Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Monday, August 29, 2011

Fiat money in theory and in Somalia

A classic question in the theory of money is how an intrinsically useless object like fiat money can possess exchange value. The modern theory of money has essentially settled on the answer first provided by Ostroy (1973). In a nutshell, circumstances may dictate that some objects are relative good for record-keeping purposes, quite apart from any other use they may have in consumption, production, or storage; see also, Kocherlakota (1998).

The basic idea is as follows. We know that monetary exchange is not necessary, even in economies where mutually beneficial bilateral barter exchanges do not exist (what economists clumsily call a lack of double coincidence of wants). This is not simply a theoretical statement; we know of (and indeed most of us belong to) small economies (networks of families and friends) that operate according to "gift giving" principles. We are willing to make individual sacrifices without monetary compensation, hoping that they will be noticed, remembered, and most importantly, reciprocated at some point in the future.

Gift-giving societies seem to work well enough in small groups. This is probably because it is relatively easy to keep track of (remember) individual contributions and rewards in small groups. This "societal memory" seems to break down in large groups. Evidently, there are limitations to how much information can be recorded securely in the collective minds of people who make up society. When this is the case, some substitute form of memory could be useful. This is where money comes in.

Imagine that there is an object that is durable, divisible, portable, hard to counterfeit, and in limited supply. A lot of commodities fit this description, including gold, silver, and salt (think of what "salary" means). Historically, privately-issued paper in the form of asset-backed securities (like the banknotes of antebellum America) have also fit this description. In larger economies, objects like these begin to circulate as a means of payment. They become money.

Let me explain the basic idea. In the past, I may have made a contribution to society for "free." Well, not exactly for free; but because I knew that my contribution would be noticed and reciprocated. But as my community grows, it becomes increasingly difficult for people to keep track of each other's contributions. Well, if that's the case, then it might make sense to record my gift in some other manner. Accepting a monetary object is one way to do this. The money in my possession constitutes information about my past contributions to society. In the language of Narayana Kocherlakota (currently president of the Minneapolis Fed), money is memory.

Because commodities (including the physical capital that may back paper money) have uses in consumption and production, an implication of this is that society must bear a cost if such goods are tied up in facilitating exchanges. Their value in exchange generally means that they are priced above their "fundamental" value; that is, they possess a "liquidity premium." (This is related to what Caballero calls an asset shortage.)

Now, here is where fiat money potentially plays a role. According to the theory described above, the role of money is to encode a particular type of information (relating to individual trading histories). But information like a credit history is intrinsically useless (one cannot eat someone's credit history, for example). So rather than tying up intrinsically useful commodities to record intrinsically useless information, why not delegate the job to an intrinsically useless asset instead? Like the U.S. paper dollar, for example. (Electronic book-entry objects can work as well.)

According to this view, the market value of fiat money consists exclusively of a liquidity premium. The asset has no intrinsic value, and yet it has a positive price. Fiat money is a "bubble" asset -- but this is a bubble that plays a useful social role (it economizes on commodities that have uses other than record-keeping).

Prior to Ostroy's work, the answer to the question of how fiat money can possess exchange value was that its value is somehow supported by government decree (the original meaning of the word "fiat"). In particular, the government could introduce paper and insist that taxes be paid in government paper.

A recent paper by William Luther and Lawrence White (Positively Valued Fiat Money after the Sovereign Disappears: The Case of Somalia) casts some doubt on the strength of the mechanism highlighted by this older view.

Evidently, it is the case that the Somali shilling continues to circulate in that country long after the government that issued that paper collapsed in 1991. Here is a quote from the paper:
One of the most astounding phenomena of the domestic market is the continued circulation of the old Somali bank notes. The Somali currency has had no central bank to back it up since the bank was destroyed and looted in 1991. Nonetheless,the currency has maintained value, and has floated against other foreign currencies that are traded freely in local markets.
One reason the shilling continues to maintain its value is no doubt related to the fact that it's supply can be trusted to remain relatively constant over time. In fact, it's supply may be contracting over time as notes wear out (I have heard stories of where old notes are laminated to make them more durable, but am unable to confirm this.) On the other hand, there is some evidence of counterfeiting; e.g.,
Perhaps the most convincing evidence that the Somali shilling held a positive value in the absence of sovereign support, however, is that individuals found it profitable to counterfeit these notes. Mohammed Farah Aideed ordered roughly 165 billion Somali shillings in 1996 from the British American Banknote Company based in Ottawa, Canada. Another 60 billion Somali shillings were imported by Mogadishu businessmen in 2001. In total, an estimated 481 billion in unofficial Somali shilling notes have been printed since 1991.
This counterfeiting phenomenon, however, does not appear to be excessive; and, indeed, it probably plays some positive role in keeping the supply of shillings relatively stable.


