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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.

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.

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.

The Value of Money: Is Economics Missing a Variable?

If money has value and if the value of money is an important factor in the determination of prices in money terms, then why doesn’t economics officially recognise the value of money as a variable in its equations? Moreover, why doesn’t economics clearly explain the role of the “value of money” in the determination of money prices and foreign exchange rates?

If you look for the term “value of money” in an economics textbook, you won’t find very much. Indeed, the standard economics textbook has little to say about the “value of money” and its role in price determination.

The reason for this is simple: economics simply doesn’t recognise “the value of money” as an independent variable.

You might ask, “How is that possible? How can economics overlook a concept that seems so fundamental?” The answer to this question is rather complicated, but it boils down to the following.

In order to isolate the “value of money” as an independent variable, economics needs to measure the property of market value in absolute terms. In order to measure market value in absolute terms, economics must adopt a “standard unit” for the measurement of market value, something which economics has not done.

Almost universally, economics measures the property of “market value” in relative terms. For example, the price of a good, in money terms, is a relative measure of the market value of that good in terms of the market value of money. Similarly, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

In both cases, economics is measuring the market value of a good or goods in terms of the market value of money, i.e. both measurements are relative in nature.

So, how does economics measure the market value of money? The most common way to do this is something called the “purchasing power of money”. The problem is that the “purchasing power of money” is also a relative measure of market value. More specifically, the purchasing power of money measures the market value of money in terms of the market value of the basket of goods. (The purchasing power of money is simply the reciprocal of the price level, itself a relative measure of value).

The problem with measuring the value of money in relative terms is that it does not allow us to isolate the “value of money” as an independent variable.

For example, the purchasing power of money can fall because either (a) the market value of money falls, or (b) the market value of the basket of goods rises. The purchasing power of money does not isolate the value of money as an independent variable: rather, it muddies the waters by mixing the value of money with the value of goods.

The view of The Money Enigma is that economics can only isolate the value of money as an independent variable by measuring the market value of money in absolute terms, that is to say, in terms of a “standard unit” for the measure of market value.

Why does this matter? Well, isolating the “value of money” as an independent variable opens a number of doors. First, it encourages us to think about why money has value and what determines that value. Second, it forces us to think about an explicit role for the value of money in the determination of prices and foreign exchange rates. Finally, and most importantly, it allows us to shed new light on existing economic theories such as the quantity theory of money.

How Do We Measure the “Value of Money”?

In our everyday life, most of us are accustomed to measuring the value of goods and services in money terms. An apple is worth one dollar. A taxi ride across town costs twenty dollars. Indeed, money is so universally accepted as a medium of exchange and unit of account that we almost instinctively measure and compare the value of economic goods in money terms.

Therefore, when somebody asks us, “how do you measure the value of money?” most of us need to pause and think for a moment. After all, how do you measure the value of something that is itself used as the measure of value?

The most common answer to this question goes something like this: if we can measure the value of goods in money terms, then we can measure the value of money in goods terms.

The value of money, in terms of the basket of goods, is known as the “purchasing power of money” and it is a popular method for measuring the value of money.

Another way to measure the value of a currency is to measure it in terms of a different currency. A foreign exchange rate is, in essence, a way of measuring the value of one type of money in terms of another type of money.

The purchasing power of money and foreign exchange rates both represent valid ways of measuring the “value of money”. However, there is a problem with this approach. Both of these measures are relative measures of value.

The purchasing power of money measures the market value of money in terms of the market value of the basket goods. A foreign exchange rate measures the market value of money in terms of the market value of another currency. In both cases, we are measuring the value of money in relative terms and, therefore, both measures are dependent upon not only the value of money, but also the value of the measurement good (the basket of goods or the other currency).

In other words, we have not isolated the “value of money” as an independent or standalone variable. Why this matters is something that we will discuss later, but first let’s consider how we might isolate the value of money as a standalone variable.

The Measurement of Market Value: Absolute versus Relative

If a physical property can be measured in relative terms, then it can also be measured in absolute terms. If we can measure the market value of money in relative terms, then we should also be able to measure the market value of money in absolute terms. Moreover, by measuring the market value of money in absolute terms, we can isolate the value of money as an independent variable.

