Home > Macro/Monetary Theory, Uncategorized > A Fiat Money Origin Story

A Fiat Money Origin Story

Nick Rowe has a recent post about Chartalism which got me thinking about the fundamental explanation for the value of money again.  He calls this an “origin story” and seems to be of the opinion that the origin doesn’t really matter, once it gets going you can remove the original source of fundamental value and it just stays up.  Kinda like Wile E. Coyote running off a cliff.  As long as nobody looks down, we’re fine.  I personally think this is nuts.  But I figure, why not try going through the explanation like an “origin story” from primitive commodity money to modern fiat money.  Maybe that will help?  I have mostly tried to avoid all of that because it seems unnecessarily confusing and I usually want to distill the story down to its most fundamental point as much as possible.  However, I think maybe this leaves people too much room to fall back on little misconceptions that are deeply lodged their thinking about this.  So why not start from the beginning and try to hammer out all the points (or most of them) in one try?  For the record, this is not a historical work.  It’s a made-up history that I think is fairly consistent with reality as it unfolded in the western world.  Whether or not the Chinese had some type of script that was linked to taxes thousands of years ago or there were some hunter-gatherers somewhere with a credit-based economy before commodity money became prevalent is not relevant to my point.

In the beginning there was barter.  And it was not good.  We all know why so I’m not gonna spend a lot of time on this.  Some goods became used as a medium of exchange because they had certain characteristics that are described in most intro texts in the chapter on money.  Those goods become commodity money.

The question at hand is about credit money.  So first, I want to do what I have done before which is try to explain that credit money can, in theory, come about without commodity money even though it didn’t (at least in most modern cases).  Then I will return to the origin story.

If we had no money, I could invent money in the following way.  Let’s say that you are a butcher and you want to buy a loaf of bread from the baker.  But you don’t want to barter directly because he doesn’t want meat right now.  Also assume that there is no other good you can trade him in place of your meat like commodity money.  I can step in and propose the following deal.  I will print up 100 little slips of paper and I will give them to you (the butcher) and we will go to the baker and tell him that these are now “money” and he should take them for his bread and then the baker will give him meat for them later.  However, this would almost certainly not work because the baker will (rationally) be worried that as soon as he trades bread for them, the butcher will refuse to trade him anything for them in return.  After all, they are just arbitrary slips of paper.

However, I am a crafty guy and I have a solution to this problem.  I print up another piece of paper-a contract.  The contract says that I will give the butcher 100 slips of paper (let’s call them dollars) but he has to give them back to me in one year.  Now, if the baker knows about the contract, and expects the butcher to honor his side of it, he will be able to trade bread for dollars knowing that the butcher will need to trade him meat for them in the future to get them back to fulfill the contract.  The debt from the butcher to the banker (I’m the banker) is the key to this crazy scheme working.

Now, this gives us a foothold on value for these notes but we still have some practical problems.  One is that it is entirely unclear how many loaves of bread or pounds of meat each one of these notes should be worth.  The other is that, let’s face it, the baker is still likely to be concerned that the butcher will end up just saying “screw it” and blowing off the contract with the banker when the time comes to repay.  (Also, with only these two there is a hold up problem but that’s not really important for my point.)  There are two ways of dealing with these problems.

Commodity-backed money

If we did have another good that was non-perishable and uniform and easily identifiable etc., we could use it to “back” the money.  The butcher could bring in 5 oz. of gold and the banker could issue him 100 notes that each say “worth 1/20 oz. of gold” on them.  The contract could then say that the notes can be redeemed for that amount of gold at the bank at any time.  Then the bank could build a big marble building in the center of town with a big vault that says “we are super stable and dependable” and try to reassure the baker that at any time he could trade the notes for gold with or without the butcher.  “We already got his gold and we are holding it for you” they would say to the baker and they would point at the big vault and the marble building.

