Monthly Archives: July 2015

A New Theory of Fiat Money

The view of The Money Enigma is that fiat money is a financial instrument and a proportional claim on the future output of society.

Assets can only derive their value in two ways: from their physical properties (“real assets”) or from their contractual properties (“financial instruments”). Fiat money is a financial instrument and derives its value from an implied-in-fact contract between the holder of money and the issuer of money.

Although the fiat monetary base is legally a liability of government, economically it is a liability of society itself. More specifically, fiat money is a special-form equity instrument and a proportional claim on the future output of society.

In this week’s post, we will examine why the “liability nature” of fiat money is important. Not only does focusing on the liability nature of fiat money provide us with a better perspective on why money has value, but it also allows us to create a better framework for thinking about what factors influence the value of fiat money.

Fiat Money: A Liability Ignored

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, is both an asset and a liability. More importantly, fiat money only has value as an asset to its holder because is a liability of society.

Most theories of fiat money focus solely on the “asset nature” of fiat money and therefore struggle to explain why fiat money has value. By focusing solely on the asset nature of money, economists are forced to invent new paradigms in an attempt to explain why fiat money can derive value in a way that no other asset can. Such attempts invariably result in the creation of circular arguments that fail on closer inspection.

In contrast, focusing on the “liability nature” of money has several advantages.

First, we can use the well established “real assets/financial instrument” paradigm to explain why fiat money has value, as opposed to creating an exception to this paradigm specifically for fiat money. Fiat money is a financial instrument and derives its value from an implied-in-fact contract: it has value to its holder because it represents a liability to society. More specifically, fiat money represents a proportional claim on the future output of society.

Second, it allows us to more clearly distinguish between how different types of “money” derive their value. The monetary base is an equity instrument and derives its value as a proportional claim against the future output of society. In contrast, a banking deposit is a debt instrument. In simple terms, a banking deposit has value because it represents a claim to money; money has value because it represents a proportional claim to the future output of society.

Third, it avoids circular arguments regarding the “demand for money” and the “functions of money”. Most theories of money demand argue that there is demand for money because it is accepted as a medium of exchange. But this represents a circular argument because money can only perform its role as a medium of exchange if there is demand for it. Proportional Claim Theory breaks the circular argument. Money can perform its functions because it has value; money has value because it is a liability of society.

Fourth, and perhaps most importantly, it provides us with a framework for thinking about what determines the value of fiat money. If fiat money (the monetary base) is a proportional claim on the future output of society, then the value of fiat money primarily depends upon expectations regarding the long-term economic prospects of society. More specifically, the value of fiat money is positively correlated with expected long-term real output growth and negatively correlated with expected long-term monetary base growth.

In simple terms, we can think of the value of fiat money as a slice of future output cake. As the expected slice of future output cake gets smaller, the value of fiat money falls. The expected size of our slice of future output cake can shrink either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

Why Does Fiat Money Have Value?

The view of The Money Enigma is that the market value of money is the denominator of every money price in the economy: all else remaining equal, as the market value of money falls, the price of a good, in money terms, will rise.

However, what determines the market value of money? Indeed, why does fiat money have any value at all? After all, fiat money is, at least superficially, nothing more than paper with pictures printed on it. So why should something that is so easy to create have any value?

In order to answer this question, we need to step back and consider a more fundamental question: “why does any asset have value?” The view of The Money Enigma is that if we can find a paradigm that describes why various assets have value then we have an obligation to see how that paradigm applies to fiat money.

Why Does Any Asset Have Value?

The view of The Money Enigma is that rather than trying to answer the question “why does fiat money have value?” by treating money as special, we should begin our analysis by treating money as if it is just another asset. More specifically, we should first answer the question “why does any asset have value?” and then, once we have established a sensible answer to that question, see how money fits into that context.

Fortunately, there is a well-established paradigm in finance that we can use to answer this question.

Assets can only derive their value in two ways: either they derive their value from their physical properties or they derive their value from their contractual properties.

In simple terms, if something doesn’t derive any value from its natural or intrinsic properties, then the only way it can derive value is if it creates an obligation on a third party to deliver something of value.

This paradigm is so fundamental that it is used as the basis of classification of assets for accounting purposes. For accounting purposes, every asset must be classified as either a “real asset” or a “financial instrument”.

Despite the fact that the “real asset/financial instrument” paradigm can usefully explain why assets have value, most economists choose to ignore this paradigm when it comes to the subject of fiat money. This is a mistake. Prima facie, a theory of money that does fit within this general paradigm is much stronger than a theory that requires money to be an exception to this paradigm.

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Money is an asset to one party because it is a liability to another. More specifically, money is a liability of society (the ultimate issuer of money) and represents a proportional claim on the future output of society.

The notion that money is a proportional claim on the future output of society is a complex idea. In order to understand this point, it helps to think about the evolution of money over time. By tracking the development of money over time, it is easier to see why there is a good prima facie case for the view that fiat money derives its value from an implied-in-fact contractual relationship.

The Evolution of Money: From Real Asset to Financial Instrument

In nearly every society, the first form of money used was some sort of “commodity money”. Commodity money is, quite literally, money that is a commodity. Early examples of commodity money included grain, rice, gold and silver. All of these early forms of commodity money were real assets: assets that derived their value from their physical properties.

The problem with commodity money is that it restricted the capability of governments to finance wars and other public expenditures. In simple terms, you can’t pay your armies in gold coin if you run out of gold.

This problem led to the invention of the first “representative money”. Rather than paying the armies in gold, the ancient kings and emperors decided to pay soldiers by issuing pieces of paper that were promises to deliver gold on request.

This first paper money was an explicit legal contract that promised, on request, the delivery of a certain amount of gold or silver from the treasury of the king. By definition, this representative money was a financial instrument and derived its value solely from its contractual properties.

Ultimately, the issuance of representative money also limited the amount of money that governments could create. Therefore, at some point the gold convertibility feature was removed. This point marks the shift from representative money to fiat money.

In effect, the explicit contract that governed representative money was rendered null and void. So why did paper money maintain any value? The view of The Money Enigma is that the explicit contract that governed representative money was replaced by an implied-in-fact contract that governs fiat money to this day.

Fiat money is not a real asset and does not derive its value from its physical properties. Therefore, prima facie, fiat money is a financial instrument and must derive its value from its contractual properties, even if that contract is implied rather than explicit.

A New Theory of Fiat Money: Proportional Claim Theory

The challenge for economics is unraveling the terms of the implied-in-fact contract that governs fiat money (what we might call the “Fiat Moneyholders’ Agreement”). Fortunately, we can leverage elements of traditional finance theory to help us create a basic outline what this implied-in-fact agreement might look like.

