• Fiat money possesses the property of market value. Fiat money must possess this property in order for it to act as a medium of exchange. But what determines the market value of fiat money? Why does the value of fiat money fluctuate and tend to fall over long periods of time? Moreover, why does the value of a fiat currency sometimes fall sharply in a short period of time?

• In last week’s post, we asked the question: “why does fiat money have value?” After all, fiat money is nothing more than a piece of a paper with pictures on it. Why does something with so little intrinsic/physical value have any value at all?

• In this week’s post, we will attempt to answer an even more difficult, but related question: “what determines the value of fiat money?” In order to do this, we will discuss the nature of the implied contract that governs fiat money.

• As discussed in last week’s post “The Evolution of Money: Why Does Fiat Money Have Value?” the view of The Money Enigma is that fiat money is a financial instrument and derives its value contractually.

• All assets are either real assets or financial instruments. Real assets derive their value from their physical properties. In contrast, financial instrument derive their value from their contractual properties.

• The first form of money used in most societies was commodity money. This early commodity money was a real asset and derived its value from its physical properties.

• Over time, paper money was introduced. Originally, paper money was nothing more than an explicit contract that promised to its holder some weight of commodity money such as gold coin. This “representative money” derived its value from its contractual properties (it was a promise to deliver something of tangible value).

• At some point, the explicit contract that governed paper money was rendered null and void. So why did paper money retain any value? The view of The Money Enigma is that the explicit contract governing paper money was replaced by an implied-in-fact contract between the issuer of money (society) and the holders of money.

• By exploring the nature of this implied contract, the “Moneyholders’ Agreement”, we can begin to build a better picture of which factors influence the value of money. Furthermore, we use this perspective to think about why the value of fiat money tends to fall over time.

• In simple terms, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. Over long periods of time, an increase in the monetary base relative to real output will reduce the value of the proportional claim and lead to rising prices across the economy. We have seen this pattern exhibited repeatedly across most Western economies over the past fifty years.

• Over short periods of time, expectations regarding the future path of the monetary base and real output are critical to the value of money. If people become more optimistic about the growth of future output, then the value of money will rise. Conversely, if people become less optimistic and believe that more money will have to be created to support the same level of future output growth then the value of money will fall and the price level will rise.

The Fiat Money Enigma

“Why does this asset have value?”

In the case of most assets, this isn’t a difficult question to answer. If we choose almost any asset at random, then we can answer this question by applying a simple paradigm: every asset is either a real asset, it derives its value its physical properties, or it is a financial instrument, it derives it value from its contractual features.

For example, land is a real asset that derives its value from its physical properties: its owner can grow crops or build shelters upon it. In contrast, a corporate bond is a financial asset that derives its value from its contractual properties: it entitles its holder to a fixed stream of future cash flows.

This paradigm provides us with a simple way to think about how any asset derives its value. Furthermore, this simple paradigm can be easily applied to early forms of money, namely commodity money and representative money.

Commodity money is a commodity that is used as a medium of exchange. The most obvious example of commodity money is gold. Commodity money is a real asset and derives its value from its physical properties.

Representative money is paper money that represents a claim against the issuer of that paper for a certain amount of a commodity on request. Stated in slightly different terms, possession of representative money makes the holder of that money party to an explicit contract that promises the delivery of a certain amount of a real asset.

The most obvious example of representative money is paper money that issued under a gold standard. In the case of the gold standard, each note issued was an explicit promise by the issuer of that note to deliver a certain amount of gold on request.

From the perspective of our “real versus financial asset” paradigm, representative money is a financial instrument. Representative money is an asset that derives its value from its explicit contractual properties.

The point is that we have one simple paradigm that can be used to explain why an asset, any asset, has value. Furthermore, this paradigm can be usefully applied to early forms of money, both commodity money and representative money.

Now, let’s ask the question: “why does fiat money have value?”

Surely, the best place to start in any attempt to answer this question must the simple “real assets/financial instruments” paradigm? After all, this paradigm seems to explain why almost any asset has value, including all the early forms of money.

Despite the strength and logical simplicity of the paradigm, most economists chose to ignore it in their analysis of fiat money. Rather, economists prefer to treat fiat money as something special, almost magical: an asset that is so unique and enigmatic that it is automatically considered to be an exception to the simple paradigm that applies to every other asset, including the early forms of money that preceded fiat money.

The problem is that by ignoring this paradigm, economists have been forced to venture into unchartered and dangerous intellectual territory. After all, if an asset doesn’t derive its value from its physical properties and it doesn’t derive its value from its contractual properties, then how does it derive its value?

Inevitably, economists have created “solutions” to this problem that seem to make sense at a superficial level, but quickly fall apart once you scratch the surface. One of the best examples of this is Keynes theory of demand for money as espoused in his “General Theory of Employment, Interest and Money”.

