• Over the past two thousand year, money, in all its many forms, has played a critical role in the development of human society. Commodity money, money whose value comes from the commodity from which it is made, has a very long history. “Commodity-backed” or “representative” money also has a relatively long history. In contrast, fiat money is an anomaly of economic history, a strange invention of the modern age.

• The use of fiat money is so widespread that many of us seldom question why it has value: it just does. But for economists, the question of why non-asset backed money or fiat money has value is fundamental.

• Surprisingly, economics struggles to provide a simple answer to the basic question “why does fiat money have value?” Most answers to this question rely, at least to some degree, on the notion that fiat money has value because it is accepted a medium of exchange. But this line of reasoning creates 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”.

• In order to break this pattern of circular logic, we need a new way to think about money. The first step in this process is asking the question “why does any asset have value?”

• For example, why does land have value? Why does a government bond have value? The answer in each case is different. Land has value because it is a real asset. In contrast, a government bond has value because it is a financial instrument.

• The view of The Money Enigma is that every asset derives its value either from its physical properties or from its contractual properties. Fiat money is not a real asset and can not derive its value from its physical properties. Therefore, fiat money must derive its value contractually.

• In order to help us think about this point, we will trace the evolution of money from commodity money to representative money (commodity-backed money) to modern-day fiat money. It will be argued that when the commodity-backed feature of representative money was removed, the explicit contract that governed representative money must have been replaced by an implied-in-fact This new implied-in-fact contract is what gives fiat money its value.

• The difficult question for economists is what is the nature of this implied-in-fact contract? This is a difficult question that we will address in more detail next week when we consider the question “what factors influence the value of money?” However, the view of The Money Enigma is that money is a special-form of equity instrument and a proportional claim on the future output of society.

Why does any asset have value?

While there are not many things that can be said with certainty in economics, one thing that can be said with certainty is that “money” remains an enigma. A simple question such as “what is money?” can trigger hours of debate among professional economists. In an attempt to lessen confusion, economists have been forced to invent multiple classifications of money such as “base money” and “broad money”. A myriad of different tests have been created to test whether an asset possesses the quality of “moneyness”. Despite these efforts, the basic of question of “what is money?” is not easily answered.

Perhaps it is not surprising then that the question “why does money have value?” is even more difficult to answer. There is an immediate and instinctive view among most economists that money is something special. It is a unique asset and, at least from a theoretical standpoint, must be treated differently from other assets.

There is no doubt that money, or more specifically, fiat money, is “unique”. After all, fiat money is a relatively recent invention when viewed on the grand scale of economic history. However, maybe money is not quite as “special” as most economists believe.

The view of The Money Enigma is that rather than trying to answer the question “why does 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. While it may be that we can’t find a perfect answer to the question by pursuing this path, at least we will have a sensible framework to begin our analysis with.

So, why does an asset have value? Let’s begin by rephrasing the question: how does an asset derive its value? 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. Another way of saying this is that an asset either derives its value from it’s the usefulness of its physical properties (for example, land is valuable because it can be used to grow crops) or from the liability that it represents to another party (for example, a bond is valuable because it represents a contractual obligation by the issuer to pay a set of cash flows to the holder of that bond).

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”.

A real asset is an asset that is tangible or physical in nature. More importantly, it is an asset that derives its value from these tangible or physical properties.

A financial instrument is, according to “IAS 32 – Financial Instruments: Presentation”, a “contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.”

A financial instrument is, by definition, both an asset and a liability. A financial instrument derives its value as an asset from the liability that it represents to another. In this sense, the value of a financial instrument can be considered to be an artificial creation of a contract entered into by economic agents.

So, where does fiat money fit in this simple paradigm? Does fiat money derive its value from its physical nature or does it derive its value from the liability that it represents to its issuer?

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 that exists between holders of money (you and me) and the issuer of money (our society).

The Evolution of Money

Money has taken many forms over the centuries. If we loosely define money as a widely accepted medium of exchange, then we can say that there have been thousands of different types of money used globally over the past few thousand years including, but not limited to, cowry shells (used as currency in Africa and China), koko (a unit of rice used in Japan’s feudal system), grain, copper, bronze, gold coins and paper notes.

However, our purpose today is not to discuss all the various forms that money has taken, but rather to discuss how money has evolved from commodity money to the fiat money that we use today.

