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The Emergence of Fiat Money: A Reconsideration
By Kevin Dowd
Introduction
One of the fundamental questions in monetary economics is why fiat money has value: Why do rational agents trade real resources for intrinsically worthless pieces of paper? Monetary economists have long understood that part of the explanation relates to the superiority of a monetary equilibrium over a barter one. However, it is one thing to explain why fiat money is better than barter, and quite another to explain how fiat money actually emerges. Recognizing this point, a number of recent studies (e.g., Kiyotaki and Wright 1991, 1992, 1993; Ritter 1995; and Williamson and Wright 1995) have sought to explain the emergence of fiat money by means of a hypothetical direct jump from barter to a fiat money equilibrium.
This paper suggests that these attempts are fundamentally misconceived. They suffer from three main problems. The first is the "start problem"—that is, the difficulty of ensuring an initial demand for fiat money balances. If fiat money is ever to emerge from barter, someone must be the first to exchange real goods for pieces of paper money that, by definition, do not provide any direct consumption services to the holder. The problem is that no agent will ever give up real goods for intrinsically worthless pieces of paper, unless he believes that others will accept them too, and an agent living in a barter economy has no reason to expect them to. Each agent would therefore refuse to accept fiat money, because he expects others to refuse it as well. People will not move away from barter equilibrium, precisely because it is an equilibrium.
Second, even if we could solve this first problem, there is the difficulty that agents generally face a choice of potential monetary objects, in which case we get a multiplicity of potential equilibria involving the use of any one or more of these objects as money. The equilibrium that actually results will then depend on agents' expectations about the acceptability of different objects, and it is not easy, to say the least, to manipulate these expectations to produce any one particular equilibrium. It will be fortuitous if all agents happened to choose only one object, and even more fortuitous if they all chose government fiat money.
Finally, the predictions of these models are at odds with the historical evidence. Fiat money did not in fact evolve in the way these models postulate: nowhere did fiat money ever emerge by means of a great leap forward from barter. Nor did fiat monies ever emerge out of thin air. Instead, fiat monies have always developed out of some previously existing money. If we are to explain the emergence of fiat money, we must therefore explain how it emerges from previously existing money, not from barter.
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