Why does the dollar bill in our pocket have value? The value of money is established, according to some, because the government in power says so. For some commentators, the value of money is because of social convention. What this implies is that money has value because it is accepted, and why is it accepted? Because it has value and is accepted! Obviously, this is not a good explanation of why and how money has value.
The Difference between Money and Other Goods
Let us try another approach. Demand for a good arises from its perceived benefit. For instance, people demand food because of the nourishment it offers them. Regarding money, people demand it, not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value—it is exchangeable in terms of other goods and services. Money is demanded because the benefit it offers is its present and future purchasing power.
Consequently, for something to be accepted as money it must have a pre-existing purchasing power. So how does a thing that the government decrees to be the medium of exchange acquire such purchasing power? We know that the law of supply and demand explains the price of a good, but how does money get its price (i.e., goods people are willing to exchange for it)? It would appear that the same law should explain the price of money. However, there is a problem since the demand for money arises because money has pre-existing purchasing power. Yet if the demand for money depends on its pre-existent purchasing power, why was it demanded in the first place?
We are seemingly caught here in a circular trap—the purchasing power of money is explained by the demand for money, while the demand for money is explained by its purchasing power. This circularity seems to provide credibility to the view that the acceptance of money is the result of a government decree and social convention.
Mises’s Explanation
In his writings, Mises showed how and why money became accepted. He began his analysis by noting that today’s demand for money is determined by yesterday’s purchasing power of money. Consequently, for a given supply of money, today’s purchasing power is established. Yesterday’s demand for money, in turn, was fixed by the prior day’s purchasing power of money. By regressing through time, we will eventually arrive at a point in time when money was just an ordinary commodity used in barter, where demand and supply set its price. The commodity had an exchange-value in terms of other commodities (i.e., its exchange value was established whatever other goods or services, or fractions of goods and services would exchange for a unit of that good). To put it simply, on the day a commodity becomes money, it already has an established purchasing power in terms of other goods through voluntary barter exchanges. This purchasing power enables the demand for this commodity as a medium of exchange.
On the first day that a commodity begins to function as a medium of exchange for indirect exchanges—trading goods to get another commodity with the plan to use that commodity for exchanges with others—the purchasing power has been established by its supply and demand. Continual and popular use, not just as a commodity, but as a medium of exchange can increase the demand for the commodity as money. Once the price of money is realized—what full or partial goods and services will be exchanged for it—then a workable basis is provided for tomorrow’s price of money (ceteris paribus). It follows then, that, without yesterday’s information about the price of money, today’s purchasing power of money cannot be established.
With regard to other goods and services, history is not required to ascertain present prices. A demand for these goods arises because of the perceived benefits from consuming them. The benefit that money provides is that it can be exchanged for other goods and services. Consequently, one needs to know the past purchasing power of money in order to establish its present purchasing power. Using the Mises framework of thought—also known as the regression theorem—we can infer that it is impossible that money could have emerged as a result of a government decree or government endorsement or spontaneous social convention. The theorem shows that money must emerge as a commodity. On this Rothbard wrote,
In contrast to directly-used consumers’ or producers’ goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold). Thus, government is powerless to create money for the economy; the process of the free market can only develop it.
But how does all that relate to the paper dollar? Originally, paper money was not regarded as money, but merely as a representation of gold (i.e. a money-substitute). Various paper certificates represented claims on gold stored with the banks. The holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money. These certificates acquired purchasing power on account of the fact that these certificates were seen as a representation of gold.
Paper certificates that are accepted as the medium of exchange opens the scope for fraudulent practices. Banks could now be tempted to boost their profits by lending certificates that are not covered by gold. However, in a free-market economy, a bank that over-issues paper certificates would quickly find out that the exchange-value of its certificates in terms of goods and services will decline. To protect their purchasing power, holders of the over-issued certificates would most likely attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market, then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold.
The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentives to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of unbacked paper certificates unevenly increases the prices of goods and services. Further, the structure of production is distorted, leading to an artificial boom that must eventuate in a bust.
To prevent such a breakdown, the supply of paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank—i.e., a central bank—that manages the expansion of paper money.
To assert its authority, the central bank introduces its own paper certificates, which replace the certificates of various banks. The central bank money’s purchasing power is established because of the fact that various paper certificates—which carry purchasing power on account of their historical link to gold—are exchanged for the central bank money at a fixed rate. The central bank’s paper certificates are fully backed by bank certificates, which have the historical link to gold. It follows then that it is only because of the historical link to gold that the central bank’s pieces of paper acquired and retained purchasing power.
Conclusion
Contrary to the popular way of thinking, the value of a paper dollar originates from its historical link to commodity money, not a government decree or social convention. Fiat money of the sort we use today could not and would not come about in a market setting. It is solely an inflationary creature of the state, taking advantage of a historical link to sound money.
