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Backing, Shmacking

Somali Shilling

I really ought to know better by now than to complain about the "backing" theory of money–the view that the value of, not just some sorts of money, but money of any sort, depends on the assets commanded by the money's suppliers. I've never been able to convince the theory's more determined proponents of the error of their ways, and I risk provoking them to mount their hobby horse every time I bring it up.

But the backing theory keeps rearing its ugly head whether I mention it or not, as it did in the pages of Monday's Wall Street Journal, in an article asking "Do Cryptocurrencies Such as Bitcoin Have a Future?" And I'll be damned if I'm going to just sit idly by while it threatens to amble its way into some as-yet uninfected brains.

The specific perpetrator in this instance was one Eric Tymoigne, an assistant professor of economics at Lewis & Clark College, who invoked the ghastly fallacy in defense of his assertion that "There is no financial logic behind bitcoins’ face value":

Monetary instruments are securities. As such, they have a term to maturity (instantaneous) and an issuer—often a central bank or private banks—that promises to pay the bearer the full face value. Gold coins are a collateralized form of such security. Paper, cheap metal, and electronic entries are the forms such securities take today. The characteristics of these securities allow them to circulate at a stable nominal value (par) in the right financial infrastructure and as long as the creditworthiness of the issuer is strong. This provides a reliable means to complete transactions and, more important, service debts.

Bitcoins, meanwhile, violate all of the rules of finance. There is no central issuer guaranteeing payment at face value to the bearer; in fact, there is no underlying face value, and subsequently no imputed value at maturity, which means they are completely impractical for use in servicing of debt. The fair price of bitcoins as measured by the discounted value of future cash flows is zero.

Although Mr. Tymoigne never actually uses the word "backing," his argument is standard "backing" fare, distinguished only in being more explicit than some other statements in referring to all forms of money as "securities." This explicitness is welcome, for it is precisely in treating all forms of money this way, whether expressly or only tacitly, that the "backing" theory goes awry.

Many types of money are, to be sure, properly regarded as securities, that is, as IOUs or promises to pay. Bank deposits fit this description. So do competitively issued, non-legal tender banknotes, like those issued by Scottish banks today, and by almost all commercial banks a century or more ago. Central-bank-issued notes qualified as well back when they were themselves convertible claims to some underlying form of money, such as gold or silver coins. Finally, a paper currency which, though temporarily irredeemable, is expected eventually to be redeemed in some other kind of money–what von Mises terms "credit money"–also qualifies. Examples of the last include Bank of England pounds during the Bank Restriction period, and U.S. Treasury notes ("Greenbacks") before 1879.

Of course "backing" matters in the case of exchange media that either are convertible into some more basic form of money, or are expected to become convertible into such at some future date. The likelihood that a bank will be able to honor its promises to pay obviously depends on the quality of the assets "backing" its IOUs. When the expected present value of those assets ceases to equal or exceed the value of its liabilities, the bank is insolvent, and its creditors face the prospect of not having their debts paid in full. Likewise, the prospects for resumption of payments on temporarily suspended monetary IOUs vary with the value of their issuers' non-monetary assets. The announcement of the Peace of Amiens substantially boosted the value of the paper pound, while that of renewed hostilities had the opposite effect. All of this is indeed perfectly in accord with the logic concerning how securities of all sorts are valued.

But in imagining that other sorts of money are also securities, proponents of the backing theory commit what philosophers like to call a "category mistake." Free-floating "fiat" moneys are not securities. Precious metal objects are not securities. Finally, bitcoins and altcoins are not securities. These actual or potential exchange media aren't claims to some underling medium into which they are, or are expected to become, redeemable. Consequently their values don't depend on the likelihood that they can be converted into something else, or on their providers' overall wealth as it informs that likelihood. Instead, their value depends on their own supply, and on the demand for them as exchange media (and for other uses, if they have such), with no role for calculations or speculation concerning the prospect of their being converted into something else.

The assets possessed by a fiat-money-issuing central bank–that is, by a bank that issues inconvertible paper, with no promise to ever redeem it in a specific amount of some other money–play no part in determining its currency's purchasing power. Such a central bank might, therefore, swap all its better assets for junk, without influencing that purchasing power in the slightest. And guess what? The Fed and the ECB have done just that in recent years, jettisoning their good assets to make room for doubtful mortgage-backed securities and Greek bonds; yet far from seeing their currencies depreciate substantially, as the backing theory predicts would happen, both, and the ECB in particular, struggled to keep them from appreciating excessively relative to stated inflation targets. It's hard to imagine a cleaner refutation of the "backing" theory than this. Oh, wait! I almost forgot about the "disowned" Iraqi Swiss dinars that remained in use in northern Iraq years after being repudiated by Iraq's Central Bank, and the "orphaned" Somali shillings that continued to be valued and used long after looters gutted the Central Bank of Somalia. Alas, no amount of empirical evidence appears sufficient to refute the backing theory in the eyes of its more obstinate champions.