Now this may cause one to ask: why even bother then, why not just use the gold to trade in the first place.  To answer that question we need to bring in transaction costs.  But there are two layers to this transaction-cost explanation.  The surface layer is straightforward.  The butcher and the baker might find it more convenient to use slips of paper than to use gold for various reasons which are well known and not worth getting into here.  But there is another layer.

Credit money

If there is no bank and only commodity money, the quantity of that money is fixed by nature (or at least the supply curve).  And commodity money has alternate uses besides exchange (some will dispute this but I  want to forgo that argument here).  The value of a long-lived, non-renewable commodity must be such that it is expected to grow at the market rate of interest, otherwise people would hold another asset.  That is, of course, if there is no reason that people would prefer holding that asset over others.  If the commodity in question is the most convenient medium of exchange, then people will prefer to hold it over all others for a given rate of appreciation.  This means that its’ rate of appreciation will be lower than other assets.  Call the differential between these rates the liquidity premium and denote this l.  The familiar Fisher equation can then be written in a slightly modified form.

m=r-l

Where m is the rate of return for holding money, r is the rate of return on other assets and l is the liquidity premium.  (Note that m equals the inflation rate times -1 and l is the nominal rate in the Fisher equation.)  But now the value of this commodity (the price level) depends on two things.  One is the relationship between the supply (fixed by nature) and demand for this commodity for uses besides the medium of exchange over all time.  The other is the demand for use of it as a medium of exchange which is manifest in the liquidity preference.

Now this is the point where theories diverge so notice what this means.  If the commodity were only used for money and not consumed in any way, then the price level could be anything and you could explain the price level based solely on liquidity preference.  For instance, if output and the money supply are going to be constant forever, then you may propose that velocity should be constant and therefore the price level must be constant so m=o and l must equal r (which is determined in the market for real investment) and then you just set velocity equal to whatever makes the liquidity preference equal to r and you make the price level whatever it has to be to make MV=PY.

But if the commodity which is being used for money does have an alternate use then things are a little different.  In this case, there is a marginal value of money in consumption relative to the consumption of other goods each period which depends on how much money is consumed (meaning separately from use as a medium of exchange).  This puts a constraint on the price level.  And that means that the price level has to be such that the commodity is consumed at a rate which will make its value grow at a rate consistent with the above version of the Fisher equation in light of the demand for the commodity in its alternate use each period for all of time.  This is a problem which can be solved if you know the demand and supply over all of time but it’s a bit more complicated.  The important point however, is that the liquidity preference might end up being kind of high.  Or in other words, liquidity might be pretty valuable on the margin and this won’t just automatically be alleviated by the price level rising until “real money balances” are high enough that the marginal liquidity preference is not that high because the price level is also bound to reflect the relative values (marginal) of the good used as money relative to all other goods.

But if you are the bank, your job is producing liquidity-those little pieces of paper which can be used as a medium of exchange.  So if gold is the most appropriate unit of account and its value is somewhat constrained by its consumption value relative to other goods and its quantity is relatively low compared to the total amount of trade that people want to carry out in the economy so that the velocity and liquidity premium are somewhat high, you can alleviate the scarcity in liquidity without producing more gold.  You can just produce more slips of paper.

Of course, if he only prints slips of paper to match deposits of gold, this is no help at all.  In order to reduce the liquidity premium, he must increase the medium of exchange beyond the quantity of gold.  But how he does that matters.  Consider two possible ways.

First, he can just start printing notes and buying stuff.  This seems to be what many in the anti-fractional-reserve-banking crowd imagine happened.  If the banker did this, and people realized that there were more notes than gold, they would likely get concerned and try to redeem the notes for gold and the whole thing would fall apart.  (Unless of course, you believe in the Wile E. Coyote theory but for some reason, nobody believes in it in this case.)

