Tag Archives: money and expectations

Fiat Money is Only as Good as the Society that Issues It

  • Fiat money remains one of the great enigmas of modern economics. Economists struggle to provide simple answers to basic theoretical questions such as “Why does fiat money have value?” and “What determines the value of fiat money?”
  • Yet, intuitively, most of us recognize that there is one simple rule-of-thumb that applies to the value or worth of any given fiat currency: a fiat currency is only as good as the society that issues it.
  • More specifically, the value of any given fiat currency depends primarily upon expectations regarding the long-term economic prospects of society.
  • If the long-term economic prospects of a society are strong, then the value of the fiat currency issued by that society is well supported. Conversely, if expectations regarding the long-term economic future of society begin to deteriorate, then the value of the fiat money issued by that society begins to fall.
  • We have seen this simple notion illustrated repeatedly across many different countries over many different time periods. Some examples are extreme, i.e. the total economic and societal collapse of Zimbabwe at the hands of a despotic regime and the associated destruction of the Zim Dollar. Other examples are more subtle, i.e. the recent decline of the Brazilian Real as the end of the China commodity bubble has damaged confidence in the long-term economic future of Brazil.
  • The question that should preoccupy economists is why is this the case? From a theoretical perspective, why is fiat money only as good as the society that issues it? And why is the value of fiat money so heavily tied to confidence in the economic future of its issuing nation?
  • In this week’s post, we will attempt to answer these questions by exploring the nature of the obligation that society creates when it issues fiat money. More specifically, we will discuss the nature of the social contract that fiat money represents.

The Value of Fiat Money and Long-Term Economic Confidence

While it may be hard to believe now, there was a time when Zimbabwe was a thriving and prosperous nation, at least by the standards of sub-Saharan Africa. In 1980, the year Robert Mugabe and the ZANU party took power in a landslide victory, GDP per capita in Zimbabwe was the same as that in Botswana and nearly 50% of that in South Africa. At that time, Mugabe was a hero in the minds of many Africans and represented the bright future of post-colonial Africa.

However, Mugabe’s time as Prime Minister and then President of Zimbabwe was marred by corruption and economic mismanagement. The problems became worse as Mugabe tried to hold on to power with ever more populist policies. Arguably, the most damaging of these policies was the implementation of the Fast Track Land Reform program in 2000, a program that, in effect, took the nation’s most productive agricultural land away from white owners and redistributed that land to the majority black population.

These programs of redistribution not only eroded any confidence international partners had in doing business in Zimbabwe, but also destroyed the productive heartland of the nation. Not surprisingly, confidence in the long-term economic future of Zimbabwe began to collapse.

As confidence in the long-term economic future of Zimbabwe collapsed, so did the value of the Zimbabwe Dollar, as demonstrated in the chart below.

ZWDvUSDchart

Now, there will be many readers who might argue that it was monetary base expansion (“printing money”) that led to the collapse of the Zim Dollar. Clearly, this is important part of the story, but it is only part of the story. Why? Well, we have seen many examples recently of more developed countries (US and Japan) that have dramatically expanded their monetary base without a collapse in the value of the fiat currency of their nation.

So, what is the difference between Zimbabwe in the 2000s and the United States today? In a nutshell, the expansion of the monetary base in Zimbabwe was perceived to be “permanent” in nature. In contrast, the monetary base expansion that has occurred in the United States over the past seven years is perceived to be more “temporary” in nature, i.e. an expansion in the monetary base that will be reversed when the Fed decides that “the time is right”.

In turn, what is the key factor that determines whether markets perceive monetary base expansion to be “temporary” or “permanent” in nature? The answer is long-term economic confidence.

Today, the vast majority of market participants believe that the United States will grow and prosper over the next 20-30 years. In this context, the Fed’s expansion of the monetary base represents a blip: a policy that will be relatively easy to unwind over the years ahead. Personally, I don’t completely agree with this rosy assessment of the situation, but I think that it represents a fair characterization of what most people believe.

In contrast, in the early 2000s, confidence in the long-term economic future of Zimbabwe was collapsing. This collapse in confidence was no doubt fueled by already significant declines in GDP and money printing. But at its core, this deterioration in confidence was fueled by fundamental concerns regarding the long-term economic survival of the nation in the face of extraordinary corruption and mismanagement. In this context, every Zim dollar printed was perceived as a permanent addition to the monetary base.

