fiat money vs. gold money and social acceptability

Prepared by: Samer Abou Zaghla10/30/2013

2013

Fiat Money and Gold Money

The purpose of this paper to compare and contrast fiat and gold money on econ and social bases.


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I. Introduction

Purpose of the paper

Paper structure

II. What is Money

Definition

Emergence of money

Function of money

Development of money and monetary systems over time

III. Fiat Money Vs. Gold Money

Comparisons

Pros and Cons of fiat money

Pros and Cons of gold money

IV. Conclusion

V. References and Bibliography


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I. Introduction

Money is considered to be the most important invention by the man kind to carry out trading

and exchanges of goods and services throughout history. The term Money has been used

throughout history to call any object used as means of exchange including gems, commodities,

gold, silver, sugar, food, animal skins, and even cigarettes. Before, inventing money people used

Barter system (the exchange of one good or service for another) in exchange and trading, which

always required what Edgeworth (1881) called a “double coincidence of wants”. The main

problem of the Barter system that it is highly unlikely to always find two persons each have a

good or service that the other demands, which is make it very difficult for any economy to

achieve an efficient allocation of its scarce resources. Whereas, Money makes it easier and more

feasible to trade, since the seller in any transaction will not be concerned whether the

counterparty can produce a useful and precious commodity or service for him. He/she will be

pleased to receive the Money, recognizing that it is acceptable by others in case he/she becomes

a buyer in another transaction. (Wayne E. Baker) For example contended that “Modern money

depersonalizes transactions and disembeds relations”. Money, in this sense, enables production

and trading, and encourages people to work and do their best in the areas of their preferences,

consequently, this will facilitate economic growth and enhances standards of living1. In addition,

money also endorses personal freedom as stated by (Wayne E. Baker) “Depersonalization

permits new levels of individual freedom. Money, Parsons (1967) argued, grants four freedoms,

you are free to buy what you want, from whom you want, and can accept or reject the conditions

under which you buy”. The first part of this paper will discuss different types and functions of

1 This was argued by Ibn Khuldoun before the advent of modern economics discipline (Khaldoun).


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Money as well as the development of money and monetary systems over times. In the following

part, the paper will focus on two types of money i.e. Gold and Fiat Money and will establish a

comparison between both in terms of advantages and disadvantages from economic and social

angles.

II. What is Money

II.1 Definition of Money:

Money can be defined as an asset that is commonly and socially accepted amongst people to

pay for commodities, services and to pay back loans, “Money is an asset that is generally

accepted as payment for goods and services or repayment of debt” (Cecchetti and

Schoenholtz). In addition, (Mankiw) defined Money as “the set of assets in the economy that

people regularly use to buy goods and services from other people”. Moreover, Money is

considered to be a debt on the society, for example it is written on the dollar “This note is a

legal tender for debts, public or private”, also on old Egyptian pounds it was written “This

note is a debt on the State treasury” .

II.2 Emergence of Money – Introduction

From reviewing the history of money, we can find out that many different objects have been

used as money over times such as, gold, silver, wheat, dates, copper, animal skins, cigarettes,

precious stones…etc. While a number of objects have been used as money, some have

functioned in a superior way than others. Those objects that functioned well, tended to have


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five fundamental features: (i) durability; (ii) divisibility; (iii) liquidity; (iv) transportability;

and (v) non-imitability. In fact, (Coleman) distinguished money into three types “Commodity

money which contains its value; fiduciary money, which is a promise to pay, and fiat money,

which is less than such a promise”. (Coleman) also suggested that the next stage of evolution

will be ‘Cashless Societies’, where electronic clearing-houses will keep records on debits and

credits rather than having cash exchanging hands.

II.2.1 Kinds of Money:

II.2.1.1 Commodity Money

Commodity money is money that takes the shape of a good and has an inherent value in itself

‘intrinsic value’ such as the six commodities mentioned in the Prophet’s Hadith (PBUH) on

Riba Al-Fadl2 i.e. gold, silver, wheat, barley, dates and salt. Also, contemporary historical

evidence shows that there are other types of commodities that were used as money like in the

war camps of World War II prisoners used cigarettes as money to trade goods amongst each

other3. Likewise, cigarettes substituted currency in Moscow after “Perestroika” and the fall of

the Soviet Union4. (Mankiw) Pointed out that “In both cases, even nonsmokers were happy to

accept cigarettes in an exchange, knowing that they could use the cigarettes to buy other

goods and services”. It was also noted that commodity money has been lightly referred to in