What does all this mean? Well, let’s start by thinking about the difference between absolute and relative measurement.

Every measurement we ever make is an act of comparison. In this sense, every measurement is relative: we are comparing one thing with another thing. However, by convention, science designates some measurements to be absolute in nature, while others are relative in nature.

The key difference between an absolute versus a relative measurement is the unit of measure being used.

A measurement is considered to be an absolute measurement if it is done using a “standard unit” of measure. The key characteristic of a standard unit of measure is that it is invariable in the property that is being measured.

For example, an inch is a standard unit of length. An inch is invariable in the property of length and can be used to measure length and/or height in absolute terms.

In contrast, a relative measurement is merely the measurement of one object, the primary object, in terms of another, the measurement object. Most importantly, a relative measurement does not require that the second object, the measurement object, is invariable in the property being measured.

For example, if I measured the speed of one car on the road in terms of another car on the road, then that would be a relative measurement of speed (i.e. one car is going twice as fast as the other car). The second car (the measurement car) is not invariable in the property of speed, therefore the measurement can not be considered to be absolute.

In summary, the difference between an absolute measurement and a relative measurement is that an absolute measurement can only be made using a “standard unit” of measurement.

The interesting thing about standard units is that they tend to be theoretical in nature. Standard units don’t occur naturally in the real world: rather, we had to make them up. Feet, inches, pounds and kilograms were all standard units of measure that we created.

And this brings us back to the main point of this article: economics needs to create a standard unit for the measurement of market value.

Every economic good possesses the property of market value. If a good did not possess the property of market value, then we would not exchange it in trade.

In theory, we should be able to measure the market value of a good in both absolute and relative terms.

Almost universally, economics measures market value as a “price”. But price is a relative measure of market value. The price of one good, in terms of another good, is relative measure of the market value of both goods.

However, if economics adopts a standard unit for the measurement of market value, then we can measure the market value of each good in absolute terms (in terms of the standard unit).

Why would we want to do this?

Measuring market value in absolute terms allows us to isolate changes in the market value of one good from changes in the market value of another good. In the most basic terms, it gives us greater insight into what is really driving the change in the price of a good.

Price is a relative measurement of market value. This means that the price of one good (the primary good) in terms of another good (the measurement good) can 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.

By measuring market value in absolute terms, we have a better way of tracking what caused the rise in the price of the good. We can track whether the price rise was caused by (a) the primary good becoming more valuable, or (b) the measurement good becoming less valuable.

This notion becomes particularly important when we discuss the determination of prices in money terms.

At the most fundamental level, the price of a good in money terms measures of the market value of that good in terms of the market value of money.

We can easily express this basic concept in mathematical terms if we measure the market value of the good and money independently, i.e. if we measure the market value of each in terms of a standard unit.

The price of a good in money terms can rise because either (a) the value of the good V(A) rises or (b) the value of money V_M falls. Note that the value of money is the denominator in our price equation: as the value of money falls, the price of the good rises.

The notion that the price of a good depends upon the value of money may seem like a very simple idea, but it is a fundamental concept and one that can only be expressed once the value of money is isolated by measuring it standard unit terms.

The Value of Money: Shedding New Light on Old Ideas

So, what are some of the interesting applications of this concept? What are the tangible benefits of isolating the value of money as an independent variable?

Let’s begin with the basics. The price equation in the slide above begs a couple of obvious question. First, what determines the market value of money? Second, if money has value and if the value of money plays a key role in price determination, then how do we incorporate it into traditional supply and demand analysis?

The traditional microeconomic view is that the price of a good is determined by supply and demand for that good. So, what role does the value of money play?

In order to incorporate the value of money into traditional supply and demand analysis, we need to rethink the unit of measurement that is used on the y-axis of our supply and demand diagrams.

The view of The Money Enigma is that every price is determined by two sets of supply and demand.

The price of a good in money terms is a relative expression of the market value of the good and the market value of money. The market value of a good is determined by supply and demand for that good. The market value of money is determined by supply and demand for money (the monetary base).