In more recent times, many of us have been watching the marked decline in the value of the Brazilian Real.

brazil-currency

Some pure monetarists might want to blame this decline in the Brazilian Real on money printing. However, while the Brazilian monetary base has quintupled over the past seven years, this expansion is almost identical to the expansion of the US monetary base over that same period!

So, once again, we need to ask ourselves if it isn’t monetary base expansion per se that drives down the value of fiat currencies, then what is the common factor? Again, my answer is that the value of a fiat currency is primarily driven by confidence in the long-term economic future of the nation that issued it.

While confidence in the long-term economic future of the United States has remained strong, confidence in the long-term economic future of Brazil has collapsed over the past 12 months. Brazil is a country that, from an economic perspective, is highly dependent upon mining and agricultural commodities. When China was booming, the outlook for Brazil was good. But as the problems in China become more acute, there are increasing doubts about the long-term economic model for Brazil.

As concerns mount regarding the long-term future of Brazil, the value of the Brazilian Real falls. Put another way, it may be that the expansion in the Brazilian monetary base over the past seven years isn’t quite as “temporary” as many originally thought it might be.

From a practical perspective, the notion the value of a currency is tied to confidence in the nation that issues it is fairly straightforward. However, from a theoretical perspective, the reason for this phenomenon is much more complex. Indeed, it is so complex that mainstream economics has struggled to explain why this relationship exists.

The mainstream view that money has value because it is accepted as a “medium of exchange” provides little basis for explaining the fluctuation in currency values. Indeed, mainstream theory struggles with the simple notion that “money has value” and the role that the value of money plays price level determination. At the other intellectual extreme, the Austrian “regression theory” of money, namely money has value because it used to have value, also offers very little scope for the role of expectations in the determination of the value of money.

Therefore, in order to explore the relationship between the value of money and long-term economic confidence, we need a different model. More specifically, we need a model of money that considers the nature of the obligation that fiat money represents and the claim that fiat money represents against the future output of society.

Why Does Fiat Money Have Value?

Let’s assume for the moment that our premise is right and that the value of fiat money is driven primarily by confidence in the long-term economic future of the society that issued it. If this premise is correct, what might this imply about the nature of fiat money?

Prima facie, it would suggest that fiat money represents an entitlement to future economic prosperity. More specifically, it suggests that fiat money represents an entitlement to the future economic output generated by society.

As discussed in the previous section, if we believe that a society will enjoy long-term economic success, then the value of the fiat currency issued by that society tends to be well support. Conversely, if serious concerns surface regarding the long-term economic prosperity of society, then its currency will begin to lose value relative to other currencies and other goods in general.

Now, if fiat money represents an entitlement to future output, then this also suggests that fiat money is an obligation. In simple terms, the holder of money can’t be entitled to an economic benefit (some portion of the future economic output of society) unless some other party is obliged to deliver that economic benefit. Who is that other party? Prima facie, it would seem reasonable to believe that it is society itself.

Think about it this way. What is the main purpose of issuing fiat money? Is it to provide a useful medium of exchange? No. Is it to help the central bank manipulate the interest rate? Maybe, but that’s a very limited view of its role. The primary purpose of monetary base expansion is as a financing tool. Society authorizes government (the central bank) on its behalf to create money in order to finance certain expenditures that are deemed to be in the interest of society. Newly printed money might be used to finance general public works, or, in current times, it might be directed towards buying government bonds.

Whatever this newly created money is used to buy, the point is that it is used as a financing tool. Prima facie, this suggests that fiat money is a “financial instrument”, an asset that has value today because it creates a future liability.

A financial instrument is both an asset and a liability. A financial instrument only has value as an asset to one party because it is a liability of another party.

The view of The Money Enigma is that fiat money is a financial instrument. Fiat money is an asset to its holder because it is a liability of society. More specifically, fiat money represents a claim against the future output of society.

In simple terms, ask yourself “Why do I go to work to earn money”? I would argue that you go to work every day because you believe that the money you earn entitles you to some portion of the future output of our society. If it didn’t, why would you bother?

