Garett Jones  

Is Fiat Money a Bubble?

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I thought the mainstream view was that fiat money was--in most mainstream theories and possibly in practice--a bubble.

Jean Tirole (Econometrica, 1985) defines a bubble (it's a conventional definition among economists), and notes that Samuelson's excellent model of money fits that definition:

Since Samuelson developed his consumption loan model it has been well  known that there exist economies in which money has a positive value in spite of the fact that it is intrinsically useless (i.e., its market fundamental is zero). In other words there can exist a bubble on money where a bubble is defined as the difference between the market price and the market fundamental.

Dow and Gorton (Econ Letters, 1993) go further, labeling money-as-bubble as often part of the "standard model": 

The standard model has the property that money is valuable in equilibrium, even though it has no intrinsic value. It is often viewed as a bubble for this reason.
 
Ross Starr (J Math Econ, 2003) reports the "prevailing" view:

The currently prevailing (alternative) treatment of the value of fiat money in the literature, Wallace (1980), Kiyotaki and Wright (1989), Samuelson (1958), etc. is to treat money as a bubble in an infinite horizon model....There are typically multiple equilibria then, including a nonmonetary equilibrium where...fiat money has zero value.

The last sentence is my favorite part of the money-as-bubble story: There's always the possibility that, as one of my professors put it, we all wake up one morning and realize, "Hey, this is just paper money!" Then we rip it all up and toss it out the window.

There are ways of ruling out these money-as-bubble equilibria, and Paul Krugman notes one: You need to pay your taxes in money.  That pins down a fundamental value to money.  

But count me among those who think this isn't empirically that important.  Glad to see tests of this, but I'm guessing if a small, fairly stable nation one day decreed "Taxes must be paid in a foreign currency," fiat money in that nation would still hold about the same value the next day.  

Another way to make fiat money work comes from a great paper by Nicolini: The government issues paper money, but in his world we "all know" that if people started getting nervous about the value of the pieces of paper, the government would tax our real assets and hand us those real assets in exchange for the paper money.  But if we "all know" the government will do that, then the government never needs to do it.  

My intuition tells me this is closer to the truth than the channel Krugman notes: I meet people who already believe the government will turn money into gold on demand, and they get a little nervous when I disabuse them of their touching faith.  Some people already "know" about Nicolini's model, and here the ironic quotation marks might have some real-world implications.  

But I suspect neither of those political stories is as important as the sociological story told by Samuelson.  Fiat money is, to use Paul Samuelson's expression, a "social contrivance " more than a fiscal one.  We take money from other people because we know other people will take it from us.  And the best part of Samuelson's story is that this "social contrivance" of fiat money can make everyone better off.  

In the right setting, we should all welcome Paul Samuelson's bubbles.  

Coda: Samuelson's original paper is just a pleasure to read.  His prose is excellent, gripping, with twists and turns worthy of a Sherlock Holmes story.  That man knew how to keep his audience engaged. 


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CATEGORIES: Macroeconomics , Money



COMMENTS (16 to date)
Tom West writes:

I think "social contrivance" is pretty much the definition of society and wealth.

The moment that enough people stop believing that the authorities will protect me, there's nothing stopping three burly guys with knives taking all my tangible possessions.

It's why I smile when I hear people talk about economic progress has to be built on *real* things, not just shuffling papers around...

egd writes:
There are ways of ruling out these money-as-bubble equilibria, and Paul Krugman notes one: You need to pay your taxes in money. That pins down a fundamental value to money.
An important point about Krugman: he ruled out money-as-bubble by redefining what is meant by bubble.

Even so, you do not need to pay your taxes in money. If you fail to pay your taxes the IRS is more than happy to take your land, house, or other property in satisfaction. Ask Valentine Byler.

Rick Hull writes:

@egd

> Even so, you do not need to pay your taxes in money. If you fail to pay your taxes the IRS is more than happy to take your land, house, or other property in satisfaction.

At the risk of not getting the "joke", the IRS is paid in dollars, not in houses. If they have to seize the house to get the dollars, they will.


@jones

> I'm guessing if a small, fairly stable nation one day decreed "Taxes must be paid in a foreign currency," fiat money in that nation would still hold about the same value the next day.

The real test is not the reaction to the announcement. Wait until after people are forced to hold the alternative currency. It seems obvious to me that the dollar's value to a person would be diminished.

Of course you could wave this requirement away by saying it will be deducted automatically from your dollar-denominated paycheck, but wouldn't this ultimately lead to alternative-denominated paychecks? I am fairly certain most employers do not want to deal the the FX risk and hoop-jumping.

Salem writes:

When the Somali government collapsed, the Somali currency held its value pretty well. From 5000 SOS/$ in 1993, to 13400 SOS/$ in 2006, and 27000 SOS/$ now. I think that means we can put a ceiling of 60% of the value of fiat money owing to government taxes.

Doug writes:

" If you fail to pay your taxes the IRS is more than happy to take your land, house, or other property in satisfaction. Ask Valentine Byler."