Therefore the price of the good in money terms is a function of both supply and demand for the good and supply and demand for money.

The key to illustrating this point is the way that we measure market value on the y-axis. In the slide above, market value is not measured in price terms, but is measured in terms of the standard unit, i.e. market value is measured in absolute, not relative terms.

This representation of price determination described above can be easily reconciled with the traditional representation of supply and demand once it is recognised that traditional supply and demand analysis implicitly assumes that the market value of the measurement good is constant.

For example, let’s take the supply and demand diagram for good A that is on the left hand side of the slide above. If you assume the market value of money V_M is constant and you divide all y-axis values for V(A) by the market value of money V_M, then you end up with the traditional version of the supply and demand representation for good A with the price of good A on the y-axis.

Similarly, we can convert the traditional supply and demand diagram with price on the y-axis into standard unit terms by multiplying all y-axis values by the market value of the measurement good, which, by the way, is already assumed to be constant in traditional supply and demand analysis.

The theory that every price is a function of two sets of supply and demand is discussed at length in a recent post titled “A New Economic Theory of Price Determination” and on the “Price Determination” page of this website.

If you are not an economist and you are wondering why this matters, then I will give you at least one good reason.

According to this theory of price determination, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

If this is correct, then Keynes’ liquidity preference theory, a cornerstone of modern economics, is wrong. This is an idea was discussed in a recent post titled “Supply and Demand for Money: Where Keynes Went Wrong”.

From a more constructive perspective, if the market value of money is the denominator of every money price in the economy, then this has important implications for macroeconomic theories of price level determination.

At the most basic level, we can use this idea to construct what is called “Ratio Theory of the Price Level”.

Ratio Theory states that the price level measures the market value of the basket of goods in terms of the market value of money. Therefore, the price level can be expressed as a ratio of two market values.

Ratio Theory highlights the importance of isolating the “value of money” as a variable. The value of money is the denominator in our price level equation above: as the value of money falls, the price level rises.

Moreover, Ratio Theory provides with a way to shed new light on old theories such as quantity theory of money. For example, does an expansion in the monetary base lead to an increase in prices because (a) it drives higher levels of economic activity and a rise in the value of goods, or (b) does an expansion in the monetary base lead to a decline in the value of money?

The application of Ratio Theory to the quantity theory of money is discussed in a recent post titled “Saving Monetarism from Friedman and the Keynesians”.

What Determines the Value of Money?

Before we conclude, it is worth spending a little more time talking about what determines the market value of money.

As illustrated above, the view of The Money Enigma is that supply and demand for the monetary base determines the market value of money. Technically, it is my opinion that this is a fair and accurate description of how the value of money is determined. However, in practice, this description leaves a lot to be desired.

The reason for this is that the value of money depends primarily upon long-term expectations of key economic variables. It is difficult to capture the complexity of these long-term expectations and their impact on the market value of money in a simple supply and demand diagram.

If you are interested in reading more about why fiat money has value and how the value of fiat money is determined, then I would highly recommend reading “The Evolution of Money: Why Does Fiat Money Has Value?” and “What Factors Influence the Value of Fiat Money?”

Author: Gervaise Heddle, heddle@bletchleyeconomics.com

Why Does Money Exist? Why Does Money Have Value?

The use of fiat currency in our modern society is so accepted that many people will go through their whole life without questioning why the dollar in their pocket has value, or for that matter, why it exists at all.

In this article, we shall seek to answer two basic questions. First, why does paper money exist? Second, why do we readily accept paper money in exchange for our goods and services?

Mainstream economics tends to answer both of these questions by referring to the role of money as a “medium of exchange”. In general terms, economists might argue that paper money exists because it forms a valuable role as a medium of exchange (barter economies are inefficient) and paper money has value because it is accepted as a medium of exchange.

While it is true that “money is a medium of exchange”, this is the wrong answer to both of the questions posited above.

The view of The Money Enigma is that fiat money exists because it is a useful financing tool for society. When governments don’t wish to pay their bills by raising more taxes or by issuing more debt, they can simply create money.