There are four basic steps in this process. First, we need to identify the parties to the agreement. Second, we need to identify the economic benefit that is promised by the issuing party under the agreement. Third, we need to consider whether the claim represents a fixed or variable entitlement to that economic benefit. Fourth, we need to consider the specific terms of that fixed or variable entitlement.

[Before we begin this process, it is worth reminding readers that we are discussing the implied agreement that governs the fiat monetary base. Going forward, the use of the term “money” means “the monetary base”.]

Parties to the Agreement: The first party to the agreement is the holder of money. The second party to the agreement is the issuer of money. While the legal issuer of money is the government, the ultimate economic issuer of money is society itself.

Society can not issue liabilities directly because “society” is not a legal entity. Rather, society must create and authorize a legal entity (government) to issue liabilities on its behalf. Money is a legal liability of government but an economic liability of society itself.

Economic Benefit: If society is the economic issuer of money, then what economic benefit can society promise to the holder of money? The answer is the future economic output of society. In order for any financial instrument to be effective, the issuing party must be able to offer the subscribing party a claim against something of value. For example, a share of common stock represents a claim against the future cash flow of the issuing corporation. Similarly, fiat money represents a claim against the future economic output of the issuing society.

Fixed or Variable Entitlement: Once we have established the parties to the agreement and have identified the economic benefit that is being promised, we need to determine whether the financial instrument represents a fixed or variable entitlement to that economic benefit. This is an important distinction because it also helps us classify the financial instrument as being a debt instrument (a fixed entitlement) or an equity instrument (a variable entitlement). So, does money represent a fixed or variable entitlement to the future economic output of society?

The view of The Money Enigma is that money represents a variable or proportional entitlement to the future economic output of society. In this sense, money is a special form of equity instrument.

Again, we can compare money with shares of common stock. A share of common stock represents a proportional claim on the future cash flow of a business. Similarly, one unit of money represents a proportional claim on the future economic output of society.

We can use this analogy to think about the value of money. A share of stock becomes more valuable if expected future earnings per share rise. Similarly, one dollar becomes more valuable if expected future output per unit of monetary base rises. Conversely, one dollar becomes less valuable if the market suddenly decides that either (a) the future monetary base will be higher than expected, or (b) future real output will be lower than expected.

Clearly, there are significant differences between money and a share of common stock. This brings us to the final point: what are the specific terms of the variable entitlement to future output?

Specific Terms: One important difference between money and a share of common stock is that a share of stock entitles you a stream of future cash flows, whereas the dollar in your pocket entitles you to a slice of future economic output. In simple terms, you can only spend the dollar in your pocket once. Therefore, money represents a claim to a variable slice of future output, not a variable stream of future output.

However, what is the exact nature of the variable slice of future output that is “promised” to the money holder under the agreement? This is a difficult question to answer, but again we can draw on finance theory to help us create a framework to answer it. [Note to the reader: the discussion that follows is very complicated. Please read The Velocity Enigma, the final paper in The Enigma Series, for an extended discussion of this issue].

In order for a financial instrument to be defined and hence have value, the nature and scope of the entitlement must be fixed. In the case of a variable or proportional entitlement, the collective entitlement of the set of proportional claims must be fixed. For example, the collective entitlement for the set of outstanding shares in a company is, typically, 100% of residual cash flows.

In the case of fiat money, the scope of the collective entitlement, the theoretical entitlement of the entire monetary base to real output, is set at the date the fiat currency is launched (typically, the day gold convertibility is removed) and, at least in principle, is fixed at that level for all future periods. For example, if the value of the monetary base at that date is 150% of annual real output for that same period, then the “in principle” collective entitlement of the monetary base is set at 150% of real output for all future periods.

Once the “in principle” collective entitlement to future output is fixed, economic agents can begin to make a critical calculation: the baseline proportion of output that a unit of money can claim in a given future period. The baseline proportion (“β”) represents the “in principle” or “theoretical” proportion of output that a unit of money should claim in a given future period. The expected baseline proportion in a future period is calculated simply as the scope of the collective entitlement divided by the expected monetary base in that future period.

Importantly, the baseline proportion is not the actual or realized proportion of output (“α”) that money will claim in that future period. Rather, the expected baseline proportion for a given future period is the “in principle” or “theoretical” proportion of output that money should claim for a given future period and, therefore, provides the best unbiased estimate of the expected realized proportion of output that one unit of money might claim in that given future period.

Value of Money Depends Upon a Chain of Expected Future Values

Once the terms of the implied-in-fact Fiat Moneyholders’ Agreement are established, we can begin to analyze what determines the value of fiat money.

The value of money today depends upon a chain of expectations regarding the value of money in future periods. When expectations change regarding the future market value of money, it has a cascading effect all the way down along the chain of expected future values until it reaches the present market value of money. Any change in the expected future market value of money creates an incentive to act now. For example, if people suddenly expect the value of money to fall at some point in the future, then this creates an incentive for them to spend money now and, at the margin, the value of money falls.

In more technical terms, if expectations shift regarding the future value of money, then a state of intertemporal equilibrium (a state of indifference) that previously existed is disturbed. In order to restore intertemporal equilibrium, the current market value of money must adjust to reflect these new expectations.

Now, we can begin to create a high-level picture of what factors influence the value of fiat money. If fiat money is a proportional claim on future output (as described earlier), then the value of fiat money will fall if either (a) the expected long-term growth rate of real output falls, or (b) the expected long-term growth rate of the monetary base rises.

It is important to note that the value of money depends on long-term expectations (20-30 year expectations) of the path of both real output and the monetary base. The reason for this is that fiat money is a long-duration asset. This idea is explored further in The Enigma Series.

A Valuation Model for Money

One of the compelling aspects of Proportional Claim Theory is that we can combine this theory with the notion of intertemporal equilibrium to build a valuation model for fiat money.

If fiat money is a financial instrument (a special-form equity instrument) and if we isolate the “market value of money” by measuring the market value of money in terms of a “standard unit” for the measurement of market value, then it should be possible to build a valuation model for fiat money, just as one might build a valuation model for any other financial instrument.

More specifically, we should be able to create a “Discounted Future Benefits Model for Fiat Money” based on the principle that the value of a financial instrument is equal to the present value of the future economic benefits that the marginal holder of that instrument might reasonably expect to receive from the nature of the claim that the instrument represents.

Creating a discounted future benefits model for money requires a number of special adaptions to the familiar “discounted future cash flow model” used to value most financial instruments.

