Why Do Fiat Currencies Have Value?

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According to what I am saying, if on Monday Congress repealed legal tender laws, started accepting tax payments in whatever form was most convenient and allowed any currency to be printed, on Tuesday, you could go to the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.

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9 Responses to Why Do Fiat Currencies Have Value?

  1. Phil says:

    I’ve wondered about this myself, and settled on the “government is willing to accept them for taxes” answer. In my view, government accepts them for two reasons: to spend, as you say, but also to guarantee that they will have value.

    That means that if government said that dollars would no longer be accepted by the IRS, bad things might happen. I agree with you that probably nothing would change, but maybe only THEN do we have the time regression starting.

    If the IRS started accepting wheat as well as dollars, nothing would happen. Everyone would know that they could switch back to dollars if they became (relatively) worthless.

    • PrometheeFeu says:

      The problem with that explanation as I see it is that there is no difference between government and private actors for this purpose. The government very much could stop accepting dollars tomorrow. It seems unlikely, but the same can be said for all businesses. Isn’t the fact that I can buy food and shelter with my currency sufficient to guarantee that I will accept currency for my services which means my employer will need and accept currency etc? Sure, maybe tomorrow stores might stop accepting dollars, but that sounds unlikely. I think this is a fairly stable equilibria even without dollar tax payments.

      • Phil says:

        “The government very much could stop accepting dollars tomorrow. It seems unlikely, but the same can be said for all businesses.”

        The government could stop accepting dollars tomorrow, but there is a huge volume of law that says dollars are required. Businesses, on the other hand, can start demanding loaves of bread instead of dollars for contracts not yet agreed to.

        So, even if McDonald’s decides not to take my dollars in exchange for a Big Mac, the government has to take them in payment of taxes it already legislated on me. “Has to,” at least, relative to McDonald’s.

        I guess this applies to any contract already formed. The bank has to accept my dollars as payment towards my mortgage — it’s in the agreement. So dollars will have value as long as such contracts remain outstanding.

        But, yeah, I see what you mean. Once all those contracts are settled, what happens then?

        • PrometheeFeu says:

          “I guess this applies to any contract already formed. The bank has to accept my dollars as payment towards my mortgage — it’s in the agreement. So dollars will have value as long as such contracts remain outstanding.

          But, yeah, I see what you mean. Once all those contracts are settled, what happens then?”

          I think the key is that more dollar-denominated contracts get written in order to fulfill existing ones. If you have a dollar-mortgage, you will need to make sure your next job pays you in dollars. That means your employer has to raise capital in dollars. And that means investors will need to get dollars somehow, etc… I don’t think this ends absent an exogenous shock.

  2. happyjuggler0 says:

    prometheefeu,

    Are you familiar with the “Wörgl Experiment” during the Great Depression in Austria, where a local government issued what was effectively a deflation-proof scrip that was widely used locally?

    Here is an article on it: http://alt-money.tribe.net/thread/70e5eb29-853d-44ca-9faa-b789d1757037

  3. Steven says:

    “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. ” Can you identify any evidence that people actually behave this way? Do two people in a cash transaction have differing views on the lasting power of the dollar? Do those differences correspond with what you posit here? I’d be beyond shocked if the answer was ‘yes’. We do not live infinitely long. The dollar will have value throughout my lifetime, so that’s what matters. When I die, my assets will be passed on. If the dollar is threatened during the next generation, they can trade their cash (including cash I left them) for goods. Otherwise, they’ll keep using cash.

    As to why the dollar has value now, I think you nail it on the head – we used to NEED to use cash (still do for taxes) and it used to be linked to an actual commodity, but now it’s just commonly accepted and so we all use it.

    If the FED gives up on the dollar though, I don’t think it would last long. Once it is known that the dollar isn’t going to be printed any more, then we enter the world you put forth where backwards induction leads to the dollar being abandoned.

    • PrometheeFeu says:

      “Can you identify any evidence that people actually behave this way? Do two people in a cash transaction have differing views on the lasting power of the dollar?”

      Well, if you sell gold to a gold bug, that is exactly what you are doing. That is also what you are doing when you sell an inflation-protected security from someone else. More generally, that’s what many speculators do. If I buy Pork Bellies on the anticipation that their price will rise and you sell them to me on the anticipation that their price will fall, another way to say this is that I am anticipating that the value of the dollar will fall relative to Pork Bellies and you the reverse.

      I freely admit that apart from the gold bug (and the survivalist in my post) the expectation is not necessarily that the value of the dollar will go to 0. But that’s just a question of magnitude. So I don’t think it’s quite as far fetched as it sounds.

      “We do not live infinitely long. The dollar will have value throughout my lifetime, so that’s what matters.”

      That’s not entirely true. Consider the purchases you might make on the last day of your life. Merchants you are interacting with do expect to live another day. So for them to accept your dollars, they must expect to be able to use them the day after you die. The induction propagates in both directions if you have a sure date.

      “If the dollar is threatened during the next generation, they can trade their cash (including cash I left them) for goods.”

      If the dollar is expected to become worthless, few people will be willing to give your children goods in exchange for soon-to-be-worthless pieces of paper.

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