The other side of the fiat coin

So far in our fiat currency thought experiment, we’ve established that the value of a fiat currency has something to do with debts owed in that currency. But how?

When we started the experiment, we noted that the reason people value fiat currencies is reminiscent of mathematical induction: I value New Zealand dollars because I can buy things with them; people I buy things from presumably value dollars because they can buy other things with them, and so on. But mathematical induction requires a base case to be valid.

Now, thinking about debts, we can see a base case. Debtors value dollars not because (or not only because) they can buy things, but because they can be used to extinguish their debts, thus avoiding repossession, bankruptcy, or whatever other consequences there might be for defaulting.

So debtors form the base demand for fiat currencies, giving them their value. This is in contrast to currencies backed by gold (for example), whose base demand comes from consumers of jewellery, electronics, and some dental work. This is my first point.

Next, recall that our experiment imagined a situation where, in one day, all physical currency was halved, as well as all debts denominated in that currency. Now, imagine taking this one step at a time. First, halve all the physical currency. Then, take each debtor in turn, and halve all their debts.

When it’s the turn of a particular debtor, that debtor is made better off when their debt is halved. But by the end of the procedure, the value of the dollar has doubled, so their nominally-halved debt is just as much a burden as it was to start off with. Something else that happened must have made them worse off.

We’ve already established that halving physical currency can’t fully explain the doubling of the value of the dollar, so the debtor must have been made worse off by the fact that every other debtor’s debts were halved. What made them worse off may have been the halving of only a couple of other debtors’ debts, or they may have been made a tiny bit worse off every time another debtor’s debts were halved.

But we can’t escape the conclusion that, when using a fiat currency, forgiving (part of) a debtor’s debts will, in at least some cases, make other debtors worse off. This is my second point.

Now, let’s look at a micro-economist’s picture of supply and demand curves:

By Wdflake at en.wikipedia [Public domain], from Wikimedia Commons
Supply and demand curves
The vertical axis is price, normally assumed to be measured in a currency per unit of the goods supplied. The horizontal axis is the quantity of the goods supplied.

The supply curve is shown in blue. It might be any shape, but generally goes up, because in order to supply more goods, suppliers will need to spend more on the increasingly scarce inputs required to make the goods. (Sometimes very low quantities will be more expensive per unit, because of economies of scale.)

The demand curve is shown in red. Again, its shape might differ from that shown, but it will drop, because if the goods are more expensive, people will buy less of them.

The actual quantity supplied, and the actual price per unit, is determined by where the curves intersect, where both suppliers and consumers will be satisfied.

Now, let’s think of the “goods” being supplied as dollars, and the price, instead of dollars per dollar (which would be pointless) should be measured in productivity per dollar.

Debtors are represented on the demand curve. Those at the top (above the intersection with the supply curve) are happy to earn dollars at their market value, and do so. Those at the bottom decide that they are better off waiting to pay off their debts later, or if payment is required immediately, that they’re better off defaulting on their debts and taking the consequences, rather than providing the productivity necessary to pay off their debts at the current market value of the dollar. (They may, in fact, be unable to be that productive.)

Creditors and those with physical dollars are represented on the supply curve. Those at the bottom of the curve are happy to part with their dollars for their current market value in productivity. Those at the top decide to keep their dollars and spend them later. Perhaps they want to buy a car, and would do so immediately if the money they had was enough, but instead they have to join debtors on the demand curve to earn more money first.

What this suggests (and I haven’t yet completely convinced myself of this) is that the value of a fiat currency relies on always having some debtors on the brink of default, or at least relies on creditors always believing that at some point in future, there will be debtors on the brink of default. This is something else to keep in mind, but because I’m uncertain of it, I won’t call it my third point.

But, keeping the supply and demand curves in mind, consider what happens if every debtor becomes more productive for less effort. Unless this also sufficiently reduces the consequences of default, it will raise the demand curve. This will raise the intersection of the demand curve with the supply curve, so that debtors have to be more productive to earn the same dollars.

One debtor becoming more productive makes that debtor better off, but every debtor becoming more productive doesn’t make them each as much better off as they would be if they were the only one to be more productive. Similar to the case of cancelling debts, we have to conclude that one debtor becoming more productive must (at least sometimes) make other debtors worse off. This is my third point.

If the debtors owed their debts in a currency backed by gold, for example, then they would only need to produce a certain amount of gold in order to extinguish their debts; no more would be required of them, regardless of how many other debtors’ debts were forgiven, and regardless of how productive other debtors were.

At the start of this experiment, we noted that becuase fiat currencies can’t be converted into any particular goods at a particular price, they appear to provide no guarantee for creditors; there is no lower limit to the value they might receive for what they’re owed. Now we see that, because no particular goods can be converted into fiat currencies at a particular price, there is no guarantee for debtors; there is no upper limit to the productivity that might be required of them to pay off their debts.

This is my main point. This is the other side of the fiat coin.

Advertisements

2 thoughts on “The other side of the fiat coin

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s