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Have we got your back?

Here is my long promised, though not likely long anticipated, post on the “backing” theory of money.

The modern controversy over "backing" originates from this article by Neil Wallace and Thomas Sargent. In the article they offer “ a simple model that is compatible with the principle of finance theory that assets are valued according to the streams of returns that back them” and appear to endorse that principle as a basis for explaining the value of money.

“Backing” clearly applies to certain cases but to my mind it just as clearly cannot serve as a general explanation of the value of the monetary base without stretching the idea so far as to make it a metaphor so vague as to have little use.

Currency boards are cases where the idea of backing is useful. Currency boards are established to provide credibility for the local currency by backing their notes, coins, and deposit liabilities (if any) 100 percent or slightly more in high-quality foreign assets. In principle, 100 percent foreign reserve backing means that a currency board can liquidate almost immediately and exchange all of its notes, coins and deposits for foreign currency at the fixed exchange rate it maintains.

For central banks, the idea of backing is less useful as an explanation of why the currencies they issue have value. Central banks can become technically insolvent with little effect on the currency, as some in fact have. (For a discussion of central bank insolvency, see this paper by Willem Buiter. Maxwell Fry’s good book Money, Interest and Banking in Economic Development also treats the subject.) As an economist I met years ago said of such cases, “The assets of the central bank are garbage; the liabilities, everyone believes in.”

There are also cases where fiat monies continue to circulate and retain value even in the absence of any politically powerful issue. Such cases happen most often during or just after wartime, when, for instance, an occupying army that has lost the war withdraws and leaves its currency behind. For example, after World War I war ended, German occupation currency continued to circulate in what are now Poland and the Baltic states during a kind of interregnum. In such cases, if the new government does nothing to hinder the currency’s use, the currency can continue to circulate even though the original issuer will not redeem it for anything.

One can reply that in the cases of insolvent central banks, occupation currencies whose occupiers have left the scene, or other examples that may be given, the currency retains value because it is either backed by the assets of the whole of the government, not just the central bank, or that in the case of an occupation currency that people expect it to receive such backing from the new ruling government. To me, that is stretching the metaphor of backing to the point of useless vagueness. A fiat currency accepted by the government in payment of taxes is not “backed” by tax revenues or even by the general assets of the government in the sense that a currency board is backed by its reserves. Holders of the fiat currency cannot necessarily redeem it for any external asset at a set rate upon liquidation.

What is the alternative, then? It is that value is based on acceptability. An unbacked currency can retain its value if people continue, for whatever reason, to accept it in payment and to hold onto it as a store of value. Conversely, a fully backed currency may not be acceptable and may not serve as a true money. As I have mentioned in previous posts, it is legal for U.S. banks to issue notes, but I cannot imagine that a bank note issue denominated in Argentine pesos, fully backed with Argentine government bonds or even with Swiss bonds segregated from the bank’s other assets, would circulate in the United States.

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Mike Sproul has the right of a guest post in reply if he wishes to use it. After that, I may or may not offer a final comment. I am now busy with a book (on currency boards, not free banking) and other projects and will be for many months, so instead of posting approximately weekly, I will be far less frequent. Without intending it I became the most frequent contributor to the blog. The editors have received my ideas for continuing a flow of content, but it is up to them whether to keep up the flow or let the blog peter out.