The reason we accept paper money as a store of value is habit. This habit has its origins in history, when banks took our gold as deposit and issued paper receipts for it. The gold has gone, but the paper with its habitual value remains, and we accept it without question. The only backing is a vague government promise.
There is no sound theoretical basis for why unbacked government-issued money should retain a store of value: it depends for its value on a market-based acceptance of financial credibility. So it follows that if a government loses all financial credibility in markets, its paper becomes worthless. This is confirmed by experience in all paper money collapses.
The fact it can and has happened elsewhere confirms that all faith can theoretically disappear from the dollar, pound, euro or yen. This is a very different understanding about currency values compared with what is commonly accepted. Instead, we assume that any change in purchasing power is tied firmly to price inflation, and we factor out any reliance upon faith. But this is a cop-out, a way of not addressing the basic assumptions that uplift the value of government-issued money from zero to what it will actually purchase.
It is vital to understand that price inflation and maintenance of fiat currency premiums are only loosely related. In a sound money economy, an economy where the medium of exchange is backed by gold, changes in the available quantity of money will affect the prices of goods and services exchanged for it. This is because sound money is itself a commodity, whose function happens to be to act as a medium of exchange. However, you cannot say this of fiat money, where the link with value is based entirely on faith. It is a mistake to assume that supply and demand factors that give sound money its value as a means of exchange also apply to unbacked government money. The value of fiat currencies is purely subjective.
In the case of fiat money, additional quantities in circulation increases demand for goods, whose prices rise driven by this extra demand: the rise in prices comes from the goods themselves, and not a change in the value of the money. In stagflation, where there is no extra demand, price rises emanate from changing values in the paper money itself, usually tied to foreign exchange movements.
The implications are profound. To state that in hyperinflations fiat money loses purchasing power because of massive issuance of money is a misunderstanding. The collapse in purchasing power is due to loss of faith in fiat money, and not from its extra supply: if it was otherwise, you would have to establish it had an objective value in the first place.
It is entirely possible, even increasingly likely in these times of growing systemic risk, that a collapse of paper-money values will happen not as a result of rising consumer prices, but of its own subjective value. If this happens there will be little or no warning and it could be substantial if not total.
So the argument in favour of a flight into sound money, best exemplified by precious metals, is getting stronger by the day.
This article was previously published at GoldMoney.com.
“The reason we accept paper money as a store of value is habit.”
And here I was, thinking it was because I could pay my taxes with them. It is all just a protection racet, and currently you must pay with “money”.
We have to include here, legal tender laws, which require us to accept fiat paper money in repayment of debts.
Actually, you make a very good point that government money need not be a good ‘store of value’ and that its ‘means of economic exchange’ function is what gives national (paper) money any value in its home state.
I agree that people are better off if we not view national money as just another commodity.
But so what?
First, if the “amount” of exchange media is appropriate for the goods and services existing, there can be no inflation by von Mises definition, let alone hyperinflation.
Second, let those who want to move from the stability of state-money holdings to an investment in any commodity do so at your advice.
Again, so what?
In the end, those commodity-holders have a bunch of stuff that is worth “money”, and you still need money to exchange the goods and services.
Given that all currencies are pretty much equally affected by hyped-up commodity bubbles, the benefits to the real economies are elusive.
Of course, if you make a buck on both the buying and the selling of those commodities, hey, this looks like a really good business decision.
Just saying.
For the Money System Common.
“First, if the “amount” of exchange media is appropriate for the goods and services existing, there can be no inflation by von Mises definition, let alone hyperinflation.”
I don’t believe Mises ever referred to an “appropriate” amount of fiat money. There was a quantity of the stuff; and when that quantity was increased by a decision of the central bank, the currency was inflated. Period [or, if you prefer, full stop.]
Joe B.
If a form of money is not a very good store of value it is not a very good form of money.
That is the “so what”.
People do not work just to pay taxes – they also (in a sane economy) work to SAVE.
Without REAL SAVINGS there can be sustainable investment (not based on credit bubbles – doomed to collapse) no real long term economic life.
As for fiat money being a commodity “like any other”.
Sadly fiat (government edict) money is not a commodity at all – that is rather the point.
To Craig and Paul
Sorry I missed these comments.
Craig,
“inflated?
Increased?
Caused inflation?
I referred to causing ‘inflation’.
pg 126 of von Mises Theory says it is expected and appropriate to increase the amount of money as the economy grows as long as it is not in excess of that needed.
There, inflation is defined as being in excess of need, and causing “a fall in the objective exchange value of the money”.
No fall in exchange value?
NO inflation.
That was my point.
To Paul
Yes, we see things differently.
Fiat money is not a commodity-BASED money.
This is true.
Fiat money is traded 24 / 7 / 365 on worldwide exchanges.
To me, that’s as ‘commodity’ as you can get.
Therefore, fiat money IS a a commodity.
As to saving and the store of value of a fiat money.
I would think that the only store of value that any fiat money must maintain is its own purchasing power.
Every money in general use that floats freely against any other money is going to see changes to its relative external values.
But the job of a national money system is to be neither inflationary nor deflationary in its internal operations.
Every saver can do what they want with their savings.
Mostly they invest it with a bank that properly accounts for all norms of financial(risk-reward) considerations.
One of those considerations is the monetary policy of the state.
Savers can buy real estate or invest in wars or oil futures, where they ‘bet’ the value of those things over time.
Where fiat money is globally exchanged all day long every day by financial capitalists wanting to make a profit, how can you fault the currency-issuer for the value lost in exchange transaction.
My point is that the primary function of a national monetary system is to provide the liquidity that enables producers and consumers of goods and services to exchange same.