Moreover, the reason we accept fiat money in exchange for our goods and services is because, as a society, we recognize that money is a financial instrument. More specifically, fiat money represents a proportional claim on the output of our society. This is the way in which fiat money derives its value and this is the reason that fiat money can perform its functions as a medium of exchange, a store of value and a unit of account.

In simple terms, money is the equity of society. Fiat money exists because it is a useful as a financing tool and it has value because it is a financial instrument (it is a special-form equity instrument of society).

The fact that fiat money is a “medium of exchange” is incidental to its nature. More specifically, fiat money does not derive value from its nature as a medium of exchange. Rather, money can only perform its role as a medium of exchange because it possesses the property of market value, a property that is derived solely from its nature as a financial instrument.

Those that claim that money has value because it is accepted as a medium of exchange are engaging in a circular argument. Why does money have value? It has value because it is widely accepted in exchange. Why is money widely accepted in exchange? It is accepted because it has value.

The problems created by this circular argument are largely ignored by most economists, despite the fact that this circular argument lies at the heart of Keynes’ liquidity preference theory. We will discuss the flaws in liquidity preference theory another time. For now, let’s take some time to explore the two simple questions we started with.

Why does fiat money exist?

The view implied by many textbooks is that fiat money exists because it is a useful medium of exchange. But was creating a medium of exchange the motivation of those who first issued fiat money?

Let’s put that question another way. Do you think that the first kings that issued fiat money did so because they felt that their society needed another “medium of exchange”? Was fiat money just part of a benevolent desire by those rulers to assist commerce? Were these rulers visionaries who saw the long-term benefits to trade of paper money?

The short answer to all three questions is “no”.

Paper money was introduced to pay the bills when the kings ran out of gold.

The kings in our early societies didn’t create paper money because they were worried that gold wasn’t fulfilling its role as an efficient “medium of exchange”. Gold and silver were doing just fine as a medium of exchange. Rather, the issuance of paper money was an act of survival: it offered a mechanism to pay the army when the kingdom was close to running out of gold.

However, there was a trick to this arrangement. In order for this new paper money to be accepted, the king had to convince the people that the money was “as good as gold”. More specifically, the money had to be issued with the explicit agreement that it could be exchanged for a fix amount of gold on request (for example, one ounce per dollar). If people believed that this promise was credible, then the paper money would trade at the same value as its gold equivalent. However, if this promise lacked credibility, then the value of the paper money would soon collapse.

Nevertheless, in most cases, this system worked, at least for a while.

Fiat money was issued because it performed a unique role as a financing tool. If the kingdom couldn’t raise taxes and was reaching the limits of its borrowings, then issuing paper money that was backed by gold was an attractive way of financing public expenses.

The point is that fiat money is a financing tool. Originally, fiat money was issued as a financial instrument that promised the bearer a certain amount of gold or silver. This is why fiat money was accepted and why it was considered by all to possess the property of “market value”.

Over time, most modern societies have abandoned the gold standard. Most fiat money is no longer convertible into gold at request. But this hasn’t changed the reason money is issued. Money is a financing tool that. Money is still issued to pay for public activities that we, as a society, don’t wish to pay for with taxes or with the issuance of government debt.

Once you strip away all the technical language, the activities of our modern central banks are simple. When governments wish to manipulate financial markets (most notably, suppressing the interest rate by purchasing government debt), they have three basic choices to fund their debt purchases: raise taxes, issue debt or print money. Issuing debt and using the proceeds to buy back that debt defeats the purpose of the exercise. Raising taxes to buy government debt is not a popular move and is likely to be counterproductive, particularly when the economy is weak. Therefore, the government, through its monetary policy agency (the central bank), issues money to buy its debt. This action lowers the interest rate and everyone is happy.

Once again, nothing has changed. Fiat money is issued to pay for things (buying debt) that the government doesn’t wish to pay for by raising taxes or issuing debt. Fiat money exists because it is a financing tool “par excellence”.

What has changed over time is the way in which fiat money derives its value and this brings us to our second question.

Why does fiat money have value?

If we go back to our earlier example, the reason that fiat money had value in the days of the gold standard is obvious: money was backed by gold.