If you cut through all the flowery language used by Keynes, his key thesis is that demand for money depends on its usefulness as a medium of exchange and its relative attractiveness as a store of value.

Superficially, this sounds plausible. Money is useful as a medium of exchange and we do use it as a store of value. Therefore, one might be tempted to argue, as Keynes does, that the reason money has value (the reason there is demand for money) is because it performs these functions.

The problem with this argument is that it fails to recognize why money can perform its function in the first place. The only reason money can act as a medium of exchange is because money has value. Similarly, the only reason money can act as a store of value is because money has value!

You can’t build a theory of demand for money based upon its functions: money can only perform its function because there is demand for it! If you rely on the functions of money to generate demand for money (i.e. the functions of money are the mechanism by which money derives its value), then you have created a circular and fallacious argument.

Fortunately, there is a better, albeit much more difficult and intellectually challenging way to think about how money derives it value. Rather than trying to invent some “feel good” solution that falls apart as soon as we scratch the surface, we could try to apply our “real assets/financial instruments” paradigm to fiat money.

Clearly, fiat money is not a real asset. As noted by many, fiat money is often nothing more than a piece of paper with some ink on it. Therefore, it is fair to say that fiat money is not a real asset and does not derive its value from its physical properties.

This leaves us with only one alternative: fiat money is a financial instrument and derives its value from its contractual properties.

The difficult question, a question that very few economists have spent any real time considering, is what is the nature of the contractual agreement governing fiat money? Clearly, the terms of any contract will not be standard or straightforward (if they were, then speculation on this topic would be well advanced). But this shouldn’t deter us from this path: if we can propose a contractual solution that is plausible, then this is far better than trying to create an alternative paradigm to explain how one specific asset (fiat money) derives its value.

Think of it this way. Prima facie, what is the better approach to the answering the question “how does fiat money derive its value?”

Should we:

a). Try to apply an already well-established paradigm that accounts for how assets derives their value, even if that path poses some intellectual challenges in explaining how this particular asset derives its value; or

b). Attempt to create a new paradigm to explain how one, only one, of all the assets that are in existence derives its value in a manner that is completely independent from all other assets?

The view of The Money Enigma is that we need to make a concerted effort to explain fiat money within the context of the existing paradigm. Therefore, this requires us to explore and speculate upon the nature of the implied agreement that governs fiat money and from which fiat money derives its value.

The Implied Moneyholders’ Agreement

Before we speculate on the nature of the contractual agreement that governs fiat money, we need to consider a few important points.

First, it helps to give the agreement a name. For lack of a better term, we will call the contractual agreement that governs fiat money the “Moneyholders’ Agreement”.

Second, we need to be careful with our definition of “money”. For the purposes of this analysis, “money” is defined as comprising solely the monetary base. For reasons that should become clear from the following discussion, the monetary base is unique as a financial instrument. Most of the assets that economists describe as money, most notably bank deposits, are created by contractual arrangements between private parties such as banks and deposit holders. In contrast, the monetary base can only be issued by government (acting on behalf of society): the monetary base, “fiat money” in the purest sense of the term, can not be created by individuals, banks or corporations.

Third, we need to recognise that the agreement that governs fiat money is an implied-in-fact contract, not an explicit contract. What does this mean? It means that there is no explicit written contract that we can read, nor an explicit verbal contract that we can listen to. Rather, the Moneyholders’ Agreement is a contract that is created by a common or mutual understanding, an understanding that can be implied from the behavior of the parties to the contract.

The implied nature of the Moneyholders’ Agreement makes it difficult to speculate on the exact terms of that agreement. But we can try to draw up a sensible term sheet, drawing on insights from the nature of other financial instruments, and then think about how these terms might influence and impact the valuation of money. To the degree that we can use the price level to provide us with some evidence regarding how the valuation of money adjusts in response to various historic events and shifts in future expectations, we can then determine whether the posited terms of the Moneyholders’ Agreement seem realistic.

So, let’s begin trying to dissect the terms of the implied Moneyholders’ Agreement.

The process of creating any financial instrument begins with determining the counterparties to the agreement. Therefore, the first question that we need to ask is in relation to the Moneyholders’ Agreement is who are the counterparties to the contract?

Clearly, one of the parties to the agreement is the “moneyholder”, those people in possession of money. As illustrated in the diagram below, money is an asset to the holder of money. However, in order for a financial instrument to be an asset of one party, it must be a liability of another. So, who is the counterparty? Who is the issuer of money?