In nearly every society, the first form of money used was some form of commodity money, money that was, quite literally, a basic commodity that had value in that society. Over time, as commerce became more sophisticated and trade became more widespread, the use of perishable commodities (such as grain and rice) as money became less common. Less-perishable commodities, such as copper, silver and gold became the predominant mediums of trade. The acceptance of these metals accelerated when they were issued in coin form.

All of these forms of commodity money derived their value from their physical properties. Early coins were accepted because the metals they were made of were valuable in and of themselves. If a government started debasing their coins, often by reducing the amount of the metal in the coin, then the value of the coin would fall and prices, as measured in terms of that coin, would rise.

Even in the times of the Roman Empire, the principle that the value of money is the denominator of the price level. As the Romans debased the value of their coins (by cutting down on the metal content of each coin), prices began to rise. “Ratio Theory of the Price Level”, the notion that the value of money is the denominator of the price level, is discussed in a recent post titled “What Causes Inflation?”

The point is that money in ancient societies, commodity money, was a real asset that derived its value from its physical properties.

The problem with commodity money is that it restricts the capability of governments to finance wars and other public expenditures: 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.

The first paper money was nothing more than a legal contract: an explicit contract that promised, on request, the delivery of a certain amount of gold or silver from the treasury of the king. The value of this paper money was derived solely from its contractual properties.

Many of the major modern currencies we use today were, at one time, asset-backed currencies. The British Pound and the US Dollar, the two currencies that dominated global trade over the last three hundred years, were both gold-backed currencies for many years. For a long time, the value of both these major currencies depended upon the explicit contract that promised holders that they were convertible into gold.

However, there was one key problem with this arrangement: it limited the amount of money that both governments could create.

At some point, it was decided that we should simply drop the gold convertibility feature. In effect, the explicit contract that promised holders this piece of otherwise worthless paper could be exchange for a real asset was rendered null and void.

So, why did these currencies maintain any value at all? After all, when these paper currencies were first issued, the only reason they were accepted in exchange was because they were “as good as gold”.

The popular view is that these paper currencies maintained their value because, after many years, people were accustomed to using them. In the language of an economist, the fiat money maintained its value when the gold convertibility feature was removed because it was already widely accepted as a medium of exchange.

The problem with this argument is that it relies on a circular argument, a form of logical fallacy.

In order for something to act as a medium of exchange it must have value. Benjamin Anderson, in his book “The Value of Money” (1917), states, “the medium of exchange must have value, or else be representative of something which has value. There can be no exchange in the economic sense without a quid pro quo, without value balancing value, at least roughly in the process”.

What does this mean? In simple terms, we are not going to part with something of value (a good or service) unless we receive something of value in return. We will not accept money in exchange unless it possesses the property of market value.

Therefore, money can only serve as a medium of exchange because it has value.

Now, let’s ask the question again “why does money have value?” Can you see the problem? Is it reasonable to argue that money has value because it is a medium of exchange if we also recognize that money serves as a medium of exchange because it has value? No, it isn’t. What we have created is a circular argument.

We can only resolve this circular argument by breaking one of its legs. Notably, we need another way of thinking about how fiat money derives it value. Fiat money must have value in order to act as a medium of exchange, so how does it derive this value?

Why Does Fiat Money Have Value?

As discussed earlier, it is generally recognized that all assets derive their value in one of two ways: real assets derive their value from their physical properties, while financial instrument derive their value from their contractual properties.

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.

Most economists haven’t spent much time speculating on the potential nature of the implied contract that money represents. This is unfortunate because such speculation could provide interesting insights into how the value of money is determined.

The view of The Money Enigma is that we can apply at least some elements of traditional finance theory to a theory of money. First, we need to identify the issuer of money. While the legal issuer of base money is the government, the ultimate economic issuer of money is society itself.

Second, we need to think about what it economic benefit is possessed or created by the issuer that could be promised to the holder of money. In the case of society, the obvious economic benefit that could be promised is future economic output. As the slide below illustrates, society can implicitly authorise government to issue claims against the future output of society. Although fiat money (the monetary base) is legally a liability of government, economically it is a liability of society itself and a claim against the most valuable economic benefit society produces: its future output.

Third, we need to consider whether the claim represents a fixed or variable entitlement to that future economic output. 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: just as a share of common stock represents a proportional claim on the future cash flow of a business, one unit of base money represents a proportional claim on the future economic output of society.

This theory is explored at length in The Money Enigma and The Velocity Enigma. Those readers looking for a short-form discussion of this idea might care to read a recent post titled “Money as the Equity of Society”.

Next week we will discuss how this theory of money can be used to think about the key factors that influence the value of money.