The Paradox of Fiat Money

Hal Varian is a very, very smart economist, now Professor emeritus at UC Berkeley, and chief economist at Google.  For a number of years, he used to write a monthly column for the New York Times.  In a January 2004 column, he posed the question “Why Is that Dollar in Your Wallet Worth Anything?.”  The first answer he considered was the one in which most lay people probably believe:  that the government makes it worth something by declaring it legal tender.  The problem with that answer, Varian observed, is that whatever the government says, nothing prevents people who want to from using something other than dollars to execute the transactions or discharge their debts.  If people didn’t find it in their own best interest to transact in dollars, all the legal tender laws in the world couldn’t force them to keep making transactions in dollars.

Varian therefore proposed another explanation, suggesting that people accept fiat money out of social convention.  In other words, the expectation that people will accept payment in dollars creates mutually reinforcing expectations, what we now call a network effect, that induce others to adopt the same expectation.  Writing in the aftermath of the US invasion of Iraq, Varian cited the experience of Kurdistan, which, having achieved de facto autonomy from Iraq after the first Gulf war, continued using the old Iraqi dinar as its local currency even after Saddam Hussein introduced a new currency that became the legal and the customary currency in the non-Kurdish part of Iraq remaining under Saddam’s effective control until the US invaded in March 2003.

That column elicited a response from Frank Shostak in the Mises Daily, a web-based publication of the Ludwig von Mises Institute at Auburn University.  Shostak made a powerful objection to Varian’s explanation of the value of fiat money.

And yet that still doesn’t tell us why the dollar bill in our pocket has value. To say that the value of money is on account of social convention is to say very little. In fact, what Varian has told us is that money has value because it is accepted, and why is it accepted? . . . because it is accepted! Obviously this is not a good explanation of why money has value.

To bolster his thesis Varian suggests that the value of the dollar is a result of the “network effect.” According to him, “Just as a fax machine is valuable to you only if lots of other people you correspond with also have fax machines, a currency is valuable to you only if a lot of people you transact with are willing to accept it as payment.”

Shostak tried a different tack, invoking the famed (well, famed, at any rate among the hard-core of the Austrian School) Regression Theorem of Ludwig von Mises, the most venerated, and most authoritative figure in the pantheon of Austrian economics.  (Many outsiders erroneously assume that F. A. Hayek is the leading figure in twentieth century Austrian economics, but among insiders, Hayek is viewed with less than unequivocal admiration for having appropriated Mises’s earlier insights in business-cycle theory, for his willingness to adopt the terminology and methods of mainstream economic theory in his exposition of Mises’s theory, for his subsequent recantation of his early opposition to any form of countercyclical policy by the monetary authority, and, more generally, an insufficiently rigorous opposition to all forms of interventionist economic policies.) 

According to the Regression Theorem, the demand for any money, i.e., an asset demanded because it is accepted in exchange, not for any direct services that it provides, is contingent on its previous value.  Thus, the value of any medium of exchange must have been derived from its value as a commodity before anyone ever accepted it as a medium of exchange.  The Regression Theorem traces back the demand for every medium of exchange to some earlier time when it had value strictly as a commodity, not as a medium of exchange.  But then, how does one explain the value of a fiat money which provides no real services and never did provide any real services that made it valuable in its own right?  The Regression Theorem asserts (some theorem!  But despite his extravagant claims to have created a purely deductive, apodictically certain, theory of human action, Mises did not overly concern himself with the logical rigor of his “proofs”) that every fiat money must, at some point, have been convertible into a real asset to have become valuable in the first place.  Only then, having acquired value through its convertibility into a real asset, usually gold or silver, could the money retain any value after the link to a real asset with commodity value was severed.

More problematic than the failure of the Regression Theorem to provide a valid deductive argument for a historical conjecture about the origins of fiat money is that the Regression Theorem completely misses the point of the whole exercise.   The difficult question, for which Varian struggled to find an answer, is why a fiat money, regardless of why it might once have had value, can retain any value.  The Regression Theorem, as its name attests, is backward-looking.  But economic problems, as Austrian economics to its credit usually recognizes, are forward-looking.  Whether a fiat money once had value is irrelevant to an understanding of why and how it retains value. 

Why should a fiat money not be able to retain value?  Well, consider the following thought experiment.  For a pure medium of exchange, a fiat money, to have value, there must be an expectation that it will be accepted in exchange by someone else.  Without that expectation, a fiat money could not, by definition, have value.  But at some point, before the world comes to its end, it will be clear that there will be no one who will accept the money because there will be no one left with whom to exchange it.  But if it is clear that at some time in the future, no one will accept fiat money and will then lose its value, a logical process of backward induction implies that it must lose its value now.

I first heard this backward induction argument from Earl Thompson in his graduate macroeconomics course at UCLA (in those days both Axel Leijonhufvud and Earl Thompson taught graduate macro, and having taken Axel’s course for credit in my first year, I audited Earl’s course in my second year).  To say that not everyone was willing to accept the backward induction proof that fiat money must be worthless would be an understatement, and for a long time, I, too, tried to resist.  But eventually, I had to yield to the force of logic that seemed compelling. 

Since I have found that the backward induction argument rarely convinces anyone that fiat money can’t have value, perhaps I should try to explain the process that led me to accept it despite my initial qualms.  While still an undergraduate at UCLA, I took Ben Klein’s course in money and banking.  Ben had just arrived at UCLA, Ph. D. not quite in hand, from the University of Chicago.  His dissertation on the Competitive Supply of Money (a portion of which was published under that title in the Journal of Money Credit and Banking) made a historic breakthrough in modeling the behavior of banks in terms of the standard theory of the firm, instead of the usual ad hoc derivation of the money multiplier, disproving in the process, Milton Friedman’s oft-made assertion that free competition in the supply of money would force the value of money down to its zero marginal cost of production.  Ben pointed out that the argument works only if banks produce indistinguishable monies and are forced to redeem each other’s monies at par.  Rather than competing to increase the amount of money they issued, banks would compete to increase the demand to hold their monies by paying interest to depositors.  Ben started a theoretical revolution in the analysis of banks and the money supply, unfortunately still not fully incorporated into modern money and banking theory.

As yet unknown to me, Earl Thompson had also developed a similar theory of a competitive money supply, except that in Earl’s model bank money was convertible into a real asset, gold.  The theoretical difference between Ben’s model and Earl’s model was that Earl argued that only through convertibility into a real asset could a private bank make its money valuable while Ben held that, even without a convertibility commitment, a bank could invest in brand name capital by incurring sunk costs that would be forfeited should it later depreciate its money. 

