I am a big fan of coinsplainers like Andreas Antonopoulos. Listening to Andreas explain how bitcoin works is a great learning opportunity for folks like myself who know far less about the topic. I am less impressed when bitcoiners engage in fiatsplainin', since they generally have an iffy understanding of the actual financial system and central banking in particular.

So for the benefit of not only bitcoiners, but anyone interested in the topic of money, I'm going to fiatsplain' a bit. (I really like this term, I got it from an Elaine Ou blog post)

Paul Krugman recently had this to say about the difference between bitcoin and fiat money:

"So are Bitcoins a superior alternative to $100 bills, allowing you to make secret transactions without lugging around suitcases full of cash? Not really, because they lack one crucial feature: a tether to reality.

Although the modern dollar is a “fiat” currency, not backed by any other asset, like gold, its value is ultimately backed by the fact that the U.S. government will accept it, in fact demands it, in payment for taxes. Its purchasing power is also stabilized by the Federal Reserve, which will reduce the outstanding supply of dollars if inflation runs too high, increase that supply to prevent deflation.

Bitcoin, by contrast, has no intrinsic value at all. Combine that lack of a tether to reality with the very limited extent to which Bitcoin is used for anything, and you have an asset whose price is almost purely speculative, and hence incredibly volatile."

Now if you've been reading my blog for a while, you'll know that I agree with Krugman's point that bitcoin lacks a tether to reality while a banknote doesn't. He mentions two forces that anchor a $100 banknote, or provide it with intrinsic value: tax acceptability and a central bank's guarantee to regulate its quantity. Let's explore each of these anchors separately, starting with tax acceptability.

The idea that taxes can determine the value of a fiat currency is easier to grasp by looking at currencies issued during the American colonial era. Coins tended to be scarce in the 1700s and there were few private banks, so the legislatures of the colonies issued paper money to meet the public's demand for a circulating medium. They had a neat trick for ensuring that this paper money wasn't deemed worthless by citizens. A fixed quantity of paper money was issued concurrently with tax legislation that scheduled a series of future levies large enough to withdraw each of the notes that the legislature had issued. This combination of a fixed quantity of notes and future taxes of the same size was sufficient to give paper money value, since the public would need every bit of paper to satisfy their tax obligations.

Examples of colonial currency (it's worth enlarging this image to see the detail) From: Early Paper Money of America

Crucially, once a colonial government had received a note in payment of taxes, it removed said note from circulation and destroyed it. If the government re-spent notes that had already been used to discharge taxes, this would be problematic. The tax obligation would be more-than-used-up, leaving no reason for the public to demand outstanding banknotes. Krugman's "tether to reality" would have been removed.


The modern day version of Krugman's tax acceptability argument is a bit more complicated. For starters, no one actually pays their taxes with banknotes. Rather, the tax acceptability argument applies to a second instrument issued by central banks otherwise known as reserves (in the U.S.) or settlement balances (in Canada). All commercial banks keep accounts at the central bank, these accounts allowing them to make instant electronic payments to other banks during the course of the business day, or to the government, which typically will also have an account at the central bank.

When Joe or Jane Public are ready to settle their taxes, they initiate a set of financial transactions that ultimately results in their bank depositing funds on their behalf into the government's account at the central bank. To satisfy the public's demand to make tax payment, commercial banks will want to have some central bank settlement balances on hand. So the existence of taxes "drives" banks to hold a certain quantity of central bank settlement balances, thus generating a positive price for these instruments. And since a banknote is in turn tethered to a central bank deposit via the central bank's promise to convert between the two at par, by transitivity the banknote is also tethered.

Unlike the colonial era, however, the tax authority—the government—can't destroy money. The government can either accumulate central bank deposits, or spend them, but it can't cancel them. What generally happens with the government's account at the central bank is that as soon as it is topped up with some tax receipts, they get quickly spent on government programs, salaries, and other expenses. So these funds simply boomerang right back into the accounts that commercial banks keep at the central bank, undoing the tethering that is achieved by tax acceptability.

Put differently, for every bank that demands settlement balances to pay taxes, and thus help gives those balances value, there is a government official who spends them away, and negates this value. So government taxes by themselves don't anchor modern central bank money.

To really anchor the value of central bank money, the government needs to withhold from spending the money it has received from taxes. The more it resists spending incoming tax flows, the more balances accumulate in its account at the central bank. If the government keeps doing this, at some point almost every single deposit that the central bank has ever issued will have been sucked up into the government's account. With almost no deposits remaining for paying taxes—and thus no way for the public to avoid arrest for failure to meet their tax obligations—the value that banks collectively place on deposits will reach incredible heights.

And that explains how tax acceptability (combined with a strategy of not spending taxes received) can provide modern fiat money with backing sufficient to generate a positive price.

Let's turn now to Krugman's second reason for central bank money having intrinsic value, the central bank itself. As I said earlier, a government can freeze deposits by accumulating them, but it can't destroy them. The only entity that can destroy money is the central bank. It achieves this is by conducting open market sales of bonds and other assets. When it sells a bond to a bank, the central bank gets one of its own deposits in return, which it proceeds to destroy.

Imagine that banks collectively decide they have too many central bank deposits and start to sell them (a scenario I discussed here). This sudden urge to rid themselves of money will cause inflation. In a worst case scenario, they will get so desperate that the purchasing power of money falls to zero. The central bank can counter this by selling assets and destroying deposits. In the extreme, it can sell each and every one of the assets it owns, shrinking the deposit base to zero. Its actions will drive the value of deposits into the stratosphere, since banks need a token amount to make interbank payments.

And that, in short, explains how central banks can provide dollars with backing sufficient to generate a positive price.

Which of Krugman's two forces—tax acceptability or a central bank's guarantee to regulate the quantity of money—is more important for imbuing little electronic bits with value?

We know that a government can anchor a fiat money purely through tax acceptability. Colonial money proves it. (Here is another example from the Greenback era) But can a fiat currency be anchored solely through the actions of the central bank, without the help of tax acceptability? Let's set the scene. Imagine that the government has unplugged itself from the central bank by closing its account and instead opening accounts at each of the nation's commercial banks. Since all incoming tax receipts and outgoing government payments are now made using private bank deposits, the government no longer generates a demand for central bank settlement balances.

This "unplugging" needn't drive the value of central bank money to zero. The central bank has assets in its vault, after all, so any decline in the value of central bank money can be easily offset by an appropriate set of central bank open market sales and concomitant reductions in the quantity of deposits. So the answer to my question in the previous paragraph is that money doesn't require tax acceptability to have intrinsic value. Tax acceptability is sufficient, but not necessary.

That being said, on a day-to-day basis the value of modern central bank money is regulated by a messy combination of both factors. Money is constantly flowing in and out of the government's account at the central bank, and this can have an effect on the purchasing power of money. Likewise, central bank open market operations are frequently conducted on a daily basis in order to ensure the system has neither a deficiency nor an excess of balances. It's complicated.

And that ends this episode of fiatsplainin.' Fiat money is indeed backed and has intrinsic value, as Krugman says, and it does so for several reasons.

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PS. If you are interested in colonial currency, you should read some of Farley Grubb's papers.

Addendum:

On Twitter, someone had this to say about my post:

Ummm one may pay taxes in Arizona in Bitcoin.

Argument fails on factual grounds.

Bitcoin is tethered to reality. @paulkrugman https://t.co/Z8ojvzw8FX

— ฿ryce Weiner (@BryceWeiner) March 22, 2018

฿ryce gives me the perfect opportunity to keep fiatsplainin'. Contrary to ฿ryce's claim, the fact that Arizona plans to accept tax payments in the form of bitcoin does not provide bitcoin with a tether to reality. For every bitcoin that Arizona accepts, it will just as quickly spend it away. The first is undone by the other. You'll notice that this is the same reason I gave for modern central bank money not necessarily being anchored by tax acceptability; whereas taxes vacuum up central bank money, government officials typically reverse this vacuum by quickly spending it, so the net effect is a wash.

