Last month the concept of a sovereign currency was introduced in this blog. We have all learned that our currency is “fiat” - it has “nothing” backing it up. Well, maybe “something” - but we don’t necessarily want to see what is behind Pehin Rahman’s “curtain”.
So today, let us take a peek behind the currency. Is there anything there, other than the Pehin Rahman’s - how shall we put it - family jewels?
What “backs up” domestic currency? There is, and historically has been, some confusion surrounding sovereign currency. For example, many policy makers and economists have had trouble understanding why the private sector would accept currency issued by government as it makes purchases.
Some have argued that it is necessary to “back up” a currency with a precious metal in order to ensure acceptance in payment. Historically, governments have sometimes maintained a reserve of gold or silver (or both) against domestic currency. It was thought that if the population could always return currency to the government to obtain precious metal instead, then currency would be accepted because it would be thought to be “as good as gold”. Sometimes the currency, itself, would contain precious metal—as in the case of gold coins. In the US, the Treasury did maintain gold reserves, in an amount equal to 25% of the value of the issued currency, through the 1960s (interestingly, American citizens were not allowed to trade currency for gold; only foreign holders of US currency could do so).
However, the US and most nations including Brunei have long since abandoned this practice. And even with no gold backing, the US currency is still in high demand all over the world, so the view that currency needs precious metal backing is erroneous. We have moved on to what is called “fiat currency” - one that is not backed by reserves of precious metals. While some countries do explicitly back their currencies with reserves of a foreign currency (for example, a currency board arrangement in which the domestic currency is converted on demand at a specified exchange rate for US Dollars or some other currency), most governments issue a currency that is not “backed by” foreign currencies. In any case, we need to explain why a currency like the Brunei or US Dollar can circulate without such “backing”.
Legal tender laws. One explanation that has been offered to explain acceptability of government “fiat” currency (that has no explicit promise to convert to gold or foreign currency) is legal tender laws. Historically, sovereign governments have enacted legislation requiring their currencies to be accepted in domestic payments. Indeed, paper currency issued in Brunei proclaims "wang kertas ini sah diperlakukan dengan nilai"; the US states “this note is legal tender for all debts, public and private”; Canadian notes say “this note is legal tender”; and Australian paper currency reads “This Australian note is legal tender throughout Australia and its territories.” By contrast, the paper currency of the UK simply says “I promise to pay the bearer on demand the sum of five pounds” (in the case of the five pound note). And the Euro paper currency makes no promises and has no legal tender laws requiring its use.
Further, throughout history there are many examples of governments that passed legal tender laws, but still could not create a demand for their currencies - which were not accepted in private payments, and sometimes even rejected in payment to government. (In some cases, the penalty for refusing to accept a king’s coin included the burning of a red hot coin into the forehead of the recalcitrant- indicating that without such extraordinary compulsion, the population refused to accept the sovereign’s currency.) Hence, there are currencies that readily circulate without any legal tender laws (such as the Euro) as well as currencies that were shunned even with legal tender laws. Further, as we know, the US Dollar circulates in a large number of countries in which it is not legal tender (and even in countries where its use is discouraged and perhaps even outlawed by the authorities). We conclude that legal tender laws, alone, cannot explain this.
If “modern money” is mostly not backed by foreign currency, and if it is accepted even without legal tender laws mandating its use, why is it accepted? It seems to be quite a puzzle. The typical answer provided in textbooks is that you will accept your national currency because you know others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an “infinite regress”: Ahmad accepts it because he thinks Siti will accept it, and she accepts it because she thinks Hua Ho will probably take it. What a thin reed on which to hang monetary theory!
Personally, I’d be embarrassed to write that in my own textbook, or to try to convince a skeptical person that the only thing backing money is the “greater fool” or “hot potato” theory of money: I accept a dollar note because I think I can pass it along to some dupe or dope.
Now, that is certainly true of counterfeit currency: I would take it only on the expectation that I could surreptitiously pass it along.
But I’m certainly not going to try to convince readers of this blog of such a silly theory. Next week: a more convincing argument. See if you can anticipate the answer.
Like a good Mexican soap opera, we need to leave you hanging. I know many readers already know the answer, and you’ve got your hands high in the air, saying “call on me, I know the Butler did it”.
But remember that this is a blog and not all of your classmates know the answer (yet). So, please don’t give away the plot line.