So there the argument stood until the spring quarter of my second year as a graduate student, when I took Armen Alchian’s seminar in applied price theory.  The seminar involved Armen discussing some current event or issue in the news or some problem for a journal article, working the problem out with us by applying the logic of economic theory.  I have never seen another economist who, using only chalk and a blackboard and elementary economic theory, could provide such a deep and empirically meaningful analysis of any problem that he put his mind to.  One of the papers that we discussed in Armen’s seminar was Ronald Coase’s paper “Durability and Monopoly” which had just been, or was about to be, published in the Journal of Law and Economics

Coase posited a monopolist over a durable good, and asked the question: what price can the monopolist charge for the good.  The surprising answer that Coase arrived at was:  the competitive price.  And the reason was that if the monopolist tried to set the price any higher, then no one would buy the good, because each prospective purchaser would assume that after selling as much as he could sell at the monopoly price, the monopolist would then try to sell additional units of the good at a lower price inasmuch as the incremental sales at that price would still exceed the incremental cost.  And after selling as much as he could at the lower price, the monopolist would have an incentive to cut price yet again to sell additional units, selling the last unit at a price equal to marginal cost.  Anticipating that the monopolist would eventually sell at a price equal to marginal cost, no purchaser would be willing to pay more than marginal cost in the first place.  After going through that argument, Coase then reasoned that to avoid having to sell at a price equal to marginal cost, the monopolist could offer either to rent rather than sell the durable good, or, alternatively, could offer to sell the durable good with a buy-back option if the price were reduced below the initial selling price.  Either way, a renter or a purchaser would be protected against a capital loss on his purchase in case of opportunistic sales by the monopolist.

At some point, I had a eureka moment realizing that Coase’s argument was simply an informal version of the backward induction argument for the worthlessness of fiat money that Earl Thompson had used.  So, after Armen’s seminar one day, I suggested to him that if Coase’s reasoning about durability and monopoly was right, Ben Klein’s argument that investments in brand name capital would enable a competitive supplier of money to maintain a positive value for its money, even without convertibility, could not be right.  I don’t know if Armen had already seen the connection, but he responded that Klein had also discussed a case in which competing money suppliers made their moneys convertible into what Ben called a “dominant” money.  The motivation for that case, it now seems to me, had more to do with a recognition of what would now be called the network effects of a single monetary standard than with the logic of backward induction or Coase’s durability and monopoly argument, but Alchian’s response persuaded me that the backward induction argument was more than an application of esoteric and possibly dubious game-theoretic reasoning, but was well grounded in basic price theory. 

So if the argument that fiat money is worthless is as strong as I believe it to be, how does one answer Hal Varian’s question why is a dollar worth anything?  There are two possibilities.  First, the real world could be less rational than pure economic logic would suggest.  I no longer would dismiss this possibility out of hand, as I once did.  But we should at least recognize that a positive value for fiat money may involve an element of irrationality.  A positive value for fiat money may be no less a bubble than tulips in 17th century Holland, or houses in 21st century America.  People may be accepting money in the false expectation that they will always be able to find some other sucker willing to accept it.  If so, everyone will eventually realize what’s going on, and the game will be over.

The other possibility, the one proposed by Earl Thompson, is that fiat money actually does provide a real service, which is that governments accept it as payment to discharge tax liability.  By making fiat money acceptable as payment for taxes, the government ensures that there is another source of demand for money aside from its use as a means of exchange for private transactions, which is all that is necessary to avoid the backward induction argument.  That the US government accepts other currencies than the dollar in payment of the taxes that it imposes does not mean that there is zero demand to hold dollars with which to discharge tax liability.  Similarly, just because most people hold money for reasons other than paying taxes does not prove that acceptability in payment of taxes is not a necessary condition for dollars to have positive exchange value.  Under a gold standard, most people did not hold gold for the real services it provided.  But without those real services, gold could not have rendered any services as a medium of exchange.

Earl Thompson wasn’t the first economist to offer this explanation for the value of a fiat currency.  Abba Lerner suggested it in the 1940s.  But the most famous source is the German economist G. F. Knapp in his State Theory of Money.  This doctrine was dubbed by Keynes as chartalism.  I believe that at least some of the bad press that chartalism has gotten over the years is due to the hostile and dismissive treatment Knapp’s theory received at the hands of Ludwig von Mises in his Theory of Money and Credit, which grossly misrepresented what Knapp was trying to say.  Offering few specifics, Mises heaped scorn on Knapp’s work, unjustly accusing Knapp of a complete lack of understanding of economic theory.  However, 15 years before the State Theory of Money was published, P. H. Wicksteed, in his magnificent Common Sense of Political Economy (1910), the most elegant and most comprehensive verbal presentation of neoclassical economic theory ever written, a work subsequently embraced by Austrian economists as one of their own despite the lack of any interaction between Wicksteed and the Austrian economists, based his explanation of why inconvertible paper money had a positive value squarely on its being made acceptable by the government for the payment of taxes (volume 2, pp. 618-22).  So any notion that chartalism is at odds with orthodox economic theory, as Mises alleged, is utterly unfounded.

Recently Scott Sumner has been engaged in some pretty acrimonious debates about whether the Fed or central banks in general have the power to control the price level with supporters of what is called Modern Monetary Theory.  One of the main tenets is of Modern Monetary Theory is chartalism.  On my, possibly biased, reading of those debates, I think that Scott has gotten the better of those exchanges.  But it seems to me that the opinion one has about why fiat money has positive value is independent of whether one thinks that central banks really can control the price level.  Perhaps I will have more to say about that in a future posting.


75 Responses to “The Paradox of Fiat Money”

  1. 1 Luis H Arroyo July 25, 2011 at 4:02 am

    “But it seems to me that the opinion one has about why fiat money has positive value is independent of whether one thinks that central banks really can control the price level. ”


  2. 2 Lars Christensen July 25, 2011 at 9:07 am

    Excellent! The introduction to Earl Thompson is a real eye-opener for me.


  3. 3 Anonymous Coward July 25, 2011 at 9:58 am

    That you accept it because you expect people to accept it is a fixed point and an equilibrium and therefore a fine explanation of why people accept it. It is silent, though, on how this state of affairs came about, but it might not be productive to worry about how equilibria come about in general.

    What about Townsend’s turnpike or Wright’s work or Wallace’s? Surely on the topic of money they deserve strictly more space than someone like Mises.


  4. 4 Luis H Arroyo July 25, 2011 at 12:46 pm

    Very good post, David, but I need some times to assimilate the consequences.
    My wowww was of enthusiam.


  5. 5 anon July 25, 2011 at 12:51 pm

    Why can’t the fiat money simply be valued as a liability of the central bank? The monetary authority is expected to preserve the value of money by buying money back if necessary in exchange for independently valuable assets (gold, foreign exchange, mortgage securities etc.). As long as this expectation holds (essentially due to istitutional factors), I don’t see where the problem is. What am I missing here?


  6. 6 Benjamin Cole July 25, 2011 at 2:40 pm

    Crickey-Almighy. The Fed is choking the American economy. Blog about that.

    Okay, on topic, consider what happens to money in most regime changes. At the end of the U.S. Civil War, the Confederate paper became worthless.

    When paper money has value it is because most human beings did not go to the Austrian School, and they understand that wealth is created by labor and management.

    I can create wealth by perfectly counterfeiting U.S. money and hiring an unemployed person to build furniture. Wealth is created out of thin air–by labor and management working on natural resources, such as farms, wood, etc.

    Paper money gives you a claim on output–agreed to by social convention by other members of your society. If we do not print too much of the stuff, then you don;t get too-high inflation, Moderate inflation is actually a positive, due to stocky prices and wages, and also I think gives lenders and borrowers some Dutch courage. Optimism is also necessary for an economy.

    Side question: Do members of the Austrian School suffer from involuntary arm spasms when martial music is played?


  7. 7 Scott Sumner July 25, 2011 at 10:59 pm

    David, Very enjoyable essay. I’d like to give an alternative explanation to taxes, (although the difference may be more a matter of appearance than reality.)