  1. Very interesting. Reminds me a bit of George Selgin's story in "Good Money." I highly recommend if you haven't yet had the pleasure.

    I have some problems with the language of the "money as memory" story, even though I think I generally understand and accept the story.

    First, in general, people aren't rewarded for contributing to society. A person is rewarded for contributing to some other person. I understand society is shorthand, usually, but I think its use is misleading in this case. What's being recorded is that you contributed something (land, labor) to someone else in the past. In a tribe, as you point out, only the memory may be necessary. Like the Amish - I helped you with your barn, you help me with mine, etc.

    But in a large, impersonal society, what's necessary is third-party recognition and valuation of the 'memory.' So here we can see the real danger of counterfeiting, right? I just print up a bunch of 'false memories' which then devalue the 'true memories' of real value added in the past.

    Now here's where I'm getting caught: why does any third party necessarily care that I have contributed something of value to someone in the past? I think that the third party values the transfer of my 'memory' to him so that he has a higher stock of 'memory' so that he may transfer that 'memory' to another and so forth for an ever-greater stock of wealth.

    If I'm getting this right, then money also economizes on reputation. If you have money now, then you did something to earn it in the past (generally this is true). Like in the past, if you had some coconuts to trade for my fish, well, you did something to earn the coconuts.

    It doesn't ensure that you respected property rights, though. Here we see electronic book-keeping as a better technology than physical money.

    Okay, I worked it out with a pencil. A good story of the value of money, it is. And it plays to my prejudice against the tax theory of the value of money.

  2. One more thing - is the counterfeiting really counterfeiting if there is no money printing law? They are just introducing new notes, aren't they? And presumably these new notes are serving some purpose.

  3. Interesting post.

    The record-keeping theory of money is pretty old. I've found it in Macleod, 1856, for instance. Kocherlakota via Ostroy is the newest incarnation. I think of it as the IOU theory of money.

    I don't like the theory much. Modern economies shouldn't be modeled as if they were prehistoric gift giving communities. A US Dollar isn't the financial liability of one member of the community to all others, but a financial liability of the Federal Reserve to bearer.

    The theory applies better to bills of exchange. Here an individual actually created a bill in exchange for some good, and that bill circulated onward upon endorsement of individual community members. But that's still pushing it.

  4. @ProfJ:

    Now here's where I'm getting caught: why does any third party necessarily care that I have contributed something of value to someone in the past?

    I'm not sure I understand what you are getting at here. This should I think of it? As a record-keeping agency with a reputation to protect? Like a bank, for example?

    It doesn't ensure that you respected property rights, though. Here we see electronic book-keeping as a better technology than physical money.

    Physical or metaphysical money does not ensure that property rights were respected because both types of objects can be counterfeited and/or stolen.

    And I agree with you comment on counterfeiting. I was actually going to ask the question "what is counterfeiting?" in this context. Thanks!

  5. @JPKoning:

    Really? Can you send me the reference to Macleod please? (I asked Ostroy personally where he got the idea and he said he was not aware of anyone making the point before him).

    Gift-giving economies are not prehistoric. I would venture to guess that a large fraction of economic activity today occurs in this manner! Think of how resources and favors are traded among family and friends.

    I never said that the USD was a financial liability of one member of the community to all others. I said that the USD is a record of past contributions to society. There is no explicit liability associated with the token. Just as there is no explicit liability associated with a reputation, or a credit history.

  6. My reading of Ostroy comes from Ostroy & Starr (1988). They ask the reader to imagine 2 individuals on an island who periodically meet to eat together. In order to remember who's turn it is to provide, they paint a stone green to remind whomever happens to hold it that the other individual owes dinner upon presentation of the stone.

    The green stone represents an IOU, or a liability of one of the issuing diners to the other to provide food. So yes, you didn't say the USD was a financial liability of one member of the community to all others. But I read into your account Ostroy's, in which the green stone is such a liability.

    In the island environment above a USD would be some liability of a third party, say a red stone, that gets traded ad infinitum amongst the two diners.

    Perhaps the point I am trying to make is that the green stone token doesn't have value because it is a record keeping device, but because it is credit. The value of credit is determined by the issuer's capacity to make good on it.

  7. @JP Koning,

    Well, I guess it depends on how one defines IOU.