The tax authorities might take other assets, but they'll still demand the dollar value of those assets. This is also why Garret's example of a country accepting foreign currency is flawed.

For example let's say I make $100,000 in income. I then go out and immediately buy 66 oz of gold at market price. Now say the price of gold falls by 30% by tax day? The tax authority will demand $100k worth of gold at prevailing prices on payment date, so now I owe them 94 oz.

The same is true of accepting a foreign currency as payment. It isn't sufficient unless they denominate value in that asset. Otherwise a basis risk exists for all non-fiat currency savings because your tax liability fluctuates rather than remains fixed.

Ritwik writes:

IMO The Kiyotaki-Moore 'evil is the root of all money' is a much superior and satisfactory explanation of the 'fundamental' value of money.

http://www.princeton.edu/~kiyotaki/papers/Evilistherootofallmoney.pdf

In a world with risk and default, there's no need of a Samuelsonian bubble.

Mike Rulle writes:

This post reminds me of why I quit my graduate program in philosopy---it is both fascinating but leads to knowhere---or it ends up where it begins.

Admittedly we use various words to define certain things, but often when we pierce the vail, these different things are really the same thing.

"Fiat Money". It is currency backed by a countries ability to seize its citizens' assets. There are no limits to its creation by the government..

"Gold backed Money". It is a currency backed by an amount of Gold per unit of currency, which, in turn, its unit of currency can be changed such that ultimately "it is currency backed by a countries ability to seize its citizens' assets". There are no limits to its creation.

I thought Milton Friedman ended all major philosophical issues about the nature of money of any kind. It just comes with human nature. In wars, cigarettes can be money. Marks on a large stone in the sea can be money. A hand shake can be money. Anything can be money. But somehow, for whatever reason, we have always had money as a convention to store value.

What is so special about what we call fiat money? All money is fiat money. Garret's professor is correct, but that theoretically applies to any object. What if everyone decided at the same time they did not want to own any anything? Money would have no value and objects would have no value.

Dostoevsky takes Garret's professor's point to its ultimate conclusion. His professor asked "what if we all suddenly realized money was just paper"?

Dostoevsky asked "what if we all realized we are just a random meaningless collection of self aware beings speeding through space on a rock heading for nowhere?" Garrets professor says we would rip up money---Dostoevsky answers his question by saying we would commit suicide. Different order of magnitude, admittedly, but same direction----loss of faith in meaning.

So faith makes the world go round

Only a desire to play with circular thinking makes this a fun discussion. I admit to enjoying it---but it really seems like just playing a game.

Joe Cushing writes:

I think the definition of bubble expressed here is a bit oversimplified or there is something not quite right here. I think one characteristic that should be included in the definition is the inevitability of a bubble to pop. Maybe its what you were getting at towards the end, that fiat money has value because of the social construct. Maybe the social construct is intrinsic in some way. One thing that gives fiat money its value is scarcity. An entity has a monopoly on its creation and like the monopoly diamond mining company, that entity gets to determine how much that money is worth.

If you take scarcity and popping into the definition, I think you could say that fiat money, in theory, is not a bubble but in practice it always has been. This forces you to explain more about fiat money, like how it gives the issuer a perverse incentive to make its scarcity less and less so because the creation of fiat money is nearly free its creator.

Under your definition, you could say that gold is a bubble because with the exception of making pretty things to wear and a few industrial purposes, nearly all of the value of gold comes from the fact that people hoard it. It's the old, dig it out of the ground, refine it and turn it into bricks, then put it back underground idea again.

Chris Cresci writes:
Of course you could wave this requirement away by saying it will be deducted automatically from your dollar-denominated paycheck, but wouldn't this ultimately lead to alternative-denominated paychecks? I am fairly certain most employers do not want to deal the the FX risk and hoop-jumping.

I am sure that companies such as ADP would be happy to provide such a conversion service for a minimal fee and that the US Treasury, given that it is supposed to be in the business of collecting revenue and not making large currency bets, could come up with a simple hedging strategy at an insignificant cost. The main problem with competing currencies (be they foreign or private) is that they need to be network goods and the US government is deeply suspicious of entrepreneurs and deathly afraid that anyone might upset its currency monopoly.

Tracy W writes:
I'm guessing if a small, fairly stable nation one day decreed "Taxes must be paid in a foreign currency," fiat money in that nation would still hold about the same value the next day.

As someone who grew up in NZ which surely meets the criteria above, I'm inclined to say that the next day the NZ currency would be worth drastically less.

Given my belief, and given that I still have a fair chunk of money in NZ, on the whole I am against empirically testing this.

Tom West writes:

Given my belief, and given that I still have a fair chunk of money in NZ, on the whole I am against empirically testing this.

Thank you for my chuckle of the day.

MG writes:

Take --

@ TracyW Given my belief, and given that I still have a fair chunk of money in NZ, on the whole I am against empirically testing this. and

@ Mike Rulle Dostoevsky answers his question by saying we would commit suicide.

and my answer is a modified version of what Mike Rulle concludes:

Faith is valuable, or lack of faith, too costly.

