A fiat currency thought experiment

As far as I know, every nation’s official currency is a fiat currency. This means that the government (or the European Central Bank, or whoever) doesn’t promise anything of value in exchange for their own currency.

This is in contrast to a “hard” currency; for example, before the so-called Nixon Shock in 1971, foreign countries could get an ounce of gold from the US government for every $35 they sent back; this was meant to ensure that the US dollar had a certain value.

At first, it appears that a fiat currency provides no guarantee for holders of the currency or for creditors owed money in that currency; no-one is obliged to give them anything valuable in exchange for the token coins, pieces of paper, or electronic records.

But four decades after the Nixon Shock, US dollars are still treated as if they have value, and most other countries have functional fiat currencies, too. So why are they valuable?

Thinking about why I value New Zealand dollars, the answer is fairly simple: because I can buy things with them. This is because the person I buy things from values New Zealand dollars, presumably because they can buy things with them, and so on. It seems a bit like a failed attempt at mathematical induction; the inductive step is fairly obvious, but the base case is nowhere to be seen.

For me, this isn’t a satisfying explanation of why the New Zealand dollar has any value. So, I propose a thought experiment.

First, consider this scenario; call it scenario A. Parliament decides that the New Zealand Dollar will be replaced by the New Zealand Pound on, say, the 10th of July. The pound is to be worth two dollars, so the Reserve Bank will pay one pound for every two dollars it receives; people can make this exchange through their banks, if they wish, so both currencies will be accepted in retail for a while. Bank account balances and other debts payable in dollars on or after the 10th of July are considered to be debts of half as many pounds.

In this scenario, it seems reasonable to believe that on the 10th of July, the pound really will be worth twice what the dollar was worth on the 9th.

Now, consider a different scenario, scenario B. New Zealand decides to stick with dollars. For some inexplicable reason, on the 10th of July, everyone who has New Zealand Dollars in physical currency decides to permanently take half of it out of circulation, by destroying it; also, everyone who is owed money in New Zealand Dollars decides to cancel half of each debt, so that all their debtors have to pay back only half as much.

Notice that in scenario B, everyone owns and owes just as much in dollars as they owned and owed in pounds in scenario A. For example, if you have $24 on the 9th of July, then the next day, you have £12 in scenario A, or $12 in scenario B.

So, the question is this: in scenario B, is the dollar worth twice as much on July the 10th as it was on July the 9th?

I intend to write in future about what we might conclude if the answer is “no”, and what we might conclude if the answer is “yes”. In the meantime, feel free to write your own ideas about this in the comments.

For this thought experiment, we might need to make some simplifying assumptions. For example, the job of the Reserve Bank is to keep inflation within a certain narrow range. A doubling in the value of the dollar would be a one-off shock deflation, and the Reserve Bank would be obliged to attempt to correct it. Knowing this, people would expect the dollar in future to be less than twice as valuable as it was on July the 9th, and expectations of future value affect the current value of the dollar.

So perhaps we should assume that in scenario B, the Reserve Bank for some reason acts exactly as it would have acted in scenario A, and that everyone knows that this will be the case. I’m not sure that this is a well defined assumption, but I hope you’ll play along with the intention that we assume that the Reserve Bank, and people’s expectations of it, don’t interfere with the effects of scenario B, whatever they might be.

We might need to make some other simplifying assumptions in order to focus on the real intention of this thought experiment, but I’ll mention those when I think they’re relevant.

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3 thoughts on “A fiat currency thought experiment

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