Aristotle’s books (350 B.C.) as he suggested that every object has two usages, the first being

the original purpose for which the object was intended, and the second likelihood is to

consider the object as an item to sell or barter. Nevertheless, it is noted that the most common

commodity that was used as money throughout history is Gold. Gold was always a key

2 (Kahf, Riba As Described in the Qur'an and Sunnah)3 (Mankiw)4 (Mankiw)


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component in the international monetary systems throughout history. In fact, Money took the

form of Gold for number of centuries. According to Herodotus, Gold money (gold coins)

were initially introduced on the order of King Croesus of Lydia, in Asia Minor (currently

Turkey) around (550 B.C.), from which it spread rapidly to Greece and then to the rest of the

world5. Since then Money was issued in the form of standardized coinage. Later the

international monetary system operated under the gold standard, which established a direct

tie between gold and paper money, with paper money being redeemable for gold on request.

2.2.1.2 Fiat Money

In contrast to commodity money, fiat money is a type of money that has no intrinsic value

and not supported by gold reserves, but rather it gains its value from being ordered by the

government and socially accepted by people. (Wayne E. Baker) argued that “Modern money

derive their definitive bundle of traits from the socioeconomic organization of the societies in

which they appear”. All currencies now (including paper, coins and digital accounts) are

considered to be fiat money, and its worth is based on the issuing country economy’s

strength. In fact, the term fiat is derived from the Latin term which means ‘so be it’ thus the

literal meaning of Fiat Money is ‘so be it money’ or ‘money by order’. Some technical

definitions of fiat money are listed hereunder: “A fiat is simply an order or decree, and fiat

money is established as money by government decree i.e. money without intrinsic value that

is used as money because of government decree” (Mankiw). “What is unique about fiat

money is that, unlike gold or silver or some other easily carried “trade” commodity that has

value in itself (and can, therefore, be traded for other things) printed fiat dollars, in

themselves, are completely worthless. They attain their value only through a social

5 (Davies)


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contract” (Smith). According to Investopedia, fiat money is “Currency that a government

has declared to be legal tender, despite the fact that it has no intrinsic value and is not

backed by reserves. Historically, most currencies were based on physical commodities such

as gold or silver, but fiat money is based solely on faith. Most of the world's paper money is

fiat money. Because fiat money is not linked to physical reserves, it risks becoming worthless

due to hyperinflation. If people lose faith in a nation's paper currency, the money will no

longer hold any value”6.

II.3 Functions of Money

Money has three main functions in the economy namely:

(i) Medium of exchange/Means of payment: money is used in this sense to facilitate

buying and selling transactions, in the absence of money people would use the barter

system. The main issue with the barter exchange, as highlighted earlier, that each

transaction requires the double coincidence of wants, which has a minimal likelihood

to exist and therefore ends up in an inefficient allocation of the Economy’s resources.

Also, (Cecchetti and Schoenholtz) have argued that people would prefer Money over

barter system since “Money is easier and finalizes payments so no further claims on

buyers or sellers”

(ii) Store of value: Money also is used as a store of value i.e. transferring the purchasing

power between counterparties over different periods of time. Even though money is

not the best asset to store value, as it depreciates over time in contrast to real estate

for instance, money is the most liquid store-of-value-asset, “Money is the most liquid

6 www.investopedia.com

http://www.investopedia.com/


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asset, but it is far from perfect as a store of value. When prices rise, the value of

money falls” (Mankiw).

(iii) Unit of account: Money also is used to measure the economic-value, determine the

prices of goods and services, and record debts, “A unit of account is the yardstick

people use to post prices and record debts” (Mankiw). Consequently this will enable

market forces to interact efficiently and allocate resources effectively.

It is worth mentioning here that Ibn Khaldoun has a pioneer contribution regarding the

functions of Money theory, and as per many researchers, it is evident that Ibn Khaldoun

put his theory of Value and Prices “Al-Qeima w Al-Athman” way before Adam Smith.

According to the Khaldounian’s theory, Money is characterized by Monetary Stability

“Al-Thabat Al-Naqdui”, which makes it suitable to act as means of exchange as well as

store of value. In addition, Ibn Khaldoun argued that there is a direct relationship between

welfare and prosperity, and the speed of circulation of Money, the higher the speed of

circulation of Money the higher the standards of living and welfare of the community.

II.4 Development of Money and Monetary systems over time

Money and monetary systems have dramatically developed and progressed over time. In

this paper I will focus hereunder on three main stages of this development.