    Perhaps people believe that there is an implicit promise to convert currency into some other real good or financial asset, should the time come when currency is not needed. I’ll go further and forecast than between 50 and 100 years from now all US currency will be removed from circulation, and replaced with electronic money. When that time comes the currency will be redeemed for fair value, and hence people need not fear for the value of currency. The euro is a good precedent for this, the holders of marks, francs, etc, were treated fairly, that’s how modern states work. So I don’t think currency holders need fear a zero value at the terminal date, and that’s true regardless of whether currency can be used to pay taxes.


  8. 8 Greg Ransom July 26, 2011 at 2:41 am

    My understanding is that this is factually false. They can and do block you — as a matter of law — from using all sorts of alternative means of exchange. No one is bound by a valid contract to accept Pesos, gold, etc. They are bound by law to accept dollars.

    “The problem with that answer, Varian observed, is that whatever the government says, nothing prevents people who want to from using something other than dollars to execute the transactions or discharge their debts.”

    Correctly me if I’m wrong — and send to the appropriate legal decisions.


  9. 9 Greg Ransom July 26, 2011 at 2:44 am

    David, I’ve got to have dollars to pay for a marriage license, to pay for parking tickets, to pay my car taxes, to pay my dog license fee, to pay my property taxes, etc., etc.

    I have a demand for dollars because the various governments are constantly demanding dollars from me.

    It this is a reliable and powerful demand that never goes away and can always be counted on to be worth my while to have a stock of dollars on hand.


  10. 10 Greg Ransom July 26, 2011 at 2:48 am

    Economics doesn’t provide deductive arguments. It provides a contingent causal mechanism — learning in the context of changing local knowledge & virtuous self-reinforcing feedback loops.

    Menger provided a contingent causal mechanism — a learning mechanism — which could explain the spontaneous origin of a common mean of exchange.

    And historians seem to bear out this explanation as not only a possible & plausible likely causal explanation.

    But as the actual explanation.


  11. 11 Greg Ransom July 26, 2011 at 2:52 am

    If wrote the taxes thing before I’d finished your post.

    Looks like I’m an Earl Thompson & Abba Lerner man.

    I’ve been making that taxes argument for years — to bird chirps from the economics “scientists”.

    Glad to hear someone finally say this:

    “any notion that chartalism is at odds with orthodox economic theory, as Mises alleged, is utterly unfounded”


  12. 12 JP Koning July 26, 2011 at 10:27 am

    “The other possibility, the one proposed by Earl Thompson, is that fiat money actually does provide a real service, which is that governments accept it as payment to discharge tax liability. By making fiat money acceptable as payment for taxes, the government ensures that there is another source of demand for money aside from its use a means of exchange for private transactions, which is all that is necessary to avoid the backward induction argument.”

    Excellent post. A pleasure to read so many viewpoints from economists across the ages.

    I don’t think that the use of money to pay taxes can be qualified as a *real service*. Discharging a tax bill with fiat money is no more unique than my phone company sending me a bill at the end of the month, a liability I can discharge with fiat money. In other words, the acceptance by the government of fiat money is just one of the millions of sources of demand for fiat money as a means of exchange, no more unique than any other.

    If my phone company’s demand for fiat money isn’t enough to avoid the backward induction argument that you have proposed, I don’t see how the government’s demand for fiat money can solve the backwards induction argument.

    Put differently, if the government’s acceptance of fiat money to discharge a tax liability conveys on money some sort of *real service*, and an escape from the backwards induction argument, then my phone company’s acceptance of money to discharge a phone liability conveys the very same service, and also an escape from the backwards induction argument.


  13. 13 jamesoswald July 26, 2011 at 10:54 am

    I agree! I look forward to seeing the reasoning behind it. If fiat money can’t have positive value, how can the price level be anything other than infinite? If it can have positive value, surely having control of the quanitity pegs the price level down, at least in the long run.


  14. 14 jamesoswald July 26, 2011 at 11:06 am

    All scarce resources have alternative uses. If we use gold for money, we can’t use it for jewelery or circuit boards or anything else. Fiat money’s opportunity cost is near 0. This is why we don’t use steel money. Not because steel has no value; precisely the opposite. The opportunity cost of using steel for money is too high.

    Menger’s explaination is good for an origin of money story, but to understand why the backing of money declines over time, you need to understand that scarce resources are sacrificed in any system except fiat. Why have money that has both “exchange value” and “use value” when you can split them into two goods and use them both ways?


  15. 15 David Glasner July 26, 2011 at 11:21 am

    Luis and Lars, Thanks for your kind comments.

    Anonymous Coward, I think that I agree with your fixed-point proof. The question is whether the expectation that fiat money will perpetually have value can be a fixed point when it must lose value in the last period and backward induction forces the value to zero in every preceding period. So I am not sure if we are in agreement or not. I must admit that I have little more than a nodding acquaintance with Wright’s work and almost none with Townsend’s. I’ve read a few of Wallace’s papers on legal restrictions theories and a fair amount of his work with Sargent. Are the legal restrictions papers what you are referring to? I am not going to argue that Mises is more or less important than these guys, but for better or for worse my comparative advantage lies with Mises, so that’s why I talk about him more than about them.

    Anon, I agree that fiat money is the liability of the central bank. The question is what economic argument explains why the liability is considered valuable when there is a seemingly compelling argument that it must ultimately lose its value and it provides no services apart from having whatever value it has. You seem to be suggesting that the monetary authority can impart value to its money some sort of promise to buy back (redeem) its liabilities if they depreciate. That sounds to me like some sort of convertibility commitment, which I think we all agree does explain how non-commodity money could have positive value.

    Benjamin, Thanks for your input about what to blog about. You are a lively and passionate commentor which helps make for a successful blog, so believe me that I don’t discount what you say at all. However, if this blog has had any success at all, it is because I have been writing about what interests me, so you will probably have to keep putting up with posts on topics that are interesting enough to me so that I am willing to make the effort (and it is an effort) to write about them. Also, I am far from being an uncritical follower of the Austrian School. However, you may inadvertently have crossed a line in your probably facetious remark about Austrian economists and martial music. Please forgive me if I didn’t get it the joke.

    Scott, Thanks for the comment. I’m sorry, but I don’t see how your suggestion gets us anywhere. Why is exchanging currency for a balance in an electronic account any different from exchanging a five dollar bill for five singles? Electronic balances seem to me to be just as problematic as paper currency.

    Greg, You may be right that there really are laws preventing transactions using other media than dollars. Nevertheless, I doubt that those laws can really account for the almost universal use of dollars. There are plenty of people that transact using dollars even though they could easily and legally transact in another currency. Do laws requiring the use of English in various legal or social situations really account for the extent to which English is spoken not just in the US but all over the world by people who are not native English speakers?

    I agree entirely with your point about governments demanding money from you and allowing you to satisfy that demand by turning over dollars.

    About a contingent causal mechanism, I am afraid that I am going to dodge your invitation to discuss that as a general explanatory strategy. However, my recollection of Mises is that he explicitly describes praxeology (the science of human action) as a purely deductive science, so I don’t think that I was mischaracterizing Mises’s conception of what he thought he was doing.

    Glad to hear that you are a Thompson and Lerner man. That will really solidify your position among your Austrian pals.