    The green stones (USDs) we have in our pockets do not constitute liabilities in any economic sense (although they do in an accounting sense). Members of society are willing to sacrifice goods and services to acquire these stones, not because they have a liability to discharge, but because they wish to have a record of their sacrifice. They carry this record forward hoping that others will be willing to perform similar sacrifices to acquire these records.

    I think of a liability as an explicit promise to deliver something of value in the future. Circulating tokens do not seem to fit this definition, in my view.

    By the way, please remember to send me the Macleod reference. Thx!

  8. If money is memory, what are new dollars willed into existence by the fed a memory of?

  9. @Anonymous,

    You are confusing the supply of money with the demand for money. My post was on the demand for money (as a substitute for public memory).

    And as for whatever point you were trying to make, you may very well ask the same question of what a fortuitous discovery of gold might be in memory of.

  10. This is a very interesting post. Here's the central thing to me:

    So rather than tying up intrinsically useful commodities to record intrinsically useless information, why not delegate the job to an intrinsically useless asset instead? Like the U.S. paper dollar, for example.

    The problem, it seems to me, is that if these monetary information tokens can be duplicated at will, then their value as informational records of previous sacrifices depends on the trustworthiness of the issuer not to give them out in the absence of the sacrifices that they would typically record. Otherwise, wouldn't people eventually catch on and start to either use a different exchange medium or third party to manage the system (if such a thing it was legal), or simply start demanding more of the monetary tokens from customers once it's realized that they have more of them?

  11. David: But ignoring US dollars, you can see why the green stone in Ostroy/Starr is essentially a liability, or credit. Upon presentation of the stone to the community, the community is obligated to provide a service.

    Macleod begins to explain his theory of money in Chapter 1, sections 9 and 10 of Theory and Practice of Banking, Vol 1. "The use of money being to preserve the record of services being due..." Macleod was a pariah amongst the economists of his day, you shouldn't be reading him ;)

  12. @Nate: Yes, you hit the nail on the head as far as the management of the supply of these tokens is concerned. Note, the same problem exists for any firm that issues "paper." I discuss this issue here:

    @JPK: Yes, I can see that. In the Ostroy-Starr setup that you described, there is no lack of double coincidence--just a simple credit arrangement with the stone keeping track of liabilities. It's a little different, I think, in multilateral networks, where the stone has no explicit issuer, and where it does not represent any explicit liability. A USD, for example, does not entitle me to anything.

    Thanks for the reference!

  13. David,

    "I'm not sure I understand what you are getting at here. This should I think of it? As a record-keeping agency with a reputation to protect? Like a bank, for example?"

    When I say third-party, I mean someone who wasn't involved in a previous transactions where "memory" was transmitted. Say A and B trade, and thereby transfer memory. Then if A goes off to trade with C, C is the third party. So A needs something to display to C that C recognizes as legitimate 'memory.'

    "Physical or metaphysical money does not ensure that property rights were respected because both types of objects can be counterfeited and/or stolen."

    Oh, absolutely. I just mean that metaphysical might be marginally better because it's harder to steal.

  14. Dr. Andolfatto: Thanks for linking to our working paper on Somalia. I am currently working on a paper regarding the role counterfeiting plays in determining the purchasing power of Somali shillings. If you'd like, I can send you the draft when it is complete. Thanks again for the link!

  15. Will,

    It would be interesting to learn more about how the purchasing power of the shilling has behaved over time, as well as the exchange rate vis-a-vis competing currencies.

    It is also interesting to think of the role of counterfeiting, though as Prof J mentioned above, not really sure how to think of counterfeiting in this environment. I presume there are no laws in Somalia prohibiting the creation of these notes?

    Anyway, looking forward reading your future work in this area!

  16. David:

    Scientists used to bend over backwards trying to explain nonexistent substances like phlogiston, ether, and caloric. Nowadays they bend over backwards trying to explain the nonexistent substance called fiat money.

    We all know that money can be backed by assets. We all know that if those assets consist of things like land, bonds, etc., then there is no cost resulting from those goods being tied up in facilitating exchanges. We also know that the backing of money can take many forms, so that it is sometimes not obvious what the backing is. The US dollar, for example, is backed by the assets of the Fed, but it is not convertible into metal. People observe the fact that the dollar is inconvertible, and jump to the conclusion that it is not backed. This in spite of the fact that the dollar is the acknowledged liability of the Fed, and the Fed holds assets designated as "collateral held against federal reserve notes".