To tether central bank money to reality, governments need to not only make it tax acceptable but also  be ready to let those balances pool up in its account, thus setting a limit on the overall supply of balances. Likewise with bitcoin. If the Arizona government were to accumulate incoming bitcoins as part of an overall policy of never spending them, then it would be removing bitcoins from circulation, in essence "destroying" them. And this would provide bitcoin with a true anchor. Of course the Arizona government isn't going to do this. It will want to rid themselves of bitcoins the moment it gets them.

Cartoon from 1864 poking fun at politicians and greenbacks (source and explanation)

During the greenback era, the Union government issued irredeemable paper money to help pay for its war against the Confederates. What many people don't realize is that there were actually two different strains of greenbacks—those printed before March 1862 and those printed after. Although these two strains had only slightly different properties, they were not fungible with each other and would go on to have drastically different values in the marketplace. Looking at the respective properties of each type gives some insights a thorny problem: why do colored bits of paper money have value?

One classic explanation for the value of fiat money is so-called 'tax-backing.' If the government stipulates that taxes must be paid using government-issued chits of paper, then that will be sufficient to give those chits a positive value. Back in 1910 economist Philip Wicksteed was one of the first economists to champion this explanation:

The Government, then, levying taxes upon the community, may say: "I shall take from you, in proportion to your resources, as a tribute to public expenses, the value of so much gold. You may pay it to me in actual metallic gold or you may pay it to me in anything which I choose to accept in lieu of the gold. If you do not give it me I shall take it from you, in gold or any other such articles as I can find, and which would serve my purpose, to the value of the gold. But if you can give me a piece of paper, of my own issue, to the face value of the gold that I am entitled to claim of you, I will accept that in payment." Now, as these demands of the Government are recurrent, there will always be a set of persons to whom the Government paper stamped with a unit weight of gold is actually equivalent to that weight of gold itself, because it will secure immunity from requisitions to the exact extent to which the gold would secure it. - The Common Sense of Political Economy, Book II Ch 7

The idea that a tax obligation can be the basis of money, or what Randall Wray has termed twintopt, is at the core of modern monetary theory, or MMT.

Let's see how the tax backing theory holds up during the greenback period. To set the context, South Carolina had seceded from the Union in December 1860, soon followed by ten other states. Hostilities between the Union and newly-formed Confederate states began in April 1861. To help fund the Union side of the war effort, an initial $50 million issue of greenbacks was authorized in July. This was to be the first government paper money emitted since the Second Bank of the United States had been wound up.

The act ruled that these notes were to be redeemable on demand in gold, a promise that was also inscribed on the face of each note (see below). They thus earned the nickname demand notes. This promise meant that, at the outset at least, their price could not deviate from par since any movement above or below their gold value would be arbitraged away. When redemption was rescinded a few months later on December 30, 1861, demand notes began to trade at a 1-2% discount to their face value in gold.

Greenbacks were introduced in 1861. Note the progression from the first issue—ie 'demand notes'—to the second in 1862—'legal tender notes'. pic.twitter.com/ELnSg3QRtB

— JP Koning (@jp_koning) October 10, 2017

The second vintage of greenbacks, known as legal tender notes, was authorized two months later by the Legal Tender Act of February 25, 1862. This act provided for an issue of $150 million, much larger than the first vintage. One novelty is that the second batch of notes was declared legal tender, which meant that a creditor could not refuse to receive them at par in discharge of a debt. The legal tender property was extended to demand notes in March 1862. The second vintage of notes was also irredeemable, putting them on the same basis as the demand notes, which became irredeemable at the end of 1861.

What distinguished legal tender notes from demand notes? As the tweet above shows, the two vintages had visible differences—unlike demand notes, legal tender note did not have the promise to redeem on demand printed on their face. Demand notes also had an extra promise inscribed on them: "receivable in payment of all public dues". What this meant in practice is that the government accepted demand notes in payment for all taxes, including customs dues, whereas legal tender notes were only receivable in a narrow range of internal revenue taxes—and not for customs dues—which at the time made up the majority of Union tax revenues.

Receivability for customs dues was an important point of departure between demand notes and legal tender notes. Duties were priced in gold and could also be discharged with gold coins. So if an importer was on the hook for $x in custom duties, they could certainly scrounge up $x in gold coin to get rid of the obligation, but $x in demand notes would be sufficient to "secure immunity" from the tax. Not so with legal tender notes.

A given importer might only need a small portion of the demand notes in his possession to pay customs duties. Anything above that amount would be worth less than their face value to him, since gold—not demand notes—was necessary to buy goods internationally. However, if that importer could find other importers who were themselves under obligation to pay customs duties, and who would therefore value his remaining stash of demand notes for their tax receivability, then he might sell them his remaining demand notes at a price quite close to the value of gold coins.

So all that was needed to have irredeemable demand notes trade near the value of gold was a permanent market of tax payers who demanded those notes, and a flow of new notes that did not exceed the rate of drainage provided by the tax outlet. After all, if the supply of notes overwhelmed the amount of tax that needed to be paid, then notes would accumulate in importers pockets with no one willing to bid for them. Once everyone's taxes had all been paid up, demand notes would trade at a discount to gold coins. 

Tax receivability was successful in keeping the value of demand notes close to their gold value. The chart below shows the price of both demand notes and legal tender notes relative to gold through 1862-63.  Demand notes never fell to more than a 10¢ discount relative to gold coin. Calomiris blames this discount on the risk that receivability for customs duties would be revoked by the government before notes had been paid in.


Legal tender notes, however, fell to an ever larger discount relative to both gold coin and demand notes, reaching a 40¢ discount by March 1863. While legal tender notes were receivable for domestic taxes, these taxes did not account for a very large share of government revenues. Nor were these taxes priced in gold. Which meant that, unlike demand notes, legal tender notes were not benchmarked to some real good or price index.

So what, if anything, determined the price of legal tender notes? Here I'll introduce another theory for the value of money; the metallist viewpoint. Rather than tax receivability driving a currency's value, a metallist looks to the currency's intrinsic value. When banknotes are fully redeemable, their intrinsic value is determined by the underlying gold on which the note is a claim, the value of which is set in the market for precious metals in technology and the arts.

In the case of legal tender notes, which were no longer redeemable, the realization of intrinsic value had only been delayed to some future point in time when gold convertibility would be re-adopted. This eventual re-mooring date was in turn a function of the Union government's ability to win the war, among other factors. According to this theory, the steady decline in the gold value of legal tender notes in the chart above can be blamed on the realization by the public that the war would last much longer than most originally thought, pushing the re-mooring date ever further into the future.

While the 1861 issue of demand notes had all been bought back and cancelled by the government by mid-1863, greenbacks remained outstanding even after the war had been won. Their discount to gold continued to widen till July 1864 at which point their price steadily rose. See the chart below. The steady return to par probably can't be explained by the tax-backing theory. Improved odds that the government's fiscal situation would allow it to resume gold convertibility—an event that finally occurred in 1879—is a better explanation. There have been a few interesting accounts written about the value of greenbacks over the full 1862-1879 period, including Wesley Clair Mitchell's A History of the Greenbacks in 1903, but also more recent contributions here (Calomiris), here (Smith & Smith) and here (Willard et al).


In sum, the U.S. government was issuing three non-fungible currencies by 1862. Coins and legal tender notes operated under the principles of a metallic money whereas the third, demand notes, seems to have been a purely tax-driven money as described by Wicksteed. So what about a modern dollar note? Is a Federal Reserve note like an 1861 demand note and mostly tax-driven, or like legal-tender notes and operating on a metallic basis?

