[A post for Alex Douglas.]
Here are two closely related questions, about Chartalism and the relation between stocks and flows of money.
1. How can intrinsically worthless bits of paper be a valuable asset that gets used as a medium of exchange?
One answer is that the government forces us to pay taxes with those intrinsically worthless bits of paper, which creates a demand for those intrinsically worthless bits of paper.
There's a problem with that answer. Taxes are a flow; they have the units $/time. Taxes create a flow demand for intrinsically worthless bits of paper. But there is a stock of intrinsically worthless bits of paper; and that stock has the units $. And if that stock of paper is strictly positive and increasing over time, as it usually does, that means the flow supply of new paper created must exceed the flow demand for paper to pay taxes. So if flow supply exceeds flow demand, why doesn't the market price of those intrinsically worthless bits of paper fall to zero?
If intrinsically worthless bits of paper paid interest, or appreciated over time, and so gave the same rate of return as other assets, there would be a stock demand for those intrinsically worthless bits of paper. Matching that stock demand to the stock supply could give us a positive equilibrium price, just like any asset, even if the stock was increasing over time. But paper currency usually does not pay interest, and usually depreciates over time. Indeed the Bank of Canada, which issues the intrinsically worthless bit of paper (OK, plastic) in my pocket, promises it will do its best to ensure they depreciate over time at 2% per year. And sometimes currency is expected to depreciate much more quickly than that, and yet people still want to hold it at some positive price. So why do I have a stock demand for that paper? Why don't I hold my wealth in some other asset instead, then pick up some of those worthless bits of paper off the growing pile littering the streets just before the government stupidly insists I must give it some?
Suppose we did have a theory of the stock demand for money. For example we could say that monetary exchange is more convenient than barter exchange, and that it is very inconvenient to spend money immediately after it enters our pockets, so we want to hold a stock of money temporarily despite it paying no interest and depreciating in value. The convenience yield of a stock of medium of exchange offsets the loss of interest and depreciation. Putting that stock demand for money against a limited stock supply of money there will be an equilibrium in which money has a positive value. (And yes, there may be a second equilibrium in which it has zero value and so cannot be used as a medium of exchange and so has no stock demand; and we are still waiting to see if Bitcoin for example stays in the first or collapses to the second equilibrium.)
If the government forces us to pay taxes in labour (like a military draft) we won't use labour as a medium of exchange. Labour doesn't work very well for that purpose. But if we have a stock demand for bits of paper to use as a medium of exchange, and if the stock supply were limited, those bits of paper could have positive market value even if we paid all our taxes in labour.
The flow demand for money to pay taxes is neither necessary nor sufficient to explain why a stock of intrinsically worthless bits of paper have positive value. Nor why they are used as medium of exchange.
Now it is true that the government is very influential in deciding what good will be used as money. Because each of us wants to use the same medium of exchange as the people we trade with. If everyone I trade with wants to be paid in those intrinsically worthless bits of paper, I will use that paper to buy food and clothes as well as to pay taxes. There's a strategic complementarity in what we choose to use as money. And governments are big players in the money game. So if the government uses something as money, there's a good chance the rest of us will all follow its lead. Just like when the government switches to Daylight Saving Time most of us just follow along. But it doesn't always work. The Cuban government tried to ban the use of US dollars, but failed.
2. What is the relation between the flow of monetary expenditures and the stock of money?
Purely as a matter of accounting identity, we can define Velocity of circulation as the ratio between the flow of monetary expenditures and the stock of money. Velocity has the units (1/time). Velocity reconciles flows of monetary expenditures ($/time) and stocks of money ($).
But velocity is not just an accounting relationship between flows and stocks. I can choose the velocity of circulation of the money I hold. I can choose to spend it very quickly after I receive it, or I can choose to spend it very slowly. So can every other individual. So any theory which has a stock of money and a flow of monetary expenditures must implicitly also be a theory of individual choice of velocity. Does that implicit theory of individual choice make sense?
