The view of The Money Enigma is that fiat money is a special-form equity instrument. More specifically, each unit of the fiat monetary base represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a corporation.

The idea that fiat money is an equity instrument begins with a simple observation: fiat money is a financing tool. Society has three options when it wants to fund public activities: raise taxes, issue debt (government debt) or print money. The monetary base represents a way to fund the public activities that we are not prepared to pay for with current taxes or future taxes (government debt).

We can compare this to the financing options faced by a typical corporation. Most companies face three basic choices when considering the funding of new projects: use existing cash flows, issue debt or issue equity.

The choice of issuing debt or equity for a corporation can be a complicated one, but generally it boils down to one simple issue: does the corporation want to create fixed claims against its future cash flows or variable/proportional claims against its future cash flows?

In the case of a corporation, the equity issued by that corporation has value because it is a proportional claim against the future cash flows of the company. The holder of that equity is party to a shareholders’ agreement that promises equity holders a variable entitlement to the future cash flows of that business.

The view of The Money Enigma is that society faces similar financing choices to those faced by a corporation. Moreover, the fiat money issued by society is, in essence, very similar to a traditional equity instrument issued by a corporation. More specifically, it is the view of The Money Enigma that fiat money has value because it is recognised as a proportional claim against the future output of society.

In order to understand this somewhat complicated idea, it helps to think about the evolution of money. In particular, it helps to step back and think about why fiat money exists in the first place.

Why Does Fiat Money Have Value?

A few weeks ago I published a post titled “Why Does Money Exist? Why Does Money Have Value?” In that post it was argued that fiat money was first introduced by the ancient kings to fund the kingdom when their royal treasury was running low on gold. When the kings couldn’t find enough gold or silver to pay the army, they created IOUs, pieces of paper (or other objects) that represented a direct claim on the gold in the royal treasury and issued these pieces of paper to the soldiers.

This ancient fiat money derived its value contractually. Fiat money was, by definition, not a “real asset”: it didn’t derive its value from its physical properties. Rather, it derived its value from its contractual properties, i.e. it was a “financial instrument”.

Early fiat money was governed by an explicit contract: possession of this ancient fiat money entitled the holder to x ounces of gold or silver from the royal treasury. This form of financial instrument proved incredibly popular both with those who issued them and those who subsequently used them in trade. Indeed, this financial instrument became so popular that it became the predominant medium of exchange in most societies.

Importantly, it allowed societies to cheat: spend a bit more today than they really could afford by issuing more fiat money than they could credibly back with gold reserves. The cost of this “cheating” was debasement of the currency, a process that sometimes occurred in small, gradual increments and sometimes in an outright collapse (for example, in 1933, the value of the US Dollar fell dramatically as the peg moved from $20 per ounce of gold to $33 per ounce of gold overnight).

The point is that this form of public finance became an extremely attractive option to the ancient kings and then, as time passed, to the populace itself. So much so, that at some point in the 20^th century, most developed nations decided to take fiat money to the next step: abandon the gold convertibility feature altogether.

While we take non-asset backed fiat money for granted today, it is worth considering what a radical step the abandonment of the gold convertibility feature represents.

If we go back to the beginning of fiat money, the only reason it had any value, and hence the only reason that it was accepted in exchange, was because it represented an explicit contract between the holder of money and the issuer for the issuer to deliver a certain amount of gold (a “real asset”) on request. Without this explicit promise, the fiat money would have been worth nothing.

Jump forward a few hundred years and we, as a society, decide to abandon this explicit contract. So how is it possible for fiat money to retain any value?

The popular and misguided view taught in the textbooks today is that money retained its value because, by the time the gold convertibility feature was removed, fiat money was accepted as a “medium of exchange”. In other words, fiat money has value because it did have value, even if the entire basis for that value is now defunct.

The view that fiat money has value because it is a medium of exchange is a circular argument and a form of logical fallacy. Why does money have value? Because it is a widely accepted medium of exchange. Why is money a widely accepted medium of exchange? Because it has value.

Incidentally, this circular argument sits at the heart of Keynes’ liquidity preference theory. Keynes begins his thesis on money demand by arguing that people demand money because it is (1) a medium of exchange, and (2) a store of value. But Keynes never addresses the issue of why money is a medium of exchange and a store of value. Money can only act as a medium of exchange and store of value because there is demand for it (it possesses the property of market value). Arguing that the demand for money is derived from these functions creates a circular argument that is never addressed by Keynes.

In short, the textbook view doesn’t resolve this circular argument.

The Money Enigma breaks the circular argument by providing an alternative view on how money derives its value. Rather than deriving its value from its functions, which it can only perform because it has value, money derives its value from its status as a financial instrument.

