Mike Sproul:

Okay, Mike, let me try a different approach. Suppose an isolated island uses only barter in trade. The island produces 95 baskets of goods and services each year. One day, the island elders decide that they will print up 1,000 $1 bank notes to be used as legal tender. The labor time saved in using the bank notes as a medium of exchange (as opposed to bartering) is used to produced 5 baskets more goods and services each year. Suppose that any additional bank notes would save not save any more labor time and thus have no additional real value.

The real value of the existence of the $1,000 money supply is thus 5 baskets of goods and services. In other words, the value of (price of) each basket of goods and services is $1,000/5 baskets = $200 per basket.

A new group of elders is elected and they issue $1,000 more bank notes. The total money supply is now $2,000.

Since the additional money issue has no additional real value, the total money supply of $2,000 is worth exactly 5 baskets, as was the old money supply of $1,000. Each basket of goods and services is, in other words, now worth $2,000/5 baskets = $400 per basket.

The above result holds whether or not there is a central bank and whether or not a central bank goes through the fiction of “backing” its money with elder committee (government) bonds.

A further comment on the discussion comparing a landlord to a government.

Mike Sproul: “The government will accept its dollars for taxes just as the landowner will accept his IOU’s for rent. No doubt a lot of people would call his IOU’s fiat money, on the spurious grounds that they are not convertible directly into silver.

Money issued by a government will only lose value if the issue of money has outrun the government’s assets. Thus there does not have to be an ‘ensuing price increase’.”

Here Mike is conflating credit money with fiat money. These are different things.

Credit money is a type of money backed by some sort of debt. This type of money have occurred frequently in history. For example, I could issue IOUs for beer payable at a certain time. If I am reliable enough in fulfilling them they could be accepted as currency.

The issuing of new credit money need not cause price inflation. I must hold assets that I can convert into beer, or hold beer directly. In this situation, if I were a brewer I could request that those who buy from me use my credit money. However, that doesn’t mean that anyone else has to deal in them.

The situation with government is different. As Jonathan Friedman would say, we have “no exit” from the state. We must deal with them, there is no choice.

A landlord or brewing capitalist who issues credit money then dilutes it will find the money falls out of favour. The state is not similarly limited, it can force people to pay taxes. It can prevent people from leaving and prevent currency and assets from leaving.

So, the state need not back it’s fiat currency in any meaningful way. Alex describes the inflationary way that the state does back it’s currencies.

cy:

One bank might issue and IOU that is redeemable at the customer’s option, while another might issue an IOU redeemable at the bank’s option. Both will have value. Financial securities that pay at the issuer’s option are fairly common. The fed’s dollars are redeemable at the fed’s option. If the fed redeems at a high rate, the dollars will have a high value, and vice versa.

Mike Sproul,

So the number of dollars that individuals are willing to accept for goods and services has no bearing on the value of the dollar?

Mike Sproul: “One bank might issue and IOU that is redeemable at the customer’s option, while another might issue an IOU redeemable at the bank’s option. Both will have value. Financial securities that pay at the issuer’s option are fairly common.”

Yes. Austrians would describe the former as fiduciary media or possibly credit money. The latter doesn’t have a clear designation in Austrian terminology.

Mike Sproul: “The fed’s dollars are redeemable at the fed’s option. If the fed redeems at a high rate, the dollars will have a high value, and vice versa.”

If you want to persuade us then explain how that follows.

Mike Sproul:

Since you didn’t respond to my last argument for the value of money, let me respond to another one of your statements. You said, “Money issued by a government will only lose value if the issue of money has outrun the government’s assets. Thus there does not have to be an ‘ensuing price increase’.”

Are you saying that the price level increases in Zimbabwe occurred because Mugabe did not print up enough Zimbabwean government bonds to hand over to the central bank while the central bank was busy printing money?

Alex:

Your island money has no backing, so it will have no value. If the elders announced that they will accept the paper money instead of coconuts when collecting taxes, then they’d be worth 1 coconut, assuming the elders maintained adequate assets to buy back the money they have issued.

The inflation in zimbabwe happened because the government bonds (which backed the money) lost value, at the same time that the central bank issued new money without increasing its assets in step with the money.

(sorry to keep this going, but I feel we’re close)

Mike-

Your answer to my question of conversion optionality leaves me HIGHLY dissatisfied.

You state-
“One bank might issue an IOU that is redeemable at the customer’s option, while another might issue an IOU redeemable at the bank’s option.”

This is 1000% false.

