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Posts Tagged ‘fiat money’

A Fiat Money Origin Story

April 3, 2016 13 comments

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. Read more…

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A Monetary Policy Base Model

March 13, 2014 22 comments

In this post I will (finally) lay out a mathematical model describing roughly how I see monetary policy functioning in view of the relationship between money and debt.  This model will look a lot like other simple macro models but it will highlight a bit more, the role that debt plays in the process.  I will then use it to tell some stories about depressions and liquidity traps.  I am going for the simplest formulation possible which still makes my point here so I will use a lot of assumptions, many of which could be relaxed to get a model with more complexity.

The most important aspect of such a model is the treatment of credit markets and their role in money creation.  I will assume that the following takes place simultaneously.

1. The central bank determines the quantity of reserves and the reserve requirement.  I assume that all reserves are held by banks and that the reserve requirement is constant (changes in the requirement and the quantity of reserves are functionally equivalent).

2. People take out a certain amount of dollar-denominated loans from the banks and use it to buy stuff.  This is where all of the “money” comes from.

3. People withdraw “money” from the economy (by selling goods or liquidating money “savings”) to pay off the debts which were accumulated in the previous period.

4.  Any interest payments to the bank from the debt in the previous period is remitted back into the economy through dividend payments and/or operating expenses.

So the money supply in each period will be the quantity of money which remains in the economy after all of this and is carried over to the next period.  I will assume that the economy starts with zero money so that in period 0, the quantity of money is equal to the amount of loans and I will assume that in this period, the banks are reserve constrained (the reserves ratio is at the minimum allowable level).  This means that, given the initial supply of reserves (R) and reserve ratio (a), the initial “money supply” (M) and new loans (L) will be the following.

M0=L0=R0/a

In the following period, this same quantity will need to be paid back plus interest, but the interest will flow back into the economy along with the quantity of money created by new loans so at any time t, the quantity of money will be given by the following.

Mt=Lt+Lt-1-Lt-1=Lt

In other words, the quantity of money in circulation is equal to the quantity of debt.  Now we must model the market for debt.

Let the willingness to hold debt (demand for new loans) be a function of the real interest rate r and the value of real goods in the economy PY.  (Y can be thought of as either real output or real wealth.)  For the sake of exposition let this be the following.

Lt=PtY(1-rt)=Y(1-ite)   for it> πe

Lt=PtY                                 for it< πe

For our purposes let us assume that Y is constant and determined by “real” factors.  So by assumption, money is neutral.  A more specific treatment of the business cycle would have to relax this assumption of course but I’m not going to do that here.  Similarly let us assume that expected inflation is constant.  For instance, assume that the central bank has an inflation target which everyone believes they will (and can) hit, at least on average.  The exact specification of this function is chosen for its simplicity not its realism but the important points are that it is downward sloping in the real interest rate and that it cannot be greater than the total value of real goods.  The maximum amount of loans possible does not have to be exactly equal to the total stock of real goods, it is likely to be somewhat less (I suspect an argument could be made for it somehow being more but this would be a bit more complicated to justify) but the important thing is that there is some maximum (the demand for loans does not go off to infinity as real rates (or alternatively, nominal rates) approach zero.

By assuming that inflation expectations are fixed, I am assuming that nominal rates move one-for-one with real rates.  This is a simplifying assumption of course.  Much of the complexities that arise in modeling monetary policy are related to the way in which these expectations are modeled but I don’t want to deal with that extensively here, though I will add some discussion of this issue at the end.

The supply of new loans as a function of the nominal rate will look like I describe in this post.  Namely, it will be horizontal (perfectly elastic) at i=0 (or alternately at the rate of interest on reserves) up to the maximum quantity which is possible to create from the given quantity of reserves and the reserve requirement.  At that point it will be vertical (perfectly inelastic).  So in “normal times” (when nominal rates are above zero) the equilibrium quantity of loans in this market (and thus the money supply) will be equal to the maximum allowable quantity and the nominal interest rate will be given by the point at which this quantity intersects the demand curve.

Mt=Rt/a=Lt= PtY (1-ite)

it=1-Rt/(a PtY)+ πe

Finally, let the price level in each period be determined by the equation of exchange.

MV=YP

And let velocity be fixed at v so that the price level in any period is given by the following.

Pt=vMt/Y=vRt/(aY)

The assumption of a fixed velocity is another drastic simplification.  This, along with inflation expectations, represent the main points of this model which deserve more careful analysis, expecially because the theory I am working from is one which holds that money demand is essentially liquidity demand and that demand aught to be related to velocity in an important way.  In other words, people find high velocity inconvenient and so they are willing to pay a price to acquire more money which lowers velocity (but likely increases prices).  But digging into this would greatly complicate things and at this point would distract from my main point.  So essentially, I am assuming that any increase in money goes entirely to prices.  One could imagine however, that some of the increase is soaked up by a decrease in velocity.

This describes a complete model of the money supply and the economy.  The path of the money supply, price level and interest rates, then depends entirely on the quantity of reserves provided by the central bank.  So let us imagine that the central bank tries to hit its inflation target every period.

Assuming some initial condition for the quantity of reserves R0, the initial quantity of money, price level, and interest rate will be the following.

M0=R0/a

P0=vR0/(aY)

i0=1-R0/(aP0Y)+ πe=1-1/v+ πe

In the next period, the central bank will try to make P grow by a factor of (1+ πe).

P1=P0(1+ πe)

This will require a proportionate increase in the money supply which requires a proportionate increase in the quantity of reserves.

M1=(1+ πe) R0/a= R1/a

R1=(1+ πe) R0

Because the demand for loans is proportionate to the nominal value of output, this demand increases proportionately with the price level and so the nominal interest rate will be constant across time as well as the proportion of debt to nominal output.

i1=1-R1/(aP1Y)+ πe=1-(1+ πe) R0/(a(1+ πe)P0 Y)+ πe=i0=1-1/v+ πe

The same thing will have to repeat in all following periods, so that at any time t, the state of the economy is described by the following dynamic equations.