I'm not entirely sure, but my guess is that it is a messy combination of both. When it comes to money, I'm not a believer in any one theory. Although the odds of a future return to the old 1972 gold redemption rule of 0.024 ounces per dollar is non-existent, the metallic explanation for the dollar's value continues to be relevant. Instead of redeeming currency with fixed amounts of metal as in days of yore, modern central banks repurchase notes with financial assets held in their vault in a manner that is consistent with hitting an inflation target. This is very much like 1800s-style metallism, except with an ever-shrinking CPI basket in the place of a fixed amount of gold.   


Sources:

Wesley Clair Mitchell, A History of the Greenbacks

PS: I recently started a discussion board here. Feel free to bring up topics not covered on my more recent blog posts, suggest posts, or discuss ideas that appear on my Twitter feed. I don't like Twitter for long-form discussion; I'd much rather divert them to the board.

PPS: Nathan Tankus responds here.

Michigan Central Railroad 3.5% Bearer Bond with attached coupons, 1902

David Glasner is frustrated that there is no satisfactory theory of the value of fiat money, noting that "it's just a mess, a bloody mess, and I do not like it, not one little bit."

According to David, the core problem is the backward induction argument. Say that a valued fiat object provides no non-monetary services so that its price depends entirely on the expectation of future resale. This is a highly precarious situation since it it inevitable that someday no one will want to exchange for that fiat object. But if it is certain that no one will accept it at some point in the future, then why accept it in the first place? The explanation for the object's value rests on an "unlimited supply of suckers", as David puts it, hardly good fodder for a long term theory of asset prices.

David proposes tax acceptability as his way out of the problem, although he doesn't seem to be entirely convinced by this explanation. (I've never liked the tax-acceptability theory, as I wrote here. )

But there may be another solution to the backwards induction problem. I'm going to show that the market establishes the value of modern fiat money under a CPI standard in the exact same way that it establishes the value of a very familiar instrument; the standard corporate bond. Since corporate bonds are not subject to the backwards induction critique, then by analogy neither should fiat paper. What follows is a gradual progression from the one to the other with the aim of showing that if you can value a bond you can value a Federal Reserve note.

1. Start with a company, say Apple, that in addition to issuing corporate stock issues bonds. These are regular bonds. Each of them has a recurring quarterly claim on a nominal quantity of Apple income as well has the right to a final return of principal upon maturity. Should Apple be liquidated, bond holders get a first claim on whatever remains of the business. The market takes these terms and conditions into account and establishes a market price for the bonds. Pretty standard stuff.

2. A few years later Apple converts some of its bonds into bearer form, ie. they are printed on paper and transferable by hand, while leaving the rest unaltered. It issues these bearer bonds in both small denominations like 1/10, 1/4, 1, 5, and 10 units, as well as large 100 and 500 denominations. Attached to each bearer bond is a series of coupons. To receive interest, the bond owner detaches the coupon and brings it to Apple each quarter in return for a dollar payment.

Despite these changes, the market continues to value bearer bonds in the same way as the firm's regular bonds. Still pretty standard.

3. Next Apple ceases to periodically redeem its bearer bonds when they mature, converting them into perpetual bearer bonds. A perpetual is not as valuable as an equivalent series of redeemable Apple bonds, but the market can still establish a positive price for a perpetual debt instrument as easily as it can a fixed term bond.

4. Say that Apple begins to accept these perpetual bearer bonds as payment at Apple stores. Other merchants copy Apple. Bearer bonds become a highly liquid exchange medium. A liquidity premium develops, with Apple bearer bonds often trading at a higher price than Apple's regular bonds, despite the former being perpetual instruments. (Apart from the unusually large liquidity premium on bearer bonds, this is still pretty standard stuff.)

5. As the liquidity services thrown off by Apple's perpetual bearer bonds grows, Apple realizes that it can reduce the coupon rate it offers without losing too many investors. Apple eventually ceases paying any interest at all—owners of bearer bonds are sufficiently happy with the liquidity return provided by the bearer bonds that they do not require a pecuniary return. The bonds have effectively become "cash", or 0% yielding paper notes.

The market values these no-interest bonds in the same way they do the normal bonds. Both have first dibs come final liquidation of Apple. The difference is that whereas the regular bonds are fixed term, bearer bonds are perpetual; regular bonds pay interest while bearer bonds don't; and the bearer bonds carry a large liquidity premium whereas the regular bonds are illiquid.

6. The economy begins to spontaneously de-dollarize and Apple-ize. Merchants first set prices in terms of both "Apples" and dollars, and eventually just Apples. Debt contracts are redenominated into Apples. The market will continue to value both bearer and normal bonds in the same way as before.

7. Initially the Apple price level moves around according to the whims of the market. Later, Apple decides to stabilize prices by targeting a 0% rate of growth in the price of a basket of consumer goods, a CPI basket. One way it can do so is by varying the quantity of Apple bearer bonds in the economy via open market operations. If Apple increases the amount of bearer bonds via open market sales, then the liquidity premium on bearer bonds is reduced and the price level rises. If it engages in open market sales, the amount of bearer bonds is decreased, their liquidity becomes more valuable on the margin and the price level falls.

Alternatively, Apple can vary the 0% coupon rate on bearer bonds. If the purchasing power of Apple bearer bonds is rising, i.e. the economy is characterized by deflation, Apple can counteract this by reducing the coupon rate (to the point of even introducing a negative Gesell tax), thereby making bearer bonds less attractive and forcing the price level back up. By increasing the fixed coupon payment, it can do the opposite and prevent inflation.

8. Now Apple decides to let bearer bonds fall at 2% a year, or allow them to purchase 2% less of the consumer basket each year. As in step 7, it varies the coupon rate or conducts open market operations to counteract any forces that would prevent it from hitting its target.

We have now arrived at a modern fiat CPI standard. What was once a standard bond has been converted into a highly liquid perpetual bearer instrument with a 0% coupon (flexible upwards or downwards) that falls in value by 2% a year, and also happens to be the economy's medium of account.  This modified bond is the equivalent of the so called "fiat money" issued by the likes of the Fed and the Bank of Canada, or what is otherwise known as cash. Since the market can easily value Apple's regular bonds without falling prey to the David's backwards induction problem, then surely it can value Apple's modified bond after taking into account all the extra bells and whistles that have been added in steps 1 to 8.

(With apologies to Nick Rowe)

While it somewhat lacked in structure, a good time was had by everyone in the live chat section of the big Warren Mosler vs Bob Murphy debate last night. You can see a replay of the debate here.

One of Mosler's running themes (and which Murphy turned into a running gag) was the idea that he (Mosler) could give his business card a positive price by requiring members of the audience to hand over said card to Mosler's bouncer should they wish to leave the room unmolested. Voilà, modern fiat money. In order to get his fiat cards out into the audience, presumably Mosler would have had to spend them into existence by purchasing stuff from the the audience. Only then would audience members be able to afford to leave the room without being subjected to the bouncer's whims.

In the MMT literature, this is called twintopt.* A state imposes an obligation on its citizenry to pay a tax, and then dictates what good or item (the "twintopt") will be sufficient to discharge that debt. Whatever is made into twintopt, be it US dollars, coupons, or business cards, they will now be valued and circulate. This is the tax-drives-money, or chartal theory of money.

I don't doubt that the theory could be true in practice. For instance, I describe in this post how McDonald's Corporation could give colourful bits of paper coupons a positive value by imposing an obligation on the burger-eating community to pay for all Big Macs with these coupons. No doubt Mosler's business cards could also earn a positive value if he required people to submit cards as an exit fee. Rather than chartalism, I prefer to call this the coupon theory of money in order to underscore that it has nothing to do with the state. Corporations and individuals can issue "chartal" coupon media of exchange just as easily as the State can.

But Mosler's business card analogy doesn't make it as far as US dollars. To see why, let's go the reverse direction and remove twinopt status.