First, the valuation model for money must be expressed in terms of a “standard unit” for the measurement of market value, not “dollars”. Second, money is a claim on real output, not cash flows: the present market value of money depends on the discounted future market value of the real output that it is expected to claim.

Third, money represents a claim to a slice, not a stream, of future output. But if the value of money could be equal to any one of a number of future slices of output, then how do we determine the current market value of money?

Mathematically, the question becomes one of probability: what is the probability that the marginal unit of money demanded is spent in any one of the n future periods in the spending horizon? Fortunately, there is a simple way to answer this question. In a state of intertemporal equilibrium, the current possessor of money is indifferent between spending the marginal unit of money now or in any of the n periods in the spending horizon. They are also indifferent between spending the marginal unit of money in one future period or another future period. If someone is indifferent between all n future periods, then the probability that they spend the marginal unit of money in any one of those periods is equal to (1/n). This simple probability distribution allows us to weight (1/n) each of the expected discounted future values of money.

The fourth challenge in building the valuation model for money relates to the role of expected nominal investment returns. All else equal, as the nominal interest rate rises, the expected future benefits received from money rise and hence the present market value of money rises. Whereas most assets must be “held” in order to receive the benefits that accrue to them, money does not have to be “held” in order to receive its future benefits. Rather, money can be invested before it is spent. These investment returns must be included in the expected discounted future benefits model.

The end result of resolving these challenges is to produce a valuation model for fiat money that looks remarkably similar to a valuation model for a share of common stock.

In simple terms, the valuation model for money implies that the market value of money depends critically upon the expected future path of the “real output/base money” ratio. More generally, if expectations about the long-term prospects of the economy become more pessimistic, then the market value of money will fall.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

Monetary Base Expansion: The Seven Stages of Addiction

Monetary base expansion is a powerful drug. Used correctly and judiciously, it has a critical role to play in the successful management of a complex economic system that relies heavily on fractional reserve banking. However, the powerful and immediate effect of monetary base expansion makes it a highly addictive drug.

In this week’s post, we will attempt to illustrate the highly addictive nature of monetary base expansion by applying the “seven stages of addiction” model for methamphetamines to the current cycle of monetary base expansion. There are striking parallels between the methamphetamine addiction cycle and the economic/market cycle that occurs following a dramatic expansion of the monetary base.

“The Seven Stages of Addiction” for methamphetamines are: (1) the Rush, (2) the High, (3) the Binge, (4) Tweaking, (5) the Crash, (6) the Hangover, and (7) Withdrawal.

The view of The Money Enigma is that markets and policy-makers are currently passing from the “Binge” stage into the “Tweaking” stage, a stage characterized by increasingly erratic (market) behavior and delusions so strong that the participants become disconnected from reality.

For first-time users, monetary base expansion has a positive and immediate impact on the economy (the “Rush”). This immediate success creates a false sense of confidence among both market participants and policy makers regarding the long-term economic prospects of society (the “High”).

This false sense of economic confidence fuels more monetary expansion (the “Binge”) and higher levels of current economic activity. Moreover, it engenders great confidence in the value of fiat currency, thereby suppressing prices as measured in money terms. Ironically, this occurs just at the point when the value of fiat currency is most at risk.

Over time, each additional round of monetary expansion becomes less effective: the market has become accustomed to the drug and every additional dose of the drug has less impact. This occurs right at a point where dangerous extremes in market sentiment have become commonplace. Market behavior becomes increasingly erratic and volatile (“Tweaking”). Markets begin to behave in ways that are “out of character” from a historical perspective and would be impossible without the drug: for example, negative nominal yields on debt securities.

Finally, the longer-term consequences of monetary base expansion become clear (the “Crash”). As confidence erodes, the value of fiat money falls and prices begin to rise. Policy makers discover that the drug no longer has any net positive impact on the economy and the economy enters into a prolonged period of stagnation (the “Hangover”). In the final stage, new regulations are introduced to prevent the future abuse of such a potent and important policy tool (“Withdrawal”).

A Powerful Drug with an Important Role to Play

Monetary base expansion is an important and powerful instrument for the conduct of economic policy. The ability to create money allows a central bank to perform a “lender of last resort” function that is critical in maintaining confidence in a fractional reserve banking system.

Moreover, the central bank’s ability to “print money” allows the government to respond quickly and decisively when other non-banking crises occur. For example, if a major war started today, monetary base expansion provides the government with a mechanism to quickly finance any emergency war-related spending.

In this sense, we can think of monetary base expansion as the morphine of our economic system. Morphine is a vitally important drug that has clear positive benefits when used judiciously. However, just like morphine, monetary base expansion only tends to mask the symptoms of underlying structural problems, rather than “curing” the patient. Nevertheless, printing money has a clear and positive role to play in times of genuine national crisis.

Unfortunately, monetary base expansion shares another common characteristic with morphine and other powerful drugs such as methamphetamines: it is highly addictive.

Why is Monetary Base Expansion so Addictive?

The history of monetary base expansion abuse is nearly as long as the history of civilization itself. For example, we know that the Roman Empire systematically reduced the gold and silver content in their coins, an act that ultimately resulted in a dramatic devaluation of Roman currency.

Invariably, experiments with currency debasement end badly. So why is the history of civilization littered with examples of currency debasement and money printing?

Monetary base expansion, or “printing money”, has always been an attractive option to politicians and governments. The reason for this is twofold:

The creation of vast sums of money, seemingly out of thin air, allows politicians and governments to achieve short-term ends that would be impossible without that ability; and
In the short term, printing money can seem like a “free” source of financing. Printing money allows politicians to avoid raising taxes or issuing more debt to pay for government expenditures. Moreover, if expectations are cleverly managed, then printing money may have no short-term impact on the value of money and, consequently, no adverse short-term impact on the price level.

In many ways, monetary base expansion can seem like a “miracle drug”. It has immediate positive effects on the economy and, at least in the short term, it can appear to have no negative side effects.

This raises an interesting question. If the long-term side effects of monetary base expansion are well understood (expansion of the monetary base at a rate higher than real output leads to inflation), then why is it possible for monetary base expansion to have no adverse impact on the value of money and the price level in the short to medium term?

This is a question that was addressed in a post earlier this year titled “Why is there a lag between money printing and inflation?”

The view of The Money Enigma is that fiat money is a financial instrument and only has value because it is a liability of society. More specifically, fiat money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society.

That’s a mouthful: so what does it mean?

