A few comments on fiat money

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.



20 Responses to “A few comments on fiat money”

  1. Gravatar of 123 123
    27. October 2012 at 06:54

    Have you seen my discussion with Nick at Nick’s blog? Basically I argue that by burning bonds, you will make NGDP options more expensive, and NGDP more volatile, while still preserving the ability to control the long term trend path of NGDP.

  2. Gravatar of Morgan Warstler Morgan Warstler
    27. October 2012 at 07:17

    Woolsey makes the hegemony argument:

    “It seems to me that assuming that the demand for base money always grows at a constant rate and that people will put up with being exploited by the monopoly issuer forever is not reasonable.”

    Nick agrees.

    The hegemony wats a storehouse of value and they will get what they want.

  3. Gravatar of ssumner ssumner
    27. October 2012 at 07:21

    123, Suppose I write on a piece of paper “the bearer of the paper receives $1 trillion from Scott Sumner.” Then I light a match and burn the paper. How does burning that piece of paper change my life?

  4. Gravatar of W. Peden W. Peden
    27. October 2012 at 08:19

    Anent nothing in particular, I got the first Market Monetarist letter ever published in the Scotsman (a major newspaper in Scotland) today-

    “George Kerevan (Perspective, 26 October) writes that monetary stimulus from the Bank of England would reduce debt via inflation, while more public spending would “kick-start” the economy. He neglects both the possible impact of fiscal stimulus on inflation and the impact of monetary stimulus on growth. Yet both policies are supposed to work in the same way: by boosting spending. Monetary stimulus boosts non-government spending. Why should spending cause growth if it is done by politicians, but raise prices if it is done by ordinary people?”

    Socratic method rules.

  5. Gravatar of Bob Murphy Bob Murphy
    27. October 2012 at 09:05

    The US federal government is the Ebay of the US currency market.

    Yes, if Ebay had once upon a time used prison sentences and $10,000 fines against anybody using a competitor.

  6. Gravatar of Mike Sproul Mike Sproul
    27. October 2012 at 09:16

    “”network effects”, and “expectation of future real backing” and “can be used to pay taxes.” All are true”

    I’m OK with future real backing, and usefulness for paying taxes (in the sense that ‘taxes receivable’ are an asset to the government).

    Network effects and “makes shopping more convenient” are on a different footing. The creation of any rival money (checking accounts, credit cards, gift certificates, travelers’ checks, foreign currency, etc) will reduce the demand created by those liquidity and network effects. This leads to the weird proposition that the issuers of these rival moneys have the same effect on the price level as counterfeiters. Central banks should thus be screaming bloody murder at the creation of checking accounts and credit cards, but of course they aren’t.

    I conclude that the value of money is determined by backing only, just like the value of stocks, bonds, options, and every other financial security. No special theory of money is required.

  7. Gravatar of Negation of Ideology Negation of Ideology
    27. October 2012 at 09:27

    I agree with everything said in the post. I just don’t understand why this concept is so difficult. U.S. dollars have value for the same reason any other security has value. If a Canadian tire store can print money, why can’t the US government?


    There’s nothing magical about it. If Wal-Mart started printing notes, or issuing gift cards and paid suppliers with them, they would have value to the extent people wanted to and could use them to do business with Wal-Mart. If large numbers of people found them useful, they might use them in third party transactions, giving them more value. Then as the network grew, they would have more value. In effect, the number of notes, cards outstanding would be interest free credit for Wal-Mart.

    The federal government is the only thing in a nation that everyone has in common, therefore it has the largest network effect. In our country, states use the federal currency. So everyone knows that anywhere in the country, the US Dollar will be accepted. It makes no difference if it’s paper or electronic. The dollar is “backed” by whatever assets the federal government bought with those assets, usually bonds backed by future taxes, which have to be paid with the same dollars that were issued in the first place. So they are “backed” by all the assets in the entire country, or the desire of people to live, own property or do business anywhere in the United States.

  8. Gravatar of Saturos Saturos
    27. October 2012 at 10:00

    Scott you have to be here: http://www.cato.org/events/monconf2012/index.html

    W. Peden, good stuff mate!

  9. Gravatar of Saturos Saturos
    27. October 2012 at 10:24

    Finally – we know who you are, MF: http://www.theatlantic.com/international/archive/2012/10/ai-wei-weis-interview-with-the-chinese-digital-thought-police/264163/

    You’ve been sent by the Chinese government to discredit libertarianism!

  10. Gravatar of ssumner ssumner
    27. October 2012 at 11:18

    W. Peden. Excellent!

    Bob, No, companies like bitcoin are free to compete.