Having been converted by Murphy, let's say that Mosler's bouncer becomes a libertarian and moves to New Hampshire.  With twinopt no longer being enforced, audience members can now leave the room without having to post a business card as payment and the market value of Mosler's cards will quickly fall back to 0. So far the chartal tax-drives-money theory of money is borne out perfectly.

Next let's migrate this idea over to the modern US monetary system. Say that the US government announces that it will no longer accept US paper dollars or US dollar-denominated cheques/deposits as payment for taxes and instead will require Mosler-issued business cards. What happens to the value of the US dollar? According to the taxes-drives-money theory, the US dollar, which no longer serves as twintopt, should rapidly become valueless, just as Mosler's business cards became valueless after the desertion of his bouncer.

Here's what actually happens. Since US paper currency and US-denominated deposits & reserves are now useless for the set of transactions involving the US government, individuals, banks, and corporations will all seek to simultaneously reduce their inventories of these instruments. After all, they're a less effective medium of exchange.

This disinclination to hold dollars will in turn drive prices up. In order to ensure that prices don't rise above their inflation target, the Federal Reserve will suck up and destroy all unwanted currency and reserves. The Fed does so by selling assets. It has gold, bonds, foreign exchange, economics books, and other things in its vaults which it will continuously use to purchase dollars until the urge to divest dollars has been quenched. Thus the run on US dollars set off by their lack of tax acceptability is just as quickly matched by a decreased supply.

Mosler's business cards will probably be fairly liquid thanks to their government prop. The interesting thing is that despite no longer being required to pay taxes, the dollar will continue to have the same value as before.  And while it will be useless in government transactions, the private sector will probably continue to use US paper currency and US dollar reserves among each other as a handy medium of exchange. Something other than taxes drives the value of US money, it would seem.

New-fangled metallism provides an explanation. I say new-fangled because it's not old-fashioned metallic backing per se that helps pin down the dollar. Rather, what does the pinning is the general financial assets that the central bank holds (MBS, bonds, stocks, gold, whatever), combined with the bank's threat to use those assets to ensure price stability. Taxes certainly contribute to the dynamic, but they're not in the driver's seat.

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*Specifically, Understanding Modern Money by L. Randall Wray

One of the world's newest monies has been born. A cryptocurrency (these seem to be coming out every week), our new unit goes by the currency code XRP. What makes this even more interesting is that XRP is a chartal currency. Unlike commodity monies, chartal currencies are intrinsically worthless. The only reason they have a positive market value is because people must get their hands on them in order to pay taxes. Just so with XRP—people must pay their "Ripple taxes" with XRP. But more on that later.

XRP and Ripple go hand-in-hand. I wrote about Ripple last week. Ripple is an online environment which allows individuals to exchange IOUs denominated in bitcoin, US$, ₤, or any other unit of account. I'm not going to go into more depth on Ripple but if you're interested, click through last week's post or read this very well-written article from Bitcoin Magazine.

What is interesting is that in order to make use of the Ripple environment, Ripple developers have required that users procure tokens, or XRPs, ahead of time. First, to open a Ripple account, users must deposit 200 XRP as a reserve. Second, in order to extend a line of credit to another Rippler, users need to deposit an additional 50 XRP as reserve. Lastly, to carry out a transaction, 0.000001 XRP must be paid. (While this 0.000001 XRP is destroyed forever, XRP held as reserves are simply released once the account is closed or line of credit withdrawn.)

Much like a sovereign issuer of chartal units, the creators of XRP (the "government") must first spend XRP into the economy so that members of the system are able to pay their Ripple XRP dues (or "taxes"). One hundred billion XRPs have been created, with the founders of Ripple getting twenty billion before distributing the remaining eighty billion to OpenCoin, the organization that will be developing the Ripple system. Potential Ripple users have had wait for OpenCoin to "spend" XRP into the economy before they could begin to use the Ripple system. The first emission was in the form of a free gifting of 50,000 XRP to anyone interested beginning two weeks ago.

Since the initial gifting, XRPs have begun to be traded on secondary markets where they are being priced at around 45,000 XRPs to 1 bitcoin (~1,300 XRP to the US$). Note how well this jives with the chartal idea that the positive value of a fiat token arises because of the obligation members have to pay their dues with that token. Just like chartal tokens are used for more than just tax payments, businesses are agreeing to accept XRP for non-Ripple related transactions.

Most cryptocurrencies, including bitcoin, litecoin, devcoin are bootstrap currencies. To earn a non-zero value, they've paradoxically had to pull themselves up by their bootstraps. No outside institution has given bitcoin or litecoin a helping hand by requiring either as a prerequisite for consummating transactions. Bootstrap currencies are highly unstable—while they've picked themselves up off the ground by pulling on their own bootstraps, they can just as easily lose grip of their bootsraps and crash back to zero.  The demand for XRP, on the other hand, is underpinned by the necessity of using them to pay Ripple dues. This demand anchors XRP's price to the downside.

You'll notice that one traditional element of chartalism is missing here: the state-nature of chartal money. Opencoin and Ripple are private institutions... and yet they have created a chartal currency. It would seem that there is nothing in the idea of chartal currencies that requires the state. (I made this same point in an older post.)

A few weeks ago, David Beckworth egged me on to write about Somalian currency. I can't resist—it's a fascinating subject. The material I'm drawing on comes from Luther & White (2011), Luther (2012), Symes (2005), and Mubarak (2003)

Orphaned banknotes

When Somalia collapsed into civil war in January 1991, the doors of the Central Bank of Somalia were blown apart, its safes were blasted, and all cash and valuables were looted.* But something odd happened—Somali shilling banknotes continued to circulate among Somalians. To this day orphaned paper shillings are used in small transactions, despite the absence of any sort of central monetary authority.

The strange case of circulating Somali shillings forces us to ask some fundamental questions about money. If the Federal Reserve and all other branches of the US government were to be suddenly swallowed up into the sea, would Fed banknotes, like Somali shillings, continue to be used? What forces conspire to keep coloured squares of paper in circulation when their original issuer has long since expired?

According to Luther & White (2011), the shillings' continued circulation within the context of a collapsed state casts doubt on the universality of the chartal theory of money. According to chartal theory, the requirement that people pay taxes with government-issued bits of paper is what drives the positive value of these bits. Since a world with no state is a world with no taxes, the continued use of shillings means that something other than tax acceptance must be driving their positive value. [As an aside, I'd note that the ongoing circulation of bitcoin also contradicts the taxes-only theory of chartal money. After all, bitcoin isn't used to pay taxes, it's used to avoid taxes].

Luther & White give what seems to me to be a very Misesian explanation for the shilling's continued positive value: the "inertia of historical acceptance". According to Ludwig von Mises's regression theorem, outlined in Theory of Money and Credit (1912), people's expectations about the value of bits of paper may "regress" into the past. An intrinsically useless bit of paper is valued today because it had a positive value yesterday, and it had a positive value yesterday because it did the day before, all the way back to day 1 when that useless bit of paper was anchored to some commodity.

This process is described as a coordination game in Luther & White. Though the central bank had collapsed in January 1991, a Somalian trader might choose to still accept shillings the day after the collapse because he had accepted them the day before and he knew that others had accepted them too. In a self conscious manner, the trader would also know that other traders knew that he had accepted them. Expectations about expectations about expectations, a Keynesian beauty contest of sorts, was sufficient to drive the use of shillings beyond the day of the central bank's demise.

Counterfeit notes and contingent redemption

Let's add some more texture to our example. Not only did old shillings continue to circulate, but several new issues of counterfeit notes joined them. These counterfeit 1000 and 500 shilling banknotes were created by warlords and businessmen subsequent to the country's collapse. Although the counterfeit notes had the same design as the pre-1991 legacy notes, small differences allowed for differentiation. According to Luther (2012), of the five known forged issues, four have the date 1996 printed on them, long after the central bank ceased to exist. The counterfeits dated 1996 are signed by central bank governor Ali Abdi Amalow who, having been appointed in 1990, had never held office long enough to have his signature affixed to genuine Somali notes. Even without these imperfections, fake banknotes would have been instantly recognizable to anyone—they would have been crisp and clean relative to the limp and dirty legacy issue.