Rt=(1+ πe)t R0

Mt=(1+ πe)t R0/a

Pt=P0(1+ πe)t

it=1-1/v+ πe

This constitutes a “base scenario” in which, in order to hit its inflation target in every period, the central bank has to increase the supply of reserves exponentially which increases the supply of “money” by the same factor and also increases prices by the same factor.  The nominal rate, real rate, and inflation rate are all constant.

Now some interesting points about this model.

Recessions

As I said, this does not explicitly model recessions but we can imagine how one would occur and what it would look like by imagining a sort of “off the equilibrium path” scenario.  Consider what would happen if at some period, the money supply failed to hit the expected quantity.  This may happen because the central bank fails to inject enough reserves or it could be because demand for new loans drops unexpectedly (which amounts to the same thing since the CB would have to fail to account for the drop).

If this happens, then prices will not rise as much as people had expected when they initiated their old loans.  Since people borrow in anticipation of paying the loans back with income generated from the sale of goods and services in the future, their income will be less than they expected in nominal terms and so will their ability to repay those loans.  But because they have real goods backing those loans, they will be competing more fiercely over the smaller-than-expected quantity of money left out in circulation.  This is what causes prices to fall.

This condition of falling prices will be accompanied by some people (more than usual) being unable to repay their previous loans.  This will cause houses to be foreclosed, businesses to close down etc.  If people expect prices to continue to fall, they will be even more reluctant to undertake further debt (inflation expectations decrease which shifts loan demand to the left and lowers interest rates) and the process may be self-reinforcing to some degree.

This process of “deleveraging” will continue until enough people have defaulted, wiping away their debt without retiring the requisite quantity of money and therefore causing the ratio of debt to real goods to drop, (or until the government/central bank intervenes in some other way to increase the money supply) that the economy reaches a new equilibrium path.

This process of default can be avoided (at least in normal times) by central bank easing (increasing reserves) which allows interest rates to fall and more money to be created (monetary policy).  Alternatively, if the CB refuses to do this for some reason, the government, because it has the ability to borrow with no collateral constraints, can add to the demand for new loans by borrowing and spending (fiscal policy).  Either one of these should work equally well, at least if not in a liquidity trap (more on that below).

In this explanation, debt essentially plays the role that “sticky prices/wages” play in most other models (though they are not at all mutually exclusive).  In my opinion, this is a far better explanation because debt is literally fixed nominally by the contract over very long time periods.  The quantity of debt in the system is huge and it is directly linked to the quantity of money by the process of money creation.  You don’t have to make any strained arguments about “labor’s” unwillingness to work for less even though it is in their interest, or businesses being unable to change their menu prices for years on end or anything like that.

“Nominal rates are not a good indicator of the stance of monetary policy.” 

I put this in quotes as a nod to Sumner (and indirectly Friedman).  There are two ways of interpreting this in the context of this model.

1.  In a model with more realistic modeling of inflation expectations, the demand for loans would shift around with those expectations.  So if the CB did something that increased the money base in the current period but also increased inflation expectations for the future, you would have loan demand shifting to the right along with the supply and you could see rates either rise or fall.  So if we allow inflation expectations to change we can easily represent this phenomenon.  (A similar thing could be done if Y were a measure of expected future wealth which depended on expectations).

2.  Even without letting these things shift about, different specifications of this model could result in credit conditions (interest rates, and leverage ratio) that are not constant over time (more on this to come).  If this were the case (and I suspect it is) then it may be the case that the interest rate associated with “neutral” monetary policy (producing the targeted inflation rate) is different in different periods.  Specifically, I think a case can be made that this will tend to get lower, the longer this system goes on.  If this is the case, one may mistakenly interpret low rates in one period as “looser” policy (more inflationary) than higher rates were in previous periods when in fact they may actually be “tighter” (less inflationary).  This type of case will be left for a later post however.

Liquidity traps

In this model a “liquidity trap” occurs if the central bank finds that it cannot increase the quantity of loans (and hence the money supply) by increasing the quantity of reserves.  In other words, it means banks have excess reserves and the supply/demand in the market for loans is such that demand crosses supply along the elastic section of the demand curve (at i=0 or the level of interest on reserves).

In the model presented here, this would occur if the real rate fell to zero or below.  In this case all of the real property would essentially be mortgaged and so the CB could print more reserves and this would have no effect on the quantity of loans and therefore the quantity of money. Alternately, it could occur without all property being mortgaged if demand for loans hits the horizontal axis (or IOR) before this happens.  If this is the case, the CB may be unable to create the quantity of money which is required to create the expected inflation and this could lead to a recession as described above which cannot be easily cured by “traditional” monetary policy.

Market For Loans

loans market zlb2

This may happen because, for some reason, demand for loans drops (inflation expectations drop, government deficits drop, a real shock to output occurs, appetite for debt declines, etc.) or it may be that the economy approaches such a state in a systematic, deterministic way.  Whatever the reason, a wave of defaults and deleveraging will occur unless additional methods of increasing the supply of money are found.

One such method, as already described, is to have the government do additional borrowing and spending.  Alternatively, the central bank can do a similar thing by printing money and buying other stuff (“quantitative easing”).  Quantitative easing as we currently know it seems to be a method of increasing demand for loans by pushing down the longer end of the yield curve.  Similarly, the CB can try to increase this demand through “forward guidance,” promising to be “looser” for longer.  If this increases inflation expectations, it will increase demand for loans.

Of course, if just pushing down the long end of the yield curve is not sufficient to get out of the liquidity trap, the CB, in theory, could just print a bunch of money and use it to buy all kinds of stuff, pushing up prices and increasing the quantity of money in circulation without increasing debt.  Of course, whether this would count as monetary or fiscal policy is debatable.

This should answer questions like “how does monetary policy work” or “how is inflation created” in the context of a credit-based theory of money.  I have some ideas about why an economy may deviate from this scenario in a systematic way but I will try to present them as variations to this base model.  Stay tuned for that.

