Via SchiffGold.com,

Fiat money is intrinsically worthless and yet people still value it. Where does this value come from? Our guest commentator cites Austrian thinkers Menger and Mises. He traces the purchasing power of paper money back its historical root: real money, i.e. physical gold.

The following article was originally published by the Mises Institute. The opinions expressed do not necessarily reflect those of Peter Schiff or SchiffGold.

Why does the dollar bill in our pocket have value? The value of money is established, according to some experts, because the government in power says so. For other commentators, the value of money is on account of social convention.

The Difference between Money and Other Goods

Demand for a good arises from its perceived benefit. For instance, individuals demand food because of the nourishment it offers them. With regard to money, individuals demand it not for direct use in consumption but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services. Money is demanded because the benefit it offers is its purchasing power.

Consequently, for something to be accepted as money it must have a preexisting purchasing power. So how does a thing that the government proclaims will become the medium of exchange acquire such purchasing power?

Again, demand for a good arises because of its perceived benefit. This is, however, not so with regard to the pieces of paper we call money. So why do we accept them? According to Plato and Aristotle, the acceptance of money is a historical fact endorsed by a government decree. It is government decree, so it is argued, that makes a particular thing accepted as the general medium of the exchange (i.e., money). In his writings, Carl Menger raised doubts about the soundness of the view that money is the origin of a government proclamation.

We know that the law of supply and demand explains the price of a good. Likewise, it would appear that the same law should explain the price of money. However, there is a problem with this way of thinking since the demand for money arises because money has purchasing power (i.e., money has a price). Yet if the demand for money depends on its preexisting price (i.e., purchasing power), how can this price be explained by demand?

We are seemingly caught here in a circular trap, for the purchasing power of money is explained by the demand for money while the demand for money is explained by its purchasing power. This circularity seems to provide credence to the view that the acceptance of money is the result of a government decree and social convention.

Mises Explains How Value of Money Is Established

In his writings, Ludwig von Mises has shown how money becomes accepted. He began his analysis by noting that today’s demand for money is determined by yesterday’s purchasing power of money. Consequently, for a given supply of money, today’s purchasing power is established in turn. Yesterday’s demand for money was fixed by the prior day’s purchasing power of money. Therefore, for a given supply of money, yesterday’s price of money was set. The same procedure applies to past periods.

By regressing through time, we will eventually arrive at a point when money was just an ordinary commodity where demand and supply set its price. The commodity had an exchange value in terms of other commodities—i.e., its exchange value was established in barter. To put it simply, on the day a commodity becomes money, it already has an established purchasing power or price in terms of other goods. This purchasing power enables us to set up the demand for this commodity as money. It follows then that without yesterday’s information about the price of money, today’s purchasing power of money cannot be established.

With regard to other goods and services, history is not required to ascertain present prices. A demand for these goods arises because of the perceived benefits from consuming them. The benefit that money provides is that it can be exchanged for goods and services. Consequently, one needs to know the past purchasing power of money in order to establish today’s demand for it.

Using Mises’s framework, also known as the regression theorem, we can infer that it is not possible that money could have emerged as a result of a government decree, for the decree cannot bestow purchasing power upon a thing that the government proclaims will become the medium of the exchange.

Once a commodity becomes accepted as the medium of exchange it will continue to be accepted even if its nonmonetary usefulness disappears. The reason for this acceptance is the fact that individuals now possess information about yesterday’s purchasing power, which enables the formation of demand for money today. But how does all that we have said so far relate to the paper dollar?

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

Note that according to the regression theorem, once the purchasing power of a certificate is established it can function as money regardless of gold since now the demand for money can be established. Remember, the demand for money is because of its purchasing power. Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. However, in a free-market economy, a bank that overissues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will decline. To protect their purchasing power, holders of the overissued certificates would most likely attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market, then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold.

The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the overissued bank not to redeem paper certificates for gold. Once banks are not obliged to redeem paper certificates for gold, opportunities for large profits are created that set incentives to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

To prevent such a breakdown, the supply of paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from overissuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank—i.e., a central bank—that manages the expansion of paper money.

To assert its authority, the central bank introduces its own paper certificate, which replaces the certificates of various banks. Various banks’ paper certificates are exchanged for the central bank certificate (i.e., money) at a fixed rate. Note again that various banks’ paper certificates carry a purchasing power because of the link to gold. This in turn provides the purchasing power to the central bank certificate. It follows then that the central bank’s certificate acquired purchasing power because of the paper certificates’ historical link to gold.

Conclusion

Mises’s regression theorem shows that money did not emerge because of a government decree. The acceptance of money is dictated by its previous purchasing power. The regression theorem shows that the purchasing power is acquired because money originated as a commodity.