Despite being easily differentiable, Somalians willingly accepted counterfeit 1000 and 500 shilling notes. Not only did they accept them, they considered them to be fungible with real 1000s and 500s. In other words, the market refused to place a discount on the fakes.

Mubarak (2003) offers a few reasons for the acceptance of counterfeits. Any reticence the public may have had concerning the legitimacy of counterfeit note was overcome by A) coercion on the part of issuing warlord; B) a financial inducement to accept new notes including an initial 5% discount to the price of legacy notes, and C) the claim that new notes were liabilities of the Central Bank of Somalia. According to Mubarak the latter instilled a "general public belief that the forged... banknotes must eventually be upheld and honoured when effective national government comes to power."

This last detail is interesting because it might explain not only why counterfeits were accepted, but also why legacy Somali banknotes continued to circulate after the Somali state collapsed. Upon the eventual reconstitution of the Somalian state, a new central bank would most likely be created. This newly recapitalized Central Bank of Somalia would hold a stock of assets funded, say, by the IMF.  The central bank might take upon itself the original central bank's note liability No longer orphans, old banknotes could now be convertible into deposits held at the new central bank and, insofar as the central bank targeted inflation via open market operations, these deposits would in turn be convertible into genuine backing assets.

Thus the promise of redemption by a not-yet existing central bank may have been enough to give present shillings, both genuine and counterfeit, a positive value.

This means that any changes in the purchasing power of shillings might be due not only  to variations in the quantity of outstanding Somali media-of-exchange. Reassessments of the probability of a central bank both being created and honouring the previous note issue would also affect their purchasing power. For instance, should the Transitional Federal Government, a government in-waiting of sorts, succeed in consolidating its position in Somalia by winning a key battle, the odds of redeemability would increase, as would the value of shillings.

Historically orphaned currencies

This tension between fiat-paper-as-redeemabale-financial-asset and fiat-paper-as-medium-of-exchange is an old one. It was at the centre of one of the greatest monetary debates of the 19th and early 20th century, a dustup that involved luminaries like Irving Fisher, Knut Wicksell, Laurence Laughlin, Benjamin Anderson, Ralph Hawtrey, and Ludwig von Mises. The discussion centered on the irredeemability of US Greenbacks.**

Greenbacks, which had been issued in 1861 to pay for the Union Government's expenses, were initially 100% redeemable in specie. The redemption clause was suspended later that year and subsequent issues of greenbacks didn't even claim to be convertible into gold. Greenbacks quickly fell to a large discount relative to the metal. By August 1864 the discount had hit its widest point as the paper traded at 38 cents on the gold dollar.***


As with Somali shillings, economists were curious about these seemingly-orphaned liabilities. Why were greenbacks still accepted? What governed their value? Wicksell, Mises, and Hawtrey held that if there is a demand for the medium-of-exchange as such, this demand would be sufficient to give value to whatever instrument was established by custom as the medium-of-exchange. Thus the continued acceptance of greenbacks at positive values was mostly due their already-favorable marketability.

Countering this panel of illustrious economists was J. Laurence Laughlin. Though Laughlin doesn't attract the same brand recognition as do these other long-dead economists, in his day he was considered to be America's leading monetary economist. In his book The Principles of Money (1903), Laughlin outlined the view that greenbacks should be treated like non-dividend paying common stock. Just as a stock might have some positive value now due to potential dividends several years down the road, the continued positive valuation of greenbacks was due entirely to the possibility of their future redemption.

To illustrate his point, Laughlin drew attention to the market's reaction upon the success of the Union Goverment in the Battles of Gettysberg and Vicksburg. After these battles the greenback's discount to gold dramatically narrowed, presumably because these victories were perceived by the market as increasing the probability of future redemption of greenbacks in specie. Laughlin also mentions the passage of the Redemption Act of 1875, in which the government declared its intention to redeem all greenbacks come January 1, 1879. Though still trading at a discount to gold, greenbacks began to steadily appreciate towards par as this date approached, just like a t-bill approaching maturity. Thus Laughlin's redemption theory held up nicely to the evidence.

While Wicksell described Laughlin's theory as "perverse and fantastic," it was hard for Mises, Hawtrey, or Wicksell to deny that the expectation of future redemption didn't have at least some effect on greenback's value. In his book the Value of Money (1917), Benjamin Anderson struck a middle ground between all parties. Anderson held that Laughlin was right to treat greenbacks like any other asset whose value was dependent on eventual redeemability. But Anderson also thought that Mises and the rest were correct to put an emphasis on greenback's unique monetary function. Anderson combined these views by illustrating how greenback's "money-use" would be captured by the market as an extra bit of ascribed value on top of redemption value, or a liquidity premium.

Just to make things more complicated: New Somali Shillings

Back to the Somali shilling. The last feature of the Somalian monetary economy that I find interesting is the presence of yet another media of exchange — the "New Somali Shilling".**** Just prior to the January 1991 collapse, Somalia had been experiencing accelerating inflation. The Somali government drew up plans to replace existing shillings with the New Somali shillings. Each New Shilling was to be worth 100 old shillings, and notes were to be printed in 20 and 50 shilling denominations

 According to Symes (2006), the first shipment of New Shillings arrived in Somalia several months after the collapse of the state. Ali Mahdi Muhammed, a factional leader in Mogadishu, seized several billion of these official New Shillings and spent them into the economy in November 1991. While New Shillings did gain acceptance, their use was limited to a small area in North Mogadishu—the area controlled by Ali Mahdi Muhammed. Nor were they fungible with the legacy notes. 500 worth of New Shillings, for instance, was not worth 500 worth of old shillings. Nor did New Shillings circulate at the pre-1991 intended value of 100 old shillings to one New Shilling. At the time of Mubarak's article, a New shilling was worth only a third of an old shilling.

This challenges Luther & White's theory that Somalians accepted shillings because of their previous experience with them. Why did Somalians accept New Shillings at all if they were not accustomed to doing so? Why not refuse and continue to trade in legacy shillings? Legacy shillings circulated in Mogadishu at the time, so traders would have presumably had a choice. Why take a bet on an untested currency?

New Shillings also challenge the Laughlin-esque theory that redemption underpins the positive value of fiat paper. If Somalians universally valued shillings because of their future redeemability, why would they not place a higher value on New Shillings relative to old? After all, according to its stated plan, the Central Bank of Somalia was willing to convert 100 old shillings into 1 New Shilling. If it was believed that a newly chartered central bank would take on the liability of Somalia's counterfeit notes, wouldn't that same central bank uphold a commitment to value New Shillings at a far higher rate than old ones? Why then do New Shillings trade a third the price of old shillings rather than at a multiple of 100?

As much as I dislike to leave more questions than answers, that's about all I can do for the time being. One major data point is yet to come. What actually happens to legacy and counterfeit notes when a new central bank begins to operate? The Central Bank of Somalia's website says this:

Towards fully assuming its functional and institutional responsibilities, the Bank has completed the reconstruction of its Headquarters in Mogadishu while the branch in Baidoa has been established and is already functioning with personnel in place.

Perhaps we don't have long to wait.
_____________________________________________________

*Abduraham in Luther (2012)
**Debate also surrounded the irredeemability of Austrian gulder banknotes. The Revolution of May 1848 resulted in the withdrawal of the convertibility of Austrian gulden banknotes into silver. The discount on gulder notes relative to silver averaged around 15% for the first 10 years and then dipped to an average of 28% from 1859 to 1865. Laughlin pointed out that by the 1860s speculation began to grow that Austria would switch from the silver standard to a gold standard. If the banknotes, still irredeemable, were to be honoured, it became increasingly evident that redemption would be in gold, not silver. At the same time, large silver discoveries were driving down the value of silver relative to gold. As a result of these forces, the market value of notes rose back to par with silver. As the market became progressively more confident that the notes would be redeemed, and redemption would be in much more valuable gold, gulder notes eventually exceeded their stated silver value. Laughlin's theory seemed to be borne out by the facts--the value of orphaned notes was dictated by their future potential redeemability.
*** From A History of the Greenbacks (1903), by Wesley Clair Mitchell
**** Mubarak refers to this instrument as the Na' Shilling.

