money supply as narrow money is withdrawn from circulation.

Narrow money generally refers to the amount of money in the field from the central bank irrespective of whether it was lent or paid for an asset. Once this is negative it can only be corrected by the sale of some asset to the bank.

Broad Money

The other banks practice fractional reserve banking and so amplify the narrow money creating the broad money supply.  The central bank may limit the broad money in the economy by setting the reserve requirements for other banks. Over lending by the other banks means risk of banks not being able to meet withdrawal demands and so going bankrupt. Lending by the other banks determines the degree of capitalism in the economy. To what extent it is sustainable.

Too much lending fuels an unsustainable boom, in the 1920s it was shares in the 1980 and on its housing, but once borrowed to the hilt the spending slows and the jobs that were sustained on that spending disappear. This means the spending drop is amplified by some factor. New jobs are needed that do not depend on the borrowed money but depend on earned money.

How can borrowers sustain their debt? If interest rates are reduced. These penalises savers. In order to keep interest rates down other restraints on borrowing must be put in place or the demand for loans will increase rates. Either that or the bank just says we have no money. This used to happen with building societies.

Banks that don't meet new capital adequacy requirements are technically bust but have to be supported by central bank. Cheap money they can lend on at a profit gives them a chance. But borrowing from the central bank adsorbs the narrow money supply in interest payments.

Value of Money

The question is what are the assets held by the central bank against which the money is issued?

Because at the end of the day its those assets that can be redeemed for the money issued by that central bank. It is those assets that give the money its most basic value to other banks. If there was an auction to buy those assets then in theory all the money and all the debts and interest payments should cancel out nicely.

Now when other banks

So is the value of the narrow money supply determined by the assets held by the central bank? No.

The value of the money is ultimately determined by the price of assets on the open market that can be bought with that money. It is determined by the offers to sell and the bids to buy in that currency's economy. While the assets are there on the market the money supply has its value from it.

The price of borrowing should be ultimately determined by the price of loans on the open market that can be bought with that money. It is determined by the offers to lend and the bids to borrow in that currency's economy. While the loans are there on the market the money supply has its value from it.


Because trade based on borrowed money is unsustainable, borrowed money should only be used for trade that does not need to be sustained, i.e. the loan necessary to establish a means for production. Large flows of borrowed money, over a period of time, can reshape the economy, but once the borrowing ceases the economy must be restored to sustainability.

The Physical Economic View


The central bank buys some financial asset from an other bank for some notes of its currency.

Banks tend to lend for anything where there is collateral and this to some extent determines in which assets bubbles are likely to form.

The asset price is determined by the notes supplied to buy it, which are increased by the availability of loans, and the fervour ("It will never go down.") that increases demand for the asset. 

The other bank lends the notes to a bubble buyer to buy a bubble asset. The bubble asset is collateral for the loan. The bubble buyer promises to return more notes than they borrowed but at some time in the future.

The bubble seller puts the notes in the other bank who lend most of them out to another bubble buyer. (Depending on the reserve requirement set by the central bank.) To increase lending banks reserve requirements were dangerously reduced.

This cycle continues, nearly all the notes end up in the vaults of the other bank as reserves. At this point many buyers have bought bubble assets.

Making borrowing easier for housing raises house prices and increased fervour "they will never go down!" Eventually it can't get any easier to borrow and so the added demand from ever easier borrowing disappears, A little later the fervour drops eventually leaving the base demand.

So what really happens in a lending bubble? Reckless lenders lend to reckless borrowers to buy an asset because "It will never go down." as an investment! Industry is turned to production of the bubble asset.

(1) the asset is the security
(2) the borrowers income pays the interest.

The borrower is subjugated to the lender. So the lender gets to spend the money the borrower earns and everybody is happy or at least anybody worth speaking of, until....
  • The borrowers reduce their earnings or,
  • The interest rates rise because there is more demand to borrow or there is less supply to lend.


Then Northern Rock happened. Suddenly many loans were seen to be junk and worth a lot less then thought. There was a risk of runs on banks that were under capitalised. Banks stopped lending to each other. Central banks lend to fill the gap.

The main dangers for the banks are;

(1) Loss of value of the collateral.
(2) Underestimation of the amount of loan defaults.
(3) A run on the bank.

As soon as the bubble asset price drops on the open market the loans lose some of their collateral and so begin to devalue effecting the banks balance sheet.

The default risk and interest paid on a loan also effects its value so if the default risk was underestimated then the loan value was overestimated which unfavourably effects the bank's balance sheet. If the balance sheet of the bank is negative then the bank is insolvent.

If investors believe a bank may become insolvent they will attempt to withdraw their savings all at once and so the bank then will have to borrow cash from the central bank against the value of its loans or sell its loans to somebody else. Either way any negative balance at the end should mean broke.

Banks become more vigilant. As new borrowing is made harder this subtracts demand for the bubble asset as loans are declined. This in turn can lead to a drop in prices.