    Mike, You said;

    “This leads to the weird proposition that the issuers of these rival moneys have the same effect on the price level as counterfeiters. Central banks should thus be screaming bloody murder at the creation of checking accounts and credit cards, but of course they aren’t.”

    But these aren’t the competitors, bitcoins is. The products you cite are completely different products, not currency. So what if they steal away a bit of seigniorage by being close substitutes, it’s trivial in the general scheme of things. During the 1980s credit cards were way more popular in the US then in Germany and Japan, and hence we had a lower currency ratio. The Federal government doesn’t care, even thoiugh they earned less seigniorage. Just as they don’t like drug smugglers, even though drug smugglers add to seignorage.

    If the Federal government’s goal was more revenue, why did the Bush adminstration cut taxes in 2001 and 2003?

    You said;

    “No special theory of money is required.”

    I agree that no special theory is needed.

    Saturos, I’d be the skunk in the room. In any case I have a job. I couldn’t go if I wanted to.

  11. Gravatar of Major_Freedom Major_Freedom
    27. October 2012 at 12:33


    Bob, No, companies like bitcoin are free to compete.

    No, they are not. In most jurisdictions, the tax authorities require income earned in bitcoins to be reported as taxable income, and the tax authorities do not accept bitcoins, but dollars. Since they require taxes in dollars, those who are earning bitcoins are coerced right back into the dollar exchange standard, because they have to go out of their way to acquire dollars from others somehow.

    That is not bitcoins competing with US dollars AS MONEY. In this situation, bitcoins remain more of a barter commodity, taxable in dollars.

    It would be like eBay threatening people with being thrown into a cage if they don’t pay eBay 35% of their incomes in “eBay dollars”, even if they only deal in US dollars or bitcoins. The, some eBay apologist asserts that you are still “free to compete with eBay dollars”. Uh, no they are not.

    Maybe the problem here is cognitive dissonance, but you don’t seem to realize the pure naked aggression that ultimately backstops the fiat dollar banking cartel.

    To respond to your numbered points above:

    (1) Agreed.

    (2) Actually, if the state refrains from imposing the “taxation in fiat dollars only” law, and refrains from imposing the “settling of legal disputes in fiat dollars only” law, then the ultimate backstop of why people are even using fiat dollars to settle their exchanges would be eliminated. The “network effect” and “expectation of future real backing” may temporarily prolong the fiat dollar cartel system, but as more and more people realize that gold and silver retain their value much better than fiat dollars, at some point, it is almost a certainty that they would eventually dominate as universal mediums of exchange. Seeing as how you are a “pragmatic libertarian”, why not advocate for legalization, true legalization, of competing currencies? Let people earn bitcoins or gold if they want and cease taxing them in dollars. Let’s see just how “valuable” those fiat pieces of toilet paper really are when individuals are free to value them without threats.

    (3) Yes, people born in a coercive society would have, at first, a difficult time imagining a non-cartel money. But we have innovative and intelligent entrepreneurs who can lead the way economically, and we also have economists, who can lead the way intellectually. You don’t WANT people to stay ignorant about money so as to protect your life’s work in fiat money political strategizing, do you?

    (4) It would do you good to start understanding value as an individual action centered phenomenon, rather than as a GDP or some other aggregate centered phenomenon. Ths is because methodological individualism is the only way to truly understand economics, indeed every social science. Yes, I realize this would require a complete philosophical overhaul for someone who is probably far too set in their worldview, but it’s never too late.

    Last point:

    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.

    It also makes justifying market monetarism more convenient.

    Actually there is an incredibly important need for a theory on why fiat money has value. It can allow one to learn how it affects economic calculation, relative demands and prices, and thus productive relations and real capital investments, and many other economic phenomena. It can also allow one to learn why cotton and linen, and electrons, have come to be the universal medium of exchange rather than more valuable commodities. On the ethical side, it can allow one to learn that fiat money is based on nothing but naked aggression from those who can initiate force with impunity. This latter fact is highly inconvenient for market monetarists and all other inflationists like Keynesians and orthodox monetarists, and is my guess on why this aspect of our monetary system is never addressed on this blog, and why when people like me bring it up, we are attacked as ideologues and other name calling.

  12. Gravatar of Major_Freedom Major_Freedom
    27. October 2012 at 12:41

    For information on how bitcoins are taxed in dollars, and thus why bitcoins are actually NOT “free to compete” with dollars, see this article.

