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

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

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

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

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

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

Why Does Fiat Money Have Value?

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

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

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

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

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

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

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

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

Money began life as a real asset.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why Does the Value of a Fiat Currency Collapse?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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