Money is a financial instrument. This means that money must derive its value contractually, even if that contract is implied. When the explicit contract was rendered null and void (the gold convertibility feature was dropped) another, albeit implied-in-fact contract must have taken its place in order for money to retain any value.

Now we get to the fun part. If money is a financial instrument, then what is the contractual agreement that is in place between the issuer of money (society) and the holders of money (individual members of society)?

What is the Nature of the “Moneyholders’ Agreement”?

Just as a shareholders’ agreement governs the contractual relationship between the issuer of common stock and the holders of that stock, so the implied-in-fact “Moneyholders’ Agreement” governs the contractual relationship between the issuer of money and the holders of money.

Since there is no explicit contract, or at least no explicit contract that is meaningful, unraveling the terms of the Moneyholders’ Agreement involves a degree of speculation. But we can at least apply the framework that is used for traditional financial instruments so that we know the right questions to ask.

Every financial instrument must possess certain characteristics in order for it to have value. First, it must entitle the holder of the instrument to some future economic benefit, a future economic benefit that the issuer has the capacity to offer. Second, it must entitle the holder to either a fixed or variable (proportional) claim against that future economic benefit.

For example, in the case of shares of common stock, each share entitles the holder to a future economic benefit (future cash flows) that the issuer (the issuing company) has, at least in principle, the capacity to offer. Furthermore, it entitles the holder to a proportional claim against that future economic benefit (the proportion of future residual cash flows each share claims varies in proportion to the number of shares issued).

Let’s think about these two characteristics and how they apply to the monetary base.

First, if base money is a financial instrument issued by society, then what future economic benefit can society offer to the holder of money? Let’s put this question another way. What does society have that it can use to pay its bills?

The answer is “economic output”.

If we circle back to the beginning of this post, we noted that society has three ways to pay its bills: taxes, debt or money. Taxes are a claim on current economic output. Government debt represents a claim on future economic output.

If society doesn’t wish to pay for current public expenditures by sacrificing current economic output, then it can issue claims against future economic output. Moreover, just as a corporate entity can issue fixed or variable claims against future cash flows, so society can issue fixed or variable claims against future economic output.

Money, the monetary base, represents a variable or proportional claim against the future economic output of society.

Now, why does this matter? The reason this should matter to economists is because we can use this idea to build a valuation model for the market value of money. In turn, the market value of money is the denominator of every money price in the economy and, therefore, the denominator of the price level.

In theory, we should be able to build an expectations-based discounted future benefits model for money just as we can build a discounted future cash flow model for a share of common stock. But there are some nuances and complications.

Those with a financial analyst background will notice one immediate difference between money and a share of common stock: 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 (you can only spend the dollar once).

This distinction creates an interesting challenge. A valuation model for money must incorporate a probability distribution for the future time at which the marginal unit of money demanded is expected to be spent. It turns out that this issue is easily resolved by the application of intertemporal equilibrium theory.

There are several other complications that are addressed at length in The Velocity Enigma, the third paper in The Enigma Series. For the sake of time, we won’t discuss these now, but those that are interested can read all about it in The Velocity Enigma, the third and final paper in The Enigma Series.

The end result is a valuation for model for money, called “The Discounted Future Benefits Model for Money” that looks very similar to a valuation model for a share of common stock. The equation below is expressed in terms of a “standard unit” or invariable measure of the property of market value. In this sense, the market value of money is measured in absolute terms.

The equation above states that the market value of money is a function of:

1. The current levels of real output, q_t
2. The current level of the monetary base, M_t
3. The current level of the general value level, V_G,t
4. The expected long-term growth rate of real output, g
5. The expected long-term growth rate of the monetary base, m
6. The expected long-term risk-adjusted nominal return on risk assets, i
7. The real discount rate applied to future consumption, d

In simple terms, the valuation model implies that the market value of money depends critically upon the expected future path of the “real output/base money” ratio. If expectations about the long-term prospects of the economy become more pessimistic, i.e. slower output growth that is supported by higher base money growth, then the market value of money will fall.

Let’s put this in a more familiar context.

The value of a share of common stock will fall if people believe that a company’s long-term cash flow growth will slow while share issuance will rise.

Similarly, the value of money will fall if people believe that a society’s long-term output growth will slow while base money issuance will rise.

In this sense, money is very similar to any other equity instrument. The value of any particular fiat currency is ultimately a bet on the true prosperity of the society that has issued it.

Finally, I will leave you with two more slides. The slides below illustrate the critical end result: an expectations-adjusted quantity theory of money. While the price level does depend to some degree upon current levels of real output and base money, it is expectations of the long-term path of these variables that is critical to the determination of the price level.