MMP BLOG #7: WHAT BACKS UP CURRENCY, AND WHY WOULD ANYONE ACCEPT IT?

Last week we introduced the concept of a sovereign currency. When I first started teaching, most students thought the US Dollar had gold backing—that it was valuable because Fort Knox was filled with gold, and if they drove to the Fort with a stash of cash, they could load up their car trunks with gold. (They were shocked to find out there had not been any gold backing since they were babies.) Today, very few students entertain such beliefs—they have all learned that our currency is “fiat”—it has “nothing” backing it up. Well, maybe “something”—but we don’t necessarily want to see what is behind Alan Greenspan’s “curtain”:

So, this week, let us take a peek behind the currency. Is there anything there, other than the Fed Chairman’s—how shall we put it—family jewels?

What “backs up” domestic currency? There is, and historically has been, some confusion surrounding sovereign currency. For example, many policy makers and economists have had trouble understanding why the private sector would accept currency issued by government as it makes purchases.

Some have argued that it is necessary to “back up” a currency with a precious metal in order to ensure acceptance in payment. Historically, governments have sometimes maintained a reserve of gold or silver (or both) against domestic currency. It was thought that if the population could always return currency to the government to obtain precious metal instead, then currency would be accepted because it would be thought to be “as good as gold”. Sometimes the currency, itself, would contain precious metal—as in the case of gold coins. In the US, the Treasury did maintain gold reserves, in an amount equal to 25% of the value of the issued currency, through the 1960s (interestingly, American citizens were not allowed to trade currency for gold; only foreign holders of US currency could do so).

However, the US and most nations have long since abandoned this practice. And even with no gold backing, the US currency is still in high demand all over the world, so the view that currency needs precious metal backing is erroneous. We have moved on to what is called “fiat currency”—one that is not backed by reserves of precious metals. While some countries do explicitly back their currencies with reserves of a foreign currency (for example, a currency board arrangement in which the domestic currency is converted on demand at a specified exchange rate for US Dollars or some other currency), most governments issue a currency that is not “backed by” foreign currencies. In any case, we need to explain why a currency like the US Dollar can circulate without such “backing”.

Legal tender laws. One explanation that has been offered to explain acceptability of government “fiat” currency (that has no explicit promise to convert to gold or foreign currency) is legal tender laws. Historically, sovereign governments have enacted legislation requiring their currencies to be accepted in domestic payments. Indeed, paper currency issued in the US proclaims “this note is legal tender for all debts, public and private”; Canadian notes say “this note is legal tender”; and Australian paper currency reads “This Australian note is legal tender throughout Australia and its territories.” By contrast, the paper currency of the UK simply says “I promise to pay the bearer on demand the sum of five pounds” (in the case of the five pound note). And the Euro paper currency makes no promises and has no legal tender laws requiring its use.

Further, throughout history there are many examples of governments that passed legal tender laws, but still could not create a demand for their currencies—which were not accepted in private payments, and sometimes even rejected in payment to government. (In some cases, the penalty for refusing to accept a king’s coin included the burning of a red hot coin into the forehead of the recalcitrant—indicating that without such extraordinary compulsion, the population refused to accept the sovereign’s currency.) Hence, there are currencies that readily circulate without any legal tender laws (such as the Euro) as well as currencies that were shunned even with legal tender laws. Further, as we know, the US Dollar circulates in a large number of countries in which it is not legal tender (and even in countries where its use is discouraged and perhaps even outlawed by the authorities). We conclude that legal tender laws, alone, cannot explain this.

If “modern money” is mostly not backed by foreign currency, and if it is accepted even without legal tender laws mandating its use, why is it accepted? It seems to be quite a puzzle. The typical answer provided in textbooks is that you will accept your national currency because you know others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an “infinite regress”: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will probably take it. What a thin reed on which to hang monetary theory!

Personally, I’d be embarrassed to write that in my own textbook, or to try to convince a sceptical student that the only thing backing money is the “greater fool” or “hot potato” theory of money: I accept a dollar bill because I think I can pass it along to some dupe or dope.

Now, that is certainly true of counterfeit currency: I would take it only on the expectation that I could surreptitiously pass it along.

But I’m certainly not going to try to convince readers of this Primer of such a silly theory. Next week: a more convincing argument. See if you can anticipate the answer.

Like a good Mexican soap opera, we need to leave you hanging. I know many readers already know the answer, and you’ve got your hands high in the air, saying “call on me, I know the Butler did it”.