    About Somalia: Maybe people figure the old notes will eventually be redeemed in another currency, as happened with the Iraqi Swiss Dinar. And Aidid was a warlord, who no doubt collected taxes from people under his rule. Suppose that one day he declared "Rather than you guys paying me taxes in chickens, I'll accept paper somali shillings instead." That makes his Somali shillings backed by his personal power to tax. They would not be a fiat money and they would not be counterfeit.

  17. @Mike Sproul,

    Good comments, Mike. Let me try to counter them.

    With respect to your opening remark, I sympathize with it. Have you seen Dror Goldberg's paper "The Myth of Fiat Money"?

    We all know that if those assets consist of things like land, bonds, etc., then there is no cost resulting from those goods being tied up in facilitating exchanges.

    Be careful here. The "we all know" is not warranted. In the models I work with, if money is backed by capital, then capital will generally be over-accumulated (and/or overpriced). These are theorems.

    People observe the fact that the dollar is inconvertible, and jump to the conclusion that it is not backed.

    I've made the same point many times in terms of fractional reserve banking. People think that just because reserves are a fraction of total assets, that bank liabilities are therefore not fully backed.

    I think you are off base on your observation that Fed notes are backed by assets. They are largely backed by Treasuries, which are claims to future Fed notes. So a Fed note is backed by a future Fed note. What sort of backing is that?

    In any case, here is the critical point you are missing (and I think the authors of the paper miss it too).

    The question is not whether fiat money exists or not. The question is how some assets can trade at above fundamental value (i.e., how can they possess liquidity premia). Fiat money is just an extreme example of money whose value is made up predominantly of a liquidity premium. But all assets possess liquidity premia in varying degrees. Monetary today deals largely with understanding the nature of these liquidity premia.

  18. David:

    If paper money is backed by farmland, for example, then the land is farmed all the same, even as it backs money. No goods are tied up, and the land will not be over-priced. Same if money is backed by bonds.

    The dollar is backed by treasury bonds, which are in turn backed by taxes, so the dollar is ultimately backed by the government's ability to take real resources by taxation. An example I like is a landlord who collects 50 oz. of silver per year rent on his land. At R=5%, his land is worth 1000 oz. One day he buys groceries by writing a bit of paper that he promises to accept as payment for 1 oz. rent. The next day, he issues a 2000 oz. bond and buys more land with it. Then he issues another 1 oz. bit of paper and buys back 1 oz. worth of his own bonds. His bits of paper (dollars) are now backed by his bonds, which are in turn backed by his rent collections.

    I accept that gold and silver can have a liquidity premium. I think the premium would be small, as such a premium would attract rival moneys. But if paper dollars had such a premium, it's a free lunch for the issuer, and the free lunch would attract rival moneys until the premium is gone. So my question is not how can assets trade above fundamental value, but why do people believe that such a violation of the no free lunch principle is possible?

  19. Mike,

    I am not sure whether you are making a theoretical or empirical statement. I can point you to models where if money is backed by farmland, and if farmland can be augmented, then there will be over-development in farmland. Whether this theoretical property holds in reality is a different question. The creation of MBS products that circulated as collateral in repo, backed by real estate, and the simultaneous boom in real estate development is consistent (though does not prove) this hypothesis.

    I am willing to make the statement that the dollar's purchasing power (market price) is partially backed by taxes. I doubt that it is fully backed in this manner, and the paper on Somalia seems consistent with this view (though you have other hypotheses).

    There is no free lunch in the models I work with. The liquidity premium cannot be bid away because there is a fundamental shortage of good collateral assets; a fact that stems from the inability of economic agents to commit to the promises they make in financial markets.

  20. "About Somalia: Maybe people figure the old notes will eventually be redeemed in another currency, as happened with the Iraqi Swiss Dinar."

    Mike, I think David's point is that Somalians who continue to use the old notes expect that they can redeem them in future trade for consumption goods, despite the fact that the notes have no government backing or any intrinsic value at all. It's a great real-world example of money-search theory in action.

    David, this is really a fantastic post and I appreciate it greatly. I've always said that search-theoretic money models have just in the last decade progressed to the point that where they are good explaining pre-Civil War monetary exchange, but this is a perfect example of how money search as it stands today is perfectly applicable to (anarchic) modern economies in the developing world.

    I'll mention this to Warren Weber at the Minneapolis Fed tomorrow. I know he'll get a kick out of it.

  21. David:

    The kind of monetary augmentation you're talking about can happen with gold, silver, etc. People find gold useful as money so they carry it in their pockets, keep it in vaults, and this extra demand for gold 'augments', or drives up its value. But if a farmer borrows $1 from a bank (or from the Fed, let's say) and pledges $1 of his land in return, then the land isn't in anyone's pocket or anyone's vault. It is growing crops just like before. The land's value is not augmented. If the farmer instead presented the Fed with bonds, then those bonds are kept in the Fed's vault instead of the farmer's. Again no augmentation.