In simple terms, we can think of fiat money as a slice of cake that we hope to eat at some point in the future. The value of fiat money varies according to the expected size of that slice of cake. The cake is future output and the number of slices the cake has to be cut up into is determined by the size of the future monetary base.

The expected size of our slice of future output cake can shrink either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

So, why is it possible for central banks to print money with no adverse short-term impact on the value of money? The answer is that the value of money depends on long-term expectations.

If market participants believe that an expansion in the monetary base is only “temporary”, then this means that the cake (future output) will be divided up into a small number of slices. However, if expectations shift and the market decides that the expansion in the monetary base is more “permanent” in nature, then our future output cake will need to be divided up into more slices: the expected size of each slice falls and the value of money falls.

Readers who are interested in learning more about this theory should read “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

In summary, monetary base expansion is a powerful drug that appears, at least in the short term, to have limited negative side effects. This potent combination makes it highly addictive to both markets and policy makers.

Unfortunately, excessive monetary base expansion has terrible long-term consequences, a concept that is (or at least should be) well understood by policy makers and markets.

So why has the Federal Reserve not made any attempt to reduce the size of the US monetary base nearly seven years after in began to experiment with quantitative easing? Moreover, why are markets failing to price assets to reflect the increasing risk of severe inflationary outcomes?

In order to answer these questions, it helps to think about the psychological cycle that accompanies monetary base expansion. This can be illustrated by comparing the monetary base expansion cycle with the addiction cycle associated with methamphetamines.

The Seven Stages of Addiction

1). The Rush – The rush is the initial thrill that market participants and policy makers feel when monetary base expansion is first announced and implemented. For those societies with little recent experience of monetary base expansion, the impact of this new policy is immediate and exciting.

The initial implementation of monetary base expansion has an almost immediate narcotic effect on the markets. Risk assets rally in a knee-jerk reaction as market participants realize that the safety net has been activated. In the case of QE1, markets that had ceased to function, such as the market for mortgage-backed securities, begin to return to life.

In a crisis, there is tremendous pressure on policy makers to appear to be doing something. When monetary base expansion is announced, the immediate political pressure on policy makers is relieved, even if the action is considered by many to be controversial.

2). The High – The early success of monetary base expansion begins to shift the focus of markets away from “risk” and towards “opportunity”. Early doubts about the effectiveness of the policy begin to dissipate. Market participants and policy makers begin to feel more confident in the economic outlook.

This rising confidence begins to feed the delusion that “this time is different”. Rising confidence in the long-term economic future of society not only leads to higher asset valuations and higher current levels of economic activity but also, somewhat ironically, acts to support the value of fiat money, thereby depressing prices as measured in money terms.

As discussed earlier, if fiat money is a proportional claim on the future output of society, then rising levels of confidence regarding the long-term growth of real output will support the value of fiat money. Furthermore, near-term economic strength fuels the belief that the monetary expansion is only a “temporary” phenomenon. A temporary increase in the monetary base has little to no impact on the value of fiat money because fiat money is a long-duration asset.

Those who might have warned against the inflationary consequences of monetary expansion look foolish as rising levels of confidence actually bolster the value of fiat currency and, in turn, create a deflationary environment. This outcome seems to vindicate the bold action of policy makers and sets up the environment for the next stage of addiction.

3). The Binge – The binge is a period of uncontrolled, or poorly controlled, use of the monetary expansion drug. In the context of recent experience, QE2, QE3 and QE Japan/Europe could all be considered to be part of “the binge”.

After the initial apparent success of the experimentation with monetary base expansion, markets and policy makers both start to believe that if a little is good, then a lot must be even better. Moreover, since the initial experimentation occurred without any obvious negative side effects, people begin to believe that it must be reasonably safe to continue with additional stimulus.

The binge is characterised by increasingly aggressive and risk-seeking behavior on the part of markets and overconfidence on the part of policy makers.

Market participants begin to lose touch with the underlying reality of the economic situation. In the case of QE, monetary base expansion allows the Fed to purchase long-term government bonds, thereby pushing up the price on those bonds and lowering the long-term interest rate, or “risk free rate”. This creates a waterfall effect across the entire spectrum of risk assets. As the risk free rate falls, the required return on capital for all assets falls, thereby pushing the price of all risk assets. See “Has the Fed Created the Conditions for a Market Crash?” for a full discussion of this issue.

Markets begin to create myths to sustain the binge. One of these myths is that elevated risk asset prices can be sustained by strong economic growth even when the monetary base is reduced (see article above for why this is a complete fiction). The second myth that begins to take hold is the notion that there will be no adverse inflationary consequences even if the central bank fails to reduce the monetary base from its historically high levels.

This second myth is fed by “economic principles” for which there is little empirical support such as the notion that “inflation is caused by too much demand”. Markets begin to believe that there will never be inflation as long as the central bank prevents the economy from “overheating”: the size of the monetary base is somehow irrelevant, despite the fact that long-term empirical evidence overwhelmingly supports the notion that “money matters”.

4). Tweaking – Market conditions are most dangerous when they cross into the “tweaking” phase, a condition reached when, after a long period of binging, the market begins to experience diminishing marginal returns from the application of additional monetary stimulus.

Judging by historical standards of behavior, markets might seem to have completely lost touch with reality. Markets become increasingly erratic and momentum driven. Asset pricing outcomes that previously might have seemed impossible become commonly accepted. Negative nominal interest rates on government securities and the second coming of a “once-in-a-lifetime” tech and biotech stock bubble are just two of the more obvious symptoms of this delusional-type behaviour.

Ironically, this is also the point where confidence in fiat money is at its highest and sentiment regarding anti-fiat assets (gold and other precious metals) is at its lowest. Despite the fact that the market is still benefitting from a high dosage of the drug in the system, the market is supremely confident that either the monetary base can be reduced with no ill effect or that inflation can be contained even if the monetary base is not reduced. Confidence in policy makers and the economic future of society is so strong that inflation is regarded as a complete “non-issue”.

Nevertheless, warning signs begin to emerge. Various segments of the global markets might begin to break down in a violent fashion. Stock market breadth begins to falter. More and more countries and industries begin to experience difficult economic times. All of these signs are explained away as being special cases, but each new event begins to highlight the underlying fragility of the system.

5). The Crash – The crash occurs as the positive effects of the drug suddenly wear off and the bubble of overconfidence begins to pop.

This sudden erosion of confidence sets up a negative feedback loop that begins to feed on itself, just as the bubble of confidence associated with monetary expansion created a positive feedback loop.

In the first instance, a sudden erosion of confidence leads to a lower risk appetite and a higher required rate of return on risk assets. Asset prices fall and economic activity begins to falter.

