My Finance Twitter feed is full of finance professionals who warn about the dangers of fiat money being ‘unbacked’. The problem is that this is just incorrect. It’s the economic equivalent of looking at a horse that’s been saddled for riding, and declaring “Those reins aren’t even part of the horse – that’s not safe!”
Of course, in that analogy, the way that the horse was bridled – whether the reins are too tight or too loose – those can all make it more or less safe for both the rider and the horse. That is a much more important discussion to have, unlike a conversation around whether the reins are too artificial, and whether they’re even real if they’re not a biological part of the animal. Fixating on the biology of saddles and bridles might get you caught in existential feedback loops around the nature of reality.
And the problem is that the feedback loop started with an odd misconception around what a rein is, and why a rider might need it in the first place.
We have the same problem with money. When people worry about money being “unbacked”, they are conceiving of it as a substance of value rather than as a measurement tool of value.
Once you see it as a measurement tool, then the conversation around money in relation to economy and to people becomes about how it works as a measurement tool for value, how it can work better, and how and when someone can jimmy it to get bad results.
But instead, we tend to fixate on whether money has value in itself. That’s the concern that underlies the fear that money is unbacked. That somehow, we’ve all been duped, and money is secretly worthless.
But money itself is backed by everything, and by nothing, and by whatever you want. It’s the piece of string whose length is as long as you want it to be.
Let me show you.
The last time money was “backed”, we were on the Gold Standard. Under that monetary measurement system, you could hypothetically go to your bank and demand to withdraw your money in gold. Gold (in effect) was the “measurement” unit of value.
Because of that historical norm, a common worry from the “fiat is unbacked” crowd is that it is no longer possible to go down to your bank and redeem your paper money for gold – instead, you just have to accept it, because a government by “fiat” declared it to be legal tender.
But this should not worry you in the slightest.
Because if you do really want to redeem your money for gold, then you can take yourself down to the jewellery shop in the same mall as your local bank branch, and indeed redeem your paper money for gold by buying some gold. You can also log into your investment account on your mobile banking app and redeem your electronic money for gold on a commodity market – or, more likely, for units in a gold exchange-traded fund.
You see? Money is still “backed” by gold.
Or by whatever you want to buy with it.
Value for your money is a choice
To get a feel for why wanting money to be backed by gold is not really what we want, it helps to imagine what it might be like if we still lived with it.
Because if we still lived in a gold standard world today, we would be asking ourselves a completely different question: “Why would we want our banks to also be jewellers – doesn’t that seem odd?”
There would be other important questions: “Why gold anyway? It’s not much use. Why not platinum? Or Or oil? This just seems like a conspiracy put together by the gold mining companies.”
To give you a different perspective of the gold standard, let’s go back to the horse and reins example. Horses were the primary mode of land-based transportation for most of human history, much like gold was the preferred store of value. You could walk, or you could ride a horse (or ride in a carriage pulled by a horse). It’s why we still measure the output of engines in horsepower.
Now I want you to imagine a world of motor cars and fighter jets and submarines where we were still insisting that all modes of transportation were operated using reins and stirrups. You’d have to twitch the vehicles’s reins to get it to move to the left or the right, pull back on the reins sharply to brake, and nudge through the stirrups to increase speed. Reversing would only be possible with about turns.
It’s laughable, but that’s what the gold standard was in the 20th Century. We were saying that “value” ought to be fixed. And we collectively defined it using one particular yellow metal of one type of asset class and it was universally valued by everyone at a perpetual and permanent relative value to everything else.
This system of value broke down in a world of economic growth. When economies grow, some goods become more available than others, while some forms of work are made more efficient. As consumable income changes, consumer tastes and preferences change as well. The rigidity of the “perpetual and permanent” relative value of gold simply could not last in the face of those market forces.
Ultimately, those market forces were using money as a measurement tool to value assets and services in real time. And when gold became out-valued relative to its measurement tool, those market forces broke the Gold Standard in much the same way that George Soros once broke the British Pound.
But we got something better in exchange
Instead of money being arbitrarily tied to a commodity that had a lot of historical value but not much practical value, we now have money freely tradeable.
If you still want to look at money as primarily being a thing, this is not a great outcome. But if you see money as primarily being a measurement tool, then it’s an enormous leap forward.
In formal economic terminology, I would express this as a fundamental change in the functions of money. Money is usually defined as “a medium of exchange that is generally accepted for the payment of goods and services, and the settlement of debts.” Its functions are “a store of value, a medium of exchange, and a unit of account.”
A more updated set of functions might be: “
a store of value, a medium of exchange, and a unit of account.” Or, perhaps: “a medium of exchange, a unit of account, and also capable of being a temporary store of value.”
Because “store of value” is still in the mix, I do need to say something more about the relationship between money and value.
Because there is a legitimate monetary concern here around what happens with inflation, and hyperinflation.
What happens when money loses its “value”?
Having both lived through and academically-studied hyperinflation first-hand (and hyperinflation is the full realisation of our fiat money fears), you might be surprised to discover that fiat money is more ‘backed’ than you may think. Because even when a currency’s value is being destroyed by money creation (like the bolivar in Venezuela, or the Zimbabwe dollar), people continue to use it.