Suppose for example you have a theory which says that government expenditure creates money and taxes destroy money. So that a government deficit means that the stock of money is growing over time and a surplus means the stock of money is shrinking over time. Also suppose that same theory says that there is a relationship between the level of government deficit and the level of monetary expenditures. But that means that a government deficit that is constant over time means the stock of money is growing over time relative to the level of the flow of monetary expenditures. And purely as a matter of accounting identity that means velocity must be falling over time, towards zero. And a budget surplus must mean velocity is rising over time, without limit.
Why would individuals choose to have velocity falling over time towards zero or rising over time without limit? Do those choices make sense?
The simple textbook's ISLM model has a clear and simple answer to those questions. It says that velocity is a positive function of the opportunity cost of holding money, so if money always pays 0% interest, a rise in the rate of interest on other assets will cause velocity to increase. You might not agree with that answer, but it is an answer.
Worthwhile Canadian Initiative 
Nick, re: gold: aren’t those just lumps of intrinsically worthless yellow metal?
Tom: my dentist disagrees with you.
Nick,
I found this online:
Click to access 9311704.pdf
The authors describe a classroom experiment where students are each giving an endowment of various food items and eating utensils and are directed to engage in barter trade to obtain their lunch. Taken a step further, the exercise could be timed with a clock and then repeated with a central market that buys and sells goods for paper money.
It should be apparent that trade will be completed more quickly using paper money as opposed to barter. And so the real value of the paper money used is the amount of time saved during trade in using that currency.
“what stops us from all suddenly waking up one morning and throwing our money on the ground because we expect it has zero market value and expect everyone else to do the same”
The government gives away pieces of papers. Person A gets four pieces and B gets one. The government announce that it will collect two pieces as taxes in the next period and those failing to pay will be punished. I’m sure paper will have some value. What do I miss?
Andrew: I gave a definition of what is a king. Nothing can be more positive than that. No value judgment. End of story.
@Philippe-You are asserting that fiat money can be spent into existence, ex nihilo, not taxed into existence. Different claims. why does the person being paid by the King accept tokens in payment? If your answer is “because the King holds a gun to his head” then you have not explained money by appeal to taxation.
@Jacques René Giguère-” I gave a definition of what is a king. Nothing can be more positive than that. No value judgment. End of story.”
“the King decides that is is not robbery but taxation.”
This is not a positive definition, it is a normative judgment. “When the President does it, it’s not illegal.”
Andrew_FL
People accept the tokens in payment because some people need them to pay taxes. So even if I don’t have to pay taxes, I’ll accept them as I know someone else does, or will have to, so I’ll be able to exchange them for goods and services.
“The King holds a gun to their head”
Well, all laws are backed by the threat of force, including private property laws. Taxation is no different in that respect.
Nick,
“We need a theory to explain why people have a buffer stock of currency. And if we have such a theory, that is sufficient to explain why currency has positive value. So the taxes theory is neither sufficient nor necessary to explain why currency has value.”
Perhaps we need a better value theory? Why does an asset “have to” possess a static value? As a for instance, in physics an object lying on the ground will have a coefficient of static friction and a coefficient of kinetic friction. The two values will likely not be the same (though the coefficient of static friction is unlikely to be zero with some positive coefficient of kinetic friction).
It makes sense to hold even zero interest money as a short term store of value. Because wages and contracts etc are denominated in money it actually has the best short term stability (in real value terms) of any asset class. Even if someone is managing wealth with a long term outlook, it makes sense to hold a certain percentage of that wealth as money to use it to re-balance against if there is a collapse in stock or bond prices.
Warren Buffett’s views on cash perhaps explain some of its value as a stock rather than just as a flow: http://www.businessinsider.com/cash-as-a-call-option-2012-9?IR=T
“”He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”
It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.
Suddenly, an investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it?”
Nick, this post and comments really highlight the main thing I’ve never understood about you. I think there is a bit of circular reasoning deeply rooted in your thinking on this. There are two separate questions here that you seem to be, at times, recognizing but at other times conflating. One is “why does money have value at all” and one is “given that money is used as the medium of exchange (which means it has value), what determines it’s value exactly?” I think your position is essentially summarized by this comment:
“We need a theory to explain why people have a buffer stock of currency. And if we have such a theory, that is sufficient to explain why currency has positive value. So the taxes theory is neither sufficient nor necessary to explain why currency has value.”