When this first begins to happen, markets may comfort themselves in the belief that the central bank will be able to provide more monetary stimulus “if things get really bad”.

However, this loss of market confidence is likely to coincide with a second and very unwelcome development: a sudden erosion in the value of fiat money and an unexpected rise in the general price level.

The view of The Money Enigma is that fiat money is a proportional claim on the future output of society. Therefore, we can think of the value of fiat money as a vote of confidence in the long-term economic prospects of a society.

If people start to believe that their society is built on shaky economic foundations, then they may start to doubt the long-term economic prospects of that society. In that scenario, people might decide that (a) long-term economic growth will be much weaker than previously expected, and (b) long-term growth in the monetary base will have to be much higher than previously expected. This combination of shifting expectations can lead to a sudden decline in the value of money and, conversely, a sudden rise in prices as measured in money terms.

6). The Hangover – At some point, markets and policy makers begin to realize that “this time wasn’t different”. Monetary base growth far in excess of real output growth leads to the same end results as it did every other time: higher inflation.

The required nominal rate of return on risk assets surges higher, leading to forced sales, massive private sector deleveraging and a cycle of declining asset values. Policy makers that seemed to be invincible are suddenly impotent. Real economic activity declines sharply while higher prices erode the general standard of living.

7). Withdrawal – Society vows “never again”. A major new round of regulations are introduced to prevent future generations from repeating the same mistakes. Unfortunately, they will.

Why Do Currencies Collapse?

Over the past few years, there has been no shortage of people calling for the collapse of fiat currency. Marc Faber, Kyle Bass and Peter Schiff have all talked about the imminent collapse of at least one fiat currency or another. Yet the days roll on and nothing happens. So, why do fiat currencies collapse? What are the circumstances that might trigger such a collapse? And why are these gentlemen so agitated about the prospects for the major Western fiat currencies?

In order to understand why the value of fiat currency might suddenly collapse, we need to understand (a) why that fiat currency has value in the first place, and (b) what factors determine the value of fiat currency.

The view of The Money Enigma is that fiat money is a liability of society. More specifically, fiat money represents a proportional claim on the future output of society.

What does this mean in simple terms? Well, we can think about fiat money as a slice of pie that we hope to eat at some point in the future. The pie is the future output of society. The number of slices that the pie has to be divided into is determined by the size of the future monetary base. The value of fiat money varies according to the expected size of each slice of this “future output pie”.

Clearly, there are two reasons for why the expected size of our slice of future output pie might shrink: either (a) there is a smaller pie (less future output), or (b) there are more slices (higher future monetary base).

Fiat currencies tend to collapse when expectations regarding both of these factors shift violently in the wrong direction. If the market suddenly decides that there will be a smaller pie (less future output) and more claims to that pie (a higher than expected future monetary base), then suddenly people expect each slice to be a lot smaller. Consequently, the value of fiat money collapses and prices as measured in terms of that currency surge higher, often leading to what is known as hyperinflation.

Why Does Fiat Money Have Value?

One of the best aspects of writing these weekly posts is the feedback that I receive from readers. Recently, I received a couple of comments from one of my regular readers regarding a post that was first published in February 2015 titled “Why Does Money Exist? Why Does Money Have Value?” This reader, who is a professional bond trader working for one of the big banks in Europe, simply observed, “Deserves to be studied line by line”.

While you may not have the time or the inclination to study that article “line by line”, the subject of why fiat money has value is an important one for which mainstream economics doesn’t provide good answers.

The view of The Money Enigma is that in order to understand why fiat money has value we need to answer a more general question: “why does any asset has value?”

Fortunately, there is a well-established paradigm that we can use to answer this question: a paradigm that can be applied to every asset, but one that for some reason is ignored by economists in discussions regarding money.

The paradigm is this: every asset is either a real asset or a financial instrument.

This distinction is important because it relates to how different assets derive their value. Real assets derive their value from their physical properties. Financial instruments derive their value from their contractual properties.

Real assets such as land and commodities derive their value from their tangible or physical nature. In contrast, financial instruments, such as bond and stocks, have little or no physical value. Rather, a financial asset is, by definition, a contract: financial instruments only have value to their holder because they represent a liability to another party.

Now, let’s apply this paradigm to the evolution of money.

Money began life as a real asset.

In ancient societies, it is likely that basic agricultural products were used as the first medium of exchange. Over time, gold and silver coins became a more popular and widely circulated form of “commodity money”.

This commodity money derived its value from its physical properties. Agricultural commodities could be consumed; gold and silver had value because they were rare and desired for their unusual physical properties.

At some point, the ancient kings and rulers decided that they didn’t want to pay their armies and workers in gold, so they decided to create something that would be “as good as gold”: a piece of paper that promised its bearer some quantity of gold or silver from the royal treasury.

This “representative money” marked the beginning of money as a financial instrument.

Representative money was nothing more than an explicit contract, written down on a piece of paper that promised the bearer some quantity of gold or silver on demand. Representative money only had value to its holder because it represented a liability to its issuer, normally the king or government of the day. More specifically, it represented a claim against the royal treasury for delivery of a real asset (gold or silver).

It is important to note that this representative money only had value because it created a contractual obligation upon its issuer. Representative money didn’t have value because it was a convenient medium of exchange. It didn’t have value because it was a useful unit of account. Nor did it have value because it was a “store of value”. It had value because it was an explicit contract and created a liability against its issuer.

All of these functions of representative money (medium of exchange, unit of account, store of value) could only be performed because representative money had value. Moreover, representative money only had value (and therefore, could only perform these functions) because it created an explicit liability against its issuer.

If we wind the clock forward another couple of hundred years, we begin to see the emergence of fiat money. The gold convertibility feature of representative money was removed.

In essence, the explicit contract that gave representative money its value was rendered null and void. So, why did this new fiat money retain any value?

The view of The Money Enigma is that when the switch was made from representative money to fiat money, the explicit contract that governed money was replaced by a new implied-in-fact contract. The old explicit contract that guaranteed gold on demand was cancelled, but it was replaced by a new implied contract that did promise something of value to the holder of money.

Why must this be the case? Well, as we discussed at the beginning of this article, every asset is either a real asset or a financial instrument. Fiat money is, quite clearly, not a real asset. Therefore, fiat money is a financial instrument and must derive its value from its contractual properties, even if the contract is implied rather than explicit.

There is a popular and nonsensical view that fiat money has value because it is a convenient medium of exchange. The problem with this view is that represents a circular argument: fiat money has value because it is accepted as a medium of exchange; fiat money is accepted as a medium of exchange because it has value.