    (We might be talking at cross purposes on this. I'm talking about land as backing for money, and you seem to be thinking about what the extra money will do to the demand for land.)

    You agree that taxes can back money, and I presume you agree that gold and bonds can back money. Nothing about that idea is weird. But fiat money is weird. You need to be very careful about taking that leap from saying "This money's value is determined by backing, even though the backing might not be obvious." to the much more reckless statement "This money has no backing. Its value comes instead from scarcity and monetary usefulness."

    Think of where the idea of fiat money came from in the first place: People saw that paper money was inconvertible, and wrongly thought it was unbacked, just because they didn't notice the backing provided by bonds, taxes, promises of redemption in the distant future, etc. That is a non sequitur, pure and simple. People invented the idea of fiat money simply because they didn't understand the many forms that backing can take.

    I can look at every so-called 'fiat' currency I ever heard of and point to its backing. For currencies like the dollar the backing is gold, bonds, and taxes. For the Iraqi Swiss Dinar, the backing is expected future convertibility. For Somalian shillings, throw in tax collections (i.e., protection money) by warlords.

    If every so-called fiat money can be explained as a case of backed money, there is no reason to accept the weird theory of fiat money, which generates free lunches for its issuers, which would be destroyed by competition among issuers, and which suffers from the 'last period problem' among others.

  22. @Mike:

    But if a farmer borrows $1 from a bank (or from the Fed, let's say) and pledges $1 of his land in return, then the land isn't in anyone's pocket or anyone's vault. It is growing crops just like before. The land's value is not augmented.

    I understand that the land is growing crops just like before. In the models I work with, the capital produces output just like before too. So that is not the issue.

    The issue is that the land or capital that is useful for backing money, or as collateral for debt, becomes favored relative to other types of capital that are not so good collateral objects. The friction that drives this wedge is limited commitment and limited record-keeping. The premium that good capital earns in this case cannot be bid away.

    Once again, I say that the issue is not so much whether money is fiat; rather, it is a question of how much of its value is exchange value (a liquidity premium).

    I accept, however, your general point that what people call fiat money is at least partially backed by state power. But to me, this is beside the point, unless you assert that the entire value of this money is backed by state power. I think that is wrong, and I think that the example of Somalia demonstrates that it is wrong. But that's just what I think.

  23. I'll support David's argument in the final paragraph that "the entire value of this money is [not] backed by state power."

    This is the argument of George Selgin's "Good Money." The state-backed money was not available in the denominations required to pay laborers, and what was available was poor quality, such that counterfeiting was easy. So manufacturers developed their own private money to fill the gap.

    Technically, the private money was a token that was backed by coin of the realm (gold, silver, etc.) so (if I recall correctly) was not different from a Bank of England note in this regard.

    One cannot say the private money was backed by state power.

  24. "The premium that good capital earns in this case cannot be bid away."

    You must be talking about a tiny premium here. Houses make excellent loan collateral, and their aggregate value is many times larger than the amount of paper or credit money that exists. Then there's land, stock, cars, jewelry, future earning power from a stable job, etc. So if I were to make a guess at the size of the premium attributable to ease of use as loan collateral, I'd say maybe 0.1%. I'm curious what your estimate would be.

    But of course the value of fiat money is not usually attributed to the premium on goods usable as collateral. It's attributed to the liquidity value of paper money, along with state-imposed scarcity of that money. Now, every so-called fiat money I know of is backed by assets of equal value (i.e., If a dollar is trading for 1 oz of copper, then you'll find the issuer holding assets worth 1 oz. as backing for that dollar.). That observation tells me that the liquidity premium is zero.

    But suppose, for example, that the Mexican peso trades for 1 oz., and it has a true liquidity premium of 0.2 oz. Any issuer of rival money can get a piece of that premium by circulating their own money. Those issuers could be issuing foreign money, or they could be Mexican private banks issuing checking account pesos or credit card pesos. Any of those kinds of money would reduce the demand for base pesos and thus reduce their premium. That competition will exist as long as there is any liquidity premium, so the only stable value for that premium is zero.

  25. Mike,

    You must be talking about a tiny premium here. Houses make excellent loan collateral,...