Some definitions- IOU means I Owe You. I think you know what the words “I” and “You” mean, but “Owe” means “to be under obligation to pay or repay.” Therefore, an IOU implies there is an obligation for the “I” party to be repaid by the “YOU” party. Once you grant the “YOU” party an indefinite option to repay, there is no longer any obligation, and therefore the fundamental structure of the IOU is completely destroyed.

You further state-
“Financial securities that pay at the issuer’s option are fairly common.”

This is one trillion % false. In fact, I’d challenge you (or anyone) to name one. Think about it- were you to loan your neighbor $10k, would you ever stipulate that the neighbor can pay you back whenever he feels like it for the rest of time?? Even if the neighbor promised to pay you back an infinite amount of interest on this loan, you’d be foolish to accept these terms, because it’s obvious to everyone that the neighbor would simply never pay you back. Perhaps you are thinking of callable bonds, in which the issuer can elect to pay the back the principle whenever it (the issuer) wants, BUT callable bonds certainly stipulate a date by which the loan MUST be paid back (again, an obligation.)

I’m sorry, Mike, but a loan, with no legal obligation for repayment, is not a loan–its charity. The fed, obviously, does posses some real assets that I suppose could loosely be thought of as a sort of backing for its liabilities, but since the fed doesn’t have any obligation to ever deliver assets to the liability holders, the liabilities may as well be backed by nothing. In other words, we’re dealing with fiat money.

cy:

I had a discussion of this with Mike Rozeff (finance prof, SUNY) a while back. I’ve pasted his discussion of convertibility at the bank’s option below.

Economically speaking, even though this kind of conversion privilege is often absent and
justifies the use of the description “inconvertible,” voluntary redemptions occur by other
means. Consider GM as a case in point. The stockholders cannot redeem into assets at will, so
GM stock is inconvertible in the standard defined sense. Suppose that GM has a tender offer for
the stock, or suppose that GM repurchases stock in the open market. Then GM exchanges its cash
(which is an asset) for shares that are voluntarily provided by those holders who wish to sell.
These processe create a kind of conversion, but instigated by the company. But since the
company is controlled by the stockholders, they are effecting a conversion. It is because these
processes can and do occur that we should broaden our concept of what convertibility means if
we are to undertand its possible influence or lack of it on value.

Banks do not have conversion of dollars for assets in the current setup. But when a bank sells
any of its assets in exchange for dollars, it is permitting its depositors to tender their cash
if they wish to. It is providing a means of conversion. Banks can buy bonds sold by the Fed,
for example, and in that way they convert dollars to assets held by the Fed.

These methods of conversion, by open market sales of assets, are economically significant. I
conclude that the dollar in fact undergoes conversion, albeit not by a traditional route of the
depositor having an option to convert at his will.

If the conversions are initiated by the company or bank, that gives it flexibility to choose
the time, manner, and amount. If it ties itself down to a particular and inflexible method of
redemption or of disgorging cash, that may not be as good for it. Companies in fact do tie
themselves down by making dividend payments, which is an alternative to repurchase of stock.

These observations add another argument to the notion that there is no fiat money. To the
extent that people have thought of fiat money being fiat partly because it is inconvertible,
the money is in fact capable of conversion and has been converted at the bank’s instigation,
not the depositors.

I find it rather worrying that in this day we still have to oppose such ancient falsies.

Mike Sproul: “If anyone, including a government, issued a piece of paper promising 1 oz. of silver in 1 year, that paper would sell for about .95 oz. today. Anything higher or lower would lead to arbitrage opportunities.”

For a normal bond that is certainly true.

Mike Sproul: “If anyone issued a piece of paper promising zero next year, that piece of paper would sell for zero today. Anything higher, and there would be arbitrage opportunities. That’s why I say that the value of so-called fiat money can’t rise above zero.”

That is wrong, you are ignoring the special properties of money. Money is unlike other goods.

Things would be the same if all goods were traded in a centralised manner. Imagine that we lived in a village. In the centre of the village there is a big board with all prices of goods written on it. On this board the bond would be valued as you describe. Fiat money would similarly be valued at zero. In fact money would be unnecessary. Direct barter would replace it entirely.

The situation is different in an “unorganized” economy. When something becomes money it must possess some sort of value. However, once it has become money that is no longer the case. The question to ask is: What concerns each person about their money? What an individual is looking for in money is to exchange it for goods. It is a form of security, it allows a person to provision for purchases they can’t yet anticipate. So, what is important is that it is widely accepted. This is the service that money provides. It is not necessary that it be “redeemable” for any asset.

Certainly when I look at money I don’t look at it as an investment. I don’t think much about “how much will this money be worth in a years time”, though I do think about it a bit. What concerns me is whether or not it will be accepted by places I want to shop. I think that those shopkeepers look at money the same way.