Reserve Requirements and Monetary Policy

March 12, 2014 4 comments

I have been trying to describe in detail the way money is linked to debt.  (If you are jus joining us start here, then go here and here.)  This leads naturally into a discussion of monetary policy which I will now begin to undertake.  I will provide a simple model of the way I look at monetary policy but first some discussion about what determines the aggregate supply of money is required.  I will begin with a gold standard in order to further highlight the similarity and difference between that system and a fiat money regime.

As I have been arguing so far, “money” as we know it is really credit created by banks.  Under a gold standard, you can take your gold to the bank and convert it into “money” (for instance bank notes or a checking account).  You can also convert other real assets into money like a house or a car or a business, this money just happens to be denominated in units of gold.  The quantity of money in circulation can expand far beyond the quantity of gold but this requires other assets to be put up for collateral. (Note that these assets may not always be as obvious as a house, they could be something like the produce of labor in the future.)

So if we want to deal with broader macroeconomic questions, we have to ask what determines the extent to which this process of money creation will be carried out.  Under a “free gold standard,” by which I mean a system free from any government restrictions other than the enforcement of the convertibility of the money into gold at the stated conversion rate, the extent to which money will be able to be created is limited by the willingness of the public to hold that money.  This is a matter of liquidity preference.

The price of gold (both the spot price and the rate of change) will be determined (at least primarily) by “real” factors in the gold market (quantity of gold, expected future production, expected future demand, etc.) and the value of money will be anchored to the value of gold.  (I say “primarily” because the evolution of the value of gold over time depends partly on it usefulness as a medium of exchange/store of value and money acts as a substitute in these regards so the extent of credit creation likely has some effect on the gold price but put that aside for now.  (For more on this topic see this post and this one and this one.  Note however that my thinking on these things is evolving fairly rapidly and some things like the definition of money may not be entirely consistent throughout.)

In this system, people are able to convert gold into money (and vise-versa) at par but the banks will find that they can issue additional money backed by other assets and charge some rate of interest.  The reason they are able to do this is that there is excess demand for liquidity when the price of liquidity is zero.  So essentially, when someone mortgages their house, they are converting the house into a different asset (money) which has liquidity characteristics more closely resembling those of gold.  It is more easily transported, divided, recognized, etc.  For this service they are willing to pay some positive nominal interest rate.

But the bank can only make a profit on the quantity of money it is able to float above the quantity of gold it has.  This money floats because of the willingness of people to hold their wealth in that form as opposed to others and this willingness will depend on the interest rate.  The higher the rate, the less money people will be willing to hold.  This may mean any of the following: they take out fewer loans, they pay off existing loans, they redeem money for gold.  Which one it means for any individual obviously depends on the financial condition they find themselves in at the time.

It is important to not here that, assuming financial markets are perfectly competitive, the marginal liquidity preference of money will have to be the same for everyone and equal to the cost of holding the money which is the interest rate.  To see why this is important notice that borrowing and lending can take place outside of banks as well.  So if one person is accumulating a lot of money to the point where their demand for liquidity is low, they can either turn it in for gold and hold gold, or they can lend it in the financial markets to someone else who’s demand for liquidity is higher.  This process of non-bank borrowing and lending does not create additional money, it only distributes the existing money in such a way that the people with highest demand for liquidity end up holding it.

But if at the current market rate of interest, the quantity of money in circulation is greater than that which can be held by the public at large when their marginal liquidity preference of money is equal to that rate, then some holders of that money will not be able to find borrowers at that rate and they will bid the rate down.  This lower rate will cause some people who were holding debt at the higher rate to “refinance” with debt from non-bank lenders and retire the money by paying off debts from the bank until the money supply and interest rates fall to a point where the marginal conditions are met for everyone.  Similar arguments can be made for other disequilibrium scenarios.  So the interest rate is linked to the quantity of money in circulation relative to the demand for liquidity.

Note that there is no need for people to redeem their money for gold unless they become concerned that the bank is or may become insolvent due to people failing to repay their loans and the value of the assets backing those loans (in terms of gold) being insufficient.  If nobody ever became concerned about this, the gold that the banks had on hand relative to the money outstanding would be inconsequential.  However, because people sometimes do fail to repay their loans, and the value of collateral is subject to market fluctuations, there is some danger of this.  The holdings of gold which the bank stands ready to redeem for their notes acts as a kind of buffer against this problem.

In theory, if a bank had a bunch of bad loans, it could go into some form of bankruptcy, liquidate all the assets it had, including good loans and collateral seized from bad loans for gold (or “money” attached to other sound banks) and distribute this to the people holding accounts at the bank or notes from the bank.  This means that some risk of loss from the loans of the bank would be born by the holders of the bank’s “money.”  The willingness to convert that money into gold at par acts as an indication of the solvency of the bank.  So in essence the willingness of people to hold money rather than gold comes down to a balancing between the liquidity premium and the risk premium here described.  These things may fluctuate over time and the bank may need to balance them by redeeming gold for money or vise-versa.

The more gold reserves a bank has on hand relative to its money outstanding (given the soundness of its loans) the lower the risk premium which will be associated with that money.  The less concerned people are about this risk, the more willing they will be to hold money at any given interest rate and the more banks will be able to expand the money supply for a given quantity of gold reserves without it coming back and being redeemed for gold.

In this way, banks allow for the conversion of less liquid assets into a more liquid form and the extent to which this goes on is determined by some balance between the demand for liquidity and the associated risk involved in that conversion.  The exact extent also depends on the structure of the banking market.  For instance, if banking is perfectly competitive, we could expect the money supply to be expanded to the point where the resulting nominal interest rate provides banks with zero economic profit.  If it is a monopoly, we can imagine the bank choosing the quantity of money and associated nominal rate in order to maximize their profit.  For more on this see this post.

As far as I know this form of pure free-market banking has never actually existed.  I suspect something similar has at some point somewhere and that this essentially describes the genesis of fractional reserve banking but if it has, it was a long time ago and I can’t point to a specific example.  An alternate way of constraining the extent of credit creation is through a statutory reserve requirement.  This can exist along with a gold standard.  In this case, there are two constraints on credit creation: the quantity that the market will bear based on the arguments laid out above and the quantity which it is legally possible to create from the quantity of reserves available to the banking system.  At any given time only one of these will be binding (except for the special case where they are both the same).