    You may have noticed something about the value of this "excellent" collateral over the past five years. ;)

    You've got me on the quantitative part; I have no idea how large these premia might be in individual cases, but I suppose they might be estimated in some manner. I suspect they can be large in some cases (like USD and Treasuries), but I have no direct way of knowing. On the other hand, you evidently suspect that liquidity premia are non-existent...not sure how you can tell.

    By the way, in the models I work with, the "premia" can manifest itself either in price or quantity. In the latter case, capital is "over-accumulated" instead of "over-priced."

    I think that the claims that you make are likely to be true under a given set of conditions. This is where a formal model would be useful.

  26. David,
    Of course "USD entitles you to something". It entitles you to keep property rights that are encumbered by debt denominated in USD, both public and private. Things like property taxes, mortgages, etc.

    Macleod is a great resource for understanding how the law and the corresponding definitions of property treats money and banking.

    PS thank you for writing about something other than Ron Paul.

  27. David,

    A. Mitchell Innes in "The Banking Law Journal, May 1913" does a great job explaining money. Similar to Macleod.

    If you have the time, I think it is well worth a read. It touches on both the IOU theory of money as well as what gives government money it's value and who's liability it is. I think, it also explains the situation in Somolia when you compare it to Innes' historical explanation money.

    I hope you are still responding to comments on this thread. I would really like to hear your thoughts. Your time permitting, of course.

  28. Reverend:

    Yes, I am familiar with the argument that legal or lawful tender laws endow government paper with a form of backing. The authors of that paper I cite are familiar with that argument as well.

    My own view is that this is probably correct; at least partially so. That is, there may be more than one force that contributes to the liquidity value of a circulating medium.

    But if this theory is completely correct, then it suggests that a suspension of legal tender status would render the USD worthless. Suppose that people were free, for example, to discharge their debts, public and private, in any type of financial instrument (note that today, we usually discharge our debt using privately-issued demandable liabilities...not government cash). Would you predict that the USD would cease to circulate? It seems to me that you must make this prediction, if you think that is all that is backing the USD. I personally do not believe that this would happen; though obviously, we have no way of knowing for sure.

    Thanks for the link. Will take a look, time permitting.

  29. Thanks for the response. I think of money/credit as a social and accounting construct. And banks as guarantors of private credit. In the case of Somalia I would guess that the path of least resistance from both a cost and societal norm perspective would be the continued use of the shekel rather than choosing a popular commodity as the unit of account. I do not believe Menger's theory on the origin of money. I can't think of money as something other than credit. Government money included. The use of gold or whatever commodity for money was still a credit transaction and was, in my mind, used to thwart conterfeiting of credit. I think the important thing is how it can be acquired. If it can be easily acquired through counterfeiting or fraud it would lose its value. I do not know how many shekels were counterfeited relative to the total shekels outstanding but assume that it matters how many people or how much something people are getting for nothing.
    Your use of demand liabilities to disharge your debt is just you transferring your right to redeem bank credit for government money to that individual who then sells it to his bank who then redeems it for government cheese at you bank. The debt is ultimately discharged with government money not bank credit.

  30. That's my interpretation, anyways. I hope I properly understood the points you made. Basically I'm saying that the cost of switching away from the shekel while it is still works as the unit of account and medium of exchange makes no practical or economic sense. As long as they are liquid in the sense that their price is not volatile i don't see any benefit in abandoning the shekel. But that could change.
    What backs the promises you make to your wife or friends and family? What gives them value? Are they intrinsically worth anything? Are they valuable because they are in short supply? What happens to the value of your promises if they deliver less than expected? Does making lots of promises make them worth less if you deliver? Not meant as snark i hope it doesn't read that way.

  31. Reverend Moon:

    I think that we may be a lot closer in our thinking than what is suggested by your reply. Still, I'm not exactly sure of all the points you are trying to make or the nature of the criticisms you are levying against my post.

    I define money as an object that circulates as a medium of exchange. It is distinct from credit. If I had access to a perfect credit market, I would not need money (I would simply purchase the things I need with IOUs taken out against myself...e.g., in the form of promises to deliver future labor).

    One can still support credit even if people cannot commit to keep their promises if there is sufficient record-keeping (and a credible threat of punishment in the event of default). Absent such record-keeping, a monetary object can serve as a substitute. Perhaps this is what you meant when you said that you considered gold as a mechanism to thwart counterfeit. If so, this would be consistent with what I am saying here. Gold, salt, paper, whatever...these are technologies for recording information (relatively) securely, especially when it is easy to fabricate or counterfeit records.

    You ask several good questions at the end of your last post. Let me answer them for you.

    What backs the promises you make to your wife or friends and family?
    The threat of ostracism.