First stage: Emergence of Money with an intrinsic value – Gold coins as an example.

Second stage: Emergence of Paper Money backed by gold – The gold-standard. Third

stage: Emergence of fiat Money not backed by Gold – Nixon Shock.

First: Emergence of Money with an intrinsic value – Gold coins as an example

In fact, gold has been used as the money of choice over time, until the emergence of

paper money. The origination of gold coins as money can be traced back to early ages,


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precisely to the sixth century B.C. when gold money were initially introduced on the

order of King Croesus of Lydia, as discussed above. Before further discussing the

following two stages, it is worthwhile to review the emergence and development of

Money throughout the Islamic History (from Prophet Muhammad PBUH until the fall of

the Ottomans).

The development of Money and currencies in the Islamic history reveals important

aspects of Islamic communities’ development and cultural heritages as well as showing

how Muslims, who used to be significantly illiterate people before Islam, have been

elevated to a level of advancement and economic development no single civilized nation

attained before in such a very short time. In fact, the pre-Islamic Arabs knew the money

and used it in trading and exchange of goods and services. At the time, Gold and Silver

coins were used as money, gold coin was called Dinar and silver coin was called Dirham,

nevertheless, these coins’ source was the Roman Empire and was not struck by Arabs

themselves. This currencies were the prevailing currencies during Prophet Muhammad’s

PBUH time until the third year of Omar Ibn Al-Khatab’s tenure, when he introduced a

newly struck silver Islamic Dirham and ordered to write on it “There is no God but Allah

and Muhammad is His Messenger”. The biggest transformation in the Islamic Money

development happened in Abdul Malik Ibn Marwan’s tenure. Abdul Malik Ibn Marwan

ordered to mint new Islamic Money inside the country to replace the Romanian coins,

following a dispute that happened between him and the Roman’s King. As a matter of

fact, Abdul Malik Ibn Marwan, struck three types of currency namely, Dinar from Gold,

Dirham from Silver and Fils from Copper. Islamic Money continued to take the form of

gold and silver throughout Caliphates times until paper money was introduced.


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Second Stage: Emergence of Paper Money backed by gold – The gold-standard

The emergence of Paper Money can be traced back to the eleventh century, when it was

initially introduced by the Song Dynasty of China. The main reason of issuing Banknotes

at the time is that merchants wanted to avoid carrying heavy weights of copper coinage in

big transactions. However, paper money at the time didn’t replace coins, both of them

were being used in parallel. Paper Money then spread and became known to the

European continent around the thirteenth century, mainly by Marco Polo’s Travels

Book7. The first European paper money were issued by the Bank of Sweden (Stockholms

Banco) during the second half of the 17th century. These issued banknotes replaced the

metal coins at the time. However, this initiative didn’t succeed and the Bank of Sweden

soon failed and stopped operations because the King of Sweden at the time ordered to

print too much paper money to finance a war, and the bank ran out of the backing metal

coins. On the other side of the European continent there was another initiative, in the

United Kingdom this time. During the 18th century, the money metal coins were only

issued by the Government, but British people preferred to keep their coins with

goldsmiths for safety purposes. With the increase demand on safety by customers, those

British goldsmiths become bankers rather than jewelers and started to issue bank-notes to

their customers with the value of coins kept with them. If the customer demanded back

their coins, they would present this paper note ‘bank-note’ to the bank to have back the

coins to spend them in the domestic markets. When shopkeepers in the local markets sold

their goods and received the coins from customers, they would go to the goldsmiths to

safe keep their coins with them and so on. Shopkeepers instead started to accept the

7 The Chapter about paper money called “How the Great Kaan Causeth the Bark of Trees, Made into Something Like Paper, to Pass for Money All over his Country”


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banknotes, issued by trustworthy goldsmiths, directly from their customers to save the

trip to the goldsmith. Over time, people got used to these bank notes and considered them

a substitute for coins. Consequently, goldsmiths’ vaults became full of gold coins,

obviously, goldsmiths were aware that this gives them a big opportunity for profits by

lending these gold coins (or even lend newly issued bank notes backed by these coins) in

return of interest. This new practice of Paper Money creation by private banks spread

from the UK to other countries in Europe and eventually reached the United States. In the

mid of the 18th century the gold-standard has emerged. According to the gold-standard

rule any amount of paper money is redeemable for its value in gold by the government.