The view of The Money Enigma is that fiat money can only perform its functions because it has value: it does not derive its value from its functions. Rather, the value of fiat money is derived from an implied contract that exists between the issuer of money and the holders of money.

So, when the explicit contract was rendered null and void, what was the new implied contract that replaced it?

While it is difficult to speculate on the exact nature of the implied contract that governs fiat money, there are a few things that we should be able to deduce with reasonable certainty.

First, the ultimate issuer of fiat money is society itself. While government may be the legal issuer, the ultimate economic responsibility for fiat money lies with society. Society can’t be the legal issuer of money because society doesn’t exist as a legal entity. Therefore, society authorizes government on its behalf to issue fiat money. However, while money may not be the legal liability of society, it only has value because it is an economic liability of society.

Second, if fiat money is a liability of society, then what does society have to offer the holder of money? The answer is the future output of society.

Fiat money is a claim against the future output of society.

When the government prints fiat money, the only reason we accept it is because we recognize that there is an implicit agreement between our society and ourselves that we can use that money to purchase real output at some point in the future.

In essence, when society creates fiat money, it is creating a claim against its future output. This leads us to our next question. Is the claim that fiat money represents a fixed or variable entitlement against that future output?

For those of you who are not familiar with finance theory, one of the defining characteristics of a financial instrument is that it typically provides either a fixed or variable entitlement to some future stream of economic benefits.

The view of The Money Enigma is that fiat money represents a variable entitlement to the future economic output of society. The entitlement to future output varies according to the amount of money on issue at that future point in time (the expected size of the monetary base).

In this sense, we can say that fiat money is a proportional claim on the future output of society. Therefore, the value of fiat money primarily depends upon (a) the expected path of real output growth, and (b) the expected path of the monetary base.

This isn’t easy stuff to understand, so let’s use a simple analogy.

Imagine that we are hoping to eat a big cake that is the future output of society.

Every dollar that is issued by the time the cake is served represents a claim to a slice of that cake.

Proportional Claim Theory implies that the value of the dollar we have in our pocket today depends upon the size of the slice of the future output cake that we expect to receive in the future.

Clearly, there are two reasons for why the slice of cake that we expect to receive could shrink.

First, the cake itself could shrink. For example, the market might suddenly decide that future output growth will not be as strong as previously expected. If this happens, then the value of a proportional claim on future output will be worth less and the value of fiat money falls.

Second, the cake may be cut up into more slices. For example, people might suddenly decide that the monetary base will be a lot higher in the future. If this happens, then there are more claims against future output, hence every claim is worth less and the value of fiat money falls.

In either case, the value of fiat money would fall.

The important point to emphasize here is that the value of fiat money depends on long-term expectations. This isn’t a cake that we expect to eat tomorrow or next year, but a cake that we expect to eat in twenty years from now. I won’t bore you with why this is the case, suffice to say that fiat money is a long-duration asset and in a state of intertemporal equilibrium the current value of fiat money is determined by a long chain of expected future values.

In summary, this theory provides us with a basis for understanding why the value of fiat money might fall. But why does the value of fiat money collapse? What could cause such a sudden and violent loss of value in something that we use so frequently in our everyday life?

Why Does the Value of a Fiat Currency Collapse?

The collapse of a fiat currency normally requires an event to occur that results in the sudden realization that the future economic prospects of a society are greatly diminished.

The most obvious negative event that can cause a fiat currency to collapse is the outbreak of war.

Why might the outbreak of war cause a currency to collapse? Well, let’s think about it using our slice of cake analogy.

First, how might war impact the expected size of our future output cake? While there might be some near-term boost in war-related production, there would be a clear negative impact on long-term output if it became an extended war with high casualties.

Second, how might war impact the expected number of slices of that cake? In this case, the impact is clearly negative. A war is expensive and almost inevitably requires the government to print money in order to finance it.

If we take these two factors together, then clearly the expected size of our slice of cake will be a lot smaller: future output will be diminished and there will be a lot more claims against that output. In this scenario, it is likely that the value of our fiat currency would fall immediately. If a few key battles were lost and the outlook for the very survival of our society was in doubt, then clearly you would expect the value of our fiat currency to collapse.

This much should be obvious. But why, if there are no immediate wars on the horizon, are some market commentators calling for the collapse of the Yen, the Euro and/or the US Dollar? Why might a fiat currency collapse in peacetime?

In many respects, we can think of the value of fiat money as a vote of confidence in the long-term economic prospects of a society.

If the underlying economic strength of a society is strong, then it is reasonable for people to believe that long-term output growth will be solid and that the central bank will be able to limit the long-term growth of the monetary base to a modest level. In this scenario, the value of the fiat currency issued by that society should be well supported: people expect that the cake will be large and that they won’t have to divide the cake into too many slices.

However, if people suddenly discover that their society is built on shaky economic foundations, then they may start to doubt the long-term economic prospects of that society. For example, imagine that the US economy suddenly started to deteriorate and nothing that policy makers did seemed to help. What might people start to think about the long-term economic prospects for the US?

If it became apparent that the US economy was structurally weak, then people might decide that (a) long-term economic growth will be much weaker than previously expected, and (b) long-term growth in the monetary base will have to be much higher than previously expected.

How would this shift in expectations impact the value of the US Dollar? Clearly, this shift in expectations would have a very negative impact on the value of the US Dollar. Using our analogy, the cake would be smaller and it would have to be cut up into many more slices. The value of the dollar in your pocket would decline precipitously and prices, as expressed in dollar terms, would rise sharply.

The perfect storm for a currency collapse involves a violent shift in expectations regarding both long-term output growth and long-term money supply growth. Such a violent shift in expectations does not happen easily, but it can happen, even in peacetime.

My personal perspective is that the developed country at greatest risk of such a violent shift in expectations is Japan. Japan has accumulated staggering levels of government debt. The demographics of Japan are terrible: over the next couple of decades, there will be fewer workers to support more retirees. Moreover, Japan has expanded its monetary base at an unprecedented pace.

Frankly, it seems as though the market is in a state of denial regarding the outlook for Japan. For some reason, people seem to believe that Japan can grow its economy over the next twenty years while reducing the monetary base from its current extended level. This scenario seems very unlikely. But let’s hope that Japan can find a new way to reinvigorate its economy, a path that doesn’t involve printing money.