The view of The Money Enigma is that, from an economic perspective, society itself is the issuer of the monetary base. From a legal perspective, government is the issuer of the monetary base. However, from an economic perspective, government is an empty shell: it is nothing more than a legal vehicle created by society in order to achieve the economic and social outcomes that society desires. The assets of that vehicle are, in truth, assets that belong to all of us: the bridges, airports and tanks owned by the government are assets of our society. Similarly, the liabilities of that vehicle are, at least from an economic perspective, liabilities of society.

An easier way to think about this issue is in the context of government debt. From a legal perspective, government debt is a liability of the government. However, from an economic perspective, government debt is more aptly considered as a liability of society. More specifically, government debt is a claim against the future output of society.

If you’re not convinced about this, then it is worth thinking about why US government debt attracts such a high credit rating. Investors in US government debt don’t feel safe because it is “backed by the full faith and credit of the US government”. Investors believe that US government debt is a low risk investment because it is backed by the future prospects of the US economy, one of the most stable and diversified economies in the world. Ultimately, it is society, through the political process, that chooses whether to honor this “government” debt, a debt that only has value because it is, in truth, a liability of society and a claim against the future output of society.

The point is that both government debt and the monetary base are liabilities of government in name only: they are, from an economic perspective, liabilities of society itself.

This raises the next obvious question: what does society produce that it can offer to a counterparty of such an agreement? Remember, every financial instrument represents some sort of quid pro quo: you give me something of economic benefit today and I will give you something of economic benefit tomorrow.

So what can our society offer as consideration for the liabilities it creates? The answer is future economic output.

At a high level, the only way our society can pay for public expenditures and projects is by sacrificing economic output. We can pay for public projects with current economic output (raising taxes today), or we can pay for these projects with future economic output. However, in order to pay for projects with future economic output, we need to create a legal vehicle (government) that can act as the issuer of liabilities that represent a claim on future output.

Once again, we need to think about the role of government (a legal entity) and its relationship to society (a non-legal entity). The view of The Money Enigma is that one of the key roles of government is to act as a legal entity that can both hold the assets of society and issue liabilities on behalf of society. (Society can’t hold assets and issue liabilities directly because it is not recognised as a legal entity).

However, in order for government to issue any meaningful liabilities (notably, government debt and money), government must be authorized by society to issue claims against the future economic output of society. This mechanism is illustrated in the diagram below.

As discussed, government debt is an indirect claim on future economic output (government debt represents a claim to future taxes that are, in turn, a claim on future economic output).

In contrast, money (the monetary base) represents a direct claim on future economic output.

In very simple terms, the Moneyholders’ Agreement promises the receiver of money that in return for their output today, they will be able to use the money they receive to claim some portion of the output generated by society in the future.

For example, let’s assume that our society wants to build a new bridge. Rather than fund this bridge by raising taxes today or raising taxes tomorrow (issuing government debt), society decides to simply issue more claims against its output (money). You, as a building contractor, accept this newly printed money, not because of its valuable physical properties, but because it represents a claim against the future output of society.

Frankly, this basic concept is fairly straightforward. The trick is deciphering the exact nature of the claim on future output.

In finance, there are two primary types of contractual entitlement: (1) “fixed” entitlements, and (2) “variable” or “proportional” entitlements.

A corporation can issue liabilities that represent either a fixed or variable entitlement to its future cash flow. A liability that represents a fixed entitlement to future cash flow is known as a financial liability or debt instrument. In contrast, a share of common stock, the most common form of equity instrument, provides its holder with a variable or proportional claim on a stream of future residual cash flows.

The view of The Money Enigma is that society faces similar options when it decides to fund current government expenditures through the issuance of liabilities.

Government debt represents, at least in principle, a fixed entitlement to future economic output. Clearly, this analogy isn’t perfect because government can debase the value of the currency in which the debt is repaid, but at least at a high level, it is a reasonable comparison.

In contrast, money (the monetary base) represents a variable or proportional entitlement to future economic output. In this sense, money is an equity instrument. (Technically, the Moneyholders’ Agreement is an equity instrument and possession of money makes the money holder party to this equity instrument.)

However, if money is an equity instrument, then money must be a special form of equity instrument. Most notably, it doesn’t entitle the holder to a stream of future economic benefits, but rather a slice of future economic benefits. Whereas a share of common stock entitles its holder to a stream of future cash flows, one dollar provides its holder with a proportional claim on output that can be used only once (you can only spend the dollar in your pocket once).

This fact impacts the next unusual feature of money: the proportion of output that one unit of money can claim seems to go up and down often in a manner that bears little or no relation to the number of claims on issue (the size of the monetary base).

We have seen a real-life example of this phenomenon recently. As the monetary base in the United States has increased fourfold, the proportion of US economic output that one dollar claims has not fallen by 75%.

The reason this is the case is because in a state of intertemporal equilibrium, the value of money must discount expectations regarding the long-term path of both real output and the monetary base.