Alternatively, he can print notes and lend them.  If he lends them, then there is an increase in the medium of exchange but it is accompanied by a corresponding increase in future demand for the same.  In other words, there will be more dollars in circulation than gold in the bank but this doesn’t mean the dollars will be worth less because everyone knows that someone will need to get them at some point in the future to repay the loan just as described above.

Now the bank can create as much additional liquidity in this way as they want.  As they increase the medium of exchange, the liquidity premium will decrease.  Note, again, that the value of the money is primarily determined by the value of gold relative to other goods because the unit of account is still tied to gold.  But as the medium of exchange (the paper notes) increases, the liquidity premium decreases and this has a secondary effect on the value of gold (and also the time path of consumption of gold).

If the bank is a monopoly, they may choose to “inflate” the money supply to a point which maximizes their profit in the face of a downward-sloping demand curve for liquidity.  If there is a perfectly competitive banking sector then they will drive the liquidity premium down to zero. (Or just high enough to cover the cost of running a bank. Interestingly, banking could be called a natural monopoly but that’s beside the point here…although worth keeping in mind for later.)  Note that driving the liquidity premium down to zero means that the nominal interest rate is zero which is the Friedman rule.  In this case, there would be deflation equal to the real interest rate.  Money (gold) increases in value at the same rate as other assets.  The bank can’t push the liquidity premium below zero because the notes would be brought back and be redeemed for gold.  Plus, they wouldn’t want to because that would push the nominal interest rate also below zero and they would be losing money.  But notice that as long as the liquidity premium is non-negative (and people believe that the bank is sound), the paper money will float because people would rather hold it than hold gold.

Now return to our two issues with credit money.  There is no reference for the value of a dollar and there is concern about the butcher (the borrower) defaulting on the obligation to repay the notes.  The convertibility into a tangible asset (gold) settles (at least partially) both issues.  First, it assigns a value to a dollar which is determined primarily by factors other than the quantity of money.  Second, the convertibility, at least partially, calms the fear to the baker of the butcher defaulting on the loan.  He doesn’t need the butcher to purchase back the dollars, he can just take them to the bank and get gold whenever.  If the butcher defaults, it’s the bank’s problem-at least to some extent.

If a lot of butchers default, then the baker has a problem because the bank will not be able to redeem all of the dollars in gold.  So the bank will probably need to do something to prevent people from defaulting.  Specifically, they will require collateral.  Generally, the value of that collateral will be greater than the value of the loan.  In other words, it will be greater than the gold which the slips of paper created by the loan can be redeemed for so that the borrower will have a strong incentive to repay and so that if they don’t repay, the bank will take the asset and maybe, hopefully, avoid their balance sheet getting upside down.

Now notice the similarities between these two transactions.

  1. Person A gives the bank 10 oz. of gold and the bank gives them 200 slips of paper.  In order to get the gold back, this person must bring them the slips of paper again in the future.  If not, the bank keeps the gold and/or transfers it to whoever ended up with person A’s slips of paper.
  2. The bank gives person B 200 slips of paper (which could each be redeemed for 1/20 oz. of gold) and Person B agreesto pay them back or else the bank takes their house. (And possibly sells it to get back the slips of paper from the people who have them or to get gold to trade for those slips of paper.)

Both transactions have an asset backing them.  Both transactions are for the purpose of converting an asset into a more liquid asset (bank notes).  Both transactions create notes “out of thin air” and both make those notes redeemable for the less liquid asset in the future.  The only difference is that in the first case, the bank holds the asset in the meantime and in the second case the borrower holds it.  Of course, because of this, someone else cannot redeem the notes at any time for person B’s house.  Only person B can.  But this is okay because most of the notes float because notes are more liquid than gold and there is a non-negative liquidity premium.  The bank only has to redeem a few notes every now and then and for that they keep a little gold around.