I've been playing the game of Settlers of Catan for ages. Over time I've gotten less cutthroat and more philosophical about the game. What I've come to realize is that Settlers is a great tool for both thinking about monetary phenomena and building different sorts of monetary economies. In this post I'll assume a basic knowledge of Settlers—if you haven't played the game by now, you're living on the moon.

1. Catan isn't a barter economy

The first thing worth noting is that Catan is not a barter economy—it's a monetary economy. This might seem like an odd thing to say. After all, the trades that we see in a typical Settlers game are all commodity-for-commodity trades.

To see why it's a monetary economy, imagine the case of autarky, or a Catan in which trade is prohibited. Here, players can only build structures using cards earned from tiles on which they have a settlement. The value of a lumber card in an autarkical economy is derived solely from its use-value, or its ability to help build settlements and roads.

The moment autarky is lifted and players are allowed to trade resources amongst each other, resource cards provide their owners with a whole new range of services. Not only is a lumber card valuable for the settlements and roads it yields, but also for its ability to purchase things from others. It has become a medium-of-exchange. Given the unpredictability of dice rolls, owning a stock of readily-tradeable exchange media provides players with wiggle room, or monetary optionality. Because an option is valuable, resources that provide optionality earn liquidity premia. The more liquid the resource card, the broader the option it provides and the larger its premium.

Monetary phenomena like monetary optionality begin to emerge the moment we exit from autarky—we don't have to wait till some hypothetical item called "money" appears on the scene in Catan, nor for so-called barter to disappear. All media-of-exchange, whether they exist in our simple Catan economy or the real economy, have money-like properties. In fact, I'll show later that there is no such thing as "money" in our modern economy, only a universe of media-of-exchange that differ along a spectrum of liquidity.

2. Patterns of resource monetization in a Catan economy

The Catan universe is a well-balanced monetary economy. By well-balanced, I mean that we tend to observe an even distribution of trade. Put differently, since Catan's five resources are all equally marketable, none of them earns a superior liquidity premia.

There are ways to tilt the rules of Settlers so that trade patterns get more skewed. One way to do this is to penalize trade in certain goods. For instance, say we institute a rule that continues to allow for full trade in sheep, brick, ore, and wheat but only permits lumber to be traded when a six has been rolled (limited autarky in lumber markets). This inhibits lumber cards from serving as full media of exchange. As a result, lumber loses some of its optionality and will trade at a discount to its prior price. The distribution of trade will now be skewed away from lumber towards the other four resources. If we penalize all resources but one, we would skew the pattern of trade dramatically in this resource's favor.

Another way to affect the distribution of trade is to endow certain resources with unique properties. Let's say that ore is more storeable than the other commodities. The rule in Settlers is that when a 7 is rolled, any player with eight or more cards must lose half their hand. If ore cards don't count to the total when a 7 is rolled (they are storable, after all) then players will be able to hold larger hands as long as they cushion their hand with ore. Players will begin to trade for ore not because they wish to build a city with it, but to protect their hands from 7s. This could increase the incidence of ore cards in trade relative to other cards. The more liquid ore cards become, the more will their monetary optionality increase, as will their liquidity premium.

There are all sorts of ways to tilt the distribution of monetary trade. Be creative.

3. Let's try Settlers chartalism

The idea behind chartalism is that some external monopolizer, say a gang or a king, sets an obligation upon citizens that can only be discharged with a certain type of settlement media. This media doesn't have to be a commodity. It might be an intrinsically useless token.

Let's imagine that the robber in Settlers requires a bribe from all players whenever a 7 is rolled. If a player doesn't pay the bribe, then they must sacrifice two cards. Say that the bribe must be paid in the form of an intrinsically useless $100 Monopoly bill. Players can only purchase the Monopoly bills from the robber on their turn for one resource card. Presumably players will purchase $100 bills since the 1 card cost exceeds the potential loss of 2 cards.


A player who has already bought enough Monopoly money to satisfy the robber should a 7 come up may wish to sell excess bills to players desperate for protection. Monopoly paper bills thereby join the five existing resources as a media of exchange in Catan. We might be able to tilt the distribution of trade in favour of the chartal medium if we encourage its marketability through rule changes discussed in section two.

4. Credit-based settlers

The existing rules of Settlers prohibit credit transactions. Relaxing these rules allows us to introduce a whole new range of resources that can be used in trade—each player's future earnings power.

There are infinite ways to structure credit transactions in Catan. Informal verbal promises are one way. I tell my trading partner that I'll buy a lumber from them now for an IOU of two sheep in the future. Due to their informality, these promises are unlikely to become liquid.

To really tilt the distribution of trade towards credit, we probably want to create standardized paper credit contracts. Standardization allows for quick appraisal, and this lowers transaction costs. Transcribing the promise onto paper will encourage its negotiability, or exchangeability from player to player. The more we streamline the process, the more likely that credit will become Catan's most liquid traded resource. The simplest IOU I can think of is a one-time paper promise to pay out all production from a 6 or 8 tile. The issuer can easily satisfy this obligation since they don't have to trade away for the media to settle it—they produce the media themselves.

When we allow for credit, players are acting simultaneously as bankers. The player that succeeds in getting his or her credit to circulate from player to player has effectively increased their purchasing power relative to everyone else and will be able to advance through the game much quicker. Players that push too close to the sun will find themselves unable to meet their outstanding promises and will default. They'll lose the trust of fellow players and will find it difficult to issue credit again, their advancement in the game slowing.

5. The social contrivance of a fiat Catan dollar

Paul Samuelson famously described how the contrivance of fiat money would allow members of an economy to efficiently solve the problem of passing on savings over time. Through a "grand consensus," worthless "oblongs of paper" would be accepted into circulation. This sort of paper is different from chartal Monopoly paper since the latter discharges a particular obligation. Samuelson's oblongs are merely bits of paper. They have no non-monetary use whatsoever.

Could we get players to accept mere paper? Our first guinea pig will only do so if they know for sure that the next player will accept it. Absent a significant amount of negotiation and coordination ahead of time, its difficult to imagine why the first player will ever trust the future negotiability of paper. Far safer for him or her to just refuse any fiat paper trades. Might players spontaneously negotiate a set of rules to encourage the circulation of Samuelsonian paper? Perhaps, but if the game already allows people several trading technologies—trade in resources, trade in chartal Monopoly money, and trade in credit—will players want to devote resources negotiating an expensive institution like fiat paper? I doubt it.

6. Catan Money?

Can the rules of Settlers be manipulated so that Catan approximates our modern world in which there seems to be one universal medium-of-exchange called money? Could we get ore to appear in all of Catan's trades, or Monopoly money, or the circulating credit of one trustworthy player?

As I pointed out earlier, we don't have to. In the real world, there's no such thing as a universal medium of exchange. Rather, we have an almost an infinite range of media that vary in terms of liquidity. The "dollar", for instance, refers to a number of different exchange media: paper dollars printed by the Fed, electronic dollars created by the Fed, private savings account dollars, chequing account dollars, eurodollars, traveller's cheques, credit card dollars, and more. Private chequing account dollars can be broken down into Bank of America dollars, Wells Fargo dollars, Citi dollars etc. The fact that these various media are denominated in the same unit should not confuse us into consolidating them into one universal medium-of-exchange. A US paper dollar, for instance, is a far more liquid instrument than a hamburger patty, but it still only appears in a small percentage of total US trades. As long as we can manipulate a game of Settlers to show a skewed distribution of trades, then we've sufficiently approximated the real world.