In other words, the reserve requirement may be meaningless (at least in the aggregate) because it may require a level of reserves which is less than what would naturally occur in an entirely free market or it may arrest the process of credit creation at some level lower than that.  In the latter case, the quantity of available reserves, along with the reserve requirement determine the quantity of total credit (money) which will be created by the banking system.

A pure free banking system would not be possible without a gold standard (or at leas some sort of similar standard) because it would create an enormous moral hazard for the banks.  Banks are able to float money because people are willing to hold it.  People are willing to hold it because they believe it will hold its value.  The reason it is possible for banks to expand the supply of credit in the way described without it losing value is that ever dollar they create creates a corresponding future liability.  This means that the supply of money created in this way is systematically anchored to the quantity of real goods backing those claims.  Over time the liabilities grow because of the positive interest rate but the money does not and the differential represents the bank’s profit.  But this is only possible with some regulating force like a gold standard.  To see why, consider two things that could occur without it.

1.  Banks could create a lot of money and use it to simply buy stuff.  This would create no corresponding liability.  Without that liability acting as a counterweight to pull money out of the system should the demand for that money decline, the only mechanism left to bring the market into equilibrium will be the price level.  So the more money they print, the more prices will rise.  But because of this, and the fact that there is no limit to what they can print, there will be no reason to believe that the value of a dollar from that bank will have a certain value in the future, and the willingness to hold it will likely collapse to zero and the money will become worthless.

2.  The other side of the coin: When someone takes out a loan, they do so with some expectation about the value of the money they will have to obtain in the future to repay the loan.  The value of the money in the future, of course, depends on the quantity of that money which is available in the future and that is at the discretion of the bank.  So a potential borrower has to try to imagine how much money lending the bank will be doing in the future.  Since loans carry a positive interest rate, there is never enough money to pay them all back without additional credit creation.  This raises the possibility that at some point, the bank could decide to stop creating more such credit and essentially pull the rug out from under its current debtors in order to make it difficult for them to repay and thus be able to repossess their collateral.  Borrowers, of course would have to anticipate this and this may lead to nobody being willing to borrow.

In either case, people on one side of the market (holders of money) or the other (holders of debt) are at the mercy of the bank who is unrestrained in their ability to expand or contract the money supply.  But a gold standard makes it impossible to alter the value of money much above or below that of gold.  If they tried, people would simply start swapping one for the other (either redeeming money for gold or using gold to repay loans).  This imposes a degree of discipline on an otherwise unconstrained issuer of credit.

A reserve requirement is an alternative mechanism for imposing some discipline on the process of credit creation.  This prevents banks from expanding credit beyond a certain amount determined by that requirement and the quantity of available reserves.  (The second problem is solved by having a competitive market for creation of interchangeable money so one bank cannot unilaterally restrict it.)  As I said, this can (and did) exist along with a gold standard but when it does, the two are to some degree redundant.  Once you have a legal reserve requirement, the gold standard is no longer necessary for the system to function.

So once you remove the gold standard, the value of money will not fall to zero because the gold was only a small part of the assets that were actually backing that gold.  But now that value will no longer be anchored to the value of gold.  It will instead be determined by the degree of credit expansion which is allowed to go on at any given time (and expectations of the same).  This, in turn, will depend (at least in “normal” times) on the quantity of available reserves and the reserve requirement which are determined by some central authority (the central bank).

So in essence, the reserves (base money) which the central bank issues are simply a license to create credit (liquidity).  Because the creation of credit is limited by the amount of reserves and the reserve requirement, and in “normal times” (more on this later) that total quantity that can be created is less than the quantity which would be demanded if the price of liquidity were zero, the price of liquidity will be positive and therefore banks will be able to make profits by creating credit and therefore, they will compete to get the reserves which allow them to do this.  This will be reflected in a positive rate on deposits (when you transfer your “money” from one bank account to another, a corresponding quantity of reserves must be transferred along with it), as well as a positive discount rate (the rate at which banks borrow and lend reserves to each other).  The price banks receive for creating liquidity is then represented by the difference between this (let’s imagine that the two previously mentioned rates are equal) rate and the rate at which they are able to lend.

In this case, the willingness to hold money, and the corresponding willingness to hold debt, will be determined by expectations about the future stance of “monetary policy” (most importantly the size of the money base and the level of reserve requirements) along with the state of the credit markets (demand for money, demand for currency relative to bank accounts, supply of goods etc.).  This willingness to hold money and debt, combined with the current supply of money/debt will then determine the state of the current credit markets (interest rates, price level, etc.).

Next (tomorrow unless fate conspires against me) I will present a simply dynamic model of this which I think provides a good explanation of liquidity traps.

 

The Value of a Dollar

March 7, 2014 22 comments

Okay, yesterday I set out to explain how the value of a dollar  is determined and monetary policy functions under my collateral-backing theory.  I typed for two hours and felt like I didn’t get half way there (much of it is just rehashing what everyone else already believes).  So I am going to try to slice off a smaller piece again.  This time I won’t promise to fit everything else into the next post (reflecting on the fact that Sumner has been trying to explain that nominal rates are not a good indicator of the stance of monetary policy for five years…).  I will just take it one bite at a time and see what, if anything, people want to argue with and go from there.

So in this installment I basically want to deal with this criticism by J.P. Koning.

2) What anchors the price level? Why does $1 buy one apple and not $10 apples? Does a Canadian dollar by 0.98 US dollars because there are less debts to settle in Canada?

Frankly, I am a bit perplexed by this question because this is exactly the problem that I think his theory (and essentially every other theory I am aware of) has and which, in my mind, my theory solves quite nicely.  So in a sense, I feel like that’s what I’ve been explaining.  Somehow, I haven’t gotten my point across (maybe because I haven’t explained it well enough or maybe because there is a flaw that I don’t see), but I’m not exactly sure where the disconnect is so once I start trying to explain I tend to want to try to come at it from every possible direction and cover everything under the sun related to money.  I will try to resist that temptation here by avoiding a detailed discussion of how monetary policy functions.

