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Fiat Money

It is common among “real money” types like myself to claim that our currency is not backed by anything.  This is in fact incorrect.  Our currency actually is backed by real assets.  The confusion seems to stem from a misconception about the mechanism by which money is created.  People seem to imagine that the government or the Fed or someone just prints money and releases it into the economy in some sort of Friedman-style helicopter drop.  This is not just a misperception among laymen, it penetrates deep into economic circles and is embodied in many macro models including the Keynesian IS/LM model. 

If the above were true, then it would be true that money is not backed by anything.  It is, I think quite uncertain whether or not a system like this would be sustainable and to my knowledge we’ve never observed one.  What we actually observe is money being printed and loaned out in exchange for a promise to pay later.  The promise to pay later is backed by real assets – the assets of the borrower.  If they can’t pay back the dollars the lender takes their real assets.  In this sense dollars are convertible into the real assets which are put up as collateral for the loans that create the dollars.

In the old days, a dollar was backed by gold.  That meant you could take a dollar to the bank and get a certain fixed amount of gold in exchange for it.  The dollar represented a debt from the bank to you.  Our current system is fundamentally similar except that a dollar represents a debt of real assets from you to the bank.  Everyone who has debt has the ability to escape that debt by acquiring dollars.  In this way the dollars are convertible into real assets but instead of people being contractually allowed to buy a certain amount of gold back from the bank, they are contractually allowed to buy a certain amount of their own assets (house, car, boat, business, etc.) back from the bank. 

This debt is what maintains the value of the currency.  As long as there are always people with debts to pay off, they will always be willing to trade some real assets for dollars because they will be able to use those dollars to pay off their debts (and keep their real assets).  The value of the dollar, to some extent (there are certainly other factors involved) depends on how many dollars are out there compared to how much debt there is. 

You may recall that the process of lending money at a positive nominal interest rate means that under normal conditions there is always more debt than dollars in circulations.  New money has to keep entering the system to retire old debts and this new money creates even larger debts to be paid in the future.  The mechanism to keep money flowing into the economy in larger and larger quantities is to keep lowering interest rates.  When rates hit zero, they can’t get enough money into the economy for everyone to pay off all of their debts.  At this point competition for the existing dollars becomes more fierce and prices fall. 

Now it’s time to consider how this situation might correct itself.  To do this I must elaborate on what I meant by “normal conditions” above.  By this I mean conditions of no (or low) default.  This is because, when people default on their loans it causes money to leak into the economy in the sense that instead of that money being pulled back out, real assets get absorbed.  It may be the case that these assets are then sold for some amount of money which gets pulled back out in that way but this amount must be less than what was actually owed or else the debtor wouldn’t have defaulted in the first place.  So in this way debts get reduced by more than the reduction in the money supply.  Every time someone defaults on a loan, some pressure gets relieved — the debt to dollars ratio gets reduced. 

The phenomenon of default and falling prices is the economy trying to relieve the pressure that builds up due to the creation of money as debt.  If we let prices fall and people default, eventually we would get to a place where things would stabilize, the people who survived would have some money and prices would be low, people would start borrowing again, prices would start to rise and we would begin blowing up another bubble that would bring “prosperity” for anther thirty years or so before bursting again. 

Of course this process would be highly destructive, and many people would be hurt (and a few banks would make fortunes…).  So there is another way to get money out there.  You can have the government borrow it and spend it.  It doesn’t matter what they spend it on, it just has to get out there.  This will prop up prices for the time being.  The problem is that this still creates debt, it just creates collective debt.  If the government could really just print money and spend it, it would actually relieve pressure but they don’t .  They borrow this money as well.  So you just end up putting the problem off for a while and in the process the government gets bigger and bigger.  They own more land, have more employees, and control more of the real wealth in the economy because they had to buy it to prop up prices.  Then eventually all that government debt comes due and the bill falls upon whoever was lucky enough to survive until that point with any wealth. 

The problem cited by bankers when creating the Fed was bank runs.  In other words, they created too much money for the amount of assets they had to back them and this eventually caused them to have to default.  All their solution did was turn the tables.  It created a system where there is too little money in circulation to buy back all of the assets backing up that money.  This means that when it eventually collapses, it’s not them that default, it’s you.

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