7. Catan economics vs. modern economics

Setting up a stylized Catan environment in order to explore monetary phenomena is akin to the approach taken by modern monetary economists. Economists realized long ago that exchange media simply had no role to play in a stylized Walrasian environment. In a world with an omniscient auctioneer who calculates the prices and quantities of all trades, and in which all trades are cleared at a central clearing house, there's no room for monetary phenomena like media of exchange or liquidity premia to arise.

To get "money" into an economy, modern economists start by introducing various refinements into a Walrasian environment. Rather than have individuals meet at a centralized market, Kiyotaki and Wright (1993) have traders meeting randomly and pairwise. Wright, Trejos, and Shi (1995) replace the auctioneer with traders who are capable of negotiating prices bilaterally. Our simple Settlers environment easily captures decentralized search and bargaining.

Some environments created by modern monetary economists are downright odd. The modern work-horse Lagos/Wright model sets up an environment with day and night markets. Day markets are bilateral and anonymous while night markets are centralized. Dror Goldberg imagines different cities which specialize in a certain good. Traders must trek between cities to secure a consumption good. Settlers, of course, will appear odd to anyone seeing it for the first time. Manipulating the rules of Settlers to see how we can generate monetary patterns is very much like letting rational agents loose in an Lagos/Wright sci-fi environment. The advantage of the former is that it's fun and real people are testing out the model, not imaginary agents.

Try experimenting with some of these rule changes the next time you play Settlers and tell me what happens. Even if you don't get around to it, hopefully I've convinced you that Settlers provides a great model for thinking about monetary economic phenomena.

Rai at the Bank of Canada - part of Canada's foreign reserves

As I pointed out in my previous post, all sorts of economists have incorporated the example of Yap stones into their monetary discourse. One of the more peculiar uses of these stones can be found in neo-chartalist L. Randall Wray's Understanding Modern Money (1998).

In Chapter 4 of his book, Wray claims that an economy becomes monetized by the introduction of state-issued tokens (what I call coupon instruments). To provide empirical support for his claim, Wray repeats the story about German administrators marking all Yap stones with paint (see previous post, #9). The Germans did so in order to motivate the Yapese to build roads. After all, in order to get the state to remove these markings from their valuable stones, the Yapese were required to provide their labour. The implications of Wray's chapter are that instead of requiring labour, the German government could just as easily have required payment in government-issued paper coupons. Thus Yap, which up till then had never been a monetary economy, would have suddenly become monetized.

Wray is in some difficulty here since Yap stones already circulated as media of exchange (see Goldberg in previous post). Thus the emergence of a monetized economy came prior to any German state-inspired monetization. This possibility is particularly harmful to Wray since he has adopted throughout his book an extreme, or "vulgar", version of chartalism in which the only way to monetize an economy is to introduce a state-issued coupon instrument. In a note, Wray tries to wriggle out of his predicament, claiming that:

Furness, almost certainly in error, called these 'stone currency' and imagined that they were used as some sort of primitive 'medium of exchange'; however, his description uncovers no evidence that there were any markets. (73)

Wray is contradicted by the anthropological evidence provided by Gillilland and Furness, who list all sorts of examples of rai acting as media of exchange. Rai were used to purchase fish, housing materials, yams, labour, women, coconuts, and many other valuable items. Yap stones original circulation as commodity media-of-exchange therefore prove Wray wrong  in his extreme view that an economy can only be monetized via state-issued coupons.

Federal Reserve Bank of Cleveland's Michael Bryan wrote a paper called Island Money (2004) in which he adopts the chartalist idea that "money" is a marker, or a credit/debit, in order to explain rai. Owning a stone meant that one possessed a credit on the rest of the Yapese or, put differently, that Yap was in debt to the stone's owner. In this way rai functioned as "memory", a means by which to tabulate who owes whom. This is an old idea going back centuries but most popularly reincarnated in Narayana Kocherlakota's Money as Memory.

Now it is certainly true that credit IOUs have and continue to serve as some of society's most liquid instruments. Bank deposits are a great example. But to assume that only credit can qualify as "money" is to commit the same sin of monetary extremism that Wray commits. Bryan maintains that

rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money... Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established. Lacking intrinsic worth, Yap stones may be an especially useful object of study for students wishing to understand the significance of U.S. dollars, which, after all, have no value other than as a monetary unit; they’re what economists call an “fiat” money.

But as Goldberg has pointed out, Yap stones did have significant intrinsic value. There is no need, therefore, to accept Bryan's fallback view that within the so-called vacuum of intrinsic worthlessness, money could only earn value from its status as an IOU, or as so-called "memory".

The other problem with the Bryan's rai-as-credit story is their sheer size. Why choose something so awkward as a three meter wide stone to record an IOU? Any small token can be used to represent either smaller or larger debts. Casinos issue chips of the same size and shape representing amounts from $1 to $1000 — no casino deems it necessary to issue human-sized intrinsically valuable (gold plated?) $1000 casino chips. Rather than using huge stones as IOUs, the Yapese could have easily used verbal promises to record debts (see #8, previous post), or coconut shells emblazoned with markings. The simpler explanation for rai's value is Goldberg's: rai were intrinsically valuable for religious and aesthetic purposes.

I'm not saying that chartalism is wrong. I've pointed out before that I think the idea of coupon "money" makes some sense—even McDonald's could create chartal coupon instruments. So while you can count me in as a soft chartalist (I'm also a soft metallist, a soft monetarist, a soft Keynesian, a soft Austrian, etc), I'm not persuaded by the extreme versions of chartalism. The contortions its advocates are forced to undertake in order to explain monetary phenomena like Yap stones lead them astray.

There is a century's old debate between metallists and chartalists on the origin of money. The metallist view is that the first spark of money emerged through barter and matured when the use of precious metals as money was discovered. The chartalists disagree. According to them, the use of credit preceded the use of precious metals as money.

At its core, the metallist/chartalist debate is a battle over the definition of the word money. In a moneyness world, there is no such thing as money. All we have are numerous media of exchange with varying ranges of liquidity. Whether moneyness first gets attached to credit or precious metals is really not important.

Imagine that a hunter encounters a trapper. The hunter has a deer. The trapper wants the deer but isn't sure what to offer. On the one hand, he can exchange the two rabbits in his belt for the deer. On the other he can offer his credit. In offering to exchange away his credit, the trapper is simply capitalizing his future earning power and bringing it forward for use in trade. Metallists and chartalists put tremendous importance on this first choice of credit versus rabbits, since one or the other will represent the so-called origins of money.

From a moneyness perspective, there are more interesting forces at play. Say that the trapper learns that the hunter will accept either his credit or his rabbits. The trapper next arrives at the realization that both items now have a degree of liquidity, or moneyness. He begins to attach a liquidity premium to both, for not only are the trapper's inventory of rabbits useful to him as food, but they can also be resold to the hunter, thereby providing the trapper with an extra range of liquidity services. The same goes for his credit. The trapper's future earning power is one of his key possessions. Now that it is tradeable, his future earnings power provides an extra margin of liquidity services. Over time the trapper will learn which one of his trade items is more liquid  and will favor that item with a larger liquidity premium. A monetary economy has now emerged in which traded goods are appraised according to their degree of liquidity and carry varying liquidity premiums.

If we split the world into money and non-money, then debates over the what items make it into the money category will often be heated. The origins debate gets especially intense because it tries to define modern money by looking back to its so-called debut. Taking inspiration from gold's barter origins, modern day metallists want a pure real/commodity based money. Modern day chartalist, who advocate state-issued inconvertible paper, look back to money's credit origins to support their view that the essential nature of money is credit.