Gold is a real asset, which is to say that it derives its value from its physical properties.

Fiat money is not a real asset. Rather, fiat money is a financial instrument, which is to say that it derives its value from its contractual properties.

Paper money has no value in and of itself. However, paper money does represent something. In the case of early fiat money, paper money represented an explicit claim to a certain amount of gold or silver. The holder of paper money was a party to a contract that stated that the holder could exchange that piece of paper for something of more tangible value.

The mystery of paper money is why it continued to possess any value once the explicit gold convertibility feature was dropped. Why did paper money continue to have any worth once the explicit contract was rendered null and void?

Conventional wisdom is that money continued to have value because, by that time, it was accepted as a medium of exchange. The problem is that this creates the circular argument that we alluded to earlier.

Money is only accepted as a medium of exchange because it possesses the property of “market value”. If money did not have any value, then it would not function as a medium of exchange (if money had no value, you wouldn’t accept money from me in exchange for your goods/services).

If that basic fact is established, then we can’t also argue that money has value because it is accepted as a medium of exchange. Either money is a medium of exchange because it has value, or it has value because it is a medium of exchange. It can’t be both.

Therefore, what we need is something to break this circular argument. More specifically, we need a better model for explaining why fiat money possesses the property of “market value” when the explicit gold backing is removed.

As discussed, fiat money is not a real asset: it doesn’t derive value from its physical properties. Therefore, fiat money must be a financial instrument: it must derive its value from some sort of contractual arrangement.

The solution is to imagine that when the gold-convertibility feature was dropped, the explicit contract that governed fiat money was replaced by an implied-in-fact contract. In other words, when the gold-convertibility feature was removed, paper money no longer represented an explicit claim to something of value. But, it did still represent an implied claim to something of value: the output of society.

The view developed by The Enigma Series is that money is the equity of society. More specifically, money is a long-duration, proportional claim on the output of society. Money is an economic liability of society, even though it remains a legal liability of government and is issued by government on society’s behalf (society can not issue claims directly because “society” is not a legal entity).

The explicit contract that governed fiat money (gold-convertibility) was replaced by an implied-in-fact contract. This new contract, which is in essence an agreement between every member of society, states that money is a proportional claim on the output of society.

This is a complicated idea, but we can think of it in simple terms.

In essence, money is a much like a share of common stock. A business can issue common stock and each share becomes a proportional claim on the future cash flow of that business. All else remaining equal, the greater the expected future cash flows of the business, the more valuable each share is. All else remaining equal, the greater the number of shares outstanding, the less valuable each share is.

Money is an economic liability of society. Society, like a business, can issue claims against the future economic benefits it expects to generate, most notably, future economic output.

Society can issue money (print dollar bills) and each unit of money (each dollar) becomes a proportional claim on the future output of that society. All else remaining equal, the greater the expected future output of society, the more valuable each unit of money is (the greater its purchasing power). All else remaining equal, the greater the number of expected units of money on issue, the less valuable each unit of money is.

When a society is doing well and is expected to remain prosperous, the value of its money should be strong (and inflation should be contained). Conversely, if output is expected to collapse and a society is printing more and more money just to make ends meet, then the value of that proportional claim on future output is going to collapse. This second scenario is the recipe for hyperinflation.

Clearly, money is not a typical equity instrument. For example, money is a claim to a slice, not a stream, of future benefits. However, in practice this difference is relatively minor. The Velocity Enigma, the third paper in The Enigma Series, explains how we can create a valuation model for money that looks very similar to a valuation model for a share of common stock. In particular, we can use the notion of intertemporal equilibrium to create a probability distribution for the expected future benefits of money. The resulting valuation model is something that equity traders would find very familiar.

In summary, fiat money exists because it is a financing tool that is too useful for our society to ignore. In order for fiat money to be able to finance spending by our society, it must offer the holder something in return. And it does. Fiat money derives its value from its contractual properties. Early fiat money derived its value from an explicit contractual property: gold-convertibility. Modern-day fiat money derives its value from its implied contractual property: it is a proportional claim on the future output of society.