So let me start by attempting to more clearly explain what I am trying (and not trying) to do here.  First of all, I don’t think I am overturning everything everyone ever thought about money and monetary policy and macroeconomics.  I think that monetary policy functions in essentially the same way that most economists do.  I just think that, on a basic level when you get to questions like “why is money valuable in the first place?” the explanations typically given are not the whole story.  In fact, I think they miss the most important piece of the story.

Once you fill in this piece of the puzzle, I do think that you can see some things that are a bit fuzzy without it more clearly and I do think that there are a few implications (or at least possible implications) that arise from this view which are missed by other simpler models of money creation though it takes a lot of analysis to get to them.  But this doesn’t mean, for instance, that I don’t think the CB can affect the value of the currency by buying and selling assets.

Now the answer to “what determines the price level at any given time,” on some level, has got to be the same for any theory.  It is determined by supply and demand.  At any given time, there is a certain number of dollars in circulation and a certain quantity of goods and services (or potential goods and services) and the dollars circulate at some velocity which is based on peoples’ willingness to hold them relative to other assets and this determines a “price level.”  This basically has got to be the case regardless of why you think the money has value.

The real question underlying this, which I have tried to answer is “why are people willing to hold money at all?”  Whatever the answer to this question, it will determine some willingness to hold money (which is to say a “demand form money” which depends on the cost of doing so) so people will hold money until the marginal benefit (from liquidity preference) is equal to the marginal cost (foregone return on other investments).  The higher the velocity, the higher the marginal liquidity preference will be (or vise-versa) and there will be some equilibrium price level.

Now, any theory about the demand for money also has to acknowledge that the willingness of people to hold money today depends on their beliefs about the value of that money in the future.  This is what makes everything complicated.  We know people must believe it will be valuable or else they wouldn’t hold it at all (and probably that it won’t be dramatically less valuable or nominal interest rates would be really high).  The question is: why do they believe this and, probably more importantly, is it reasonable to believe it?  Another (more rigorous) way of putting this is to ask whether the equilibrium is based on beliefs that are rational off the equilibrium path (is it a subgame perfect NE)?

For instance, if peoples’ willingness to hold dollars is based entirely on the belief that others will be willing to hold them in the future, and the value of them (either now or in the future) is not anchored to any real goods in any way, then if people started to question that belief, for whatever reason, you could see the willingness to hold them drop dramatically, possibly substituting other goods for use in exchange (essentially allowing P to decouple from M, V, and Y), and the price level could shoot off to infinity and the dollars become basically worthless in a Weimar/Zimbabwe-style hyperinflation.  This seems to be what most people who think the dollar is backed by nothing fear, and that fear would be reasonable if it were actually backed by nothing .

Similarly, if you think that the dollar is “backed” by the expectation that the CB would be willing to trade real goods for dollars to prevent the real value of the dollar from falling, then one must wonder whether they have enough such assets to do this if people “lost confidence” in a manner similar to that described above.  It is hard to see how this theory can explain a total value of the dollars which is much beyond the value of the real goods that the central bank has available to trade for them (accounting for a liquidity premium) without relying on the same type of logic, i.e. people know the CB couldn’t cash out all the dollars for gold at the current price of gold but they just hope that, for some reason, people will keep being willing to take the dollars at the current elevated value and so the CB will never have to do this.

The willingness of the CB to buy and sell a little on the margin does not seem to rectify this problem, if the promise to go all the way is not credible (due to insufficient real assets).  A classic Ponzi-scheme works for a while because the person perpetuating it stands ready to cash out people who demand their money but once it becomes clear that they do not have enough money to cash out everyone, it collapses.

I think what I have done is provide an explanation for why it makes sense for people to expect the dollar to continue to be in demand that does not rely on any kind of belief that could suddenly evaporate at any moment but instead is based on real exchange rates between dollars and real goods that are fixed in long-lasting, legally binding contracts.  In order to explain this further, let me start by defining what I mean by “money.”

Going forward, when I say “money” or “dollars” I mean anything that can be directly (without being converted to another form) used to repay debt from a bank.  I think the line may be a bit blurry in some cases but for the most part this includes, essentially cash and bank deposits (checking and savings).  I don’t count stocks or bonds because these must be sold at a market price for money before debt can be repaid.  Some things like money market funds or certificates of deposit are a bit tricky but I don’t want to get too distracted by this issue for now.

The important thing to notice is that I am coming at the “money supply” from the opposite direction of people who begin their reckoning from the money base.  This is only significant because they often talk about the willingness to hold money as the willingness to hold currency (cash) whereas I am talking about the willingness to hold dollars in any form.  Since currency and deposits can be converted into one another at any time at par, the composition of peoples’ “money holdings” between the two will be determined by the different liquidity of each.  While this willingness to hold cash has an important mechanical function in determining the amount of total “money” which will be created from a given quantity of base money at a given nominal interest rate, and is therefore important for modeling the effect of CB policy, this is not what I am after and so this distinction between cash and deposits is not of particular interest for my purpose.

So let us acknowledge that the CB has tools that can alter the quantity of money which is created at any given time and put the discussion of what those are and how they work aside for now.  It is true that people are willing to trade real goods for dollars and hold some quantity of those dollars.  This means that they must believe the dollars will be sufficiently valuable in the future (given their other options for holding wealth).  The question is why does this belief make sense?

The reason for the reliance on “network effects” to explain this, I think, stems from the Macro 101 view of the role of money in the economy.  This is essentially that money circulates through the economy like a perpetual, circular river and the CB simply determines how much water it wants and pours it into the system.  It can add water or take it out but it essentially has no purpose but to circulate and is not directly connected to the value of any real goods except by the seemingly arbitrary rate at which people choose to push it perpetually through the system.

I think this does serve as a reasonable approximation of how money functions but that the fundamental nature of this money is somewhat different.  I am saying that money does flow through the economy in this way and the quantity is determined by CB policy but that the meaning of those dollars is in fact anchored to specific real goods because of the way the dollars are created.