This was meant to increase the confidence of the newly introduced paper money since it

is now linked to something valuable i.e. gold. Under the gold-standard rule almost all

countries linked their money to a fixed amount of gold, or in some cases linked their

money to the currency of country which did so. Most countries’ economies worked well

with gold-standard until WWI 1914 – 1919, when some nations started to abandon the

gold-standard and printed huge amounts of paper money not backed by gold, to finance

their military forces. For instance Germany put the gold-standard on hold and printed too

much money, which eventually led to hyperinflation to the extent that, the purchase

power of 1 trillion marks in 1923 was equivalent to the purchase power of only 1 mark in

1914. However, the gold standard was restored back after the end of the war, realizing its

benefit to a nations’ economy, until the great depression in 1929 when the US

government had to abandon the gold-standard again due to the rush of people trading

their dollars for gold. In 1933 US President Roosevelt instructed American people to

return back their gold in return of US Dollars, and no longer allowed people to redeem


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the gold for dollars again, even though it was never officially announced that the US

abandoned the gold-standard. The accumulation of gold by the Federal Reserve made the

American government the largest in holding gold reserves (about ¾ of the world’s gold

supply).

Third stage: Emergence of fiat Money not backed by gold – Bretton Woods and Nixon

Shock

After the end of the WWII biggest countries including USA adopted another system

replacing the classical gold standard – so called Bretton Woods system. In 1944 most of

European countries and the USA signed an agreement in the Bretton Woods conference,

whereby European countries had to fix their currencies against the US dollar (because

USA was the largest holder of gold supply), and the US dollar was fixed against gold in a

rate of 35 dollars to 1 ounce of gold ($35/oz). This system worked very well and the

world economies grew steadily under what so-called the Keynesian policies, until 1971,

when US president Nixon untied the link between the US dollar and gold.

In the year of 1971 the Nixon-Shock announcement has broken the link between the US

Dollar and gold and led to the collapse of the Bretton Woods system. Since this move, all

the world’s important, if not all, currencies became pure fiat money including US

Dollars, Sterling Pound, and Euro.

When fiat money emerged and widely used some commentators started to argue that the

Rabawi-money (money which is subject to Riba) is only the gold and silver money, based

on the fact that both types have intrinsic value, whereas the fiat money doesn't have

intrinsic value, and its purchasing power diminishes over time due to inflation.

Nevertheless, large number of prominent Muslim Scholars have rejected this argument,


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for instance Sheikh Youssef Al-Qaradwi dismissed this argument in his book "Banks'

Interests is the Forbidden Riba"8 and argued back that "Part of these argument is false

and the other part is true but leads to false conclusion. The false part is to confine the

Cash/liquidity ( ) and Precious/valuable (النقدية characteristics of money to only gold (الثمنية

and silver, and not consider the fact that fiat money has currently become the means of

exchange, the store of value (the most liquid store of value asset) and the tool of saving,

regardless the material from which it is made. In fact, this argument will have a

dangerous implications such as revoking Zakat, which is the 3rd pillar of Islam, and

legalizing Riba, which is one of the biggest 7 sins ( السبع (القرضاوي) ".(الموبقات

III. Fiat Money versus Gold Money

Comparison on Social and Economic basis

III.1 Pros and Cons of Fiat Money

Fiat money is not a scarce resource as gold, therefore, the quantity of fiat money supply is

not limited by scarcity like gold but can be controlled by central banks to serve the

monetary system of a country. In fact, central banks through money supply can control the

economy and effect the society. Also the production cost of fiat money is fractional in

comparison to the production cost of gold money. Fiat money doesn’t have an intrinsic

value, which is viewed as an advantage in some school of thoughts and disadvantage in

other school of thoughts. At one end of the spectrum, some argue that this enables

government to print money with little effort and cost to distribute wealth amongst their

citizens. At the other end, some argue that this may induce governments to print too much

quantities of money which leads to hyperinflation and eventually to exacerbate poverty.

(القرضاوي) 8


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However, this notion of ‘intrinsic value’ was criticized by some reporters on the grounds

that value of commodities and money may differ from one person to the other, hence,

nothing has an inherent value, neither commodities nor fiat money, “Paper money, such as

the note above, is sometimes criticized by ‘commodity money’ theorists on the grounds that

it has no intrinsic value. But is there really such thing as ‘intrinsic value’? I would say that

people will value goods and services differently, depending upon each person’s character

and circumstances. Gold may in fact be quite value-less to the producer of goods. Value is

always subjective, never ‘intrinsic’. When people make market exchanges, each gives the

other something they value less at the time in exchange for something they value more.