And it’s not because people are generally law-abiding – people in hyperinflation break laws routinely.
They do this because almost all governments respond to hyperinflation by imposing price controls and trying to control the rate of exchange. Price controls are meant to preserve the value of the hyperinflating currency when it comes to buying goods and services. Controlled exchange rates are meant to preserve the value of the hyperinflating currency when it comes to exchange for “stronger” foreign currencies. And those same people who use the hyperinflating money will simultaneously and happily flout those laws by breaking price controls and engaging in black market foreign exchange.
So if it’s not for pure legal reasons, why do people still use a hyperinflating currency?
To answer this question, I’m going to start at a tangent and talk about how a company works.
How business does business
A company will have revenue, which will come from either selling a good or providing a service. And it will also have all the costs associated with generating that revenue: salaries, overheads, rentals, etc.
In most countries, companies are also appointed as tax collectors. They collect tax from:
- Their clients (usually in the form of Sales tax or VAT); and
- Their employees (payroll taxes).
They also pay tax themselves, in the form of:
- VAT, when they are purchasing goods and services from other ‘tax collector’ businesses;
- Income Tax, when they make a profit; and
- Customs Duties, levies, licence fees, permits and municipal rates.
Often, a business will also obtain some services and goods from parastatal companies. Depending on where you are in the world, these could include:
- Utilities: electricity, water, and telephone services;
- Almost anything, really. There’s no limit to the variety of parastatals in the world.
And when they’re not busy collecting tax or paying for other state-related stuff, most businesses are attending to their cash flow. Which involves banks, and credit cards, and overdraft facilities.
Why do I mention taxes, utility payments, and loans?
Because those activities are all practically always payable in fiat money.
A government has to accept the tender that it, itself, has declared as legal*. And the banking sector also cannot refuse to accept ‘legal tender’ as a settlement of a debt – the Central Bank doing all the money printing generally makes that a condition of having a banking licence.
*To be clear, the occasional government department may try to refuse the legal tender when the hyperinflation is extreme – especially those that have foreign currency obligations (for example, a parastatal fuel importer). But those examples are usually isolated – governments only end up accelerating dollarisation (which is the complete abandonment of the local currency) when they themselves stop accepting their own money.
On the other side of the equation, a government will almost always pay its bills in its own legal tender.
Which means that if companies want access:
- to the spending of civil servants;
- to the proceeds of government contracts; and/or
- to the spending of those companies and individuals that have already accepted that spending and those proceeds;
Then they too must accept settlement in legal tender.
What does this all mean?
If you still want to talk about the need for money to have value, then the answer to the value question of “What backs fiat money?” is “taxation and loans and government spending“.
Those systems are anchors for the usefuless of a currency. As long as you can use a currency to pay taxes (and your government on-spends those taxes), and as long as you can use a currency to settle debts, there will be a demand for it.
But I would look at this differently, and say that we’re still in the vicinity of money just being a measurement tool. And even badly calibrated measurement tools like hyperinflating currencies are useful if large institutions are still willing to use them. In fact, they are even more useful in those situations, because you are able to use a bad measurement tool to secure better value in your favour.
This is why hyperinflations tend to last. It’s not because folks are forced to use the depreciating currency by government. It’s because it’s extremely advantageous to do so – especially if you are a borrower.
And if you want some proof for this, you should take a look at some of the actions taken by Zimbabwe’s Central Bank last year to control their spiralling inflation. In particular, that short window of time where the Zimbabwean authorities simply banned all bank lending overnight.
The main point: money’s value is a supplementary concern, not a primary one
When the Bank of England writes on the 10 pound note “I promise to pay the bearer on demand the sum of 10 pounds”, we should read it as a note from the British Government and the Financial System saying:
“We promise to accept this note on request as settlement of a tax and/or a debt obligation with us for 10 pounds.”
That is: fiat money is backed by its government’s commitment to measure future taxes in that currency, and its banking sector’s commitment to record future debt settlement in that currency.
I realise that’s hardly a comfort to those who dislike fiat money, because those folks also usually dislike taxation and credit.
But it’s important to show this, because even when money is failing to be a store of value generally, it still continues to function (albeit inefficiently) as long as there are institutions (governments and banks) who are willing to accept it as a medium of exchange.
It’s why we need to calm down around trying to ensure that money has value in itself. That’s a huge drive for the cryptocurrency community, but it’s also why crypto fails as a currency even if it occasionally works as a commodity.
Instead of that value debate, we need to focus on ensuring that money continues to be an efficient medium of exchange, which means keeping its supply sufficiently stable.
One important implication is that this way of thinking does not force you to condemn inflation as universally bad. Inflation is a consequence of more factors than simply “rampant money creation”, and it needs to be evaluated on those terms. For example, if inflation in bread pricing is caused by a shortage of wheat due to bad harvests, should we be rushing in to control the inflation with hiked interest rates? Obviously not. But it’s what we tend to do.
The bottom line: we need to be a bit more skeptical of the monetary skepticism. At least some of the time, it comes from folks who have gotten themselves caught in feedback loop around the nature of reality, and reality is already terrifying enough, thanks.