Now let us pause and take stock of our monetary situation.  We have little bits of paper that are functioning as the medium of exchange.  They may seem “intrinsically worthless” to the casual observer but they are backed by a network of contractual obligations.  There are two obligations involved.  One is the obligation of the bank to redeem them for gold.  The other is the obligation of all the borrowers who were involved in the creation of the money to repay all the additional money that was created at some point in the future or else forfeit other assets.  So the assets “backing” all of this credit money consist of a little bit of gold in the vault and a whole bunch of houses, cars, businesses, etc.

The gold, however, is serving a special purpose.  Actually two special purposes.  One is that it is acting as a buffer between the highly liquid but “intrinsically worthless” paper and the intrinsically valuable but highly illiquid assets which are backing most of the money so that on the margin people can swap the notes for gold and everyone feels nice and comfortable.

The other one is more important.  Because there is a fixed rate at which the notes can be swapped for gold, the value of the notes is anchored to the value of gold.  Or, in other words, gold is the unit of account.  So basically what has happened is we have created an alternate medium of exchange which can be increased easily and cheaply to meet the demand for liquidity but we kept ounces of gold as the unit of account.

The gold in the bank vaults is not the asset “backing” most of the money.  It is the lubrication that smooths out fluctuations in demand for liquidity and it provides a reference point for the value of the notes.  But the whole system is propped up primarily by a network of debt obligations and a multitude of highly illiquid assets which collateralize those obligations.  Let me stress that this is already the case before suspension of convertibility.

Now, if the bank comes out at some point and declares that they will no longer be redeeming dollars for gold, a person who mistakenly believed that the entire house of the dollar was built on the foundation of gold would probably panic.  If the ability to exchange the notes for gold were the only useful thing one could do with them aside from using them as the medium of exchange, it would be reasonable to think that the value would quickly fall to zero, thus making them unsuitable as a medium of exchange or anything else other than tinder or toilet paper.

However, if everyone initially had that thought and ran out to try and dump their supposedly worthless dollars for whatever they could get, someone would realize “wait a minute….I actually could use those dollars cause my mortgage is denominated in those bits of paper.  Maybe I shouldn’t dump them in the street after all….In fact!”  And he would gather up a bunch of junk he had laying around and hold a big yard sale with prices like:

Weed whacker, broken: $10,000

T-shirt, only 2 holes!: $2500

Couch, all cushions at least one good side left: $800,000

After all, these are all bargains if a dollar is just an intrinsically worthless piece of paper.  But then his neighbors might start to wonder why he was trying to get all these worthless slips of paper.  And this might cause them to realize that they all have mortgages too!  And car loans, and boat loans, and business debt, and student loans…. Suddenly, they might all become not so willing to dump their dollars on any real good they can get.  The house of the dollar is still standing.

An observer who doesn’t notice all the debt and all the collateral may look at this and find it curious.  Thinking that the foundation of the dollar was gold and seeing that foundation washed away, they would expect the house to come crashing down.  But the gold was not the foundation, it was just a thin layer of topsoil obscuring the bedrock on which the house actually rests, and had always rested.  However, if one insists on continuing to believe that there was no bedrock there, only topsoil, they will feel as though they are observing a stunning bit of sorcery.  They will reach strange conclusions like “I guess you only need a foundation to get the house up, once it’s up it will just stay there and you can remove the foundation.”

This is not to say that the suspension of convertibility does nothing.  It does change the unit of account from gold to dollars.  This means that the value of a dollar will no longer be influenced by the relative value of gold to all other goods.  But that does not mean that it is not affected by anything other than demand for liquidity.  The gold leaves a legacy because, at the time of suspension, all the debt contracts were denominated in dollars (or if not they were converted to dollars upon suspension) and the number of dollars a person was able to borrow against their house in the first place was determined by how many ounces of gold the house was worth.  After suspension, the value of a dollar will need to find a new equilibrium but that equilibrium will be influenced heavily by the ability to trade dollars back for houses and such at the rate determined when dollars represented ounces of gold.  However, over time the value of a dollar will be free to wander independently of the value of gold.  But the way in which it does this is limited now by the relationship between dollars and debt (and collateral).  This matters!  If you fail to notice this relationship, you are likely to come up with strange theories about how money works.

