Continuation of Part II: Standardized coinage and Representative money.
Fiat money
Fiat money refers to money that is not backed by reserves of another commodity. The money
itself is given value by government fiat (Latin for "let it be done") or decree, enforcing
legal tender laws, previously known as "forced tender", whereby debtors are legally relieved
of the debt if they (offer to) pay it off in the government's money.
By law the refusal of
"legal tender" money in favor of some other form of payment is illegal, and has at times in
history (Rome under Diocletian, and post-revolutionary France during the collapse of the
assignats) invoked the death penalty.
Governments through history have often switched to forms of fiat money in times of need such
as war, sometimes by suspending the service they provided of exchanging their money for gold,
and other times by simply printing the money that they needed (eg. see
Germany of World War 1). When governments produce money
more rapidly than economic growth, the money supply overtakes economic value. Therefore, the
excess money eventually dilutes the market value of all money issued.
This is called Inflation.
In 1971 the US finally switched to fiat money indefinitely. At this point in time many of the
economically developed countries' currencies were fixed to the US dollar (Bretton Woods
Conference), and so this single step meant that much of the western world's currencies became
fiat money based.
Credit money
Credit money often exists in parallel with other money such as fiat money or
commodity money,
and from the user's point of view is indistinguishable from it. Most of the western world's
money is credit money derived from national fiat money currencies.
Strictly speaking a debt is not money, primarily because debt can not act as a unit of
account. All debts are denominated in units of something external to the debt. Hence credit
money is not strictly money at all.
However, credit money certainly acts as a money substitute
when it comes to the other functions of money (medium of exchange and store of value). As such
the existence of credit money may dampen demand for the real money and in so doing alter the
dynamics of money's market value.
When paper money is merely an IOU for something such as gold, then the paper itself is not
a unit of account but merely a convenient medium of exchange. Under a rigid gold-standard
with convertiblity, paper currency is merely a debt instrument.
However, when paper money
floats, its value is not defined by reference to an external unit of account. It is no
longer a debt instrument but rather it becomes purely monetary and its value is a product
of the dynamics of supply and demand. Typically a central bank forces supply and the private
sector forces demand.
During the Crusades in Europe, precious goods would be entrusted to the Catholic Church's
Knights Templar, who effectively created a system of modern credit accounts. Over time this
system grew into the credit money that we know today, where banks create money by approving
loans - although the risk and reserve policies of each national central bank sets a limit
on this, requiring banks to keep reserves of fiat money to back their deposits.
Sometimes,
as in the U.S.A. during the Great Depression or the Savings and Loan crisis, trust in bank
policies drops very low and government must intervene to keep the industry of credit in
operation.
Part I: Bartering and Commodity money
Part II: Standardized coinage and Representative money
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