But remember that this is a Primer and not all of your classmates know the answer (yet). So, please don’t give away the plot line. In the comments, let us stick to the “gold standard” vs “fiat money” or “legal tender” and “hot potato” theories of money. I am sure we’ve got at least a few “goldbugs” out there. You probably cheered when Ron Paul asked Bernanke whether gold was money. Is gold money? Can it be money? If gold no longer backs money, why does the Fed hold it? Could a currency be backed by nothing more than “trust”—the expectation that someone, somewhere, will take it?

Have fun pondering.

19 Responses to MMP BLOG #7: WHAT BACKS UP CURRENCY, AND WHY WOULD ANYONE ACCEPT IT?

  1. Mexican soap opera? You must be watching a channel that isn't on basic cable where I live.But seriously, since the biggest leftward trend in the world right now is in South America, is there any thought of translating NEP into Spanish?

  2. dale: very good idea. My Understanding Modern Money is indeed in spanish, published by UNAM. (also portuguese and forthcoming in chinese) I hope this MMP also can be translated–but it will be a while.

  3. By currency here, do you mean currency only or the medium of exchange supply?I have an answer for the "backing question", but it might indirectly give away your "plot line". I'll wait for now.

  4. When I say "currency" I mean currency. As I said last week, in my view far too much emphasis is placed on "medium of exchange" or "medium of cocaine delivery"–functions of "money things". Forget medium of exchange–at least for now. It is just about the least important thing about money, and draws your attention to all the wrong things.

  5. One of the UMKC graduate/post grad students?? wrote an interesting paper explaining methods of how 19th century Germany monetized an African colony. Kind of a primative form of IRS tactics..

  6. OK, so we know that gold *can* be money because it has very often been money in the past. Fiat currency didn't come into being overnight either – the two co-existed in a number of complex ways. There was a back-and-forth process that went on for a century or so. I don't see a difference between fiat-as-a-theory and the 'hot potato' theory – as stated, neither is a theory at all, but just an endless restatement of the very question that needs to be explained.So the only unanalyzed theory is the legal tender theory: we accept the government's intrinsically worthless paper money and deliver up our real goods, services and labor in exchange for it because refusing to do so would somehow be illegal. And I can see a limited sense in which this is kinda-sorta true. Let's go to court.Summary judgement is rendered in my favor after a dispute with my landlord. He owes me one hundred dollars in excess rent. But I don't want his stinkin', worthless paper dollars. I don't trust 'em. So I ask the judge to order my landlord to pay me the current equivalent value in a green-colored commodity I do trust – Quaker State motor oil. What will the judge say when he get's done laughing?Maybe something like – "Sorry, pal. These notes and other instruments known as "dollars" are legal tender for all debts – whether public or private. But hey, even if you really feel the way you say you feel, just take your dollars to the corner and buy all the motor oil you like."But this special case aside, legal tender statutes are empirically known to carry no weight when the state's money loses its credibility. Whenever a large segment of a country's economy is driven underground – due to hyperinflation or rationing for example – people with real goods or safer foreign money in hand barter their goods for other real goods or trade in foreign money. As a practical matter, legal tender statutes can't really be enforced, so they fail to explain the normal and near-universal case – everyone accepts and saves in the national currency even though we know perfectly well that nothing is backing it except the government's I.O.U.So George W. Bush was actually telling the truth when he went out to West Virginia and looked for the "Social Security Trust Fund". There's nothin' whatsoever in the filing cabinet with that name on it but a bunch of fancied-up government I.O.U.s. Nothing of any real, intrinsic value has been "saved up". So if I believe the government will continue to honor Social Security, whether the fund becomes "exhausted" or not, I have to believe it for some other reason. I have to believe that there is some completely real and dependable reason why, (absent wildly abnormal conditions like those discussed above), there will *always* be takers for the government's money – for its next round of I.O.U.s.And if that's too broad a hint, you can fine me. But only if I can pay you with motor oil…

  7. Anonymous at 12:26 may be referring to this, though I can't be sure:http://www.epicoalition.org/docs/pavlina.htmAnyway, it's a terrific article.

  8. The upshot: Money is nomos (custom, law, norm, rule), not physis (nature). The entity designated as money is just the embodiment of a social relationship, a relationship that can change because of an act of will or common agreement or by chance.A great article.