Builders stop building and reduce supply to match and try and maintain prices. Sellers hold rather than sell. (Panic selling hasn't happened.) At this point the fervour may tip and go the other way!


However the day can be saved by the central bank effectively distorting the free market prices. It can;

(1) Buy debt at higher than the market price to effectively give banks capital.
(2) Effect interest rates buy buying bonds to lower interest rates and thus reduce defaults.

So central bank buys debt (Quantitative Easing) sometimes at inflated prices so as to take it off other bank balance sheets and give them money instead. This can do two things; it provides money that can be used immediately i.e. improves liquidity and capital adequacy, and sometimes improves the other banks balance sheet at the expense of the central bank.

Buys debt from domestic firms to try and "kick start the economy". Some money presumably helps to reform the economy but probably most simply props up the old system XXX

The central banks demand for debt raises the price of debt which brings down the yield.

The Bank of England predominantly buys government bonds from various institution including, insurance, pension funds and other banks,  but also buys debt from high street banks just sufficient to re-capitalise them.

The Europian Central Bank has ,,,,?

The low yields of debt encourages investors to sell debt and buy everything else so they push up prices of everything else. Bubbles have developed in shares and then commodities. The run from shares to commodities was driven by concerns of economic recession.

This keeps borrowing money easy but inflates the money supply. Keeps mortgages very affordable. "Buy to lets" laugh. Savers and pensions cry. Cost of borrowing reduced. Higher spending and more investment. Keeps home prices high. Encourages more reckless spending.

Other banks sensibly hang on to the new cash to be less reckless but government To require 20% deposit. Government puts up 15%!  try and keep new buyers in the market and keep prices high.

The reserve requirements have increased and the lending is more restricted, keeping many first time buyers out of the market and forcing them to rent, thus limiting the demand for housing. Interest rates are being maintained artificially low by the central banks thus keeping many property owners from repossession and thus controlling the supply of housing.

These property owners can continue to spend because their mortgages are not a burden at the given interest rates. Meanwhile investors struggle to find something to give them a decent return and pension funds are up the spout.

So by limiting borrowing by other means than simply the interest rate the central bank has managed to keep new debt in check while going easy on old borrowers. At least that is the theory.

The final problem is the supply of new houses with no first time buyers to buy into them. How can you keep the builders from building?


Depending on where this new lending goes i.e. what it is spent on will determine how prices in general become inflated. Clearly if it is initially spent down the old bubble channels then it will be some time before it flows into the general economy and inflates that. Although its initial intention might be to maintain the bubble asset price its effect will be to slowly inflate prices down the money stream. This inflation will only be counteracted by proportionally more supply of downstream products and services keeping prices stable. Otherwise the bubble asset prices will remain stable while everything else around them rises but with a delay.

While interest rates are lower than inflation, you are effectively paid to be in debt. And penalised for being in credit. The question is what to buy to be in debt. Do not buy bubble assets i.e. anything people have been or are over enthusiastic about.

Bank of England says if inflation goes above 2% it could raise bank rate and sell assets to remove the extra money it put into the economy HAHA

Money is drawn out of the economy by interest payments to the central bank, it is a deflationary force. If the bank is true to its word it will increase interest rates to draw money out of the economy. But raising interest rates will accelerate the housing crash and so banks will be short on collateral. In US a default you can walk away from. Elsewhere you end up with negative equity.


What will tip this little pile of sh..

To avoid inflation the money supply must not be expanded. However inflation is the best way to reduce debt to affordable levels and to recapitalise banks. so since creditors are in the minority this is what will happen in any country where both the government and people are in debt it is a forgone conclusion. Where only the government or the people are indebt it is less so.

Where an economy is a net creditor of the rest of the world then it will not inflate its currency unless it tries to protect its export industry as the Swiss did.

How to understand this? What happens when people buy rice instead of shares to hold value? Then rice farmers buy what they want instead of sellers of shares buying what they want.

The rice is stored not used. If a share had been bought a possible new enterprise might have been born. There is a change in the economic effort from production to storage.

What happens when people lend instead of spend? The defer consumption for higher consumption in the future.

Lenders instead of lending as a store of wealth tend to buy commodities inflating the prices of them. Sellers then have extra money which goes where? Well gets spent right?

But the commodities are taken out of the economy promoting inflation.
Lending takes nothing out of the economy and so in that respect is a better way to hold wealth.


The central bank balance sheet is a reflection of the debt owed to it by the economy. If the economy owes the central bank it must give it assets it wants, financial commodities such as gold, to get back in balance.

So government creates jobs paid for by taxes. This means that the real earners subsidize the government created jobs.

Essentially the debtors must give something back to the creditors, something worth having. Not some government made up nonsense like current health and safety inspections. As creditors we can only buy what is sold in the given currency. The debtors produce nothing we want, we get our money back but have nothing to spend it on.

ECB: Monetary aggregates


© Tom de Havas 2011. The information under this section is my own work it may be reproduced without modification but must include this notice.