The CB does not just print dollars “out of thin air” and dump them into the economy.  Dollars are created when someone borrows.  CB policy does limit the extent to which this process can go on but that is what I’m trying not to get into here.  So I see the fundamental economic function of the banks as manufacturing liquidity.  Under a gold standard, if you don’t want to lug your gold around, weigh it for every transaction, slice it into pieces etc. you can take it to the bank and convert it into a more liquid form (bank notes) which are easier to use for transactions.

But this is not the only–or even the most significant–form of transaction cost that banks help people overcome.  For instance, if you are a shoemaker and you want to trade half the shoes you will make over the next twenty years for a house, you can offer this to the owner of the house but they will likely be reluctant to take it for several reasons.  For one, they don’t know you and don’t know if it is credible of you to promise this.  For another, they don’t want that many shoes and would have to be constantly re-trading them for the stuff they did want.

But you can overcome this by going to the bank.  The bank will verify your income, asses the value of the house and offer to lend you the money (or part of it) to purchase the house in return for a promise to repay some amount of money in the future or else lose the house.  You then trade this newly created money for the house.  The seller of the house now has an account representing the value of the house he just gave up which he can use to purchase other goods (including other investments) in whatever form or quantity and at whatever point in time he wishes.  You, on the other hand, are obligated to work (presumably producing shoes) for the next twenty years to get those dollars back to pay off your loan and keep your house.

So the question then is, why is the seller able to take those dollars and trade them to third parties for other goods?  The answer is that they know that somewhere out there is a guy who is obligated to produce shoes and trade them for those dollars in the future (as well as a bunch of other people producing other goods).  In this way, money is created by converting other real goods into a more liquid form.  This more liquid form of wealth then circulates in the economy in the way commonly understood and the willingness of people to hold it determines a velocity and a price level.  But that willingness to hold money, based on the belief that someone else will be willing to trade real goods for it in the future is “anchored” by all the people willing to trade “shoes” to get dollars and the rate at which they are willing to trade shoes is “anchored” to the rate at which they are contractually able/obligated to trade those dollars for their houses.  This rate, again, is nominally denominated and fixed (doesn’t fluctuate with market conditions or “confidence” in the dollar or anything like that).

So at any point in time there is some quantity of dollars circulating and there are people trying to get the dollars and “retire” them by paying off debt and there are people creating new dollars by securitizing new real assets and this determines the change in the quantity in circulation.  The CB can “steer” this quantity by altering the constraints on the creation of new credit (changing the money base for instance) or potentially by doing other things which I don’t want to get into.

Naturally, when someone enters into a long-term debt contract, they do so with some beliefs about market conditions in the future which will affect the price of the goods they intend to produce.  This depends largely on the rate of growth in the money supply relative to output and this depends on some belief about CB policy going forward.  Just how to model this becomes a complicated question which I will leave for another time but the central point remains that the real value of the dollar is inextricably “anchored” to real goods by these contracts.

This, I believe, is why we don’t see sudden losses of confidence leading to dramatic declines in the value of the dollar.  On the contrary, at times of financial panic (to put it dramatically) we tend to see the opposite.  People try to liquidate other assets and hold dollars, leverage dries up and we see defaults.  I suspect that if we drilled down, we would find that there are actually not enough dollars to pay off all the debt but doing so is not as easy as I first thought.

Finally, it should become clear how exchange rates are well defined here.  There are some quantity of US dollars circulating in the US which are “backed” by real goods in the US and represent claims on those goods and indirectly on the goods and services provided by the people holding the debt contracts on those goods.  This quantity along with the liquidity premium and associated velocity defines a price level in terms of US dollars in the US and the same process is going on in Canada with Canadian dollars.

When someone in Canada wants to buy shoes from the shoemaker in the US, they have to trade Canadian dollars for US dollars and vise-versa.  The flows of trade between the two countries, along with people speculating about future flows of trade and credit conditions in the two countries make a market for the currencies and the relative price is determined by supply and demand in that market in the way commonly believed.  But both currencies are “anchored” to real goods by debt contracts denominated nominally in their respective currencies and securitized by real goods.

On the Convertibility of Fiat Money

March 3, 2014 6 comments

Okay, I got some good comments from J.P. Koning and others, for which I am grateful, on my “debt chartalism” theory explaining the value of fiat money.  I set out to answer them all in one post but as I dig into it I realize that there is a lot there that I take for granted that probably deserves a more careful explanation so I will begin here with a more thorough discussion of the fundamental nature of fiat money relative to a convertible currency explicitly backed by a hard asset.  Then in a future post, I will try to delve into monetary policy, inflation, determining the specific value of a dollar etc.

The important thing to notice here is that the nature of fiat money is actually not that different from “hard” money.  To see what I mean, let me start with a bank issuing gold notes and go through some minor alterations that I think most people would agree would not destroy the value of those notes.  In what follows I will represent the banking sector with a single bank.  The relationship between the CB and individual banks raises a bunch of issues which I don’t think are necessary to make my point (and are distracting) so I will abstract from them for now.

We start with a bank that has no assets and some people who have gold and want to exchange it for bank notes because the notes are more liquid (easier to use for transacting).  People take their gold to the bank and the bank creates notes “out of thin air” which they, or anyone else, can return at any time and exchange for “their” gold.  Most people seem (rightly) to have no difficulty seeing why these notes would be valuable.

Now imagine that instead of taking your gold to the bank and getting notes, the bank comes to your house, verifies that you have the gold, issues you the notes and tells you that in one year, you have to “redeem” the notes or else they will take your gold.  These notes may be convertible by anyone at any time at the bank or they may not be.  In the first case, of course, the bank will have to have some other gold in their vaults to deal with these redemptions but as long as there is sufficient demand for liquidity relative to the quantity of notes in circulation, most of the notes will float and redemptions will be limited.  But the important point is that you have not turned a perfectly legitimate enterprise into a Ponzi scheme by letting people hold the gold in their individual vaults rather than the bank’s vault.  The gold is still backing the notes because of the nature of the contract that created them.

