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The Money Contract

I seem to look at money differently from most monetary economists.  I think it is because I took an unusual path to the issue.  I always thought that the treatment of money and macro in school didn’t make sense.  I thought the things that they assumed seemed wrong but I didn’t have any better ideas so basically I figured they probably know what they are doing and I just didn’t get it and it and I distanced myself from it by taking a micro path through grad school, studying things like industrial organization, property rights, game theory and contract theory.  Then, being a staunch libertarian, I sort of got drawn into the whole Austrian thing that happened after 2008 but (luckily) I had enough training by that point to realize there are a lot of problems there.  But that got me thinking about things like money and inflation and interest rates and then one day I had a sort of epiphany.

I thought that might allow me to make sense of a lot of the macro that didn’t quite seem right before, and frankly, I figured that I would discover that everyone else knew what I just figured out all along.  The first part of that did work out but after spending quite a bit of effort trying to confirm the second part, I am becoming more and more confident that the profession as at large is suffering under a particular misconception–a sort of mythology–that is highly problematic.

This mythology can be summed up in the words of Narayana Kocherlakota.  “But of course, money itself is intrinsically worthless.”  This is a deeply ingrained belief that everyone from top economists to conservative talking heads seems to take for granted.  But it is complete nonsense.  The misconception has two dimensions.

1.  “Hard” money

[This is a bit of a rehashing of my last post.]

Here is Scott Sumner on gold as money.

We all agree that gold need not be “backed” to have value.  The QTM implicitly thinks of cash as a sort of paper gold.  It’s a real asset that has value because it provides liquidity services.

The implication being (at least it seems to me, maybe I am misinterpreting him) that gold would have no value if it were not used in exchange (providing liquidity services).  This I think is clearly not the case.  Rather than reinvent the wheel here is what I said about it in the last post.

Here is one possible scenario:

Imagine we are in a primitive society with some knowledge of metal working.  Some guy discovers a shiny gold metal that is pretty rare.  He thinks it looks cool.  He digs some of it out of the ground and takes it to the blacksmith and says “can you make a cool looking design in the shape a dragon on my shield with this?”  The blacksmith says “beats me, let’s find out.”  He tries it and discovers that he can and it looks pretty cool.  Then this guy goes around with his cool looking gold dragon shield and everybody is like “whoa that guy has the coolest looking shield I’ve ever seen how did he do that?”  They all want shields and swords and plates and cups and what-have-you with the shiny gold metal because it looks cooler than these things look without it.  So they start looking for the metal.  They discover it is fairly hard to find.

Also, these people have quite a bit of other goods like grain and goats and stuff like that and some of them have so much that they are willing to trade some for seemingly frivolous items like a gold-plated shield or candelabra.  So the price of gold becomes fairly high.  Now, in light of this, people eventually realize that gold is very durable, uniform, easily divisible and has a high value to weight/volume.  So these people figure it is more convenient to accumulate some of their wealth in the form of gold than additional grain, goats, etc.  And then, having some of their wealth in that form, they discover that it is easier to carry out transactions using the gold than using the goats.

In this scenario, gold becomes valuable because people think it looks cool and then it becomes a medium of exchange.  It’s ability to provide liquidity services no doubt adds a liquidity premium above what it’s price would be otherwise, but it does not account for the entire value.

Alternative scenario:

On the other hand, imagine a primitive society where somebody discovers a shiny yellow metal and nobody cares, nobody has any particular use for it and it has no value.  But then that guy figures out “hey, this stuff is durable, uniform, easily divisible, and has a high….er, zero value to weight/volume–but if I could convince everyone to use it to trade because it would be easier than using other goods, it could be a high value because of its ability to provide liquidity services, so I just have to do that.”  And then this guy set about convincing everyone to trade stuff for the otherwise worthless metal that nobody cared about and somehow managed to do that and it became valuable purely because of its utility in exchange.

I think it is fairly obvious which one of these is more likely.  But if you are still not convinced that the first scenario is totally plausible just look around at how much of our wealth we currently devote to stuff that looks cool.  Is a Gucci or Prada handbag really that much more functional than a $20 bag from Sears?  Or just imagine that there was a particular kind of cool looking pebble that could only be gathered in small quantities at the tops of very tall mountains.  Do you suppose that people would go to a lot of trouble to climb those mountains and get them and make little necklaces and bracelets and paperweights out of them to impress their friends?  And do you think people who had never climbed a mountain might go on ebay and pay significant sums of money for them….to impress their friends?

Maybe you think that these pebbles would only be valuable because they would be rare.  Well there are pebbles on the tops of mountains.  There are only so many pebbles on Mt. Everest.  Why aren’t they valuable?  Answer: because they don’t look cool!  People value things that look cool.  When something looks cool and is rare, the value tends to be high.  Is it “rational” for people to value things just because they look cool?  Sorry, that’s a fundamentally non-economic question, you’ll have to ask someone else.

For a more detailed treatment of this concept check out this post.

