• 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