The previous post described the long phase-out of the gold standard. During the commodity money era we developed a dual medium of account (MOA), both gold and cash were MOAs. For there to be two media of account, the price of one in terms of the other must be fixed. Once gold prices started rising in 1968, only currency remained a medium of account; gold became a mere commodity. (Silver was demonetized in the 1800s.)
Why does fiat money have any value at all? This is actually two subtly different questions. First, what is the value to society of having a medium of account? And second, how can a fiat medium of account have value? The MOA generally serves as a medium of exchange, and to some extent a store of value. How valuable is an asset that fills those roles? A medium of exchange is probably worth something like 1% of GDP, and as a store of value the MOA is worth another 1% to 10% of GDP. How do we know this? Because MOA traditionally didn’t pay interest, and hence the net present value of foregone interest from holding the entire stock of cash is simply the currency stock itself. And currency stocks tend to be about 2% to 11% of GDP.
Thus if the nominal interest rate was 5%, and the currency stock was $1 trillion, then the (opportunity) cost of holding currency was $50 billion per year in foregone interest. That could be viewed as the flow of liquidity services provided by currency (unfortunately including the flow of tax evasion services.) If you divide this perpetual service flow by 5% to get its net present value, you get $1 trillion, which is the currency stock.
So what do people mean when they say that fiat money is “intrinsically worthless?” They mean it has no value if it loses the role of being the MOA, whereas gold and silver had significant value in other areas of life. (I.e. Confederate paper money after the Civil War.) So this begs the deeper question: Yes a monetary system is valuable, but what explains why this particular asset is accepted as money? What gives it value? There are several theories, which are not mutually exclusive:
1. Its nominal price is fixed (unlike T-bills), which makes it convenient in transactions. It comes in convenient small denominations (unlike T-bills). Private small denomination currency issue may be banned.
2. There is a sort of social contract/network effects/focal point thing going on. People accept it as money because others accept it as money.
3. There is an implied backing in an emergency. For instance, if technological change was expected to make cash obsolete in the year 2047, the public may believe (correctly in my view) that the government would redeem it for some sort of real asset, rather than allowing hyperinflation. One could think of this as the public having confidence that the government will do what is necessary to prevent hyperinflation in the future.
4. The government allows one to pay taxes with currency.
5. And in deference to Mike Sproul, because the cash is “backed” by assets on the central bank balance sheet. (I don’t think this one matters, but it’s arguably related to point 3.)
Obviously all 5 reasons may be true, and they may work together. It’s also worth discussing the peculiar evolution from gold-backed currency to fiat dollars. I own a 1928 $20 bill, which looks almost exactly like a 1995 $20 bill. Indeed pretty much like a just issued twenty, except Jackson’s portrait was smaller in the 20th century. But the 1928 and 1995 twenties were radically different. In 1928 the public viewed gold-backed currency as we would view personal checks; ”an interesting piece of paper–now let’s see if we can take it to the Treasury (or bank) and get some real money.” In 1928 “real money” was gold, whereas in 1990 we took a personal check to the bank to try to get “real money” in the form of cash. So the monetary system evolved one level, what was considered debt in 1928, is no longer viewed as debt. Cash is now the ultimate form of liquidity. Cash can’t be cashed into anything more liquid.
Under the modern gold standard people actually used relatively little gold for transactions, mostly preferring cash and small coins. So they got used to viewing cash as money. To an economist studying inflation, the 1968 decision to end gold’s role as a medium of account seemed momentous. But the public just yawned—they were already used to cash being the only MOA of relevance to their lives. Appearances are very important—if something is regarded as money, it’s money.
From that point on “the social contract/network effects” story was probably enough, but clearly other factors like implied backing/stable monetary policy are lurking in the background. If the public suddenly expected a policy of hyperinflation to be adopted in 2014, the value of cash would collapse right now.
This post has already run too long, so I’ll do the quantity theory of money in the next post. We’ll see how the central bank can control the value of money (and NGDP), by changing the currency stock.