Now, removing the gold convertibility could still blow up the whole system.  Because the dollars were partly backed by gold, one might imagine that when you remove the gold, there would be more dollars than debt and this would mean that the equilibrium value of the dollar that comes only from the requirement to repay debt (in other words independent of demand for use as a medium of exchange) would be zero and you would be in exactly the situation that Nick describes regarding Chartalism. However, there are a multitude of relatively simple and realistic ways to explain this once we are only talking about a marginal excess of dollars over debt and not imagining the entire stock of dollars as a surplus.

One way would be to apply a “Chartalist fix.”  We could say that the government runs a temporary surplus until they soak up enough dollars to put the thing back into a long-run equilibrium and then they burn the dollars.  Another way would be to assume an “implicit promise” by the banks to buy back the dollars with gold if their value fell below some level (Sproulian fix?).  Although in a sensible model, I think this would involve them just selling back all the gold and then things would balance and everything would be fine.  This doesn’t seem to be quite what happened  but notice that it could happen and that everything would work out and there would still be a bunch of dollars floating around and a corresponding quantity of debt.

My preferred explanation is simply that banks accumulate some equity which is sufficient to fill the gap.  Another way to think of this is basically that the banks gradually bought up all the gold in their vaults with the profits from banking and then once they had done so, they simply declared it.

The potential for this can easily be seen by noticing that if you want to buy a $100,000 house and you borrow $80,000 with a 30 year mortgage to do so, $80,000 is created but the total amount of dollars you pay back over 30 years is much more than $80,000.  So if ten years go by, you may have already paid back that $80,000 and still owe a large sum of dollars to avoid losing your $100,000 house.

Now the temptation as an economist, when building a model, is to assume that banking is competitive and that banks make zero profit.  This would mean that all the interest paid to the bank is paid out (in dollars) to someone else (perhaps the treasury).  If this were the case, then the dollars outstanding would always equal the principal on the loan.  However, if the banks earn positive profits, it is easy to imagine that they accumulate enough equity to own the gold and still have at least as much debt outstanding as there are dollars in circulation.  (Note that in most places, banking is organized into a government or quasi-government-run cartel somewhat prior to suspension of convertibility.)

Once all of this has taken place you have what we would call “fiat” money, meaning money that is not convertible into any other tangible asset by way of a fixed contractual obligation.  But that is not exactly accurate.  It is convertible into tangible assets by way of a fixed contractual obligation.  It’s just that the contract is a debt contract and the assets are collateral.  The only difference is that the assets are idiosyncratic rather than uniform and so the conversion contract is not one blanket contract for everyone but a set of individual contracts for individual people and individual assets.

This fact, I believe, has important implications for economic models.  Not all of them are clear to me but I hope it is clear that it at least might have important implications and it is worth investigating that question.  Our current models of money which involve a fixed stock, chosen by the central bank, not attached to debt in any meaningful way whose value is levitated from nothing solely by demand for liquidity are not sufficient to do so.

 

A note on base money: My sense of this issue is that some people will get caught up in the distinction between base money and the broader money supply.  What I have described here is a situation in which all dollars are created as bank credit which may lead some to remark “that’s all well and good for bank credit but it doesn’t explain why Federal Reserve notes are valuable” or something like that.  I believe the principle is the same but there are a lot of nuanced points involved in this distinction that will take another post to delve into.  This one is long enough already.  I will try to do that post in the near future.

 

 

 

 

 

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  1. Oliver
    April 4, 2016 at 11:50 am

    Hi Mike
    Interesting post!