On a final note, if you are interested in the determination of foreign exchange rates then I would recommend “A Model for Foreign Exchange Rate Determination”. If you are interested in learning more about Proportional Claim Theory and why fiat money has value, then I would recommend the following posts: “Money as the Equity of Society”, “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

Saving Monetarism from Friedman and the Keynesians

Monetarism is a good idea that has been poorly executed. At its heart, the core principle of monetarism is that “money matters” to economic outcomes. More specifically, money creation, in excess of growth in real output, is the leading cause of inflation over long periods of time.

This is a “good idea”, an idea that has been shown to be true in hundreds of empirical studies. Unfortunately, monetarism has largely faded from view due to its one key underlying weakness: its inability to correctly articulate the transmission mechanism from money creation to inflation.

Monetarism’s failure in this regard stems from the fact that most advocates of monetarism were (and still are) in-the-closet Keynesians.

Monetarism, as it is presented in the textbooks today, is built on a foundation of Keynesian theory. More specifically, monetarism accepts wholeheartedly the inherently Keynesian notion that supply and demand for money determines the interest rate.

For all the great work done by Milton Friedman, Friedman never challenged this core principle of Keynesianism. And yet, it is this one flawed Keynesian principle that undermines the true potential of monetarism.

The view of The Money Enigma is that monetarism needs to be reinvented. This reinvention needs to start at the most fundamental level by recognizing that (a) the price level is a function of both the market value of goods and the market value of money, and (b) supply and demand for money (or more specifically, supply and demand for the monetary base) determines the market value of money, not the interest rate.

The market value of money is the denominator of the price level. Creating too much money, relative to output growth, over long periods of time reduces the market value of money, thereby raising prices as expressed in money terms. This is the primary transmission mechanism from too much money to inflation. The Keynesian view of the transmission mechanism, namely that too much money lowers interest rates and creates “too much demand”, is at best a secondary transmission mechanism.

A Quick Overview

The view of The Money Enigma is that the price level is a ratio of two market values: the market value of the basket of goods (“V_G”) and the market value of money (“V_M”). The market value of goods is the numerator of the price level: as the market value of goods falls, the price level falls. The market value of money is the denominator of the price level: as the market value of money falls, the price level rises. This theory is called “Ratio Theory of the Price Level” and was discussed in last week’s post.

At the most basic level, Ratio Theory implies that the inflationary outcome of any policy action needs to consider the impact of that policy on both (a) the market value of goods, and (b) the market value of money.

Historically, most monetarists have focused only on the impact of money creation on the numerator in our equation: the market value of goods. In essence, the traditional monetarist view is that base money creation leads to lower interest rates and, in turn, lower interest rates lead to an increase in aggregate demand. This lift in economic activity leads to “tightness” in the system as demand outpaces supply, the market value of goods rises and, therefore, prices rise.

This “monetarist” view is, in fact, an inherently Keynesian view of the world. In essence, it is a modified version of the view that inflation is created by “too much demand”.

The only real adaption by the monetarists is that it is too much money that creates too much demand which, in turn, leads to higher prices as the economy pushes up against its capacity limits. Moreover, this view implicitly assumes that money creation can not create inflation if the economy does not “overheat”.

The problem with this view of the monetary transmission mechanism is that it denies any role for the impact of money creation on the market value of money, the denominator in our equation.

Traditionally, monetarists have left themselves no other choice but to ignore the role of the “value of money”. The reason for this extraordinary oversight is that most monetarists, including Milton Friedman, ascribe to the view that supply and demand for money determines the interest rate. There is no role for the “market value of money” in current monetarist thinking because monetarists don’t recognize the market value of money as a variable in their equations nor do they recognize that supply and demand for money determines the market value of money. Therefore, monetarists are left with only one avenue to explain the impact of money on the price level: more money equals lower interest rates equals too much demand equals higher prices.

The view of The Money Enigma is that this (Keynesian) transmission mechanism is, at best, only a secondary transmission mechanism. This sequence of events can lead to higher prices, but it is of secondary importance.

The primary transmission mechanism from money creation to inflation is far more direct. Supply and demand for money determines the market value of money (see recent post “Supply and Demand for Money: Where Keynes Went Wrong”). Creating “too much money” leads to a fall in the market value of money and a rise in the price level.

Over long periods of time, creating too much money, relative to output growth, leads to a direct reduction in the market value of money. The market value of money is denominator of every money price in the economy. Therefore, as the market value of money falls, the price level rises. This is the primary transmission mechanism and is the primary reason for why base money growth in excess of real output growth leads to a rise in the price level over time.

Monetarism needs to throw out Keynes’ liquidity preference theory playbook and focus on what really matters: the impact of money creation on the market value of money. Once monetarists begin to do this, we can have a much more sensible debate about the role of monetary policy and the risks of aggressive monetary policies such as quantitative easing. Moreover, monetarists may be able to construct a better model to explain why significant levels of monetary creation lead to high inflation on some occasions but not on others, an issue we will discuss briefly at the end of this article.

But before we continue with this debate, let’s step back and see put these ideas in context.

Why Do Prices Rise?

Before we can begin a discussion about the role of money in price level determination, we need to be able to answer a simple microeconomic question: “why do prices rise?”

Let’s ignore complicated macroeconomic theory for a moment and think about the price of apples in money terms. What could explain a rise in the dollar price of apples?

In order to answer this question, we need to ask a more fundamental question: “what is a price?”

A price is a ratio of two quantities exchanged.

The price of apples, in dollar terms, is the ratio of two quantities exchanged: a quantity of dollars for a given quantity of apples. For example, the price of an apple might be two dollars for one apple.

At the most basic level, this ratio of quantities exchanged is determined by the relative market value of the two items that are being exchanged. More specifically, the ratio of the two quantities exchanged is the reciprocal of the ratio of the market value of the two goods. This relationship is illustrated in the slide below.

What does this means in non-technical language? Well, all the formula above is really saying is that if one apple is twice as valuable as one dollar, then the price of one apple, in dollar terms, is two dollars.

That’s not rocket science. If one thing is worth twice as much as another, then you will have to offer two of the second thing to purchase one of the first thing.

What makes the slide above slightly more technical is the way in which the property of “market value” is being measured.

Price is a relative measurement of market value: a price measures the market value of one good in terms of another. However, it is also possible to measure the market value of a good independently of the market value of another good by adopting a “standard unit” for the measurement of market value.

In the slide above, V(A) and V(B) represent the market value of goods A and B respectively as measured in terms of a “standard unit” for the measurement of market value. In this sense, both measurements can be considered to be absolute measurements of the market value of A & B.