Let’s assume that the Moneyholders’ Agreement states that the “in principle” proportion of output that one unit of the monetary base can claim at a future point in time is the expected “baseline proportion” for that given future period. Furthermore, the baseline proportion at that future point in time shall be determined with reference to the initial baseline proportion at the time the Moneyholders’ Agreement came into effect (the day the fiat currency was launched) adjusted for the increase/decrease in the size of the monetary base since that time.

Now, will the proportion of output that one unit of money can buy today (the “realized proportion”) be equal to the “in principle” proportion of output that the same unit of money should be able to buy today (the current “baseline proportion”)? The answer is “probably not”.

The reason for this is that the value of money today discounts a chain of future expected values.

As mentioned, we can only spend the dollar in our pocket once. Therefore, we need to choose when to spend the marginal dollar in our possession: we could spend it now, in six months, in six years, or in twenty years.

Part of this decision process involves calculating what the value of that dollar in pocket will be over time. For example, if we think the value of the dollar in our pocket is about will significantly over time, then we will prefer to spend it now.

The problem is that if everyone suddenly decides that the value of money will fall significantly at some point in the future, then the value of money will fall today. If everyone decides that the value of money will fall in the future, then more people will attempt to spend money today and fewer people will be willing to accept money in exchange for real goods/services at the going rate.

In economic terms, a state of intertemporal equilibrium is disrupted. The only way to restore intertemporal equilibrium is for the value of money to fall until it reaches the point where people are indifferent about spending the marginal unit of money today, in 6 months or in 20 years.

Expectations of the “Real Output/Monetary Base” Ratio Are Key

Now, let’s bring this back to the terms of the Moneyholders’ Agreement. As discussed, money represents a proportional claim on the future output of society. The Moneyholders’ Agreement allows us to calculate the in principle proportion of output that one unit of money can buy at any point in the future (the baseline proportion at launch of the fiat currency adjusted for any increase or decrease in the monetary base).

If the market suddenly decides that, for much of the next 20 years, output growth will be lower than expected and the monetary base will be higher than expected, then what happens to the current value of a proportional claim on future output?

Clearly, the current value of that claim must fall: there is less future output for each unit of the monetary base to claim and there will be more claims against that future output (the size of the monetary base will be higher than previously anticipated).

Even though there has been no change in current output or current levels of the monetary base, the value of money depends upon a chain of future expectations and, therefore, must reflect expectations regarding the long-term path of real output and the monetary base.

Conversely, the opposite could be true. As we have seen recently in the United States, the monetary base can be increased dramatically, with little or no impact on the value of money, if the increase in the monetary base is perceived to be “temporary”.

Money is a long-duration asset: its value depends upon expectations of the long-term (20-30 year) path of the “real output/base money” ratio. It matters little to the value of money if this ratio falls and is expected to remain low for a few years. What matters is the long-term path of this ratio.

In this sense, the value of fiat money provides us with a gauge of market confidence regarding the expected long-term economic prosperity of the nation that issued it. Presently, global markets remain optimistic about the long-term economic future of the major fiat currency nations (US, Japan, Europe). However, if this confidence is eroded, then the value of those fiat currencies will fall, increasing the risk of a return of high levels of inflation in those nations.

Proportional Claim Theory vs Quantity Theory of Money

Proportional Claim Theory (the theory espoused above) provides us with a useful explanation for why the quantity theory of money works over long periods of time, but not over short periods of time.

If money is a proportional claim on the future output of society, then one would expect that over long periods of time, if the monetary base grows at a rate far in excess of real output, then the value of money would fall significantly and the price level would rise significantly.

However, as discussed above, over short periods of time, changes in the current ratio of “real output/base money” has little impact on the value of money. Money is a long-duration asset. Therefore, in the short-term, fluctuations in the value of money are driven primarily by shifts in expectations regarding the long-term future path of real output and the monetary base. Therefore, over short periods of time, the price level is primarily driven by swings in these future expectations.

This idea can be expressed more clearly by developing a valuation model for fiat money. If we combine Proportional Claim Theory and the notion of intertemporal equilibrium, we can derive a valuation model or “discounted future benefits” model for fiat money.

The valuation model for fiat money suggest that the value of money depends on not just current level of real output and the monetary base (q and M above), but also on expectations regarding the long-term growth rate of real output (g) and the long-term growth rate of the monetary base (m).

Not surprisingly, the value of money is positively correlated to confidence in the economic future of society. If people believe that output growth (g) will be strong and that monetary base growth (m) will be constrained, then this supports the value of money. Conversely, if people become more pessimistic about the growth of output relative to money, then this will undermine the value of money.

If you are interested in reading more about this issue or exploring some of the ideas discussed above, then please download The Velocity Enigma, the third and final paper in The Enigma Series.