  16. 16 David Glasner July 26, 2011 at 12:05 pm

    JP, Thanks for the compliment. I see your point about acceptability in terms of payment not being unique to a government. That’s true, but it only works for the entity that is issuing the currency. The phone company has not incentive to accept a money just to give it value. On the contrary it would be pretty stupid of Verizon to accept someone else’s money just so that someone else could earn the profit from creating money. But there have been historical cases in which businesses (usually mines), owned an entire town and also paid their workers in scrip which they made valuable by agreeing to accept in payment at the company store.

    James, I more or less agree with your comment, I am not sure how you think it applies to what I was saying. Concerning your earlier comment in response to Luis, you are right that my statement has a bit of a paradoxical sound to it. The point is that, as you said, if fiat money has no value then the price level is infinite. So there is a distinct theoretical problem in explaining how fiat money can have a value. In the context of the argument that Scott Sumner was having on his blog about Modern Monetary Theory and chartalism, there was a suggestion that if you accepted that a currency gets its value from being made acceptable in payment of taxes that the quantity theory wouldn’t work to explain the value of the currency, because the value of the currency depends on tax collections. My point is that you just need acceptability in payment of taxes to provide a non-monetary source of value for the currency. However, once you have that non-monetary source of value, the quantity theory does in fact have some explanatory power in accounting for how the value of the currency fluctuates over time.


  17. 17 JP Koning July 26, 2011 at 8:22 pm

    “But there have been historical cases in which businesses (usually mines), owned an entire town and also paid their workers in scrip which they made valuable by agreeing to accept in payment at the company store.”

    Yes, I’m aware of the example of scrip and “coupon monies”. I don’t think modern fiat money can be explained with a theory of coupon money. That’s because the creation of fiat money and the provision of services settled through payment of taxes are carried out by two different institutions, and not a unified mine/company store entity.

    For instance, from 1797-1821, during the period of pound inconvertibility, the privately-owned Bank of England created fiat money. The British crown accepted pounds for services rendered, as did private businesses. But the crown could not create money via the Bank, nor did the payment of taxes to the crown extinguish the Bank’s liabilities. Thus the crown was by no means equivalent to “the company store”, nor was the Bank of England the government-issuer of scrip. Yet the pound remained valuable despite there being no “company store” in place to allow the pound to escape your backwards induction problem.

    I would argue that the example of the Bank of England and the crown applies to the modern world in which one institution – the government – provides services, and an entirely different institution – the central bank – creates circulating liabilities. The mining company/store analogy doesn’t apply. Something else is necessary to escape the backwards induction problem.


  18. 18 jamesoswald July 27, 2011 at 1:26 pm

    Money is a coordination game: which good is used doesn’t matter as long as everyone uses the same good. Which good is ultimately chosen depends on the good’s characteristics. It should be portable, uniform, durable, and as I noted, have a low opportunity cost. The government is a clear focal point to provide a currency. It comprises a significant percentage of the economy, it has a comparative advantage in violence, so it can stop competitors as noted by Greg Ransom above and it can create demand for its currency by taxing as noted by the chartalists. I don’t think any of these factors are conclusive by themselves, but combined create a powerful force pushing towards government fiat currency.

    Most people just can’t do reverse induction. No one cares that in 50 years their money won’t be worth anything, they just have to believe that they can spend the money before it becomes worthless. It’s a self fulfilling prophecy, and the only people who question it are navel gazing economists like ourselves. Everyone is made better off as long as the illusion is maintained. Government certainly doesn’t want anyone else to have access to the seigniorage revenue, or the economic power that comes with a currency monopoly, and since no one person can disrupt the coordination point, it’s all incentive compatible.

    The Onion has a reply to your post:,2912/


  19. 19 David Glasner July 27, 2011 at 3:39 pm

    JP, I am not sure that I am keeping track of the discussion. I just mentioned company scrip as an example of what I was talking about. I didn’t mean that accepting payment for taxes was the same as an employer accepting scrip. My point was to show when a private company might have an incentive to accept payment of a money for the purpose of giving the money value. It would seem to be a fairly special case. I agree that the government and the central bank are not the same, but their incentives are more closely aligned than the incentives of most other pairs of independent entities.

    James, I actually don’t know why fiat money has value. I think that it is paradoxical. I don’t deny that it may be that everybody accepts it because, well, because everybody accepts it. On the other hand, even if you don’t think that backward induction is a very powerful objection, I think it does suggest, at a minimum, that the equilibrium may be very fragile if not buttressed by something else. Acceptability as payment for taxes at least provides a basis for the value of money that is not as ephemeral as pure social convention. But I admit that I am perplexed, and it does make my head hurt when I think about it for too long.


  20. 20 Lorenzo from Oz July 28, 2011 at 12:37 am

    Money proper starts with coins: coins start with kings. Kings paid for things with coins and accept coins as taxes. This is why the Austrian argument does not make sense for me: all it gets you to is a medium of exchange and that is not money. Money is a medium of account.

    Of course, once the biggest transactor has established such a useful way of meeting obligations, then it is sensible for other folk to “piggyback” off it (the network effect): which makes coins work even better for kings.

    Paper money takes the commodity element out, but everything else continues to operate. So, clearly, the crucial thing was not the metal in the coins. (Even Gresham’s law requires the unit of account embodied in the medium of account to have independent legal power.) So, chartalism is surely on to something (if not as much as the MMT folk think.)

    But I am less convinced about the backwards induction argument, even as boosted by Coase. My problem is that the user of money is concerned with whether the (often unknown) person they intend to exchange with will accept it at a given value. They do not reason back from (in fact, forward to) some utterly indefinite future. That is, there are time horizons involved in the calculations of value. If the end of the sequence of exchange has no significant expectation of being within that time horizon, then it has no basis for affecting their judgements.

    Benjamin Cole’s example of Confederate money works because, suddenly, the failure of exchange for Confederate dollars is within people’s time horizon, and they act accordingly. That is, there is information about when the chain of exchange is likely to actually end. Without such information, they have no reason to expect the chain of exchange not to continue long enough to work fine.

    That something will come to an end is not a constraint unless there is reason to expect that end to occur soon enough to affect expectations about actions. If a person has no reason to think that the people they are exchanging with have any reason to expect that the chain of exchange will not continue long enough for them, then an end in a completely indefinite future does not matter. The relevant temporal framing is always that of the actual agents, not an atemporal non-agent.


  21. 21 Lorenzo from Oz July 28, 2011 at 12:55 am

    To continue my previous comment, consider asset bubbles. If people could reliably predict turning points, there would be no asset bubbles because no one would buy at a price which would be caught by the turning point. In the absence of reliable knowledge of such a turning point, chains of expectations about capital gains beyond the income value of the asset can (and do) operate. The analogy is not perfect, because a typical feature of asset bubbles is a belief that there will be no serious turning point. Nevertheless, while the asset bubble is operating, the time horizon of agents only extends to expectations of capital gain. That prices may go way beyond any current income value does not stop them: until it does, until expectations of capital gains reversing enters within their time horizon. Until that time, the prices are very real no matter how extravagantly based on expectations of future capital gains they are–you can profit from them, borrow against them, be taxed on them: they are as “real” as any price is.

    Time horizons are based on available information for as far forward as will affect your actions and those likely to transact with you. They do not extend to events so indefinite that you have no information about when they will happen, no matter how “certain” their eventual occurrence may be.


  22. 22 Nick Rowe July 28, 2011 at 5:27 am

    David: I just read this post, after writing myself partly on the exact same subject!

    Very good post.

    I disagree with you, however.