Author: Gervaise Heddle

Every Price is a Function of Two Sets of Supply and Demand

In last week’s post, we reviewed the theory that price is a relative expression of two market values. For example, the price of bananas, in money terms, depends upon both the market value of bananas and the market value of money. If the market value of bananas rises, the price of bananas rises. Conversely, if the market value of money rises, the price of bananas falls.

In more technical terms, we explored the idea that the price of one good, as measured in terms of another good, depends upon both the market value of the first good (the “primary good”) and the market value of the second good (the “measurement good”).

This week we will extend this idea and explore the theory that every price is determined by not one, but two, sets of supply and demand: supply and demand for the primary good, and supply and demand for the measurement good.

In simple terms, the key elements of this theory can be described as follows:

Every price is a relative expression of two market values (the market value of the “primary good” and the market value of the “measurement good”);
The market value of a good is determined by supply and demand for that good; therefore,
Every price is determined by two sets of supply and demand, namely, supply and demand for the “primary good” and supply and demand for the “measurement good”.

This universal theory of price determination is illustrated in the diagram opposite.

The price of good A in good B terms, denoted P(A_B), is a function of the market value of good A, denoted V(A), and the market value of good B, denoted V(B). Supply and demand for good A determines the market value of good A, V(A). Supply and demand for good B determines the market value of good B, V(B). Therefore, the price of good A in good B terms is determined by both supply and demand for good A, and supply and demand for good B.

Some readers may be thinking that this just can’t be right. After all, doesn’t supply and demand for a good determine its “price”, not its “market value”?

The key point that I would make here is that the model above is compatible with the standard supply and demand theory taught at college. The “price” of a good is just one way of measuring the “market value” of that good. More specifically, the “price” of a good is the market value of that good as measured in terms of the market value of another good.

Traditional supply and demand analysis, with “price” on the y-axis, simply assumes that the market value of the “measurement good” is constant. We want to be able to relax that assumption and analyze the impact on the price of a good if supply and/or demand change not just for the “primary good”, but also for the “measurement good”.

In order to understand how it is possible to represent a price as a function of two sets of supply and demand, we need to think about the different ways in which the property of “market value” can be measured.

Market value can be measured in absolute or relative terms. We are so accustomed to thinking of market value in relative terms (in terms of a “price”) that we struggle with the notion that market value can be measured in absolute terms. But all properties can be measured in either absolute or relative terms.

For example, let’s think about the property of “height”. The property of height can be measured in either absolute or relative terms.

Let’s imagine that we have a girl standing next to a tree. The tree is three times taller than the girl.

Typically, we might measure the height of the girl in inches. An “inch” is an invariable and universal measure of height. Similarly, we can measure the height of the tree in inches. By measuring the height of the girl and the tree in inches, we have measured the height of both in terms of an invariable and universal measure of height. In this sense, we have measured the height of both the girl and the tree in “absolute” terms.

But there is another way to measure the height of either the girl and/or the tree and that is in “relative” terms. For example, we could measure the height of the tree in girl terms. The tree is three times taller than the girl. Hence, the height of the tree, in girl terms, is three girls.

Similarly, we could measure the height of the girl in tree terms. The girl’s height is one-third of a tree.

Does the girl’s height change if we measure it in “absolute” terms (in terms of inches) or in “relative” terms (in terms of the tree)? No. The girl’s actual height doesn’t change. All that has changed is the way in which we measure her height.

We can apply this same principle to the property of “market value”.

“Market value” is a property of economic goods (goods that are traded in our economy). If goods do not possess “market value”, then they are not traded and there is no price for them.

The market value of goods can be measured in absolute terms or in relative terms. Typically, we measure the market value of goods in relative terms. More specifically, we measure the market value of most goods in terms of the market value of money. For example, a banana is twice as valuable as one dollar and hence the price of a banana is two dollars. This “price” is a relative expression of the market value of bananas relative to the market value of money.

However, we can, at least theoretically, measure the “market value” of each good in absolute terms. Just as we measure height in absolute terms, in terms of an invariable measure of height such as inches, so we can measure market value in terms of an invariable measure of market value.

