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