Gesell argues it is solely its utility in the act of exchange that should give money its value

and that attempting instead to give money an ‘intrinsic value’ is attempting to conjure a

phantom”. (Jones)

On the other hand, many economists argue that the biggest disadvantage of fiat money is its

exposure to devaluation (the decrease in its purchasing power). Many commentators also

argue that fiat money under today’s fractional reserve banking system, induces banks to

create more money, which could lead eventually to inflating the money supply within an

economy. Consequently, this economy will suffer from price bubbles, which always results

in financial and economic crisis.

III.2 Pros and Cons of Gold Money

Since gold is a scarce resource then its supply is limited to its scarcity and cannot be fully

controlled by central banks to serve the monetary system of a country, which may have

negative implication on the economic growth. Gold money is not cost-efficient since it


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requires a long and expensive production process from mining to coinage, with the

involvement of several production resources such as capital, labor, land…etc. Also, one

of the most important disadvantages of gold money for governments, the restriction it

imposes on their ability of issuing public debt as well as the limitations on credit lines

extension, since a 100% reserve is required in case of gold money. On the other hand,

some commentators suggested that the main advantage of the gold standard its ability to

maintain lower levels of inflation. Nevertheless, it was argued by some commentators

that on the long term this is a disadvantage rather than an advantage. “When money does

not rust, those with money have a store of value immune to deterioration, while those

holding goods do not. Hence those with money will have superior bargaining power to

those with goods. They can wield this advantage in every market exchange, exploiting it

to accumulate more and more money for themselves. Over time then, the “gold-bug

utopia” goes bad – almost all the gold coins end up in the possession of a few people (the

1% you might call them!), who can then exploit their gold monopoly to trap everyone

else into peonage. Producers still require a temporary means of exchange, but this has

been monopolized by the holders of gold to serve as their incorruptible store of ever

accumulating value. So gold must be borrowed at almost any rate of interest demanded

by its lenders. Ironically enough, the Gold Standard advocated by Austrian economist

Friedrich Hayek can itself be “the road to serfdom”!” (Jones). Therefore, it was

contended by the advocates of this argument, that fiat money is more advantageous in

comparison to gold money since it devalues over time, which leads to striking balance

between money and the commodities it can buy, and consequently facilitates wealth

distribution amongst different social classes.


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IV. Conclusion

Generally speaking, we can conclude that it is proved that money, throughout history, has

increased economic growth, social welfare and standard of living when compared to barter

exchange. In addition, it is noted from historical evidence that barter system was used in

relatively uncivilized simple communities since it required a double coincidence of wants,

while when the man-kind started to become more civilized and transactions became more

complicated, monetary exchange started to be used, whether in a commodity form (like

gold) or in fiat form. It was also observed that money and monetary systems have been

evolved dramatically over time from commodity money to fiat money. In fact, this

evolvement had number of implications on man-kind from both social and economic

standpoints as highlighted earlier. Fiat currency now can be viewed as a social custom

supported by government rather than economic relationship.


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Bibliography

Cecchetti, Stephen G. and Kermit L. Schoenholtz. Money, Banking and Financial Markets. McGrew-Hill/Irwin, 2010.

Coleman, James S. Foundations of Social Theory. Cambridge: Harvard University Press, 1990.

Davies, Glyn. A History of Money from Ancient Times to the Present Day, 3rd ed. Cardiff: University of Wales Press, 2002.

Jones, David A. "Positive Money." 14 March 2012. Positive Money Web Site. Document. 1 October 2013.

Josh Ryan-Collins, Tony Greenham, Richard Werner, Andrew Jackson. "Chapter 3. The nature and history of money and banking." Josh Ryan-Collins, Tony Greenham, Richard Werner, Andrew Jackson. Where Does Money Come From? London: New economics foundation, 2011.

Kahf, Monzer. "Islamic Finance: Business as Usual." 25 September 2006.

—. "Riba As Described in the Qur'an and Sunnah." 1997.

Khaldoun, Ibn. Muqademat Ibn Khaldoun. 1377.

Mankiw, N. Gregory. Principles of Economics. 2009.

Smith, Devin. "The strange reality of fiat money." (2013).

Wayne E. Baker, Jason B. Jimerson. "The Sociology of Money." The American Behavioral July/August 1992: 678. Document.

. يوسف, الشيخ المحرم القرضاوي الربا هي البنوك الدوحة. فوائد , n.d.

fiat money vs. gold money and social acceptability

Economy & Finance