From a moneyness perspective, the money-or-not debate is distracting. The origins of liquidity and liquidity premia is complex and probably not subject to study. There never was a single dominant instrument that could claim the mantle of money, only multiple goods and forms of credit, each with different degrees of moneyness. As for the metallists and chartalists, a pox on both their houses.

While chartalism is usually associated with the state and its ability to tax, there's no reason that this must be so. In fact, I like to think of chartalism as stateless. I call this the McDonald's coupon theory of money.

What I'm specifically addressing here is the chartalist idea that paper notes issued by the state have value because the state imposes a liability on its citizens that can only be discharged by the use of this paper.

McDonald's Corporation can do the same thing if it imposes an obligation on the burger-eating community to pay for all Big Macs with McDonald's-issued coupons. One coupon buys one Big Mac, say. In order to pay their "tax" and get a burger, Big Mac fans have to somehow acquire these coupons ahead of time.

McDonald's pays for a portion of its supplies by printing and issuing these coupons as payment. So one way that Big Mac fans can get their hands on coupons is by providing services to McDonald's... say cleaning floors or selling them pickles. Another way fans can get coupons is by approaching someone else who is already a supplier to McDonald's and offering them gold, silver, or some other media in exchange for coupons. An active secondary market would probably develop for these coupons.

McDonald's is required to spend enough coupons into existence so as to meet the very real demand people have to settle their obligation to buy Big Mac's with coupons.

Because McDonald's and Big Mac fans are everywhere, it's likely that these coupons will begin to circulate broadly. For instance, corner stores may begin to accept McDonald's coupons in payment for stuff, as will hotels and other merchants. They'll be willing to do so because they know they can pass the coupon off as change to a Big Mac fan at some later point in time. If not, they themselves may want to use it to buy a Big Mac. McDonald's coupon become ever more liquid, their degree of moneyness increases, and they emerge as a globally-useful medium-of-exchange.

Now burger lovers needn't submit to the McDonald's "tax". Burger King still allows customers to buy a Whopper without having to secure a coupon ahead of time. But if Burger King, Wendy's, A&W, and other burger joints institute a similar coupon-mechanism, then burger lovers will have to submit to some sort of coupon-tax.

In any case, I hope you can see why chartalism needn't be explicitly intertwined with the state. We can imagine worlds without states that have circulating chartal media-of-exchange. This is a world of private coupon monies. Theorizing in this way makes monetary discussion easier since it removes the political aspect of the debate, rendering it purely technical.

While I can imagine chartal worlds, I don't think the real world is particularly chartal. Coupons exist, but they rarely circulate outside of a very proscribed range. Here is one example of a circulating chartal money, in which Zimbabweans started to widely use gasoline coupons during the Zim$ hyperinflation. Chartal monies certainly become more prevalent during times of monetary stress.

Nor do I think modern central bank liabilities are chartal coupon monies. In my hypothetical example, McDonald's spent coupons into existence. Modern governments can't fund themselves by issuing coupons, they can only spend after having taxed or issued bonds. Nor are people obligated to use central bank notes or deposits to discharge government obligations – they can, and typically do, use other media. The upshot of this is that if governments announced that they'd only accept gold in payment of taxes from here on in, central bank liabilities would continue to be a valuable and popular medium of exchange. Not so our hypothetical McDonald's coupons. If McDonald's ceased accepting coupons for Big Macs, they'd be worthless.

PS. Just because I am saying that modern central bank money is not chartal doesn't mean that I think we can ignore the state in understanding how modern money gets valued in the marketplace. I think that acceptance of particular media of exchange by the state helps drive the liquidity premia of those media. See this old post.

In the name of monetary experimentation I bought some bitcoins a while back and have been watching them fluctuate in value. Bitcoin is a digital form of exchange created back in 2009 that has since grown to considerable proportions. One bitcoin is worth around $11 these days, up from a fraction of a penny just two years ago. With around 10.2 million coins outstanding, the entire value of bitcoin stands at around $120m. That's small fry compared to $1 trillion paper US dollars in circulation, or the $5 trillion or so worth of gold, yet it's big enough to deserve attention.

Bitcoin creates problems for two theories that attempt to explain why a new fiat money might gain traction and continue to have value - the Regression Theorem and chartal theory of money.

In order to delve into these two theories, here's some data on the debut of bitcoin as a currency that should help out. Back in March 2010, someone tried to offer bitcoin for pizza in but never managed to get a bid. Later in May a bitcoin user named Laszlo finally managed to trade 10,000 BTC for a pizza. Given that the pizza was worth $40, this valued bitcoin at around a half-a-cent each. But even before the famous pizza exchange there were trades going at the Bitcoin Market, a formal bitcoin exchanges. The first published trade from late April involved 1000 coins at 0.003, a princely sum of $3. Back in October 2009 New Liberty Standard began publishing an exchange rate based off the electricity cost of generating bitcoin, though there is no indication of how much trade was actually done.

The thinking behind Ludwig von Mises's regression theorem is that people's expectations "regress" into the past. An intrinsically worthless fiat token (like US dollars or bitcoin) trades at a positive value because it had a positive value yesterday, and it had a positive value yesterday because it did the day before. This regression continues until day 1 of the fiat money's debut. What on day 1 might have generated the positive value necessary to initiate this chain of cause and effect? Mises's answer: the token wasn't a money on day 1, it was already being traded for its non-monetary value. This initial positive value provides the seed that eventually leads to the phenomenon of fiat money. Along the way the money could lose its non-monetary use -- a gold linked currency could be decoupled from gold -- but it will continue to have a positive value.

Bitcoin challenges Mises's Regression theorem because bitcoin never had an initial non-monetary use. They are just bytes. You can't eat them, wear them, or decorate with them.

There are three ways you can proceed with this.

1. Actually, bitcoin did have an initial non-monetary use so the regression theorem still applies. In its initial form bitcoin was valued as a sign of geekiness, a demonstration of one's devotion to technology. Based on this initial non-monetary value, a Misesian progression could proceed. This explains why seemingly valueless bitcoin was eventually accepted in payment for a pizza and why it continues to be valued as money today.

2. No, Bitcoin never had a non-monetary use. It's intrinsically worthless. It's a ponzi scheme. In the short term, people can irrationally bid up the price to some non-zero amount. But in the long term the logic of the regression theorem requires that the price of Bitcoin fall to zero.

3. The regression theorem is wrong.

The second theory that Bitcoin challenges is the chartal theory of Georg Frederich Knapp. The chartal theory of money says that a fiat money gains value because a government places an obligation on its subjects (say a tax) that can only be discharged by payment of those fiat tokens. This generates a demand for the tokens so that they trade at a positive value in the market.

The obvious challenge to this theory is that bitcoin has emerged spontaneously. No government asks that its taxes or bonds be paid in bitcoin. Yet bitcoin is a positively valued money token.


You can go a few ways with this.

1. Bitcoin isn't money, it's purely anomalous. The chartal theory doesn't have to explain it. Bitcoin will fall to zero.

2. Chartalism is wrong.

3. The chartal theory of money can describe a few types of fiat money, and some monetary phenomena, but shouldn't be expected to explain other types of fiat money or phenomena.

I think both theories cut the cake in a way that prevents them from seeing from a better vantage point. They treat money as a noun, not an adjective. The problem with treating money as a noun is that it implies that somewhere along the line of its development, bitcoin crossed some invisible line from being a money to a non-money.

If you think of money as an adjective, then "moneyness" becomes the lens by which you view the problem. From this perspective, one might say that Bitcoin always was a money. A degree of moneyness was attached to it from the moment the first bitcoin user realized that their bitcoins could traded to another user for something else. Bitcoin's moneyness would have only increased as bitcoin became involved in more and more transactions.

If you treat money as an adjective, the regression theorem and chartalist theory are irrelevant. Whether moneyness gets attached to a fiat token issued by the government to discharge taxes, or whether it gets attached to an object valuable for religious or industrial purposes, is unimportant. The degree of liquidity - or moneyness - is the variable of interest.