The measurement of market value is an important and somewhat complex subject. I highly recommend that you read the following post “The Measurement of Market Value: Absolute, Relative and Real” when you have some time.

So, let’s return to the original question: “Why do prices rise?”

If price is a relative expression of the market value of two goods, then there are two primary reasons for why the price of a good may rise. The price of one good (the “primary good”), in terms of a second good (the “measurement good”), may rise for one of two basic reasons: either (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

The first explanation for a rise in the price of the primary good should be obvious. If the primary good becomes more valuable, then it will require more units of the measurement good to purchase it.

The second explanation is less obvious and, for some reason, seems to evade professional economists. If there is no change in the value of the primary good, but the measurement good becomes less valuable, then it will require more units of the measurement good to purchase the same number of units of the primary good.

In our money-based economy, the good most often used as the “measurement good” is money. The market value of all things is measured in money terms. Therefore, if the market value of money (the measurement good) falls, all else remaining equal, it will require more units of money to purchase the same basket of goods and services.

In the slide above, we have isolated the market value of the basket of goods and the market value of money by measuring each in terms of a “standard unit” of market value (a theoretical and invariable unit). By doing this, we can clearly see that the price level is a function of two variables: (a) the market value of the basket of goods, and (b) the market value of money.

How Does Creating Money Impact the Price Level?

Let’s think about this question using the Ratio Theory framework presented above. How might creating money impact: (a) the market value of the basket of goods (the numerator of the price level); and (b) the market value of money (the denominator of the price level).

(a) Impact on The Market Value of Goods

Arguably, we might expect that an expansion in the monetary base leads to an increase in the market value of goods. I use the term “arguably” because it is not clear, nor certain, that an expansion in the monetary base leads to an increase in the market value of goods.

When money is created, that money is used. In the current system, the central bank uses that money to buy government fixed-income securities, thereby raising the price of those securities and lowering the interest rate on those securities.

The Keynesian view is that this process of creating money and using it to suppress interest rates leads to higher aggregate demand (more consumption, more investment). This increase in demand leads to tightness in the economic system that, in turn, leads to higher prices and wages.

As is common with Keynesian theory, this analysis seems quite plausible. Unfortunately, it also misses half of the picture.

The view of The Money Enigma is that lowering interest rates increases both aggregate demand and aggregate supply.

When the central bank lowers “the interest rate”, the central bank effectively lower the required return on capital across the entire risk spectrum. This is a subject that was discussed in a recent post titled “Interest Rate Manipulation and the Illusion of Prosperity”, so I won’t discuss it in too much detail here. But the bottom line is that when the Fed buys government bonds, it creates a domino effect across all risk assets, raising the price of those assets and lowering the expected/required return on those assets.

Lowering the required return on capital leads to an increase in aggregate supply. At the margin, a lower required return on capital allows more new businesses to be formed and allows more existing business to expand capacity.

If both aggregate demand and aggregate supply curves shift to the right, then the impact on the market value of goods is likely to be negligible. While there may be an increase in economic activity, that increase in economic activity is met with an increase in capacity. Therefore, the net effect on the market value of goods is likely to be small.

In summary, contrary to Keynesian wisdom, expanding the monetary base and using this money to buy government securities may have little to no impact on the market value of the basket of goods, the numerator in our price level equation. Moreover, while there may be some short-term positive impact on the market value of goods, that impact is unlikely to be sustained on a longer term basis: ultimately, aggregate supply will react to the increase in demand.

(b) Impact on the Market Value of Money

If an increase in the monetary base is unlikely to have any significant impact on the market value of goods, then how does an expansion in the monetary base lead to inflation? The view of The Money Enigma is that the answer to this question involves an analysis of the impact of money creation on the market value of money, the denominator of every money price in the economy.

The view of The Money Enigma is that, over long periods of time, growth in the monetary base that is in excess of growth in real output will lead to a decline in the market value of money and that it is this decline in the value of money that is primarily responsible for the rise in money prices over long periods of time.

This notion represents what one might consider to be a “pure” or “true” monetarist perspective on the world: a version of monetarism that is unadulterated by the Keynesian worldview.

The challenge for this pure version of monetarism is explaining why the market value of money depends on the level of the monetary base relative to real output. After all, why should it matter to the value of money if money growth dramatically exceeds real output growth?

The answer to this question involves a reexamination of economic theories regarding the nature of money.

The view of The Money Enigma is that fiat money is a financial instrument: fiat money derives its value from it contractual properties. More specifically, fiat money represents a proportional claim on the future output of society. In more slightly technical terms, the fiat monetary base is a special-form, long-duration equity instrument issued by society under an implied-in-fact contract.

The key phrase in that last paragraph is “proportional claim on the future output of society”. To its holder, fiat money represents a variable entitlement to the future economic output of society.

One way to think about this is to imagine that future economic output is “the pie” and each unit of the monetary base represents “a share of the pie”. Clearly, each unit of money is more valuable if either (a) there is a bigger pie, or (b) there are fewer shares to that pie.

In slightly more formal terms we can say that the market value of fiat money depends upon long-term (20-30 year) expectations of the path of real output relative to the monetary base. The market value of one unit of fiat money will become more valuable if either (a) people decide that future real economic growth will be stronger than previously expected (“there will be more pie”), or (b) people decide that the growth of the monetary base will be lower than previously expected (“there will be fewer shares of the pie”).

This is a complicated subject which is addressed in several recent posts including “Money as the Equity of Society”, “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

In the short term, the market value of money is highly sensitive to changes in these long-term expectations. This shouldn’t be surprising: the value of any long-duration asset (equities, property, 30-year bonds) is highly sensitive to small changes in long-term expectations.

Similarly, one of the unexpected but important implications of this theory is that in the short term, the market value of money can be highly insensitive to the current level of the monetary base. A massive increase in the monetary base can have little or no impact on the market value of money, particularly if that increase in the monetary base is perceived to be “temporary” in nature.

However, the other implication of this theory is that over very long periods of time, the market value of money will fall if the growth in the monetary base far exceeds the growth in real output.

These observations can explain why quantity theory of money works in the long term but not in the short term. “Too much money” (relative to real output) will reduce the market value of money over long periods of time, but not necessarily over short periods of time. It is this decline in the market value of money that is the key driver of higher prices and inflation.

In summary, the challenge for monetarism is to retake the high ground in the economic debate. There is a clear path to do this, but it involves the recognition that the price level is a relative measurement of market value: the market value of the basket of goods in terms of the market value of money. Once the “value of money” is isolated as an independent variable, the challenge for monetarists is to provide a credible theoretical framework for the determination of the market value of fiat money.

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