    Governments print money because they want to spend more than they collect in taxes. OK. Suppose I said “Here are 11 bits of paper per person. Unless you each give me back 10 bits of paper per person at the end of the year I will beat you up. How much will you bid for these bits of paper?”

    The competitive equilibrium price of those bits of paper is zero.

    The Chartalist theory is totally false. (And Knapp’s book is awful. I tried to read it once).

    Von Mises is roughly right, I think. His regression theory should be understood as how a Schelling focal point equilibrium in a coordination game can be established by custom, so we are in one equilibrium (we drive on the right, paper money has value) rather than another (drive on the left, paper money has no value). What we did in the past is a very strong focal point.


  23. 23 Nick Rowe July 28, 2011 at 5:46 am

    Let’s make it even simpler, by distinguishing stocks and flows.

    There’s a stock of bits of green paper lying on the ground. The government says it will beat us up if we don’t each give it a flow of 10 bits of green paper per year. And the government will give us a flow of 10 (or more) bits of green paper in exchange for 10/P goods. The equilibrium value for 1/P, the value of money, is zero. The government is giving us a flow of paper, and we are giving it right back to the government, with no goods changing hands, and nobody getting beaten up.


  24. 24 David Glasner July 28, 2011 at 9:21 am

    Lorenzo, You said:

    “That something will come to an end is not a constraint unless there is reason to expect that end to occur soon enough to affect expectations about actions. If a person has no reason to think that the people they are exchanging with have any reason to expect that the chain of exchange will not continue long enough for them, then an end in a completely indefinite future does not matter. The relevant temporal framing is always that of the actual agents, not an atemporal non-agent.”

    This is the key point, and I can’t say that I am convinced one way or the other about which is the right view. However, from the standpoint of a theory of the value of money, I should think that people would be a bit uncomfortable, or embarrassed, to admit that their explanation for the value of money rests on a continuing asset bubble. I am not sure which direction Benjamin Cole’s citation of Confederate money cuts in. The money began to lose value rapidly, moving into hyperinflation territory, as it became clear that the Confederacy was going to lose the war. That meant that Confederate banknotes would soon become unacceptable in payment of taxes.

    Nick, Thanks for directing me to your blog post which I very much enjoyed reading. After reading your post, I can unequivocally say that you are totally wrong. You don’t disagree with me!

    The necessary condition for an asset to be used as money is that people be willing to accept the asset in exchange even if they have no demand for it apart from the expectation that other people will accept the asset in exchange. But I believe that it is difficult not to assert that a necessary condition for this necessary condition is that the asset have some real use that is independent of its use medium of exchange function. So despite the slightly mocking tone about Mises’s Regression Theorem that I adopted in my post, I agree with you that it does express a deep insight, which is that in order to take advantage of the network effects already captured by an existing money, a new money, in order to gain acceptance as a medium of exchange, needs to be made convertible into an already existing medium of exchange. Regression gets you to some commodity that originally served simultaneously as commodity and money. However, once convertibility is withdrawn, what keeps a money from going the way of the Confederate dollar? I say that you need acceptability for tax payment. And so, apparently do you. I faulted Mises for his treatment of Knapp, not because I thought Knapp’s book was any good (and you have extinguished any flicker of desire on my part to ever try reading it), but because he did not address Knapp’s key claim about acceptability in payment of taxes, satisfying himself with ridiculing Knapp as a bad economist and an etatist. In this Mises shared with Keynes the bad habit of ridiculing ideas and people he disagreed with, although Mises, in this capacity at any rate, was no match for Keynes. But as I pointed out, P. H. Wicksteed had made precisely the same theoretical point 15 years earlier. And no one ever accused Wicksteed of being either a bad economist or a bad writer.


  25. 25 Luis H Arroyo July 28, 2011 at 11:02 am

    I think it is necessary to distinguish between normal and exceptional times. In normal times -economy growing at its potencial rate- peharps the answer is the capacity of legal money to redeem taxes.
    In exceptional times, for example 2008, the answer is that everybody trusts only in government.
    If the goverment is not trusty, people will search any other legal tender money, foreign one, for example.


  26. 26 Nick Rowe July 28, 2011 at 12:54 pm

    David: Thanks!

    “I say that you need acceptability for tax payment. And so, apparently do you.”

    No. I explore that idea, then reject it. My mind is clearer now than it was when I wrote my blog post, which obviously wasn’t as clear as it should have been.

    I think we pretty much agree on the rest.


  27. 27 David Glasner July 28, 2011 at 5:09 pm

    Luis, You raise an interesting point. In bad times the demand for money goes up, so if a government has a decent reputation, it stands to make up some part of its deficit from the additional revenue it can earn because people are shifting from holding non-monetary assets or from holding bank money to government supplied base money. Unfortunately, the US government and Fed have been turning around and giving that money right back to the banks by paying interest on reserves yielding twice the rate on short term Treasuries.

    Nick, Sorry for not reading your post carefully enough, I guess that there was a bit of wishful thinking on my part in wanting us to be in 97 percent agreement, just as I am with Scott. Oh well. But I haven’t given up hope. I also just read your recent post on the difference between the Fed and money market mutual funds, which I thought was superb. Did you know that Mike Sproul is also from UCLA and wrote his thesis on the real bills doctrine under Earl Thompson? I like his papers on the real bills doctrine a lot, but he seems to ignore the fact that governments have considerable monopoly power over the supply of their currencies, which, I think, is what allows him to derive some of his weirder results.


  28. 28 Nick Rowe July 28, 2011 at 5:24 pm

    David: Thanks!

    I didn’t know Mike was a UCLA Earl Thompson student. I really disagree with his version of the Real Bills doctrine. And agree that monopoly power, based mainly on network effects, is the key problem. But I think Mike does a truly excellent job of explaining and defending the RBD. Much better than anyone else I have read. “Clear enough to be wrong”, intended as high praise, of course.


  29. 29 David Glasner July 28, 2011 at 5:54 pm

    Nick, You, of course, are presuming that what Mike is talking about has anything to do with the real-bills doctrine as it was ever understood. Remember David Laidler’s piece on Sargent and Wallace’s version of the real-bills doctrine? I think that there may be a similar problem with Mike’s version. But Mike is a smart and interesting monetary theorist, in the best Thompsonian tradition.


  30. 30 Norman July 28, 2011 at 7:45 pm

    First of all, excellent post. I enjoyed the discussion in the comments as well, although I confess to not having read them all.

    I think the Regression Theorem is a pretty good explanation of why an existing currency can be supplanted by another, but I find it less satisfactory in explaining why a currency can maintain its value once it has become dominant and the convertibility ends.

    I think the Coase example and the backward induction argument for fiat currency are different. The key, I think, is this phrase: “But at some point, before the world comes to its end, it will be clear[…]”

    In Coase’s case, we are dealing with a monopolist and a specific set of durable good buyers. Since each of these buyers expects to be around long enough to buy at the competitive price, so no one is willing to pay the monopoly price.

    In regards to currency, however, we are dealing with nearly infinite time scales and real life agents who have finite life expectancies. Thus, as someone pointed out earlier, the time horizons relevant for forward-looking behavior are not infinite, and it is not quite right to call this irrational for finitely-lived agents.

