We know of no country, of course, that actually uses chocolate chip cookies for money. In most countries, money takes a particular form called fiat money. Fiat money is money that is not backed by any physical commodity, such as gold. Instead, the currency is intrinsically useless pieces of paper that attain value in exchange.
Fiat is a Latin word that means “let it be.” Fiat money is money just because the government says so. In a fiat money system, the government does not promise to exchange goods for money. In addition, money is not generally something that we can directly consume: most people would not enjoy eating a dollar bill. So if it doesn’t taste good and the government doesn’t promise to give you something in exchange for it, what gives fiat money value? Why are we all willing to work hard to get pieces of these—intrinsically worthless—pieces of paper?
The answer is because these pieces of paper are acceptable as money. Other people will accept them, so you and I will as well. To put it another way, fiat money has value because everyone believes it has value. Think back to the story with which we opened the chapter. The US economy uses green and white pieces of paper as money. US residents are willing to give up valuable goods and services in exchange for these green and white pieces of paper because they believe that others, in turn, will accept them. Such an arrangement sounds fragile, and it is. If everyone stopped believing that fiat money had value, this would be a self-fulfilling prophecy. [***Something very much like this happens in the circumstances of very high inflation rates, as explained in Chapter 11 "Inflations Big and Small".***]
Suppose the money in an economy changed overnight from green pieces of paper to purple pieces of paper, as we fancifully suggested at the beginning of this chapter. Everyone now works for and accepts the new purple currency. You are forced to follow. It would be foolish for you to work and accept green paper because no one would give you goods or services in exchange. Instead, you demand to be paid in purple paper because that is what you now need to buy goods and services.
Of course, we do not often observe these switches across colors of paper within an economy. People get used to one type of currency, and it is difficult to change everyone’s behavior at once. Still, Europe did, in effect, switch from green pieces of paper to purple pieces of paper. Sure enough, no one in Europe these days is willing to accept French francs, Portuguese escudos, or Finnish marks. These are the old pieces of paper. Now people will accept only the new pieces of paper.
That conversion was not truly instantaneous. Prior to the changeover to the euro, there was a switch to a dual unit of account: French bank statements in 2001 gave balances in both French francs and euros, for example. Even now, years after the changeover, bills in Europe often still appear in both the old local currency and euros. It was also possible to use the euro as a store of value before the changeover because banks started establishing accounts in euros.
Even though fiat money issued by the government is, in the end, just pieces of colored paper, it typically does have one particular property that stems from the power of the state. The US government states that it will accept dollars in settlement of government debts—most importantly, tax bills. The government also states that dollars can be used in settlement of private debts. Dollars are legal tender. [***There is a subtle question here about whether this aspect of money means that even intrinsically worthless currency must always have some value. If people owe debts to the government that are specified in money terms, then they will be willing to pay something for legal tender currency.***]
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