    What gives them value?
    When your promise to deliver some good or service in the future is desired by one or more individuals.

    Are they intrinsically worth anything?
    If it is a promise to deliver something of intrinsic value, then yes. (Note: your credit history, the information needed to support good behavior, is, however, intrinsically useless.)

    Are they valuable because they are in short supply?
    If you mean value at the margin, then yes. Even oranges derive their marginal value by being short in supply.

    What happens to the value of your promises if they deliver less than expected?
    Your existing and future promises will be discounted by the market.

  32. David,

    Thanks for the response.

    I think we are too.  My first post was referencing what i thought you had implied about government money not being a government liability.  I think it is. You said that government money doesn't entitle you to anything.  I said that it entitles you to discharge debts denominated in that monetary unit like property taxes and mortgages.  Having money also entitles you to buy anything for sale in that currency also.  I think of money specifically as a right.  A right that, like all rights depends of the consent of those around you.  Usually rights are secured by government that has the consent of the governed.  I think that the former government of Somalia no longer exists because they could not make good on their liabilities which were to produce the public goods, the institutions and laws and their enforcement among other things. They no longer had the consent of those who live there.  I think you're right that money unit is the unit of memory and since the death of the Somali government did not at the same time destroy all the financial social and contractual relationships,  and it didn't change the fact it was used to record past transactions. It is not a one off game for the citizens of that country if you had a debt denominated in shillings you likely still had a debt denominated in shillings.  Shillings are just used to determine the relative values of things.  If you were owed something you still had a right to collect on that debt that is granted to you by those who live around you.  It was not a debt jubilee.  I guess it was for those who owed the government.  Plus, the fact that there was no internationally recognized government does not mean that there was no "government".  I would be surprised if those in charge  of the clans did not spend shillings and "tax" their respective populations as their fought their civil war. Though, I don't think that's necessary for its continued use.  Integrity of the money is.  Which is why Somaliland now has their own shilling.  
    Also, I do not think legal tender laws are needed to compel people to use government money. It is the path of least resistance.  Which in economics and politics is usually the rule.  

    I think i get what you were saying about the marginal value of money.  But probably not.
    I'm not sure it makes sense to talk about the marginal value of money that way since it has no value except in relation to things for sale.  And though I may value 1 dollar more very little I would really value a million more.  Unless there was nothing to buy with it of course.

    I don't think money is not a normal good (in fact i dont think it is not a good at all) otherwise we would have to assume Warren Buffet is not just irrational but bat shit crazy. Wouldn't we?  
    I probably just don't get what you said.  If you could help me understand what I'm not getting about I would be grateful.

    I was only disagreeing with that one point I mention at the beginning. After that it's just my ADHD babblings about what I believe. Not necessarily any disagreement. I guess I didn't read that way.  

    I prefer orange juice to eating oranges. 

    I hope what I wrote makes sense.  Its quite a ramble.  

    Thanks. I've appreciate your continued engagement.

  33. Should read "I don't think money is a normal good"

  34. Reverend:

    Having money also entitles you to buy anything for sale in that currency also.

    Can't say that I agree with this, though it is probably a quibble. You would argue that the implicit consent of others is what confers this right.

    Anyway, you should go read the paper by Luther and White; they anticipate some of your concerns about other local governments accepting Shillings.

    Also, if you don't get the money is memory idea, I recommend you read Narayana Kocherlakota's piece "The Technological Role of Fiat Money." It is published in the Federal Reserve Bank of Minneapolis Quarterly Review and is available online for free.

  35. David:

    To the extent that you can be entitled to anything, I think I'm right (and not just from a philosophical perspective). And it probably is, just a quibble. I think you put it well when you wrote that "the implicit consent of others is what confers this right" which is why, I think, entitles you to anything and what gives it value. Unless there is some magic force that that entitles people to stuff that I'm not aware of.

    I did read the paper by Luther and White I don't think it was well researched. I feel I learned more about the situation in Somalia, in 5 minutes, doing my own research on the web.

    I most definitely understand the money is memory idea since I think about money in terms of accounting. I think I have read the Kockerlakota piece previously but, will check it out again.
    My writing is, I guess, not comprehensible. which doesn't surprise me.

    On a related note to the Narayana piece, have you read "The Destruction of Economic Facts" by Hernando de Soto?

  36. Reverend:

    Unless there is some magic force that that entitles people to stuff that I'm not aware of.

    If I default on a debt obligation, my creditor may send a sheriff to seize my property without my consent.

