Home > Macro/Monetary Theory > Misconception #2: Money isn’t Backed by Anything

Misconception #2: Money isn’t Backed by Anything

If I had it to do over again, this would be number 1.  Even most economics textbooks don’t get this right.  They usually say something like “The only reason a dollar, or a franc, or a Euro has any value is because we have a stable system in which people are known to accept these pieces of paper in return for something valuable.”  This creates an impression of money as this worthless paper that is out there circulating around which, although it has no particular value to anyone, is somehow magically able to be exchanged for things which do have value.  There are two main intellectual consequences of this.

The first one is that many people come to the conclusion that this doesn’t really make sense which is true.  The second one, is upon coming to this conclusion, most people further conclude that because it doesn’t make sense, it won’t be able to go on forever and that when it fails, it will be because people, for some reason, become no longer willing to accept the money, having no particular value, in exchange for goods and services.  Or in other words: the money will become worthless.  Or in still other words: we will run into hyper-inflation.

This reasoning I find to be a fascinating study in what people are willing to question.  The thinking seems to be something like this:

1. Textbooks are correct.

2. A textbook says that this is why money works.  Therefore, this must be why it works.

3. But it doesn’t really make sense that money could work this way.

4.  Therefore, at some point, it must stop working.

As usual, the flaw turns out to be a false premise more so than false reasoning (though there is a bit of both).  If it doesn’t make sense for money to work like that, it wouldn’t be working now.  The real problem is that that explanation of why money works is completely bogus.  Once you relax the premise that the textbook must be right, things change dramatically.

The reality is that money is backed by debt (see misconception number 1).  Nobody owes you anything in return for your dollar (like they would if there were a gold standard for instance), but instead you most likely owe somebody dollars.  This serves a similar purpose.  For instance, if you have a $100,000 mortgage, then you can “convert” your dollars into your house at the rate of $100,000/house.  You don’t take the dollars down to the bank and turn them in for a house but if you fail to turn in your dollars for a few months, the bank will come to you and take your house.  This is not the same as a gold standard of course, but it is far from a situation where “money isn’t backed by anything.”

Now ask yourself: “if everyone else suddenly stopped being willing to accept money and the value of it plummeted, what would I do?”  Would you shrug and say “well I guess the dollar is worthless now” and start using your cash to blow your nose, wipe your butt and start fires to keep warm until the bank comes and takes your house?  Or would you go out and trade a loaf of bread for $100,000 and pay off your loan?  If you answered the latter, then consider that everyone else with a mortgage/car loan/boat loan/student loan/credit card debt would probably reason along similar lines and that the number of people finding themselves in that category comprise nearly the entire population of these United States and then realize that this is precisely why the dollar never suddenly becomes worthless.

Once you notice this fact, this should start falling into place.  Number 3 should go a long way toward explaining why recessions happen.

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  1. littlefish
    September 5, 2012 at 5:16 am

    I got this one. I had trouble following the first misconception, but this one made perfect sense. I definitely would pay off my loan.

  2. Free Radical
    September 5, 2012 at 6:01 pm

    Good (=

  1. September 5, 2012 at 2:09 am

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