  13. Gravatar of 123 123
    27. October 2012 at 13:05

    Scott:”Suppose I write on a piece of paper “the bearer of the paper receives $1 trillion from Scott Sumner.” Then I light a match and burn the paper. How does burning that piece of paper change my life?”

    Scott, while I agree with your convenience value view, and while I agree that the Fed could peg the NGDP futures market even if all the bonds were burned, I am sure that bonds make a difference during a financial crisis.

    Suppose there is a “real” financial crisis, where NGDP market ensures NGDP expectations are on target, but the price of NGDP options skyrockets, as the probability of two opposite scenarios of 3% undershooting NGDP and 3% overshooting NGDP is increasing at the same time. If the Fed has a strong balance sheet, it could drive down the price of NGDP options by intervening in this market. If it has a weak balance sheet, we could see a repeat of September 2008 when Bernanke and Paulson argued who should bear the burden of fighting the market volatility.

  14. Gravatar of Mike Sproul Mike Sproul
    27. October 2012 at 17:14

    “So what if they steal away a bit of seigniorage by being close substitutes”

    Whether the effect is small or big, it’s still weird. Nobody thinks that the issuance of call options on GM stock causes any depreciation of GM stock, and we all agree it would be a topsy-turvy world if calls diluted the value of GM stock. But checking account dollars are a call option on green paper dollars (with a strike of 0 and no expiration date) and quantity theorists think that they have an actual dilution effect on the value of the green paper dollars.

  15. Gravatar of Saturos Saturos
    27. October 2012 at 23:35

    Scott, damn, there goes my fantasy. Can’t you get a special “saving the world” leave of absence? (I imagine the Daily Planet would have offered much more flexible work-schedules if they knew what Kent’s second job was…)

  16. Gravatar of Saturos Saturos
    27. October 2012 at 23:36

    Maybe Bill or David could go instead? Hang on, I’ll ask them.

  17. Gravatar of ssumner ssumner
    28. October 2012 at 06:19

    123, I suppose one can construct scenarios where it matters, but they seem a real stretch.

    Mike, It’s because I completely reject the analogy using stocks. Currency is nothing like stocks, it’s more like paper gold.

    In a country w/o corruption (tax evasion) a currency stock is valued at 1% to 2% of GDP, for transactional purposes. If you increase the nominal stock 20 fold via OMPs it’s still going to be valued at about 1% or 2% of GDP.

    Obviously in this example I’m assuming we aren’t at the zero bound. Take a country with a trend inflation rate of 10%, and then do a once and for all 20 fold rise in the currency stock, and then return to the 10% trend inflation. You’ll have a once and for all 20-fold rise in the price level, even if the new currency injections are fully back by bonds.

  18. Gravatar of Mike Sproul Mike Sproul
    28. October 2012 at 14:51


    If the central bank increases money 20x, and if the money starts to drop in value from (say) 1 oz/$ to .99 oz./$, then IF the central bank has an open channel of reflux where people can get assets worth 1.0 oz, then the all the dollars will reflux to the central bank. If the central bank has no such channel of reflux, then the dollar will keep falling until some channel opens up, perhaps at 1/20 of the old value. If no channel of reflux every opened (or was expected to open) then the dollar would fall to zero.

    Failure to accept refluxing dollars=loss of backing.

  19. Gravatar of ssumner ssumner
    30. October 2012 at 05:55

    Mike, But I’m talking about fiat money regimes, where there is no promise to redeem money for a fixed amount of anything. I thought you claimed that OMPs were not inflationary because the new money was backed, but helicopter drops were inflationary because the new money was not backed. I’m claiming that even if the central bank has lots of bonds on it’s balance sheet, you’ll still get high inflation because the central bank might choose not to take back the money it injected, but rather let the price level rise. It has the backing, but chooses not to use it. If you agree on that point then I’m not sure what we are debating.

  20. Gravatar of Mike Sproul Mike Sproul
    30. October 2012 at 06:55

    Scott: If the bank has the backing but chooses not to use it (now or ever) then that is tantamount to dumping the assets in the ocean. We agree on that. We also agree on OMP’s and helicopter drops. So what’s left for us to argue about? For one thing, I’d say that if the bank loses half its assets without any change in the quantity of money it has issued, then its money will lose half its value. I think you’d say that the value of the money would not change.

    Also, am I right in thinking you agree that IF the bank always stands ready to buy back its money for 1 oz, (or something of equivalent value), and IF the bank’s assets are enough to act on that promise, then no amount of money issuance by that bank or other banks will change the value of the dollar from 1 oz/$?

Leave a Reply