Read about the situation with Austrian Krone and Gulden in the 19th century that Ludvig Von Mises describes in the Theory of Money and Credit.

Mike Sproul: “People spend US dollars in mexico all the time. I’ve never heard of them being arrested for it.”
Certainly. I don’t think that taxes can be paid in dollars though. I think that outside of tourist places there are probably many shops that don’t accept dollars. So, the dollar isn’t a substitute for the peso.

Mike Sproul: “If it is taxes that give money value, then those taxes are backing money just as the landlord’s rents back his money. But it’s backing just the same. If the state lost the ability to collect taxes, its money would lose value.”

You are attempting to confuse the issue. If a government could no longer collect taxes then the only form of revenue it would have would be the printing of money. The value of money would fall in advance of that event.

Also, once the state could no longer charge taxes then a free-market in money would operate. New forms of money could be created. This would take a long time, but it could be done.

This is not similar to the situation with a landlord. Unless that landlord was the landlord of a whole country. In that case the landlord is the government.

Newson:

The point of your last post is not clear.

Current:

Money is unlike other goods? You mean money is not subject to arbitrage? As soon as you recognize that there are competing moneys in the world, you should start asking how any of those moneys can be valued above its backing. The answer is that it can’t, since arbitrage would eliminate any excess value. Governments are not all-powerful, and currencies can easily cross borders. When they do, they reduce the demand for any local so-called fiat money, thereby reducing its value to zero.

I assume you mean this passage from Mises:

“How could it come about that the government bonds, bearing interest at five percent, could be valued less highly than the non-interest-bearing currency notes? This could not possibly be attributed, say, to the fact that people hoped that the currency notes would be converted into gold before the bonds were redeemed. There was no suggestion of such an expectation. Quite another circumstance decided the matter.

The currency notes were common media of exchange—they were money”

The answer is that money does bear interest, it’s just that money also has a cost of issue, and this cost normally eats up the interest. But people are willing to hold money anyway because of its liquidity services, while the same is not true of bonds. This is explained in my “No Such Thing as Fiat Money” paper. If the cost of issuing money is c%/year, then today’s value of an IOU promising 1 oz. in 1 year would be 1/(1+r-c), and if c=r, today’s value would be 1 oz. The money would thus appear to bear no interest. But the cost of issuing a bond is relatively small compared to its interest, so the bond will sell for more like 1/(1+r). Thus it is no surprise that the money sells for more than the bond, even though they are both claims on the same creditor.

Cy:

Gosh, I hope Mike Sproul answers your last post.

Mike Sproul:

“I’ll go you one better. I’ll print up some green pieces of paper and promise to print only so many of them. As believers in fiat money, you would naturally be willing to hand me valuable goods for those papers, even though they have no backing.”

I’m not sure what you mean by “believers in fiat money,” but would the government please “only commit to print only so many of them” (actually, would they only commit to create so much of a monetary base.” These green pieces of paper are money only because the government has decreed them to be legal tender. I and others accept these bits of paper only as long as I believe yet others will accept them in exchange for goods and services.

Mike-

For the record, I’m not convinced I’m on the right side of this argument. I’m simply reading, thinking, and commenting as things come into my head. As a professional trader, I’m constantly trying to explore new ways of thinking about money, relative values, etc., and you’ve exposed me to a new way of thinking about currencies… for which I thank you. Part of my process for learning new ideas is trying to try to poke as many holes as possible and see what sticks. If I’ve come off as snarky or dismissive, I apologize: it was not my intent.

Obviously, as I’ve stated, the fed, BOJ, ECB, etc. certainly do have assets on their balance sheets, so I do agree that currencies are not the completely unbacked “fiat currencies” they are often thought of. However, I’m still not convinced these currencies are all perfectly offset by central bank assets. It seems to me that if a gov’t wanted to create a means of exchange it could freely debase, starting with a fully convertible currency and gradually closing off more and more convertibility options would be a pretty effective way to do it. Especially when combined with legal tender laws that make contracting in any other means of exchange impossible.

cy:

The wikipedia article notes that the authorities eventually redeemed the iraqi swiss dinar for some other currency. Thus people valued the dinar because of this expectation, and the dinar was in fact backed by the currency into which it was redeemed. When the south lost the civil war, nobody expected anyone to redeem the confederate dollars, and they lost all value, as the real bills doctrine implied.

The real bills doctrine says that the value of money is equal to the value of the assets backing it. (If the currency were worth more or less, there would be arbitrage opportunities.) So if some government issued currency in exchange for assets, and then started squandering those assets, or otherwise removing them as backing for the money, then the currency would lose value.