    Even more importantly, though, there is a great deal of uncertainty regarding when “it will become clear.” I can’t cite a proof, but quite a few accepted macro models, the kind presented in David Romer’s text, are premised on the idea that when agents are faced with a sufficient degree of uncertainty regarding the total number of repeats in a game, backward induction will not arrive at a valid equilibrium. In essence, enough uncertainty in a finitely repeated game leads to the equilibria one would get from an infinitely repeated game. “before the world comes to its end” is about as uncertain as things get.

    It’s only when uncertainty about the end date is drastically reduced, and that end date is within the time horizon of living agents, that the system rapidly breaks down. I take this as the explanation of the Confederate currency case.

    On a more tangential note, recent work in IO regarding durable good monopolists take advantage of dynamic pricing effects and demonstrate (quite in accord with general observation, in my view) that monopolists *do*, in fact, start out with monopoly prices and then lower their prices closer and closer to the competitive level over time. They are able to do this because buyers are heterogeneous in their level of patience, allowing the monopoly to extract the highest rents from “early adopters.” We see this most dramatically in consumer electronics, but books also start out with their highest markups on the hard back edition, then drop the price radically when the paperback version is released later.


  31. 31 Nick Rowe July 29, 2011 at 4:39 am

    David: Yep. I should have called it the “backing theory”, which is a more descriptive name, and avoids the problem of its relationship to the historical Real Bills doctrine.


  32. 32 David Glasner July 29, 2011 at 11:18 am

    Norman, Thank you for your very enlightening comment. I think that we agree on the strength and the weakness of the regression theorem. Your point about how Coase’s argument differs from a backward induction proof is well taken. Some earlier commenters may have been trying to make the same point, but I don’t think I grasped it until I read your comment. At any rate, for me Coase’s argument made the backward induction argument seem empirically more powerful than when I first heard Earl Thompson use it in connection with fiat money. I agree that in practice monopolists can sell their products at high prices even though it is generally understood that the price will fall over time. In those cases, it is because the good is not perfectly durable either because of changing styles and fashions or because of technological advance. I don’t think that those cases undermine the basic Coase argument, however. Again, thanks for commenting.


  33. 33 Peter Laan July 30, 2011 at 4:56 pm

    Thank you for a very interesting post!

    Are you familiar with bitcoins? They were created in 2009 and have no ‘acceptable as taxes’ help and no nation backing them. It’s currently traded at 12$ for a bitcoin. It’s a decentralized digital currency.


  34. 34 David Glasner July 30, 2011 at 7:08 pm

    Peter, Thanks. I have just started to notice the term “bitcoin” being used without knowing what it meant. I will have to start learning about them.


  35. 35 Richard W July 30, 2011 at 7:26 pm

    How do you explain the United Arab Emirates dirham having value when there are no taxes in the UAE? There was also the curious case of the Gulf rupee, which although a liability of the Reserve Bank of India only circulated outside of India.


  36. 36 Lorenzo from Oz July 30, 2011 at 10:31 pm

    David: thank you for your re-assuring comment (it is always good to know you have grasped the key point!). On the embarrassment point, it does not seem to embarrass folk in actual asset bubbles but I agree, it does seem somewhat odd when confronted with it for something as basic as money.

    But if one looks at the actual history of paper money, there does seem to be something like that going on. Paper currencies can suddenly and drastically lose value.

    On the other hand, we can also point to chains of paper money operating across centuries, if not fiat money as such (so far: though some of those chains involve moving back and forth from fiat money). So claiming that fiat money rests in part on the strength of/confidence in the authority providing the fiat does not seem such an odd thing to say.

    Even then admitting such authorities are not eternal–and what the consequence of that is–is confronting. But we can still be talking of potential chains which extend beyond a particular state if there is some chance that any successor will exchange new notes for old.

    But we can imagine a future where this is seen as an “obvious” fatal flaw in fiat money. Just as in any post-asset-bubble situation, the flaw in the high prices is “obvious”.


  37. 37 Peter Laan July 31, 2011 at 2:06 am


    I liked this economist article on bitcoins:

    Otherwise, you have the original paper here:

    This quote shows how weird bitcoins are.

    “Nodes can leave and rejoin the network at will, accepting the proof-of-work chain as proof of what happened while they were gone. They vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced with this consensus mechanism.”

    I suspect they initially gained popularity (or value) for three reasons: you only have to spend processing power to get bitcoins (your electricity bill will go up, but it doesn’t feel like you are spending any money), speculation that their value would go up later, and a desire from some people that wanted them to work so we would get an alternative to government money. I suppose a fourth reason might be an interest in the mathematics behind them.

    Now they do have some real use. There are some internet sites that accept them as payment. And you can exchange them for other currencies at


  38. 38 David Glasner July 31, 2011 at 1:15 pm

    Richard, Sorry I have none, I am not aware of any particulars about the UAE monetary system. As I write this, however, the thought occurs to me that maybe the way to think of UAE is as a company town in which the company issues scrip which they accept in payment at the company owned stores. The scrip may then become a medium of exchange for people living in the company town. That is mere speculation off the top of my head. I will try to follow up later on the sources that you supplied.

    Lorenzo, Although as I explained I think that there are some persuasive reasons for believing that acceptability of currency in payment of taxes is a key factor in explaining why fiat money can have value, I am far from certain that it is the only or even the best explanation. My impression is that the positive value of fiat money is simply based on some sort of quantity theory argument without really confronting the deep theoretical issues. So the point of my post was as much to expose the gap in conventional discussions as to say that there is a logically or empirically unassailable solution to the puzzle. I don’t believe that there is. It is a deep puzzle and I don’t think that there is yet any definitive solution.

    Peter, Thanks I will have to try to read up on this. Right now I have no idea what is going on.


  39. 39 Mike Sproul August 1, 2011 at 9:59 am

    David and Nick:

    Think of Feb 26, 1797. The day the Bank of England suspended convertibility. Before that date, the Bank would redeem its paper pounds at about 4 pounds/oz of gold. After that date, it would not pay out gold. Would you say that the pound was backed before feb 26 and suddenly became fiat money on that day? The Bank still had the same gold and bonds in its vault. It is much more reasonable to say that the pound was backed and convertible into gold before feb 26, and after feb 26 it was backed and inconvertible. But by 1801, Thornton was claiming that the Bank’s assets were irrelevant to the value of the pound, and by 1810 Ricardo was saying the same thing. The idea of fiat money developed in this period, but it was based on nothing but the simple mistake of observing a currency that was inconvertible, and concluding that it was unbacked. We could tell the same story about the dollar in 1933 and 1971. The reasonable explanation is that the pound and the dollar were backed but inconvertible, but people jumped the the weird explanation that the pound and the dollar were fiat money. They rejected the idea that paper money was valued for the same reason as any other liability (stocks, bonds, etc) and started to build this fantasy that paper money has value for reasons that were entirely unique.

    Along the way, believers in fiat money blithely spoke of “obvious” cases of money that had no backing: John Law’s notes (actually backed by Mississippi lands), the continental dollar (actually backed by the taxing ability of the US government) and the assignats (actually backed by confiscated church lands). I don’t actually know of ANY currency (of positive value) that had no assets backing it. If the idea of fiat money were correct, we should be able to point to lots of examples of paper money with no backing at all. Varian points to the Iraqi Swiss Dinar, but that is easily explained as a currency that was later made convertible into another currency.

    So which theory is weird? The one that says that paper money is valued according to its backing, just like everything else? or the one that says that paper money has value because people demand it for liquidity, while at the same time people demand it for liquidity because it has value? And to top it off, the issuer of fiat money gets a free lunch, while there are no free lunches anywhere in the backing theory.