In this light, it makes perfect sense that the value of the fiat money we have in our pocket should be tied to the perceived future economic prosperity of our society. If money is a claim against future output, then its value should be tied to expectations of future economic success. In other words, fiat money is only as good as the society that issues it.

We can take this analysis one step further.

As a general rule, every financial instrument represents either a fixed or variable entitlement to a future economic benefit. For example, a bond typically represents a fixed entitlement to a set of future cash flows, while an equity instrument represents a variable or proportional claim on the future cash flows of a company.

It is almost impossible to make the case that fiat money represents a fixed entitlement to the future output of society. In contrast, a plausible case can be made for the notion that fiat money represents a variable or proportional claim against the future of society.

More specifically, fiat money represents an entitlement to the future output of society and that entitlement varies according to expectations regarding the future size of the monetary base. Just as the number of shares outstanding (both now and in the future) determines the proportion of cash flow that each share will claim in the future, so the size of the monetary base (both now and in the future) determines the proportion of future output that each unit of monetary base can claim in the future.

If this theory of fiat money is correct, then we can say that the value of fiat money will be positively correlated to expectations regarding the long-term path of real output and negatively correlated to expectations regarding the long-term path of the monetary base.

In other words, the value of fiat money is a barometer for confidence in the long-term economic prospects of society.

As people become more optimistic about the long-term future of society (i.e. solid output growth and contained monetary base growth), the value of the fiat currency issued by that society should rise. Conversely, as people become more pessimistic about future economic prospects (i.e. poor economic growth and high levels of monetary base growth), the value of money should fall.

In an extreme situation, such as Zimbabwe in the 2000s, where people believe that economic activity will decline markedly and money printing will remain rampant, the value of a proportional claim on the future output of that society will collapse, i.e. the value of the currency will collapse just as the Zim Dollar collapsed in the 2000s.

Ultimately, fiat money is only as good as the society that issues it. Fiat money has value because it represents a proportional claim on the future output of society. If the market expects a society to collapse, due to rampant corruption and/or war, then the fiat money issued by that society quickly becomes all but worthless. However, if a society is doing well economically and people expect it to remain strong and prosperous for the foreseeable future, then the value of the fiat currency issued by that society should remain buoyant.

A Bubble of Confidence Obscures the Risk of Inflation

A quick scan of recent financial headlines would suggest that the Western World is on the verge of a major contraction in prices. One commentator after another argues that deflation is the great risk to global economies and markets.

Ironically, the current period of relatively low inflation is the flipside of the overvaluation in global bond and equity markets. More specifically, there is a bubble of confidence in all asset classes. This bubble of confidence is supporting not only debt and equity markets, but supporting the value of the major fiat currencies. It is this overconfidence in money that is keeping a lid on the price level in the major Western economies and helping to drive the price of commodities (and gold in particular) to new lows.

The Federal Reserve’s unprecedented actions since the 2008 crisis have led to a surge in confidence regarding the long-term economic prospects of the United States (and thereby the long-term prospects of the world economy). The notion that the United States is steaming ahead and will pull the rest of the world with it is a common theme in current financial market commentary.

This surge in confidence regarding the long-term outlook has permeated global asset markets. Government bond prices have soared (particularly in the European periphery ex-Greece) and this has fed a search for yield in corporate debt. Prospective risk-adjusted, nominal returns on a broad portfolio of global government and corporate debt are close to 0%. (You don’t have to have many positions go wrong in a global fixed income portfolio with an ex-ante 2-2.5% headline yield for the ex-post yield to be 0%).

Furthermore, as prospective fixed interest returns have collapsed, investors have chased global equities higher and higher to the point where prospective ten-year nominal returns on the US equity market are also close to 0%. (See John Hussman’s commentary for an excellent discussion of this issue replete with long-term valuation charts).

More interestingly, this surge in confidence has supported the market value of fiat money, the denominator of every “money price” in the economy and thereby suppressed prices as stated in money terms. Despite the massive increase in the US monetary base, the market value of the US Dollar has been supported by a surge in confidence regarding the long-term prospects of the US economy.

