I have been chatting with David Glasner under one of his posts for the past few days about a fundamental question: Where do fiat currencies get their value from? Why can you exchange pieces of paper for food, shelter and other things? Why do you accept pieces of paper in exchange for your hard work?
The explanation I favor is that it is simply a stable equilibria: You accept dollar bills as payment because you expect that tomorrow, you will be able to spend those same dollar bills in order to get things you want. How did we get to that point? Maybe it’s because the bills were once redeemable for gold. Maybe it’s because the bills were needed to pay taxes. Maybe it’s because laws were passed that forced merchants to accept dollar bills during the Revolutionary War. It does not matter at all. Those are things that got us in the current equilibrium but they are no longer necessary to maintain us there. The network effects create a strong enough positive feedback loop.
According to what I am saying, if on Monday Congress repealed legal tender laws, started accepting tax payments in whatever form was most convenient and allowed any currency to be printed, on Tuesday, you could go to the Supermarket, give dollar bills at the cashier and walk out with a dozen eggs.
Now, there is a weakness in this reasoning which I readily admit. Eventually, dollar bills will no longer accepted as a form of payment and so we should see infinite regression to the present. Let’s say that at time T, the world ends and everyone knows that fact. That pretty clearly ensures that everyone will know at time T-1 that there is no point in accepting any dollar bills in exchange for anything. After all, there won’t be any use for said dollar bills. So really, dollar bills become worthless at time T-1. But then, at time T-2, we all know that dollars are just about to become worthless. So why accept them for payment? It goes on and on until T-infinity and nobody ever accepts dollar bills.
So there must be something wrong either in the argument I just outlined or the theory above. As it turns out, we can give and answer to the argument. There is significant uncertainty as to when dollar bills will lose value. So really, we are all engaged in what I like to call “end of the world arbitrage.” People who think dollar bills will be worthless soon will try to use dollar bills to buy things from people who think dollar bills will be worthless later. That’s why a survivalist will feel really good about blowing all his life savings on his supplies. Those dollar bills are about to become worthless anyways. It’s a steal! On the other hand, the supplies salesman expects those dollar bills to be valuable for a while. (That would suggest that people who warn you about the end of the world and wish to sell you space in a bunker might be less than honest.)
Now David argues that this is incredibly messy. (No argument from me.) And that the tidier explanation is that we have to use dollar bills to pay taxes. According to that theory, dollar bills are get-out-of-jail cards for tax day. Then, we use the vouchers largely because everyone needs them and therefore they make for a nice medium of exchange. Much tidier.
While I would be happy to accept his theory if the only difference was in messiness, his theory predicts that if the government stopped collecting taxes (or started accepting any currency) the dollar would stop being used. My story predicts that nothing would change. (Apart from a little bump in inflation, anti-IRS vouchers are useful) But more importantly, I don’t think David’s idea saves us from needing a solution to the infinite regression problem.
Think about the story that dollar bills are anti-IRS vouchers. One must then ask: Why are dollar bills effective anti-IRS vouchers? Whether you consider the government a benevolent actor or the sum of special interest groups locked in an influence battle, there are few who would disagree that the government wants dollar bills so it can spend them. But if that is the case, the government faces the same infinite regression problem as other people. Eventually, dollar bills are no longer useful which means the government stops accepting them as taxes, which means everyone stops using them.
The best way to settle this would be if Congress would oblige us and stop collecting taxes in dollars, repeal legal tender laws etc. Somehow, I think that’s an experiment that’s not very likely to happen.