    About monopoly: Paper money first developed in the American colonies, where it faced lots of competition from barter, credit, coins, other paper moneys, etc. If you’re going to claim that monopoly is a key element of money’s value, then that claim wont explain the early development of paper money. Nor will it explain so-called fiat moneys issued today by countries that are small, weak, and close together, so that their currencies often cross borders. I addressed money monopoly in my “No Fiat Money” paper. Basically, monopoly issue can make the demand for money slope down (with dollars on the horizontal axis and oz./$ on the vertical), but the supply of money, and money substitutes, must be horizontal (say, at 1 oz./$). Thus money monopoly gives no extra value to paper money. Remember, the old Bank of England had monopoly power, and you didn’t see the paper pound selling at a premium over its asset backing.

    For the record, I took undergraduate macroeconomics from Earl Thompson at UCLA but didn’t take any graduate classes from him. He believed in the existence of fiat money, but never mentioned the real bills doctrine or backing theory in class. I got to know him when I was a graduate student, and he was the chair of my dissertation committee. But my dissertation was on the effect of cartels on prices, which later became a JPE article “Antitrust and Prices”. Earl and I were friends, but my ideas about real bills and backing developed long after I graduated from UCLA. I had learned my macroeconomics from Mike Darby and Axel Leijonhufvud. Axel never mentioned real bills or backing, and neither did Darby. I’m pretty sure that both would have opposed the ideas.


  40. 40 David Glasner August 1, 2011 at 12:46 pm

    Mike, It’s nice to have you visiting my blog. Just to start, let me apologize for my use of the adjective “weird” in my comment to Nick. I can’t speak for Nick, even though I suspect that he would agree with me about his interpretation, but when I used the term I was using it facetiously to mean “unusual” and “unconventional.” I think that the tone of our discussion bears out that we both think that your arguments are not weird and that you defend your assertions with some very powerful arguments. That said, I think that we both remain unconvinced by all of your arguments, but we are trying to assimilate what you are saying into our own mental framework for thinking about money to understand what we need to revise to take into account your arguments and what we feel remains valid despite your criticism. If you got a different impression from reading our exchange, that is unfortunate, but it was not at all intended on my part and I very much doubt that it was on Nick’s.

    Thanks for the reference to your discussion of the monopoly argument, which as with a lot of your arguments seems to me partially correct but subject to many qualifications. But I hope to get a chance to read it more carefully another time.


  41. 41 Mike Sproul August 1, 2011 at 4:29 pm

    Hi David:

    I hadn’t taken offense at the word “weird”. If anything, I’m not used to the high level of politeness that you’ve maintained on your blog. But I would like to hear you or Nick or anyone else make some more specific defenses of the idea of fiat money against the idea of backed money. We all know that fiat money is a weird concept, while there is nothing at all weird about the idea of backed money. What I find weird is that the weird theory is mainstream, while the easy and coherent theory is considered weird.

    I first started puzzling over real bills ideas in 1989. It took me until 1994 to come to the conclusion that fiat money is an imaginary concept like phlogiston, caloric, ether, etc. I’ve only been working on you (and Nick) for a year or so. I’ll wait.


  42. 42 Lorenzo from Oz August 3, 2011 at 1:15 am

    I have a question: which assets would the backwards induction argument not apply to and why?


  43. 43 Peter Troutman September 15, 2011 at 7:45 pm

    I have not read this article yet, but I consider the subject the holy grail of finance/economics. The question being, “what is the value of an inconvertible paper currency?”

    I will post another comment after this post. I only scanned the article for about 5 seconds.

    I have spent the last 4 years intensely studying money, credit, banking, and prices. I can say with absolute confidence that:
    1) Inconvertible paper currency’s do have independent sources of value

    2) Credit is a medium of exchange, and does not effect prices, except insofar as it reduces the monetary demand for the standard of exchange (now irrelevant and historically of little significance, even when credit entered the scene to replace gold as a medium of exchange)

    3) Legal tender laws are NOT a source of value, it is simply an expedient to standardize contracts legally. If payment in air was legally required, and the unit called a dollar, no value would be created. The government’s “promise,” if unsupported, is the same thing. Bimetallism had silver and gold as legal tender. Gresham’s law was clearly at work and had the cheaper currency being used for payments, with the overvalued currency being EXCHANGED FOR IT ACTUAL VALUE. A unit made legal currency without value support will not stabilize at some point and be capable of serving the monetary function of exchange. Money, is just the GOOD that takes the least discount in all exchanges of products. That is how it serves its function as an intermediary of exchange.

    4) The quantity theory of money is false. This can be deduced logically from the 3 facts stated above. Supposed the gold standard is in effect. If the world supply of gold increased by 20%, prices would not correspondingly increase by 20%. At every point of exchange, there is a value comparison between gold (money), and the article to be exchanged. This is the exchange ratio (price). An increase in supply of gold without an associated change in the value of gold, relative to all other goods, will therefore have no effect on prices. Gold is simply a historical standard to serve as an example of the effect of the change in the raw quantity of any standard on all prices. Basically then, it is a value relationship, not a quantity relationship. Quantity change does not necessitate value change, due to the changing relationships of the demand of all goods.

    5) This is the last fact that is necessary in the equation to this problem. An inconvertible paper currency, can actually have exchange value from the EXPECTATION of the issuer to set the currency in question back to a convertible currency at some rate. It is possible for a government to establish a gold reserve at some point in the future, even if a government has no gold right now. The chance and rate expected, both are a factor into the discount on par of the currency unit.

    The prior information, and extended off point 5, there would be an indication that the ABILITY, not the intention, of a government to establish a convertible currency from a currently inconvertible currency forms the primary source of value of an inconvertible paper currency.

    The source of that ability stems from the ability of the government to establish a sufficient reserve to allow the currency to be truly convertible in to whatever good chosen takes the least discount in all trade, or more simply stated, convertible to goods period. The government must therefore be able to convert the $ into goods.

    In order to establish a reserve of goods, the government obviously must be able to obtain assets for that purpose, while also financing its normal government activities. The government has the power to SEIZE goods. The ability to seize goods depends on some factors. The factors are:
    1) The total production of goods that the government resides over
    2) The willingness of society to let the goods be seized

    Clearly, the future expected production of goods can be borrowed against as well, which also can be used to finance the reserve.

    The only logical conclusion I have reached is therefore that it is the ability of a government to establish a convertible currency that gives value to the inconvertible currency.

    I have thought about other options, and I have found other options be wrong. For example, the utility in some unit of currency in liquidating government debts sounds nice, but it is false. There is an infinite logic loop, being: how many dollars does the government ask for to satisfy your obligation to them? This asks for an external reference point as to what value in goods that the government demands. If it is supposed to be the value creation point as well, the logic behind it simply breaks down. The quantity of dollars requested by the government has no reference point.

    The major problem with studying current monetary issues today, is the inability to differentiate a change in the value of dollars from changes in the value of goods (the two sides of the price ratio independently). Price indexes are not worth as much as productivity studies.

    I would really appreciate any comments on this post.


  44. 44 Peter Troutman September 15, 2011 at 8:01 pm

    Here is my follow up comment.

    The above economists are stupid when it comes to money, finance, and banking. Sorry, but its true.