Looking at it this way, hopefully we can see that it is not the universal convertibility that gives the notes value.  This, of course, may give them somewhat more value but mainly it is a mechanism which imposes discipline on the bank and inspires confidence in the holders of their notes.  This is a discussion for another time.  But consider whether these notes would still be valuable if the bank withdrew the universal convertibility.  By this I mean that you still have to have 100 oz. of notes in one year to keep your gold (let us call this individual convertibility) but if you trade the notes to someone else, they can’t just take them to the bank and cash them in for gold.

Will these notes still be valuable?  The answer I think is yes because they are still convertible.  It is just that they are only convertible at a given time by a specific individual.  But because there are some individuals who are able to “convert” the notes to gold at a fixed rate, those individuals will always be willing to trade real goods and services for those notes.  In this way the gold is still “backing” the value of the notes, it is just that the convertibility has been changed from a general obligation to a specific obligation between the bank and certain individuals.

Finally, imagine that the bank accepts other goods besides gold to back their notes.  This raises the issue of denomination.  You could have “silver notes” and “ruby notes” and “corn notes” because these are essentially commodities but these notes would make general exchange somewhat more complicated (everyone would have to keep track of the relative values of all of these things) and you could not create specific notes for idiosyncratic goods like “house notes” and “car notes” and “boat notes” because one man’s house is not worth the same as another’s.

One solution to this problem is to denominate all notes in a single good.  So if you want to convert your house into notes, instead of the bank issuing you “house notes” they issue you gold notes for a quantity of gold equal to the value of the house (or somewhat less).  Then you have the right to “redeem” some quantity of “gold notes” for your house at some point (or points) in the future at a specific, predetermined rate.  In this case, even though the notes represent a value denominated in gold, it is your house that is actually “backing” those notes.

But if the notes are not universally convertible into gold, the denomination is arbitrary.  The bank can just as easily issue you notes denominated in “quatloos” and say that you need to return 1,762 quatloo notes in order to keep your house.  People can put up whatever assets they want, the bank can assess their values in quatloos and issue notes which are redeemable at various rates for various asset.  As long as these notes are interchangeable and denominated in the same units (even if that unit is completely arbitrary), they will be able to trade them amongst themselves and there will be a somewhat stable demand for them because there are always people who can “redeem” them for real assets at various rates.

In this way, the quatloo notes are still backed by real goods, it is just that those goods are not as obvious because the type of goods and the rate of convertibility vary from person to person.  To get a better feel for the similarity between the creation of universally convertible notes and individually convertible notes, note (haha) that under a classical gold standard with fractional reserve banking, the two actually exist side by side.

Let us return to our bank which starts with no assets.  The bank attracts some “depositors” who deposit 100 oz. of gold and are issued universally convertible gold notes.  The gold goes on the bank’s balance sheet as an asset (obviously) and the notes go on as a liability because the holders of the notes can bring them in at any time and redeem them for gold.  The balance sheet then looks like this:

Assets                                          Liabilities

Gold: 100 oz.                                 Notes outstanding: 100 oz.

Now imagine that somebody else comes into the bank and wants a loan worth 100 oz. to buy a house.  The bank creates “out of thin air” another 100 oz. of gold notes and lends them to this person and accepts the house as collateral.  The bank’s balance sheet then looks like this.

Assets                                          Liabilities

Gold: 100 oz.                                 Notes outstanding: 200 oz.

Acc. Receivable: 100 oz.

The accounting is the same except the asset which goes on the books is an account receivable instead of gold.  But there is a real asset behind that account receivable, namely the house.  The house is backing the notes of the bank in the same way that the gold from the first guy is.  The fact that the bank does not have enough gold to redeem all of its notes does not make it insolvent.  This is where Rothbard’s people go off the rails.  Fractional reserve banking is not based on deceiving people into thinking that there is more gold in the vault than there actually is.  It is just a method of turning various types of assets into a more liquid form.  The total assets backing that money grow along with the supply of money.

If the house burns down and the borrower defaults, then the bank will become insolvent.  There will be too many notes outstanding for the total assets on the bank’s balance sheet.  Then people may rush to redeem their notes and find out that there is not enough gold.  But this only happens because the demand for notes from the borrower becomes removed from the market without reducing the number of notes (or delivering the house, which could be sold for notes, to the bank).  (Of course, a bank could become illiquid without being insolvent but this is a matter of demand for notes, liquidity preference, etc. that is well-understood, and not worth getting into here.)

In this case, you have a situation where anyone can redeem notes for gold and one person can redeem notes for gold or for a house.  The gold-redeemability only keeps the value of the notes anchored to the value of gold.  This prevents the bank from issuing so many notes that the value of them falls.  If they issue enough notes that the risk/liquidity premium on them relative to gold becomes negative, then people will start redeeming them for gold.  If this is not the case, the notes will float and the bank will be able to keep issuing more.  But the gold is not the sole source of backing.

Of course, the more loans a bank makes in this way, the more other assets will make up the “backing” of their notes.  If at some point, they drop the universal gold redeemability, the value of a note will no longer be anchored to the value of gold but it will not  just evaporate into thin air because there will still be a large amount of other assets “backing” it.  People will still have individual convertibility in various assets.  In fact–especially if it is a monopoly–the bank may be able to accumulate profits over time which can allow it to basically absorb the value of the gold on its balance sheet.

So this change from convertible gold notes to fiat money is not as dramatic a shift as many make it out to be.  Once it is accomplished, the value of a dollar comes down to flows of credit–how much new credit is being created relative to how much needs to be paid back (and of course expectations about the future matter a lot).  The CB can influence this in various ways.  I will try to dive into that discussion soon, though I admit up front that I don’t have everything perfectly pinned down yet.

 

Is Fiat Money an IOU?

February 27, 2014 34 comments

J.P. Koning has a post (make that two posts) about the IOU nature of bank notes.  While I agree that bank notes (fiat money) are not a Samuelsonian bubble asset, I think he still comes up short of the full explanation of why these are valuable.  Of course I think that I have that explanation but first let me explain why I think his is not fully satisfactory.

The meat of his argument is this.