However, since no good possesses the property of invariable market value (the market value of all goods varies over time), we need to create some theoretical measure of market value that is invariable. The Inflation Enigma proposes a standard for this called “units of economic value” or “EV” for short. Units of economic value are just like feet or inches, except that instead of measuring the height of an object, they measure the market value of a good.

Once we have created this standard and invariable measure of market value (“units of economic value”), we can measure the market value of all goods, including money, in absolute terms. More importantly, we can illustrate supply and demand for each good in absolute terms.

In the diagram opposite, the price of good A in money terms is illustrated as a function of two markets. On the left hand side, supply and demand for good A determines the market value of good A. Note that the unit of measurement being used on the y-axis is not money (a relative measure of market value) but units of economic value (an absolute measure of market value).

On the right hand side, the market value of money is also being measured in terms of our theoretical and invariable measure of market value (units of economic value). Supply and demand for money determines the market value of money (not the interest rate!).

The price of good in A, in money terms, is a relative expression of both the market value of good A and the market value of money. Therefore, the price of good A is determined by two sets of supply and demand: supply and demand for good A (the “primary good”) and supply and demand for money (the “measurement good”).

Let’s quickly examine what happens if there is an increase in demand for good A. If demand for good A increases, the demand curve for A (on the left hand side of the diagram) will shift to the right and the equilibrium market value of good A will rise. Furthermore, if the market value of money is constant (there is no change on the right hand side of our diagram), then the price of good A will rise.

This is the standard outcome generated by traditional supply and demand analysis. In this sense, the model above is perfectly consistent with traditional microeconomic theory.

However, what happens if demand for money increases? In this scenario, the demand curve for money (on the right hand side of the diagram) shifts to the right and the market value of money rises.

Now, what happens to the price of good A in money terms? The price of good A falls.

There has been no change in supply and/or demand for good where supply and demand are expressed in terms of our invariable measure of market value. However, the price of good A will fall because the market value of the measurement good (money) has risen.

The theory that every price is determined by two sets of supply and demand is one of the key theories developed in The Inflation Enigma, the second paper in The Enigma Series.

It is important to note that this theory is a universal theory of price determination. It can be applied to price determination in a barter economy (“good/good” prices), price determination in a money-based economy (“good/money”) prices) and foreign exchange rate determination (“money/money” prices).

The Inflation Enigma extends this microeconomic theory of price determination to a macroeconomic theory of price level determination called the “Ratio Theory of the Price Level”. Ratio Theory is particularly helpful in framing discussions regarding the causes of inflation.

Inflation or Deflation: Which is the Greater Risk in 2015?

Could 2015 be the year the markets experience both a “deflation scare” and an “inflation scare”?

The recent collapse of crude oil prices below $60 per barrel, combined with additional signs of global economic weakness, have renewed fears about an outbreak of deflation in the United States. Six years have passed since the US Federal Reserve first embarked on its current path of quantitative easing. The US Federal Reserve’s balance sheet has increased five-fold and other global central banks have followed in their footsteps. Despite this remarkable growth in the global monetary base, inflation has remained subdued.

The view of many in financial markets is that global deflationary forces are just too strong and that global central banks are increasingly impotent in their battle against deflation. This also seems to the view of at least one dissenter at the US Federal Reserve, Fed “dove” and Minneapolis Federal Reserve Bank President, Narayana Kocherlatkota, who argued that the Fed should be willing to further expand the monetary base if inflation continues running below the Fed’s 2% target.

While it may not be explicitly acknowledged by those who hold these deflationary expectations, this represents a quintessentially “Old Keynesian” perspective regarding the way the world operates. In essence, it is the view that if aggregate demand is weak, then prices must fall. Moreover, if global competition is pushing the aggregate supply curve to the right, then this only compounds the deflationary pressures.

The problem with this view is that it represents a very “one-sided” perspective on how “money prices” are determined in our economy. While it is true that well-entrenched deflationary forces (i.e., falling oil prices, global economic stagnation, and increasing global competition) have, and will probably continue to, put downward pressure on the value of global goods and services, there is a key element that is missing from our analysis: the future path of the value of money.