I agree that taxes are not sufficient to determine an exact value of money under the circumstances, you need some type of liquidity preference. And it’s true that if you start by assuming that people have demand for money as a medium of exchange, you can determine its value from that (and it will be positive). But that doesn’t answer the question of WHY people are willing to hold it in the first place and use it as a medium of exchange (your original question #1). You can’t answer the question “why are people willing to use this for exchange?” with “because it’s the medium of exchange.”
At times you are acknowledging this question as unresolved but you are relegating it to an “origin story” and say “those origins stories are like car’s starter motors — needed to get the thing up and running from an initial zero value and zero stock, but they just get in the way once the engine has started moving and is running on gas.” Now that MIGHT be the case (I don’t think so) but it is a matter of faith. It doesn’t follow logically that this shouldn’t fall apart in the absence of some explanation (in other words that taxes, or something else is not necessary as an explanation). SOME explanation is certainly necessary, otherwise this is the greatest magic trick ever accomplished. Especially since anybody can produce pieces of paper and would love to figure out how to make them into a medium of exchange. But for some reason certain bits of paper are super valuable and others are not.
It seems like you don’t find an explanation necessary only because you have accepted another explanation in the form of some collective confusion or force of habit. But that explanation IS necessary. Without it, this whole thing makes no sense. It’s just that that explanation sucks. Claiming, sometimes, that you don’t need an explanation allows you to ignore the fact that its a sucky explanation but you still have it to throw out there whenever you back yourself into a logical corner that actually DOES require an explanation.
Mike: I think we certainly do need an explanation for: 1. why people use a medium of exchange (as opposed to say barter); 2. why people demand a strictly positive stock of medium of exchange; 3. why people us this particular good as their medium of exchange (and not something else).
These are very standard questions in monetary economics. And there are answers out there, but this post is not about those answers. And the tax story adds nothing to those answers, with the possible exception of 3, as I mentioned above (about the government being a big player, so others may follow it’s lead in a positive feedback game).
Briefly, the standard answers are:
1. Because barter has higher transactions costs (and different theories give different explanations of why).
2. Because it is costly to perfectly synchronise your purchases and sales (again, different explanations for why).
3. Because some goods have lower transactions costs than others (again….), plus positive feedback.
Yeah, actually I agree with you about taxes. And I think your point about perpetual deficits regarding that theory is accurate. I sort of glossed over that because I have something else in mind. So just to be clear, this is not an argument for chartalism. Also I completely agree with your answer to those three questions but they are mostly unrelated to the question I am talking about. Of all the goods (“good” implying things with positive value to begin with) the one with the lowest transaction costs becomes the medium of exchange. That’s a perfectly reasonable theory. But that’s different from saying that we just create something out of thin air which would otherwise have no value whatsoever and decide we will all use it for trade and because of that it becomes valuable. That is a much more questionable claim. Maybe it’s true but there are a lot of good reasons to be skeptical about that and if it is true it’s an amazing economic phenomenon. I just think it’s weird that people are so satisfied with that answer.
Mike: we are on the same page.
Suppose that intrinsically worthless bit of paper are used as medium of exchange (they have the lowest transactions costs once everyone else is using them, and are valued because there is a demand to hold them, because of the costs of synchronising payments and receipts). But that still leaves open a question that needs answering. There are two different ways to pose what is at root that same question:
1. How did it get started? Did people just pick up worthless bits of paper off the ground, and suddenly start valuing them because they could use them as media of exchange? Was there some sort of initial social contract to use them as money (highly dubious)? (Which is how von Mises posed the problem)
2. There are two equilibria: one in which the paper is used as medium of exchange, so is demanded, so is valuable; and a second in which the paper is worthless so cannot be used as a medium of exchange and so is not demanded and so is worthless. How come we stay in the first equilibrium and don’t suddenly all lose faith and jump to the second? (Which is how Hahn posed the problem).