    Are you saying that gold or any other commodity is essential to your origins theory, i.e. that credit money will always have evolved from a commodity previously used as medium of exchange? If so, I would have to disagree even if I agree very much with the rest of your story. I think you can construct a perfectly plausible credit theory without an external MOE of reference. You can drop gold (and barter, too for that matter). The first bank on earth could just have declared its currency unit to be worth 1/100 of a cow or bride or whatever, even if they were never traded before.

    By that token (pardon the pun), it is (credit) money that allows for trade to take place and not vice versa. That isn’t to say that commodities have no place in a theory of money, but I don’t think they’re vital to an origins story. And barter seems so insignificant that it can easily be ignored.

    Just my 2 cows…

    • Free Radical
      April 5, 2016 at 7:24 pm

      Oliver,

      Yes, I agree. I used to write it like that (notice that I first introduced the credit money with no commodity to try to show how it is possible to create it without that.) But people always seem to want a story that more closely tracks the evolution of money as they know it. Also, I believe you need some point of reference to real goods. In other words, you couldn’t just say “here is a hundred ‘dollars,’ they are now the money supply, trade until you get sick of holding them and that will determine a price level.” The reference could come directly through collateral though. You could say “here are 100 dollars, pay them back in one year or we will take two cows from you.” This would put a ceiling on the person’s willingness to trade real goods to get the dollars back if he had to trade anything more than 2 cows to get them, he would just default. Similarly, it puts a floor under them at the point when the loan is due. Obviously in reality we have a lot of different people with different loans with different collateral and different time frames but this all amounts to some demand for dollars which is related to real goods in a concrete way.

      • Oliver
        April 6, 2016 at 9:37 am

        Thanks for your reply, in which case I absolutely agree with you. I remain suspicious of any origins story that relies on a commodity fetish and I suspect any argument to that extent will turn out to be circular upon closer inspection. Why is gold valuable? Because it’s used as money. Why is it used as money? Because it’s intrinsically valuable…

      • Free Radical
        April 7, 2016 at 4:52 am

        Yes! Gold is valuable because people like it. It once was used as money because it was valuable (to begin with) and it had the other characteristics that make is a suitable medium of exchange (uniform, easily divisible, high value per weight/bulk, easily identifiable, non-perishable, etc.) It’s silly to act like we just grabbed up something off the ground that nobody cared about and converted it into money and that made it valuable.

      • Oliver
        April 7, 2016 at 8:12 am

        OK, the discussion is getting as circular as I feared it might :-). I’ll take one more jab starting from here:

        Also, I believe you need some point of reference to real goods. In other words, you couldn’t just say “here is a hundred ‘dollars,’ they are now the money supply, trade until you get sick of holding them and that will determine a price level.”

        In order to receive credit, the creditor must render something to the debtor. That something is recorded by the bank and credited to the creditor in the form of money. That something need not be gold, nor need it be uniform, easily divisible etc., nor need it have a price tag / denomination before the transaction.

        The world’s first entrepreneur could have gone up to the world’s first bank and received his neighbour’s 100 sheep, for which his neighbour would have been credited say 1’000 shekels. The creditor would then have been entitled to goods or services valued at the equivalent of 100 sheep. That one transaction would have theoretically sufficed to establish a new Babylonian sheep standard at the exchange rate of 10 shekels / sheep.

        Of course, to make good on his credit of 1’000 shekels / 100 sheep, the creditor would have to have produced proof of his status as creditor to a seller, in which case gold or some other precious metal may have come in very handy. But that is a practical matter after the fact. Gold had the same function that my debit card has nowadays. It is portable proof of my credit worthiness. It is not, however, itself a form of credit / money.

        Further, it is that unambiguous connection between the object of credit (the sheep) and the credit itself (the 1’000 shekels) that gets blurred once one starts looking at a monetary system from a central bank downwards. Issuing money in exchange for financial claims that are already denominated in monetary terms is an act once removed from that which connects object with money as described above. And it is that distinction which is desperately lacking in discussions about monetary policy, IMO.

        But again, just my 2 sheep.