  45. 45 Peter Troutman September 17, 2011 at 10:24 pm

    Actually the quantity of money does not have a direct relationship to the price level. The quantity of currency outstanding, even if inconvertible, the ability for it to become convertible must remain as the quantity of the currency increases, other wise the value of the currency will decrease, and monetary inflation is what this is called. The original increase in the currency if supported by goods is originally merely a forced loan, but as the support in goods dissipates, it becomes a tax in the form of inflation through the reduction in goods coverage. To take it further, if some how it was physically possible for governments to back pay in goods all of the resources which they missappropriated towards themselves through inflation, there would be serious monetary deflation, and anyone holding the currency would feel much richer because it would be the same thing as all of those “loans” historically defaulted on being paid back.


  46. 46 Peter Troutman September 17, 2011 at 10:33 pm

    Actually money does not give one a claim on output based upon social convention. Money is just the good that takes the least discount among all products as the common denominator in exchange. The fact that most people can’t see the source of value in an inconvertible paper currency is their problem, but the fact is that it does have a value based upon it’s potential convertibility into goods.


  47. 47 Peter Troutman September 17, 2011 at 10:40 pm

    Electronic or paper makes no difference. These are just changed in the medium to effect payment of the standard. A bank note is the same thing as a deposit. The bank note transfers the right to the standard currency, as does a check written on a bank deposit of the same. If checks are written electronically makes no difference. Most people highly misunderstand credit.


  48. 48 Peter Troutman September 17, 2011 at 10:46 pm

    And how does the government know how many “dollars” to ask for, or any other participant in the economic system setting prices, etc. Clearly the value of the currency is independent of legal tender or government requests for it in payment of taxes. The flow of goods in the economIc system does provide the government with the ability to establish convertibility, and this has relative value.


  49. 49 Peter Troutman September 17, 2011 at 10:54 pm

    Actually the opportunity cost has nothing to do with it. The stability in value is key. Anything with the highest stability in value automaticly and by definition has the most value as money. Credit and the reserve system greatly reduce the amount of actual output of whatever is chosen for the standard to be used for money purposes. And by the way, steel is super cheap, and has large fluctuations in value.


  50. 50 Peter Troutman September 17, 2011 at 11:10 pm

    While the central bank does have the dollar as a liability, it is not a creator of value for the dollar. The banking system is a distributor of money. A common economic fallacy is to assume that only something with utility has exchange value. To have value a commodity must have scarcity, utility, and transferability. To have “exchange value,” as differentiated from something with value, it simply must be convertible or potentially convertible into something with value. The central bank today, as in the past has been separate from the source of value of the standard that it operates as distribution system for. This was true under the gold and every other standard, as now as well.


  51. 51 Peter Troutman September 17, 2011 at 11:25 pm

    If the company store closed, but if there was the chance and financial ability for the store to reopen in the future, the company coupons would have an exchange value. When the bank of England ceased convertibility, the same situation arose, but the closing of the banking doors to convertibility arose due to a shortage of money (goods) to be there for convertibility. The period of time of inconvertibility is a forced loan. The loss of interest and the clear inability to cover the currency with goods in the future cause a discount on the inconvertible currency, and this is seen as inflation, and it is effectively a tax.


  52. 52 Peter Troutman September 17, 2011 at 11:37 pm

    Money proper does not start with coins, it starts with stability of value. A metal that was historically used as money was only coined for convenience. Paper or bank deposits based on the same metal is just another medium of exchanging that metal, which is the thing of value more cheaply transferred. The only real functions of money are 1) standard of value, 2) medium of exchange, 3) common denominator. Other things such as 1) store of value, 2) standard of deferred payments, 3) unit of account.. are not functions but happenings.


  53. 53 George Selgin March 23, 2012 at 5:34 am

    David, have you seen my paper “Quasi-Commodity Money”? It has some interesting parallels with your post.


  54. 54 David Glasner March 24, 2012 at 7:12 pm

    Peter, Somehow I lost track of this thread and never responded to your comments from six months ago until I George Selgin’s comment arrived. Sorry about that. I am not sure that I understand everything that you are saying, but much of it seems sensible.

    George, Thanks for the link to your paper. I think I saw references made to it previously, but I will now make a point of reading it.


  55. 55 Shahid May 8, 2012 at 7:53 am

    David, need to ask you something. i will admit that i didn’t get it even when i first read this fascinating blog of your’s. But i guess its never too late when it comes to intelectual pursuits! You discussed at length the theory proposed by Ben Klien, and Ronald Coase’s paper about monopoly. My impression is that you were trying to make a connection between the competetive supply of money by an institution (possibly a monopoly in its own right) and the irrationality of individuals willing to accept the said institution’s fiat money at its prescribed value. Am i right in forming this conclusion? Please let me know if i am not getting it right.


  1. 1 Browsing Catharsis – 07.26.11 « Increasing Marginal Utility Trackback on July 26, 2011 at 8:10 am
  2. 2 An Explaination of Government Fiat Money « azmytheconomics Trackback on July 29, 2011 at 3:10 pm
  3. 3 Potpourri Trackback on August 1, 2011 at 2:19 pm
  4. 4 Expectations Are Fundamental « Uneasy Money Trackback on November 1, 2011 at 5:46 am
  5. 5 John Kay Puts Legal Tender in its Place « Uneasy Money Trackback on February 8, 2012 at 9:48 am
  6. 6 The Midnight Economist Reminisces About His Colleague and Co-author Armen Alchian and the Brief but Wonderful Golden Age of the UCLA Econ Department « Uneasy Money Trackback on March 19, 2012 at 6:27 pm
  7. 7 Expectations of Monetary Value | Economic Thought Trackback on March 20, 2012 at 10:41 am
  8. 8 On Fiat Money | The Everyday Economist Trackback on March 23, 2012 at 8:55 am
  9. 9 Where Does Money Come From? « Uneasy Money Trackback on August 19, 2012 at 9:15 pm
  10. 10 OK, Tell Me — Please Tell Me — Why Bitcoins Aren’t a Bubble | Uneasy Money Trackback on April 18, 2014 at 11:33 am
  11. 11 Monetary Theory on the Neo-Fisherite Edge | Uneasy Money Trackback on May 6, 2014 at 8:05 pm
  12. 12 TheMoneyIllusion » Reply to Mike Sproul Trackback on June 4, 2014 at 4:56 pm
  13. 13 The Backing Theory of Money v. the Quantity Theory of Money | Uneasy Money Trackback on June 9, 2014 at 7:30 pm
  14. 14 Repeat after Me: Inflation’s the Cure not the Disease | Uneasy Money Trackback on June 4, 2015 at 6:13 pm
  15. 15 Neo-Fisherism and All That | Uneasy Money Trackback on July 24, 2015 at 12:20 pm
  16. 16 TheMoneyIllusion » Recent links Trackback on August 8, 2015 at 7:00 am
  17. 17 Is “a Stable Cryptocurrency” an Oxymoron? | Uneasy Money Trackback on January 25, 2018 at 7:01 pm
  18. 18 The Golden Moment – Rando Calrissian Trackback on February 2, 2018 at 4:56 pm
  19. 19 What’s Right and not so Right with Modern Monetary Theory | Uneasy Money Trackback on July 1, 2020 at 7:38 pm
  20. 20 My Paper “Fiat Money, Cryptocurrencies and the Pure Theory of Money” is now available on SSRN | Uneasy Money Trackback on November 2, 2020 at 6:43 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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