Mark Bahner writes:
Given my belief, and given that I still have a fair chunk of money in NZ, on the whole I am against empirically testing this.

I have a fair amount (a majority, in fact) of my retirement savings in broadly indexed stock funds of international countries.

Ideally, I'd like to put all that money into countries that:

1) Have a high index of economic freedom (per the Heritage/Frasier index of economic freedom), and

2) Have a low debt-to-GDP ratio.

One of the countries that best meets those two criteria is New Zealand. It is ranked fourth- highest in the world in terms of economic freedom, and has a debt-to-GDP ratio of 35%. Australia is also an excellent choice (3rd highest ranking for economic freedom, and national debt about 25% of GDP).

P.S. Note to self: look into buying property in New Zealand or Australia.

Payam writes:

Money has value because it people are forced to pay taxes, fines, fees, etc. Of course it all started with taxes, and is in fact where the school of thought of "chartalism" comes from. First of all, chartalists understand that money formed not from barter, but from credit. See Innes (1913 and 1915 I believe) for more info on this, or for recent work see Debt: 5000 years by David Graeber. That is, money derives its value not from a metallist point of view (a la Menger) but from credit. The State theory of money is simply an extension of this. Money is still a debt-credit relationship with chartalism, and for it to gain social acceptance is by issuing a tax on individuals living in that country. You are quite right that, if tomorrow for some idiotic reason the US government decided that taxes are now due in some other currency, that the dollar would still be used to some extent (though not nearly as much as today). Of course by doing so the government gives up it's ability to issue more money (ie no longer has a sovereign currency) and could and would eventually become something like the next Greece. But your example is flawed in a more fundamental way as mentioned by Doug above. Money also derives it's value due to liquidity preference as Keynes mentioned so long ago (remember q-c+l?) I didn't think so. You guys would really do well to go back and read the General Theory, particularly chapter 17.

Those of you saying money has value due to scarcity really need to get your heads checked. By your definition alone it isn't sufficient to say someone would prefer holding money over something else. In order for the unit of account to be accepted it must have something intrinsic about it that gives it it's value. Those answers I laid out above. You guys can't simply post your opinions without giving this more thought.

Kaleberg writes:

Mark Bahner: "I'd like to put all that money into countries that: ... high index of economic freedom ... low debt-to-GDP ratio"

You really don't want to do that.

Those right wing business friendly measures are terrible for investors. In the 1960s, the smart right wing money was on Pakistan. (I'm not making this up. They were ranked number one for growth prospects based on crap like economic freedom for years running while India, sitting in the middle, was considered a permanent basket case with its citizens doomed to famine.) Relying on that kind of analysis is like relying on the Wall Street Journal editorial page for investment insight. Don't do it, not unless you really have something against fiat money and want to get rid of it.

Also, watch out for low debt to GDP ratios. Spain was running a surplus, as was Ireland. That's a terrible metric. You don't look for debt free firms. Borrowing is often a sign of future growth. Look at what the money is being spent on. If it's being pissed off on tax cuts, run. Otherwise, take a look at the ROI.

Finally, Australia is in a property bubble right now. It's being held up by high natural resources prices which have driven up wages, but an Asian slowdown or alternate sources could put an end to this. You'll have bought in near the peak. I considered NZ real estate maybe ten years ago, but its prices are rather high now as well.

Mark Bahner writes:

Mark Bahner: "I'd like to put all that money into countries that: ... high index of economic freedom ... low debt-to-GDP ratio"

Kaleberg: "You really don't want to do that."

Wanna bet? Seriously.

Today (October 26th) the S&P ASX200 (Australian Stock Exchange) was at about 4500. And the current conversion is 1 Australian dollar equals 1.04 U.S. dollars.

And the NZX50 was about 4000. And the current conversion rate is 1 New Zealand dollar equals 0.82 U.S. dollars.

The U.S. S&P 500 was about 1410.

I'll bet you any amount up to $50 each (so 100, total) that the Austalian and New Zealand stock indexes listed above outperform the S&P 500 a year from now, adjusting for the currency conversion rate.

For example, let's say the S&P goes up by 10 percent, to 1551. And let's say the Austalian ASX200 also gains 10 percent (to 4950), but the Australian dollar loses 5 percent to the U.S. dollar. Then I'd lose. But if the Austalian dollar gained 5 percent to the U.S. dollar, I'd win.

Another thing is that the bet has to allowed to continue each year, unless the "net" loser calls it off. For example, suppose I lost $50 on both Australia and New Zealand. You would have to allow the bet to continue to the next near, unless I wanted to call it off. So If I won on Austalia the next year, but lost on New Zealand, I'd still be down $100, and you couldn't call off the bet if I wanted it to continue. Conversely, if I was ahead after the first year, I couldn't call it off. Only you could call it off.

How about it?

Mark

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