Debt gives value to money

What gives value to money? There was a time when money was pure gold. Later, money was a certificate that you own a quantity of gold in bank (banknotes). Now the money are just quality paper, without any deposit behind. How that it has any value?

Some said that money is just a convention, and the fact that the state accepts that coin as the "legal tender" gives it value. However, we know many coins that lost theirs value despite the state effort to  sustain it. How that other coins survives?

I claim that debt is the one that gives value to the today's (fiat) money.

Let's make a mental experiment, regarding a fictional coin, named CoinX. This coin is used in it's country and it has a relatively stable value of purchase.

Let's assume that one day all the people decide there is no reason to trust the value of CoinX. Nothing changed in the economy, it's just mass psychosis. Nobody believes that CoinX worth more than the paper that is printed on.

We know that money tends to lose value based on psychological contagion. Let's say the perceived value of CoinX went from it's usual value to absolute zero overnight. What could save our CoinX from sudden extinction - like other hundreds of coins through history?

Depending on the amount of debt existing in the economy, we have the following scenario.
  1. nobody has any dept in CoinX
  2. all CoinX are created by loan, and loans are enforced by laws
  3. there is some debt in CoinX, however a lot of money were printed just to cover state expenditures

1. Nobody has any dept in CoinX

If there is no debt in CoinX, and you cannot buy anything with it, there is no reason for anybody to want to have more of this coin. People refuses to be paid in CoinX and chose, say, trusted CoinY for selling goods and services. People will not want to work for a salary in CoinX. At this point, CoinX is pronounced dead, and nothing could reverse the mass psychosis.

2. There is some debt in CoinX

CoinX is covered by loans if there are enough bills, mortgage guaranteed loans, etc in that coin. Of course, we should have laws for debt to be payed, that are also enforced - like jail for not paying debt.

In this case, we will still have some people that are in need of CoinX, even if they also thought initially that CoinX worth nothing. They will realize that, if they are not able to obtain that "worthless papers", they risk losing the mortgaged house, business bankruptcy, jail or other legal repercussions. The value of the CoinX money for this people that owes CoinX is not really zero, they kind of need it...

If there is a certain scarcity of CoinX, people will compete in buying CoinX, increasing it's value until the initial value or even a little more. Buying CoinX includes accepting salary in CoinX (in exchange for work), selling goods or services on CoinX or exchanging another trustful CoinY for CoinX.

3. there is some debt in CoinX, however a lot of money were printed just to cover

If there is plenty of CoinX that is not owed to anyone, probably the debtors could obtain the CoinX in exchange for something of small value (huge depreciation of CoinX).

Normally, the value exchanged for CoinX will not exceed the cost of not paying the debt in CoinX. A loaner with a mortgaged house will tend to "buy" CoinX with a value less than the current value of the house at stake. However, it's not unlikely that people would accept to "buy" CoinX at a value close to the value when they contracted the loan.

The level of CoinX's perceived scarcity in relation to the quantity of debt is the key for maintaining the value of CoinX.

If there are plenty of CoinX that does not need to be payed back to anyone, than CoinX could significantly reduce his value, because the supply is higher than the demand. When people starts to realize this, they will rush to sell CoinX at lower value than before. This is because, when all the loans are payed, the remaining CoinX will not be needed by anyone, so they will actually value zero. There would be a spiral of depreciation for CoinX.

If the perception is that the supply of available CoinX is just below the total debt in CoinX, then people will fight to get CoinX before there will be no CoinX available. In this case,  CoinX will keep or increase his usual value. Of course, it is a game of perception. There are debts that needs to be payed in years, the demand/supply is happening only for what is needed in the near future. There are a lot of things that could distort the perception of CoinX's supply (like central bank actions).

Some consequences:

If there are many loans in default (see "subprime" loans), the quantity of demand for CoinX will be reduced. In general, nonperforming loans are not a good thing for a coin's value. However, there are still other mechanisms that a central bank has to increase the CoinX's scarcity.

A coin that has many loans tends to increase it's value. The quantity of debt is a little more than the loaned value (because debt includes interest) so the demand from the debtors will increase in the the following years. When the supply of that coin is relatively concentrated on powerful actors, higher demand could result in increasing the value of that coin even on the short term, see CHF.

For maintaining the value of a coin, it is important to have a balance between the quantity of current debt re-pay rate and the quantity of money that are available for paying something else than debt. "No debt" would not be good for the current currency system.

A coin does not work if there is no powerful enough state that enforces the paying of debts in that coin. States that have a powerful army (like United States) are able to loan their coin and enforce the re-pay of that debt. Fortunately, most of the time, the army only need to be shown, not used. Switzerland is a special case, it uses a very soft power to enforce the repay, but I guess that maximum one country could have this special status on Earth.

Bitcoin (and similar) will not fly without a significant quantity of debt denominated in that coin. Even if banks will start to borrow bitcoins, there will still be a path to pay all the debt and have some remaining bitcoins that are not needed for removing any liability. Also, a fixed volume coin is kind of deflationary and tends to make people to keep that money until it increases it's value; this is not good for a coin that have to intermediate economical exchanges of goods.

Disclaimer : I do this analysis as a hobby, I am not in any way certified to give economical advice. Use this conclusions at your own risk!


Gabi said...

"Let's take the case when there exists significant debt in coinX, including bills, mortgage guarantied loans and some enforced laws for debt to be payed, like jail for not paying debt." - just that this is artificial situation. If there is a true mass psychosis no-one will value coinX, including the ones that lent coinX in the past. At any point in time modern day FIAT can disappear as you explain above once this convention fails (and it should fail since it is backed up by governments that do a lot of "strange" actions when it comes to monetary policy).

Bitcoins (and other cryptos) on the other hand can have this "debt" created by people actually opening their eyes and seeing that the current system is fully non-functional, but they still need some form of money, so they can "sell" they work for bitcoins.

Anonymous said...

I tend to agree with the value of the fiat money being given by the debt after reading The Black Obelisk by Erich Maria Remarque that explains how the government was using the "weird" money printing process to pay off external debt after WW1 and what were the consequences on the common people. There is a greate remark in there, "in the inflation war the greatest casualty was the provident saving little german deponent.

MV said...

The observable reality is that, after a credit bubble, central banks fight with deflation. Even after the 2008 economic crisis, where trust in coins went very low, the dollar did not depreciate, despite the huge amount of created money by QEs.

You can still blow up the current fiat system, however it will not happen by accident. It will take some irresponsibility and a lot of rule breaking to do it.

I don't think Bitcoin is a better solution. A deflationary coin is doomed to not circulate, that it makes it useless for economical exchanges. You can achieve a constant mass even with the fiat money (just put a serial number on it), but it is really good? What happens when the money velocity is changing, how do you compensate for this? Thighs are more complicated. A new monetary system, the same as a new software, is even more prone to bugs than the old one.

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