Bottom line: gold, silver, sea shells etc. became money because they had some other intrinsic value.  The liquidity services they then provided surely increased the value but I think it is silly to imagine that they just materialized for the sole purpose of providing liquidity when nobody cared about them for any other reason.

2. Paper money

With paper money, we have the issue that the actual paper it is printed on is (at least practically) worthless.  That is undeniable.  But here the issue is different.  The deed to your house is printed on paper as well.  Is that intrinsically worthless?  Or the contract between you and your employer or your clients, is that worthless?  Of course not, because we have a system of laws and those papers entitle you to some other items of “intrinsic” value.  Paper money is the same.  It is a piece of a contract and it is the contract that makes it valuable.  The fact that it is highly liquid is a consequence of the type of contracts that it relates to and this liquidity does affect its value relative to other forms of wealth but this value does not spring forth inexplicably from nothing or rest on some strained “network effect.”  It is written clearly in black and white on otherwise intrinsically worthless pieces of paper.

When it comes to convertible notes, this is obvious.  When a bank issues a note that contractually obligates the bank to redeem it for a fixed amount of a real good like gold or silver, it is easy to see that this contract anchors the value of the note to the value of the gold or silver for which it can be redeemed.  This is not difficult to understand.  And, unless you believe that the gold or silver is also intrinsically worthless and has value for some mysterious network-effect reason, then it is easy to see how this contract instills an otherwise worthless piece of paper with “intrinsic value” equal to that of the real goods for which the contract allows it to be exchanged.

But modern “fiat” money is not convertible into anything like that, I can almost hear you exclaim.  So how can that be valuable if not for pure liquidity services and mysterious network effects?  Well there is still a contract there.  It’s just that the contract is not as straightforward.

With fiat money, there is no contract obligating someone to redeem it for gold or silver at a fixed rate.  But there are still contracts requiring people to redeem it for real goods.  To see this, you only need to look at how money is created (“multiplied”) by banks.  Banks–at least collectively, if not individually–create money by lending.  When they do this, they create a contract.  They give the borrower some quantity of dollars (or pesos or yen or euros or whatever) and the contract clearly states that you have to pay back a specific number of dollars (usually more than you go) at some point in the future or else they are going to take your house or your car or something like that.

So there you have it, the dollars are convertible into your house at a fixed rate and this rate is fixed by a contract that is enforceable by law.  It’s just that simple.  The only difference is that not just anybody can take in a dollar and redeem it for your house at that rate.  Only you can.  But you are probably going to want to do that and, since you probably spent the dollars you got in the first place, this means that you will be willing to do stuff and trade stuff to get dollars back in the future.  And a lot of people are making these contracts all the time so there are always a lot of people that are able to redeem dollars for real goods at fixed rates and are willing to trade stuff to get those dollars because the dollars a piece of everyone’s debt contracts.

These dollars are not just floating around, unconnected to any real assets in any contractual way.  The contracts are right there.  They are easy to see.  You just have to look for them.  These dollars still serve as a medium of exchange and a store of value and the monetary authorities can still pump more of them into circulation in various ways which result in more dollars chasing the same number of goods and driving prices up (at least for a while but that is a bigger can of worms) but the reason they function this way is because they do have intrinsic value, or at least they are contractually connected to things with intrinsic value.  We don’t need to look for magical network effects.

I think that sums it up.  Every time I try to explain it, it seems simpler.  Hopefully that means I am getting better at explaining.  So if you are thinking that this is obvious then I am making progress.  If not, please tell me whatever you think is wrong with it and I will work on it.

Categories: Uncategorized
  1. June 8, 2014 at 2:57 am

    A Store of Value? A banker can create any amount of bank credit which acts like money with some counter=signatures and a keystroke or ten and the money so created, out of thin air, is a Store Of Value?

    How does that make any sense?

    • Free Radical
      June 8, 2014 at 6:23 pm


      I can’t help but feel like this might be a rhetorical question. If that is the case, I am confused by your reasoning since you seem to be coming to the conclusion that it doesn’t make sense for money to be a store of value. And yet money is a store of value. This is an inescapable fact. This aught to lead you to question your premise or your reasoning that led you to that counterfactual conclusion.

      Just in case that is actually what you are doing and I am misinterpreting you though, let me see if I can further explain. First, it’s not right to say that “a banker can create any amount of bank credit.” In America, there is a reserve requirement that puts a maximum on the total amount of bank credit that can be created on a given quantity of base money. An individual bank is limited in an even more strict sense because most credit creation will drain their reserves. See this post.

      Furthermore, those banks cannot just print as much money as they want and do whatever they want with it like buy up land and throw expensive parties. They create credit through lending which means that inject more dollars into circulation which might seem like it should decrease the value of the dollar (and to some extent it does in the near term) but it also creates a sort of counterweight in the form of a debt which must be paid in dollars at some point in the future. You can think about this as increasing the quantity (supply) of dollars but also increasing the future demand for dollars which insures that in the future, the dollar will still be valuable. Thus it acts as a store of value and because of that it is a convenient medium of exchange.

      I will try to do a post on the short-term dynamics of this process soon.

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