Nick Rowe has a very good post on the observational equivalence of fundamental and bubble theories of money. I think he’s right. I’d like to discuss a few tangential issues that have come up:
1. It’s doubtful that a central bank could promise to go bankrupt by burning bonds. The Fed is viewed as an arm of the Federal Government, even more so than the GSEs. And everyone knew the GSEs were backed by the Treasury. If the Fed burns a trillion in T-bonds, there is no effect on the consolidated Federal balance sheet (as the loss to the Fed is exactly offset by the gain to the Treasury.)
2. It’s very hard to discriminate between theories of the value of fiat money such as “network effects”, and “expectation of future real backing” and “can be used to pay taxes.” All are true, and if you remove any one of the three the others will be enough to give fiat money purchasing power.
3. The political reality in the US is that the public does regard currency as a Federal Government liability (but not as a Fed liability.) Most people assume that if a technological development suddenly made currency obsolete, the currency stock would be cashed in for something of value, like gold or bonds. And they’d probably be right (obviously about bonds, not gold.)
3. My preferred way of thinking about the value of fiat money is that a combination medium of account/exchange has great convenience value. This gives a currency stock a value of roughly 1% to 2% of GDP. The actual ratio is higher than 2% in most countries, as additional currency is held for purposes of tax evasion. Network effects assure that there is likely to be a single dominant medium of account/exchange, and recently this has been monopolized by governments. The US federal government is the Ebay of the US currency market. It doesn’t ban bitcoins, but (like Ebay) it doesn’t quake in its boots about the competition.
And I agree with Josh Hendrickson that the existence of a very small probability of currency becoming technologically obsolete each year is not enough to dislodge currency from its dominant role as the medium of exchange (and facilitator of tax cheating), as the convenience factor is so powerful. Think of domestic currencies that continued to be widely used in Latin America despite decades of high inflation that fell just short of hyperinflation. For the same reason that people will pay a service charge to use ATMs, they accept a 1% or 2% loss in purchasing power between the time that they receive a currency note and the time they spend it a few weeks later. The probability of currency losing its dominant position in facilitating exchange during any given year is much smaller than ATM fees and purchasing power loss costs, which we know with 100% certainty that consumers are willing to accept.
There’s no need for a special theory of why fiat money has purchasing power. It has purchasing power for the same reason that wallets have value—it makes shopping more convenient.
Some have argued that destroying the central bank balance sheet is a credible way to inflate. But as I pointed out in this post, it’s easier for the central bank to simply say it plans to inflate.