To be fair to those champions, they are merely giving their intellectual stamp of approval to a view that has always had a substantial popular following. Consider, for example, the definition of a fiat money system as one "based on a government’s mandate that the paper currency it prints is legal tender for making financial transactions. Legal tender means that the money is backed by the full faith and credit of the government that issues it. In other words, the government promises to be good for it."

"Promises to be good for it?" And just what is this "it"? It is…well, nothing, actually. Because modern Federal Reserve Notes are, in fact (in former New York Fed President John Exter's famous formulation), so many "IOU nothings."

It's a bit more disappointing to find the backing theory endorsed by government officials, as it is in an otherwise competent CRS brief on the history of Gold Standard:

The U.S. monetary system is based on paper money backed by the full faith and credit of the federal government. The currency is neither valued in, backed by, nor officially convertible into gold or silver. Through much of its history, however, the United States was on a metallic standard of one sort or another

and in boilerplate included in the U.S. Comptroller General's annual Financial Report on the United States Government:

FRBs issue Federal Reserve Notes, which are the circulating currency of the United States. These notes are collateralized by specific assets owned by the FRBs, typically U.S. government securities. Federal Reserve Notes are backed by the full faith and credit of the United States Government.

In fact the only "faith" that matters for a fiat currency is the public's "faith" in the monetary authorities, that is, the public's willingness to believe that those authorities will refrain from issuing oodles of the stuff. "Credit" has nothing to do with it: once again, a piece of "fiat" money is not a credit instrument. It is not a promise to pay anything. Consequently its issuer's credit standing is of no immediate consequence. (It matters indirectly because, were the U.S. government unable to borrow by selling actual Treasury securities, it might be tempted to issue greater sums of fiat money instead, provided it could get the Fed to go along with the plan.)*

More troubling still are endorsements of the backing theory by Federal Reserve experts. Those experts are supposed to know something about how the value of the U.S. dollar is determined. Yet that doesn't prevent some of them from saying things like "Since 1971, U.S. paper money has been backed by the 'full faith and credit' of the U.S. government", or "Compared with commodity money, which has an intrinsic value, such as gold, or official fiat money backed by a sovereign entity, the current market value of bitcoin to any given user hinges entirely on her expectation of others’ willingness to accept it later at a sufficiently greater value". In truth neither bitcoin nor Federal Reserve dollars have "intrinsic" value, understood in the usual sense to mean non-monetary value. And as for governments being able to prop-up the value of fiat money by means of legal tender laws, tell that to all the governments that imagined that doing so would suffice to rule-out hyperinflation.

Most disturbing of all is the fact that some central bankers themselves appear to subscribe to the backing theory. Take, for example, Alan Greenspan's remarks concerning Bitcoin, given in the course of a December 2013 Bloomberg News interview. :

"It’s a bubble,” Greenspan, 87, said today in a Bloomberg Television interview from Washington. “It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”

“I do not understand where the backing of Bitcoin is coming from,” the former Fed chief said. “There is no fundamental issue of capabilities of repaying it in anything which is universally acceptable, which is either intrinsic value of the currency or the credit or trust of the individual who is issuing the money, whether it’s a government or an individual.”

"Capabilities of repaying it"! Tell us, Mr. Greenspan, just when does the Fed plan to "repay" the holders of all those Federal Reserve "liabilities" created during your watch, let alone the far vaster quantity created since? And what will it "repay" them with?

If you imagine that Mr. Greenspan can answer these questions, you imagine too well.**
*Even when used, less inappropriately, in reference to actual U.S. government securities, the "backed by the full faith and credit" language is misleading: unlike private debtors the U.S. government doesn't have to possess a stock of valuable, productive or interest-earning assets in order to service its debts. Its securities are instead "backed" by a combination of (1) its power to tax and (2) its ability to rely, at least to some extent, on the Fed's willingness to monetize its debt.
**A commentator thinks I am being too harsh here, as Greenspan merely assumes that Federal Reserve dollars, being "universally acceptable," differ from bitcoins in not having to be secured by a promise of repayment. Greenspan's language isn't the easiest to follow, but I still think his statements beg the question. For my further remarks see the comments below.