So in the case of the two central banks that I’m most familiar with, banknotes are ultimately claims on whatever stuff the central bank happens to have in its vaults. This means that on the occasion of the winding down of the Fed or the BoC, note holders are entitled to receive real assets, in the same way that a bond holder or stock holder would have a claim on a company’s property, plant, & other assets upon the dissolution of that company. Banknote holders have an added bonus of being senior to other claimants, since notes provide a “first claim” in the case of the BoC, and a “first and paramount lien” in the case of the Fed.

But this does not fully address the problem.  This is because the process of unwinding a central bank, along with a currency, is fundamentally different from unwinding another type of entity.  Consider an individual bank that issues dollar-denominated bonds and uses the money to buy assets including some “real assets” (land, buildings, gold bars etc.) and some financial assets (loans) and imagine that the default rate on the loans is unexpectedly high and this causes the bank to become insolvent and need to be unwound.

The bonds, in this case represent a senior claim on the remaining assets of the bank.  The question is how much of those assets are the bondholders entitled to?  The answer in this case is straightforward because the bonds are denominated in dollars and the value of a dollar is determined independently from the state of this individual bank.  In other words, you can just liquidate all of the assets (convert them into dollar terms) and then assign that value to the various claimants in the order of seniority relative to the size of their claims in dollars.

If you are unwinding the central bank, you are unwinding the dollar itself.  So let’s imagine that the CB has some amount of gold in its vaults and it has some amount of notes outstanding which are denominated in dollars.  Those dollars are said to be a senior claim on the assets of the bank (the gold) and let us assume that there are some other claims (these may be dollar denominated debt or undenominated equity).  But the notes do not entitle the bearers to a specific quantity of gold.  So how much of those assets are they entitled to?

In this case the assets cannot be converted into dollar terms and divvied up in the same way as with an individual bank because the value of a dollar is not clear.  The whole market for dollars which forms the basis for the valuation of the assets relative to the various claims in the former case is the very thing being unwound in the latter case.  So how much of the gold goes to note holders versus other claimants?  The answer is not at all clear.  So it is hard to see how this claim serves as any kind of foundation for determining the value of a dollar.

The actual explanation for the value of fiat currency, which I have been trying to argue, (also here) I think is actually fairly simple but seems to be absent from all discussion of the topic.  One dollar is precisely what is required to extinguish one dollar worth of debt.  When money is created, there is always a corresponding debt created.  The central bank creates base money by buying government debt or MBS or lending to banks.  Banks then “multiply” this money (create additional money) by making loans to businesses and consumers.  But these loans eventually need to be paid back.

When a person takes out a mortgage the money supply (some measure of the money supply at least) increases.  But this also sets in motion a 30-year process by which that person must grab money back out of the economy and pay back the loan.  If they don’t do this, they will lose their house.  In this way the increase in money is accompanied by a built-in increase in demand for money in the future.  And in this sense money is “backed” by real assets.  In this case the borrower is able to “convert” dollars into his house at a specific rate.  It is just that this rate, and the convertible asset, varies from person to person rather than applying uniformly to everyone.

This demand for money to repay loans is fundamentally different and separate from the demand for liquidity (though demand for liquidity also factors into the value of a dollar).  It is also not based on any kind of “greater fool” or “bubble” mentality.  It is (at least to some degree) stable in the sense that it does not depend on mysterious, arbitrary feelings about the value of a dollar.  The amount of debt owed is a real number that is denominated in dollars.  It is the product of actions that have taken place over a long period of time and it doesn’t suddenly change drastically or disappear because people “lost confidence” in the dollar.

This in fact explains why people don’t lose confidence in the dollar.  If the value of the dollar were based only on the expectation that someone in the future would accept the dollar at a given rate in exchange for goods and services and that belief were suddenly called into question for some reason, the “bubble theory” leads us to believe that everyone would start trying to get rid of the dollars and the value would plummet.  But if this happened, we would find that many (most) people would actually try to take advantage of the newly weak dollar by exchanging newly valuable (in dollar terms) goods and services to get the dollars to pay off their debt.  In this sense, that demand is backstopping the real value of the dollar and because of this, that scenario never occurs (at least in major “developed” economies).

This also solves the unwinding issue.  Imagine that we wanted to abandon the entire system of central banking we currently have and replace it with nothing, no new fiat currency, just whatever the market wanted to use.  We stop creating new dollars and set a date by which all current debt obligations have to be settled using the current supply of dollars.  These dollars would not become worthless, people would be trying to get them before that date to pay off their debts and keep their homes, cars, boats, businesses, etc.  This would mean that there would still be a market for them in terms of other (real) goods.  You might have to refinance your mortgage in some other terms (gold, silver, Yen, whatever) but this would be better than defaulting and losing it all together.  The quantity of dollars would not exactly match the quantity of debt (I suspect it would actually be much less but haven’t been able to quite figure out the right way to observe this) so there would probably need to be some method of settling the excess dollars/repossessed property, and the whole thing would admittedly be pretty messy, especially the issue of how to treat government debt which is not collateralized and makes up the bulk of CB balance sheets, but when you look at it this way, I think you can see that dollar denominated debt (and the collateral backing it) is the main factor guaranteeing the value of the dollar.

In this way a dollar can be said to represent an IOU but I see it as exactly the opposite.  Rather than an IOU from the bank, it is a means of extinguishing an IOU to the bank.  It can be seen either way because the two look the same on the bank’s balance sheet.  If the bank takes in gold and hands you an IOU redeemable in gold the gold goes on its balance sheet as an asset and the IOU as a liability.  If you take out a loan, you are essentially writing an IOU to the bank for a quantity of dollars and the bank hands you the dollars.  In this case, the loan goes on as an asset (account receivable) and the dollars go on as a liability to balance out the new asset.  The gold IOU in the first case is a liability because it can be brought back and redeemed for the asset (gold).  In the second case, the dollar is a liability because it can be brought back and redeemed for the asset (debt).  In both cases the rate at which this redemption occurs is fixed and not subject to market fluctuations.  The accounting is the same but the meaning is somewhat different and this seems to me to be why people have difficulty seeing dollars as an IOU.

Misconception #2: Money isn’t Backed by Anything

August 25, 2012 3 comments

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.