      • Oliver
        April 7, 2016 at 9:44 am

        In contrast, the alternative, commodity money story goes somehow as follows:

        One or more commodities have certain physical attributes which allow them to be used in bilateral exchanges where they act as stores of value and medium of exchange for the holder.

        Money is thus a thing, a commodity, with positive value which circulates in an economy. Using a commodity as money is actually a type of barter.

        But then, because commodities are heavy, not easily divisible on the spot, and most of all scarce, banks are invented.

        They hold commodities in safe storage boxes for customers who don’t currenctly need them. And, instead of handing them out physically to debtors, they hand out commodity IOUs instead which then circulate as commodity proxies. Eventually, they come up with the brilliant idea that they can issue more IOUs than they have commodities in storage. Fractional reserve banking and funny money is born. Funny money, too, can be stored at the very banks that issue them. Savers are kept acquiescent by being offered a cut of the profits in the form of interest on their deposits. They change from being consumers of a storages service to being investors in banking enterprise.

        I think those two stories (credit vs. commodity) are pretty much mutually exclusive. You cannot tell a story that postulates an evolution from one to the other. At best you can claim that both existed in parallel and you prefer to call one or the other money proper. I personally prefer the prior because I find the evolutionary tale from barter to safe deposit to funny money a bit iffy.

      • Free Radical
        April 7, 2016 at 8:01 pm

        Oliver,

        The first reply you made is what I’m trying to say (more or less) exactly. I’m not sure exactly where you quote begins and ends but just to make sure, I’m saying that you DO need some reference to real goods and that it is right there for anybody who wants to look. It’s the debt contract. I agree that to good and the conversion rate don’t need to be uniform (that’s basically my point).

        The only thing here that I think I disagree with is this:

        “I think those two stories (credit vs. commodity) are pretty much mutually exclusive. You cannot tell a story that postulates an evolution from one to the other.”

        But it sort of depends what you mean. I think you can (and we did) go from basically having commodity money to having credit money which is “backed” by fixed conversion into a particular commodity to having credit money “backed” by various idiosyncratic assets. It’s just just the story you are referencing goes off the tracks in my opinion when they start calling it “funny money” or something like that. As soon as people start talking about a mass, collective delusion propping up the value of the money, I think they are missing the point. This goes for both the “hard money,” anti-fractional-reserve-banking folks as well as the mainstream “liquidity preference only” folks (like Nick). They both believe in the same explanation for the value of a dollar, it’s just that the former thinks it is unstable and the latter thinks it is stable. I think they are both missing the point.

        Also, it’s worth mentioning, that I am giving a slightly different explanation for banking. You mention that bank notes are more suitable for use in trade than the actual commodity. I believe that may be true but I think mainly, what the bank is doing is EXPANDING the medium of exchange. So we have more notes than gold. This is just two ways that they are manufacturing liquidity but I think the second one is the most important. It wouldn’t work without corresponding debts tied to real goods though.

      • Oliver
        April 7, 2016 at 8:59 pm

        Thanks again for engaging. I think I agree with most of that. I’ll give your evolutionary story some more thought. Maybe I was being too categorical. And the ‘funny money’ thing is just a pejorative term that the hard money types like to use. Certainly not a term I use. Quite the contrary.

      • Free Radical
        April 8, 2016 at 5:00 pm

        Yeah I think we mostly understand each other. It’s not so much the term “funny money” that is the problem, it’s the fact that they seem to think there is something dishonest about it. I don’t see it that way, I just see it as converting less liquid assets into a more liquid form. And thanks for commenting!

