Legal tender is the currency that national law dictates is a valid payment of any debt, tax, or charge. In most modern countries, the national currency is the legal tender. The most notable exceptions to this are the euro in the EU and bitcoin and the U.S. dollar in El Salvador.
Legal tender laws declare what is accepted as money, and generally exclude any alternative currencies. Let’s take a look at how they work, the history of legal tender in the U.S., and what it means for investors.
Definition and Examples of Legal Tender
Legal tender laws determine what currency is acceptable, by law, as payment for any debts, charges, or taxes. Legal tender laws specifically deal with what currency must be accepted in the payment of a debt. In the U.S., legal tender laws do not require businesses to accept dollars as payment. For example, some businesses may not want to deal with high denominations and some businesses may only accept payments via credit card.
Legal tender laws also determine what institutions will create and manage the currency. In the U.S., these institutions are the Department of the Treasury and the Federal Reserve. The Treasury currently issues coins and currency in the denominations: 1, 5, 10, 25, 50, and 100 cents and $1, $2, $5, $10, $20, $50, and $100.
The Federal Reserve dictates when more dollars will be issued and tries to use that power to manage inflation and unemployment, which are typically opposing forces.
How Legal Tender Works
Economists agree that money must be widely recognized as a medium of exchange, unit of account, and store of value. Historically, money was made of a common commodity that fit those requirements, like gold or silver. Currencies backed by gold were said to be on a gold standard.
More recently, legal tender laws created fiat money/currency, which is money that is not backed by gold or any other commodity. Instead, it is backed by the law of the country. Fiat currencies are more easily manipulated by governments to lower interest rates in attempts to fight unemployment.
Historically, legal tender laws have effectively crowded out any alternative currencies. In the U.S., there are very few businesses that accept anything other than the U.S. dollar. Prior to bitcoin’s recent jump in popularity, there were basically none. This is because it becomes exceedingly difficult to use the U.S. banking system and complete any more complex transactions if you do not use dollars. You can’t pay taxes without using them. You won’t stay in business very long if you don’t pay taxes.
Note that the U.S. dollar is the country’s only legal tender currency. Non-U.S. currencies and various cryptocurrencies are sometimes accepted, but the owners of businesses would have to convert those currencies to dollars to pay taxes and transfer the proceeds from a sale into a bank account.
Here is a (mostly U.S.-focused) history of notable happenings in legal tender law:
- 1690: The first paper currency was issued in the now-U.S.
- 1775: Continentals (fiat money) issued to fund the Revolutionary War became basically worthless. The phrase, “not worth a continental,” was popular into the 1900s. Eventually, the dollar, then backed by gold, won out over other potential currencies.
- 1861: The government issued demand notes, nicknamed “greenbacks,” to finance the Civil War. These greenbacks were accepted as legal tender into the 1870s.
- 1913: The Federal Reserve Act created the Federal Reserve to manage the currency, and Federal Reserve notes became legal tender.
- 1933: Great Depression-era policies severed the gold standard, and the government confiscated gold from American citizens. The next year, the Gold Reserve Act restored the gold standard but only for other countries that redeem dollars from the Federal Reserve.
- 1971: In the “Nixon Shock,” President Nixon severed the last link between the dollar and gold, making the dollar a 100% fiat currency.
- 2021: El Salvador makes bitcoin legal tender, along with the U.S. dollar.
What It Means For Individual Investors
Many newsletter writers and so-called “permabears” recommend investing in gold and/or bitcoin because it is a “real” currency and thus offers a hedge against a collapse in the dollar. While there is certainly some substance to arguments that all fiat currencies fuel inflation, until the U.S. financial system sees a major overhaul or legal tender laws change, gold and bitcoin are unlikely to become widely accepted currencies.
However, that does not mean they are bad investments. Do research before making any decision to buy or sell investments. There are pros and cons for investing in both gold and bitcoin, beyond expectations for holding cash.
- Legal tender laws establish what currency must be accepted in the payment of debts.
- In most countries, the national currency is legal tender. The most notable exception is the euro in European Union countries.
- Legal tender laws do not mean that a business must accept legal tender currency when making a sale—just that creditors must accept it to pay off a debt.