The value of money is the denominator of every “money price” in the economy. Every money-based transaction involves an exchange of two items of value. When you buy your morning cup of coffee, you receive one good of value and, in exchange, offer another good of value in return. This is the simple principle of all economic transactions dating all the way back to the barter economy of our ancestors. In our modern money-based society, the good of value that you offer in exchange for your morning cup of coffee is money.

The price of your morning coffee can rise for one of two basic reasons: the value of a cup of coffee can rise, or the value of money can fall. If the value of money falls, then, all else remaining equal, your local coffee shop will require you to give them more dollars for that morning cup of coffee.

We can extend this simple concept to the price level and changes in the price level (inflation). The value of money is the denominator of every “money price” in the economy and therefore the denominator of the price level. As the value of money falls, the price level rises.

In simple terms, this is the “Ratio Theory of the Price Level”, an economic theory of price level determination developed in The Enigma Series. Ratio Theory suggests that any “inflation versus deflation” debate needs to begin with a simple equation. Mathematically, the price level “p” can be described as a function of the value of goods and services “V_G” and the value of money “V_M” (see image below).

Inflation can be thought of as a game of “tug-of-war” between these two opponents. Currently, the world is experiencing strong deflationary forces that are placing downward pressure on the numerator in our equation, the value of goods and services. The current fall in oil prices should only accentuate these forces.

The bigger question relates to the future path of the value of money? The value of money has been relatively stable over the past few years, despite the massive expansion in the monetary base. However, is it reasonable to expect this stability to continue? And if the value of money does fall, then will it overwhelm the steady decline in the value of goods and services? In other words, will the denominator in our equation fall by more than our numerator?

You may ask why economics doesn’t present the “inflation/deflation” debate in these simple terms. Mainstream economics struggles with the concept outlined above because it does not recognize “the value of money” as a variable in its equations. In technical terms, economists struggle with the notion that price is a relative expression of two market values (the market value of a primary good as expressed in terms of the market value of a measurement good). Moreover, economics has largely failed to recognize that the property of “market value” can be thought of in both “absolute” and “relative” terms.

But before we get carried away with economic theory, let’s return to the topic at hand. What is the inflation outlook for 2015?

It seems reasonable to believe that the current weakness in the oil price, should it be sustained, will have some flow through effects over the course of the first few months of 2015. Energy costs represent a significant input cost for many industries and lower oil prices should contain any inflation over the next few months.

However, it seems unlikely that deflation represents the greatest risk to investors in the second half of 2015. Rather, the greatest risk to long-term investors remains a sudden collapse in the value of money and a significant jump in the rate of inflation. Indeed, 2015 may be remembered as a “flip-flop” year: fears of deflation in the first-half of the year rapidly switch to fears of inflation in the second-half of the year.

So, what is the risk of a sudden collapse in the value of money in 2015?

After six years of experimentation with the monetary base, many investors have been lulled into a false sense of security regarding this issue. The view of some investors is that if QE was going to negatively impact the value of the US Dollar, then it would have already happened by now. However, this is a naïve and simplistic view.

Ultimately, the value of a fiat currency is a function of the confidence that markets have in the long-term economic prospects of the society that issued it. More specifically, the value of money reflects expectations regarding the long-term path of the “output/money” ratio.

Over the past few years, markets have become more optimistic regarding the long-term prospects for the US economy. The view is that the US economy will continue to grow strongly over the next 10-20 years, even as the monetary base is “normalized” from its current extended levels.

However, if confidence in this view is shaken, then the value of the US Dollar will come under pressure. For example, if the Fed does reduce the monetary base, even modestly, and this results in a recession in the US, then investors’ long-term confidence in the path of the “output/money” ratio could be quickly shaken. The question for all investors is whether 2015 is the year that confidence turns.

Clearly, the role of expectations in the determination of the value of money and the price level is a complicated matter and future articles will be dedicated to exploring this issue further.

So, is deflation or inflation a greater risk in 2015? Near term, the risks may be on the side of deflation. But longer term, the risks are squarely in the inflation camp.

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