Saturday, May 9, 2009

A False Assumption

I’d like to comment on a statement one routinely sees in nearly every critique of the dollar or fiat currency—the fallacy that it is "backed by nothing." This sentiment is all over the blogs, even otherwise good ones supporting free market principles.

Granted, the only use of paper money I can think of other than spending is to patch side wall tears in bicycle tires: due to its durability you can stick paper money between the torn tire and the inner tube and get home that way. Otherwise it is already printed on so you can't use it as notepaper, and due to paper money’s poor absorbent qualities it wouldn’t even be good for the usual uses of throwaway paper.

Okay, there isn’t much intrinsic value in the bill itself, unlike gold coins which could be melted down to make jewelry, arthritis medication, or a handful of other industrial uses.

But fiat currency is backed by the law. It’s legal tender. So legally, it is backed by all things for sale in the American economy; in a 10% fractional reserve system, credit accounts for around 90% of the money supply, so it is not something a merchant could easily turn away. In practice dollars can be conveniently and easily exchanged for goods and services. For anyone who holds the dollar, it is backed by any and all things for sale in America.

In this light, let us compare paper money to a stock certificate. Those who would disparage the dollar would tend not to say that a stock certificate is backed by nothing. But practically speaking, it is not like you can exchange some certificates for machinery from a factory, even if you are supposedly a part owner of it. The stock certificates gives one power over the management, supposedly, and the potential for dividends. But beyond that, company stocks can only be exchanged for dollars. So really a stock certificate is backed only by that which many consider to be backed by nothing, or fiat currency.

So paper money has all kinds of backing. Any criticism built on the premise that fiat currency is backed by nothing is illogical, dead wrong, and can be safely dismissed.

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