Why has the US Dollar seemingly ignored the massive increase in the monetary base? And why has the market value of the US Dollar been so sensitive to a surge in market confidence regarding the long-term economic future of the United States? The answer to both questions is that money is a long-duration, proportional claim on the output of society.

The theory developed in The Money Enigma, the first paper in The Enigma Series, is that money is a long-duration, proportional claim on the future output of society. In essence, what this means is that the value of money today depends upon expectations of what the ratio of real output to base money will be over the next 20-30 years. The ratio of output/money as it stands today is somewhat irrelevant to the value of money. What matters is the expected path of that ratio over the next 20-30 years.

Let’s break down this concept into its two main components.

  1. Money is a long-duration asset

If an asset is described as being a long-duration asset, then all this means is that a large part of the current value of the asset is tied up in benefits that should be received from that asset in the distant future. For example, a 30-year government bond is a long-duration asset because the principal repayment on that bond is not due for 30 years and the interest payments are spread out over the next three decades.

Money is a long-duration asset because its current market value depends largely upon benefits that will be received from spending that money in the distant future. More specifically, in a state of intertemporal equilibrium, we are indifferent between spending the marginal unit of money demanded now, in 5 years from now or in 20 years from now. (If this were not the case then the economy would not be in a state of intertemporal equilibrium). This somewhat complicated notion is explored at length in The Velocity Enigma, the final paper in The Enigma Series. Fortunately, there is a simpler way to think about this issue. The value of money depends upon a chain of expected future values.

When I buy a product from you and give you money in exchange, you expect that the money I give you should have a similar purchasing power (a similar market value) when you spend it. When you spend the money, the next person accepts it because they believe it will have a similar future purchasing power. This process continues all the way down a chain of thousands of people.

Therefore, if the market suddenly decides that money will have less value in some distant future period, then that will have an immediate impact on the current value of money.

Conversely, if the market is optimistic in regards to the future of money, then that confidence will support the current value of money, even if the monetary authority has recently created a lot more money (does this sound familiar?).

The point is that money is a long-duration asset and its value today depends upon future expectations. But future expectations of what? This brings us to the second part of the earlier statement.

  1. Money is a proportional claim on the output of society

Money is a financial instrument. This means that money derives its value contractually. More specifically, money is a special-form equity instrument issued by society (money is a legal liability of government, but an economic liability of society) and money represents a proportional claim on the future output of society. The view of The Enigma Series is that an implied-in-fact contract exists between the issuer of money (society) and the holders of money (again, society) that recognizes money as a proportional claim on the future output of that society.

Money is much like a share of common stock. One share of common stock is a proportional claim on the future cash flows of a company. If the number of claims rises (the number of shares on issue rises), then all else equal, the value of each claim falls. Similarly, if the expected future cash flows of the company fall, then the value of each proportional claim on those cash flows falls (the current value of each share falls).

Money is a proportional claim on the future output of society. If the number of claims rises (the monetary base increases), then all else equal, the value of each claim will fall. However, if the expected future output of society rises, then this will increase the value of the proportional claim on that future output (the value of money rises).

In summary, money is a claim on the future output of society and the current market value of money depends upon expectations of the long-term path of the “real output/base money ratio”.

So, how does a surge in confidence regarding the future prospects of a country impact the value of the currency issued by that currency? Clearly, such confidence will support the market value of that currency.

The near-term path of the “output/money” ratio is fairly irrelevant to the value of money. If the market expects the monetary base to decline over the next ten years and economic output to continue to grow strongly over that period, then that confidence is enough to support the value of money and, conversely, keep a lid on inflation.

However, there is a risk.

If confidence in the future prospects of the US collapse, then we would naturally expect the bond and equity markets to suffer. However, such a collapse in confidence will also impact the market value of the US Dollar.

As discussed in last week’s post, every price is a relative expression of the market value of two goods. If the market value of money suddenly declines, then, all else remaining equal, the price of all goods, in money terms, will rise sharply.

The markets are not prepared for this eventuality. But the prospect of a sudden and severe increase in the rate of inflation is a far more likely than a return of 1930s-style deflation. All it will take is one pin that pops the bubble of confidence that currently permeates all global asset markets.