    I'm sorry that you did not find Luther and White informative. Thanks for the link to DeSoto. I have read some of his monetary history book; it's very good.

  37. David:
    I think you're misunderstand what I mean. .
    If you think of government as being created to secure rights, that are basically social conventions or accepted morals, that are made into laws to be enforced, and that government power to enforce those laws comes from the consent of the governed then what I said makes sense. Government power has to come from somewhere doesn't it? Check out the 'Declaration of Independence' it says the same about where government power comes from. Though, if you read the bit about self evident truths, endowed by the creator literally it could seem like it came from magic. ;)

    Even in thinking about a place place ruled by a dictator, they rule because the people in the army and all the other people around ultimately have consented to their government and its laws.

  38. No, I figured that that is what you meant. I think this might be largely semantics. Thanks!

  39. David:
    I might even go as far as to suggest that what money is, is an agreement. Much like debt. In that sense I think inflation can be thought of as the renegotiation of that agreement. If that makes sense.

  40. Yes, that makes sense. People have studied the idea of state-contingent inflation rates as making nominal debt contingent on real factors (without explicit renegotiation).

  41. Hyperinflation is the end of the agreement.

  42. David:

    Yes, exactly. I really like the way you put it, because that's what I'm trying to say. Thanks.

    " nominal debt contingent on real factors (without explicit renegotiation)"

  43. This comment has been removed by the author.

  44. US dollars, a "fiat" currency, have value for three reasons:

    1. People with debts in dollars must repay them in dollars. They need those dollars to pay as agreed. This is likely why Somalia continues to use the old currency -- people have long term debts in that currency.

    2. People need dollars to pay court judgments. They are denominated in dollars, and must be paid in dollars.

    3. People need dollars to pay taxes, and cannot pay in any other asset.

    All three of these factors work together to support the demand for fiat dollars, and it makes dollars a form of "real" wealth; as real as anything else, because value is always determined by demand. If individuals value or desire something, it is wealth (as long as it can be owned/traded), even if it appears to have no utility, and appears to lack "intrinsic" value. It is a mistake to separate paper money from other assets; they all have value only because of the needs and wants of the individuals that trade them.

    It is interesting to note that no matter how many dollars are printed and spent by the government, a person with a debt in dollars is still entitled to repay in the hyper-inflated paper. A man with a mortgage against his home is still able to take full ownership of the home using dollars, no matter how worthless they become.

    In this way, dollars can be considered to be "redeemable" not in gold, but in the homes, cars and other assets that generate new bank loans. Just as a gold-certificate holder can always redeem his paper for gold, a man with a mortgage can always "redeem" his notes for a house.

  45. The story about two men and the green rock is a good one, and the method they use to generate money is the same one that we use today to generate US dollars.

    One man issues a debt (an IOU for a meal) to the other, who paints a rock green (prints new money) and trades it for the IOU. It is a trade -- an asset for new money, with an agreement to trade them back to each other in the future. The trade, and the agreement to trade them back, has "monetized" a debt, and created new money (the green rock) "out of thin air."

    The same thing happens when a modern bank issues a new loan. It accepts de facto ownership of an asset (home or car used as collateral) in exchange for new money the bank generates with a few keystrokes. The home is analogous to the meal-IOU, and the new US dollars are analogous to the green rock. Further, the bank and the borrower agree to trade the assets back to each other in the future. Not all at once, as is the case on the green-rock island, but over time using a series of trades (mortgage payments to the bank).

    In both cases, money is generated by a trade of a newly generated, arbitrary item (green rock, US dollars), and an agreement swap them again in the future. The islander values the green rock for the same reason that we value US dollars today (one of the reasons) -- because of the agreement to trade the rock for a meal in the future. It is that agreement that gives a formerly "useless" object value.

    US dollars are not a "memory." They are generated as part of an agreement, be it a bank loan or a meal swap. Without that agreement, the rock is worthless. They become valuable when they are created, and each time a bank issues a new loan it is creating new green rocks, swapping them for an asset (collateral agreements), and agreeing to exchange the rock for the original asset at any time.

    The three-step process for creating "fiat" money:

    1. Print new money
    2. Trade the money for an asset
    3. Agree to trade the asset for the new money

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  47. This is probably because it is relatively easy to keep track of (remember) individual contributions and rewards in small groups. China Direct

  48. Dear professor,

    the paper highlights a paradigmatic case of memory and relative stability of the coordination game but it clearly states that the taxes-drive-money mechanism is still crucial in launching a new currency, albeit the latter might survive without continuous support from the government.

    The creation of the focal point is still a government business as far as I can learn from the paper.