  2. April 4, 2016 at 2:41 pm

    Alternate story:

    In 1685, the government of Quebec owed 30,000 livres (a made-up number) to its soldiers, but the boat bringing those coins was 8 months late. The desperate governor cut up some playing cards and wrote “1 livre”, “5 livres”, etc on them. He promised that when the boat arrived, the possessor of those paper livres would be able to redeem them for coins. The paper livres circulated, held their value because they were backed (though not convertible), and ended a recession because they relieved the cash-starved Quebecians from having to struggle with barter. A few years later, some yoyo thought that since the paper livres were inconvertible, they were also unbacked. (He didn’t realize they were backed by the coins on the boat.)

    In 1690, Massachusetts had soldiers to pay. There was nothing in the treasury, and no boat-load of coins on the way. The desperate governor knew that the colony’s only asset was 100,000 shillings (another made-up number) of expected future taxes receivable. So he printed up 20,000 paper shillings, paid them to the soldiers, and assured people that the paper shillings would be accepted for tax payments. This meant that the 20,000 paper shillings were more than adequately backed by the 100,000 of taxes receivable. In fact, the governor could issue another 80,000 shillings before he would get in trouble. The Mass. shillings also relieved a recession and held their value because they were backed by taxes receivable. But somehow, the yoyo from Quebec made his way to Boston, saw that the paper shillings were inconvertible, didn’t realize they were backed by taxes receivable, and declared that they were unbacked fiat money. Along the way, he developed Chartalism: the mistaken idea that taxes create a demand for money, when in fact they serve as an asset to back the money.

    • Free Radical
      April 5, 2016 at 7:43 pm

      Mike,

      “Chartalism: the mistaken idea that taxes create a demand for money, when in fact they serve as an asset to back the money”

      I don’t think I see the distinction there. At any rate, I’m not an expert on Chartalism but I think both of your stories could work but are different from reality. The reality is not that the notes become convertible into “Livres” at some point in the future (when the boat gets here) but they just aren’t convertible at the moment. There’s no boat coming. Similarly, it’s not that it’s impossible to create a paper money “backed” by tax obligations, it’s just that I don’t think that is an accurate description of the paper money we have. Nick points out a perfectly good reason why this doesn’t work in our current situation.

      It’s worth mentioning though, that you wouldn’t pin down a price level just with taxes unless you tied it to something else. For instance, you are assuming there is already a tax liability for 100,000 shillings (whatever that is) and tying the “paper shillings” to that. If the unit “shillings” is made up out of thin air as a tax liability, you need to say “here are 100,000 shillings and next year you (collectively) need to pay back 100,000 shillings.” This does nothing to explain what a shilling will be worth in terms of any real good. In order to figure this out, we need to know what the penalty for not paying will be. If it is a slap on the wrist, the value will be less than if it is death. (If the liability exactly equals the quantity in circulation and this is a one-time thing, the price will be difficult to determine anyway but the general point here is still valid.) If there are 1000 people and each person has to repay 100 shillings or else the government will take 2 cows from them, then the value a shilling will most likely be right around 50 shillings per cow. But all we’ve done in this example is create the exact system I’m describing except that it is compulsory instead of voluntary and it is the same standard for everyone. (So in terms of the implications for the price level over time and interest rates, it will be more like commodity money with fixed convertibility. Unless the punishment is changing over time….)

  3. Max
    April 5, 2016 at 5:36 am

    A lot of academics define fiat money as permanently inconvertible money and go from there. That’s fine, except there’s no proof that dollars, pounds, yen, etc. fit this definition. It’s sloppy reasoning to jump from “not convertible for an indefinite period of time” to “permanently inconvertible”.

    • Free Radical
      April 5, 2016 at 7:27 pm

      Max,

      Yes but that’s why I say “not convertible according to a fixed contract” or something like that. Anyone can imagine all the “implicit contracts” they want in order to make something make sense. But my point is basically that there is still an implicit contractual convertibility, it’s just that the money is “convertible” into houses, cars, boats, etc. rather than gold and only certain people (debtors) can convert it into certain assets at certain rates instead of anyone who happens to be holding the note being able to convert it into gold or silver at a fixed rate that is identical for everyone.

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