The main critics of fiat money come mostly from the Austrian school and the various hard-money schools. Since I'm most familiar with the Austrian position I'm going to try argue why fiat money can be as effective or more effective than gold in providing a stable monetary system for the economy to evolve within, while staying consistent with Austrian principles.
To start, the core of the Austrian argument goes like this:
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In his writings, Mises had shown how money becomes accepted. He began his analysis by noting that today's demand for money is determined by yesterday's purchasing power of money. Consequently for a given supply of money, today's purchasing power is established in turn. Yesterday's demand for money in turn was fixed by the prior day's purchasing power of money.
So, for a given supply of money, yesterday's price of money was set. The same procedure applies to past periods. By regressing through time we will eventually arrive at a point in time when money was just an ordinary commodity where demand and supply set its price. The commodity had an exchange value in terms of other commodities, i.e., its exchange value was established in barter. To put it simply, on the day a commodity becomes money it already has an established purchasing power or price in terms of other goods. This purchasing power enables us to set up the demand for this commodity as money.
This in turn, for a given supply, sets its purchasing power on the day the commodity starts to function as money. Once the price of money is fixed, it serves as input for the establishment of tomorrow's price of money. It follows then that without yesterday's information about the price of money, today's purchasing power of money cannot be established.
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Using the Mises framework of thought, also known as the regression theorem, we can infer that it is not possible that money could have emerged as a result of a government decree or government endorsement or social convention. The theorem shows that money must emerge as a commodity.
On this Rothbard wrote,
In contrast to directly used consumers' or producers' goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold). Thus government is powerless to create money for the economy; the process of the free market can only develop it.
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From this analysis, many readers develop ideologies dictating that
fiat money can never be money because there is no commodity to gauge past prices. This is the idea I intend to attack the most because the rationale is senseless.
To start, fiat money clearly can be money. Empirically, we've all used it and seen it used for the purpose of money. Im as sure fiat money can be real world money as the sky being blue.
So why the discrepancy?
I dont think many realize that fiat money is not the same as "play play" monopoly money. Fiat money is not a claim to nothing. The price of fiat does not arise out of air. Rather, fiat money, like all money, is based on past prices. Without this factor, fiat money would in fact be as good "play play" monopoloy money. However, in actuality,
the decreed aspect of government paper is where the value of their money comes from and this is where laws forcing citizens to redeem paper for goods comes into play as well.
The national productivity of a nation is what is used to back the issuance of currency - not nothing. The national productivity of the nation satisfactorily fulfills the incompleteness of the Austrian postulation of regression ad infinitum with regards to the value of money as well as any commodity does.
Where does the animosity to paper money come from then?
I think the right place for Austrians to place blame is in the creation of new paper money. Once a given supply of paper money is created and the value is determined based on an evaluation of the past price of national production, assume then someone goes about to create new money that represents redeemable notes on the same claim of assets as the previous money supply. This what counter fitting is defined as, so far as i can tell. The negative effect of this will be the dilution of the marginal value per existing note. This only really becomes problematic since this dilution is not uniform and precise in time or space. Simply -put, the counter-fitter's early expenses will set the dilution in motion, stealing value from all holders of paper money as dissemination occurs. This process has a variety of adverse effects on the economy but no need to get into this here since most already accept and understand the costs of inflation to an economy's health.
In today's world the problem with fiat money is not economically based but rather the economic side targets the fraudulentness of the system of central banking, managed interest rates and open market operations.
Without the fraud a stable fiat money supply that is allowed to free float will provide as useful a monetary structure as any other general commodity based money system.
Why does fiat money have the potential to be even better than gold?
Well the costs of dealing with gold on top of the perpetual increase in the gold supply include the productive resources and storage resources. A fiat money without the fraud would not entail any of the above.
Some may counter that gold is valued precisely for the fact that it is fraud-proof or much more so than any fiat money. This is likely true but doesn't counter the fact that a properly managed fiat system can bear all the benefits of a commodity standard.