I prefer the von Mises way of thinking about it. And his answer (the “Regression Theory”) was that paper money started out as convertible into something valuable, to get the thing off the ground and into the air, but once it gets flying you can withdraw convertibility and it keeps flying. Though Bitcoin is maybe a fascinating counterexample. JP Koning did a good post on it about a year ago. And maybe Chartalism gives and alternative answer.
It’s a bit like asking how languages get started. How can intrinsically meaningless noises come to have common meanings? Eric Lonergan did a good post a couple of weeks back on Hume and language and money.
Yeah, I think we just disagree on the explanation, I don’t think that is the explanation, I’m just trying to separate this out from the questions you listed initially (in your response to me) and from the issue of liquidity preference. Sometimes it seems like when someone proposes an explanation for why money is valuable (chartalism is also a sucky explanation in my opinion but I’ve got my own kooky explanation) you say no, there has to be some value related to its use as a medium of exchange, which I agree with and then you jump to: because there is some value from being used as a medium of exchange, no other explanation is necessary. But that last part basically just skips over the question that I think is interesting (which you accurately describe in the second response).
Now I think both of those answers (Mises and Hahn) are mistaken. You were closer to the truth here:
“Miami: I actually have some sympathy for that thought. All financial assets are promises written on bits of paper. (Or sometimes the promise is written in a book or website somewhere). They are worth what those promises are worth. The Bank of Canada promises: “We sorta promise that we will do our best to ensure that this bit of paper (plastic) depreciates at around 2% relative to the CPI basket of goods, and we will adjust the supply as needed to try to make that happen. Unless we really need to change our mind.”
However, that is NOT the legal promise which is attached to the bit of paper. Plus that also skips over the question of how it can be valuable by assuming that they creators of the bits have the power to determine their value. But there is a specific legal promise attached to the paper and that is the ability to extinguish $1 of debt. The same debt which is created upon creation of the money. I told myself I wouldn’t turn this into a debate about the actual answer though, I just wanted to try to highlight the important question. Maybe later I’ll try to push my crazy theory on you again.
BTW, I find this kind of ironic but I think you have a situation here where your equilibrium is “unstable” in the way that we both wish we could call “not trembling-hand perfect” but which isn’t really what that means. As long as everyone else keeps using this stuff, I might as well keep using it, but if other people stop, it will be a race to the zero-value equilibrium. Doesn’t it seem odd at all that that has held up for so long if that’s all that is keeping it from falling apart? In other instances, that seems to make you skeptical…
Mike: I think money is a locally but not globally stable equilibrium. Like a lot of network things. If 20% of people stop using it I keep using it. If 80% stop using it I stop using it too.
Nick,
This is the problem you get with people who spend too much time with mathematics and not enough time in the real world.
Imposing taxation on somebody is a liability in a denomination with a deadline. You get the denomination by the deadline or you go to jail.
That is enough to get people to give up real goods and services for the denomination and instantly spend it on the taxation – transitively throughout the economy. That is what gives a denomination value in the flow dimension.
People save the denomination not because of interest rates, but because of time uncertainty, insurance and vanity. They choose the particular denomination largely due to the denomination of their flow commitments for all the usual minimising risk reasons. That is the value in the stock dimension – why it gets saved to excess.
MMT doesn’t say that taxes give value to the currency. Rather it has that taxes are sufficient to create demand for the state’s liabilities if the state only accepts its own liabilities in payment.
MMT holds that a currency sovereign has a monopoly over currency issuance, and like other monopolists is able to set the price it is willing to pay in markets that operate using its currency. Specifically, the state can set the own rate of the currency through monetary policy.
I wrote the “origin story” using you as a foil sort of. I’d love for you to read it. Even if you don’t, I find that you make a very good foil, so I appreciate that. Anyone else who thinks the “Wile E. Coyote” theory is a bit suspect, please click below.
http://realfreeradical.com/2016/04/03/a-fiat-money-origin-story/