  9. Why would people in other countries circulate dollars instead of or in parallel with their own domestic currency? Because there are 300 million americans throwing a $14T dollar denominated party every year and a dollar represents a piece of that action.The dollar's claim on US GDP is what backs it and the operational linkage enforcing that claim is… *spoiler removed*

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  11. @atung: Thanks for sharing the nomos/physis comparison! Had not seen that expression before.Chartalism FTW!

  12. When kids play together and one owes the other – that’s ‘money’. When all ‘credits and debits’ dissolve, money disappears. When the kids grow up and play with the skin of the earth and its resources nothing changes. When they keep ‘account’ with numbers that’s just a rather boring variant plug-in. When human beings value themselves (and by proxy each other) far more than they value numbers (and all that they represent) – that’s called clarity. When a human being experiences clarity, it is because they are in touch with their heart – mind and ego are coming under the governance of the heart. Everything rests on the pillars of both the good and bad in human nature: concepts, emotional bias, egos and the world extant are just a dynamic reflection. There are egos in this world that have whole countries and armies, the media or the financial system at their disposal – that is our human problem! The ‘good’ in a human being respects freedom and creates ‘credit’ without debt because that is its nature (the women of the planet who are more intelligent than the men understand this far better): selfishness on the other hand loves creating control and debt. What we really need is an earth full of people and leaders who are self-aware and choose good over greed. I think it’s really that simple!! There are no excuses. Maybe then the plug-in might work. I hope this is where evolution is leading us (besides comic books, fables and fairy-tales): otherwise we’re screwed!!Cheers …jrbarch

  13. Fiat money exists since the old agrarian empires (Mesopotamia, Egypt, etc.), it's basically a by-product of accounting systems of credit/debt. Origin of money is to be found in debt, both were born at the same time, and both born with the evolution from a gift economy (not in anyway a barter economy, which is a fairy story told by economists) to a sedentary and surplus-based State economy (which its own legal and power structure). Bullion came later, and was the by-product of war between states and commerce between strangers.And about what backs up fiat, the answer is straightforward but it gives way up too much plot hehe. However there are serious limitations: we can say that social stability and institutional strength are key to the acceptance of fiat money.It's the ability to settle quantized (unit of account) debts which gives money such power as a tool for humans. Way more than medium of exchange, and store of value, which are secondary, and (again) a by-product of the first.

  14. Nobel Prize laureate Frederick Soddy said that the value of money is given by the wealth that is given up at the moment money is accepted in its stead.Could you please comment on this?Thank you

  15. Personally, I’d be embarrassed to write that in my own textbook, or to try to convince a sceptical student that the only thing backing money is the “greater fool” or “hot potato” theory of money: I accept a dollar bill because I think I can pass it along to some dupe or dope.Personally I think that the Chartalist notion of international money is exactly that ("greater fool" theory).So the story goes that foreigners come and sell their products, accept "non-convertible" dollars and for them as a whole to sell these dollars, some other foreigners will need to purchase them, with the banking system acting as brokers as opposed to acting as *dealers*. This "non-settlement" had been realized long back and hence "asset settlement" (via Gold) was introduced, now changed to the general concept of convertibility – we live in a world of convertible currencies. Some reading of the "The Fund's Concept of Convertibility" will help. Sorry my comments on MMP seem unwelcome, but couldn't resist!

  16. RE: RamananPersonally, as someone trying to understand this stuff well, I welcome civil and constructive criticism so that the core issues can be fleshed out and one can come to expect what the common criticisms, right or wrong, of MMT will be.That said, I would be interested to see Ramanan's point addressed, but I don't see it as a direct challenge to the possibility that there could be something else backing up sovereign money beyond the "hot potato" factor.

  17. @ RamananAs I said above: "When all ‘credits and debits’ dissolve, money disappears" … then what are you going to convert it to?Cheers,jrbarch

  18. Sovereign currency is the only thing acceptable to the sovereign in payment of taxes.

  19. As a student of Anthropology and therefore human nature, I see money as being based on “status”. Humans are primates and like most all primates are members of a “society or troop” wherein status is very important to how well you live.
    I don’t know the deep history of money, however, gold has the attributes on money (like almost intinite dividability and combinability) and gold was money for centuries (at least to those who moved back and forth between countries).
    Gold is a universal status object, women confer status and they want gold, paper money slowly replaced gold and now paper money is fiat currency.