What is the intrinsic value of fiat currency?
What is the intrinsic value of fiat currency?
A derivative value of the issuing nation-state
Fiat currency ultimately derives its intrinsic value — both as a medium of exchange and a store of value — from being sanctioned by its nation-state.
As a medium of exchange, fiat currencies — whether in traditional or digital forms — will most likely always dominate transactions that take place within a common economic zone.
As a store of value, fiat money will be as strong as the nation-state that backs it. If you live in a stable, well-run nation-state, fiat money is an attractive store of value for most cases. If not, fiat currencies from strong nation-states are also attractive alternatives.
Fiat currency will likely be dominant as long as the concept of nation-states and organized economic zones exist.
Borrowing language from the blockchain ecosystem, one can loosely think of a nation-state as a “protocol” that has developed and matured through the years: A system based on laws, cultural norms and processes that evolve in an effort to drive improvement in the lives of its members.
This is the first in a three-part series where I will explore the intrinsic value of various forms of money: Fiat currency, gold and Bitcoin. Please refer to my blog post for some of the summary observations:
Blockchain and exploring the intrinsic value of money
The Case for Fiat Currency
In the context of money, intrinsic value is based on an object’s features as either a medium of exchange or a store of value. It can be both, but it does not necessarily have to be both; its intrinsic value can be derived from only one.
Fiat currency is money that has been established by regulation or decree by an established authority. Today, these authorities are typically nation-states. In the case of the Euro, this is a loose federation of nation-states (instead of a single nation-state) that has agreed to create a common currency zone.
Historically, fiat money took the form of materials that had some potential uses e.g. materials like copper or gold. But today, while there are limited instances of this (i.e. coins), most physical money is in paper form and the vast, vast majority of money sits in non-physical form (e.g. demand deposits, time deposits, money market accounts) which does not have any physical intrinsic value.
In other words, there is very little if any intrinsic value tied up in the physical form of money today. I would even argue that in the past when money tended to take physical form, the majority of its intrinsic value was tied to something else. What is that something else?
At its most basic level, the intrinsic value of fiat currency is the concept and sustaining power of the nation-state itself.
Since humans have been organizing into groups that are larger than hunter-gather societies (e.g. Dunbar’s number), fiat money sanctioned by some authority has been used to make the process of trade more efficient1. Instead of having to arbitrarily establish value through the inefficient bartering process, common units of account like commodity money lowered the the friction costs of trade. Lowering the frictional costs of trade leads to increased trade and increased trade generally leads to increased wealth.
Managing a common currency zone is a basic, essential function of any nation-state. That is because the vast majority of economic trade happens within a single economic zone. This is even more the case in large countries like the United States and China:
Our inter-national trade pales in comparison to our intra-national trade.
If you were to split the U.S. up into fifty individual countries, you would find that the amount of trade that goes on between these fifty individual countries dwarfs the amount of trade between this group of fifty individual countries and the rest of the world. In other words, we produce most — 88.5%, according to the table above — of what we consume.
Fiat Money as a Medium of Exchange
One of the most important features of being a valuable medium of exchange2 is stability — so that it can be used reliably as a consistent unit of account. The relative value of goods and services is always changing but one of the key functions that organizing into a single economic zone is that you can smooth out a lot of these fluctuations. This is why one nation-state tends to avoid denominating its transactions in another nation-state’s fiat currency3.
For transactions that take place within the economic zone of the nation-state, the sanctioned fiat currency is almost always going to be your best option. Indeed, economic efficiency is one of the fundamental reasons that nation-states form in the first place and a common medium of exchange is one of the basic functions that every nation-state strives to provide.
In contrast, gold is terrible as a medium of exchange in the post-industrial world. Among other things, it is not divisable, not accepted widely and is a pain to store and keep. As I discuss later in Part 2, essentially all of its intrinsic value is tied up in its function as a store of value.
The problem that Bitcoin (or another crypto asset) faces as a medium of exchange is that they are fundamentally “non-sovereign”. In other words, the latest value of Bitcoin is going to be driven by its collective use in multiple economies around the world. This results in an effective exchange rate that will always fluctuate relative to any single economic zone.
In other words, on top of the normal everyday fluctuations in price ratios within an economy, you are adding another layer of variability often due to factors that are not within the control of that economy. The only way that crypto assets can get around this problem is by providing greater utility in other ways (anonymity, convenience) that offset this negative feature. As I understand it, this is fairly fundamental to the way public blockchain works, so it is not necessarily something that can be “fixed” by future development.
For transactions that take place within an economic zone, fiat currency is the most efficient. But as I will explore in Part 3, cross-border transactions (between nation-states) may be where Bitcoin or another public blockchain-based currency has some interesting advantages.
Fiat Money as a Store of Value
The features that make something a good medium of exchange are different from the features that make something a good store of value. A good store of value is something that can be “reliably saved, retrieved and exchanged at a later time and be predictably useful when retrieved.”
For store of value, what you care about is preservation of value in the context of two factors:
Period of time
The specific scenario(s) that you are planning for
Each of these factors are unique to the person or entity.
For example, let’s take a mundane example: Me. I like to hold around six months worth of immediately accessible U.S. dollars to plan for a “rainy day” scenario. In a “rainy day” scenario, I do not want to be a forced or distressed seller of assets that are less liquid or where the current market price may be detached from its “real” value for a period of time.
For me, due to my specific personal needs, the U.S. dollar is a fantastic store of value in the short-term. For long-term planning, I am content to invest in a more diversified array of financial securities, hard assets like real estate and illiquid private investments with the goal of maximizing long-term compounded growth at an attractive return relative to the risks I am taking.
But that is just me. Other people may have different planning scenarios. For example, some people are really worried about truly worst-case scenarios like nuclear wars and zombie apocalypses. People who are worried about their nation-state collapsing are understandably not going to believe in the resiliency of their nation’s currency and will instead look to other avenues, including fiat currency of a more stable nation-state (e.g. the U.S. dollar), gold and possibly Bitcoin or another public blockchain-based “non-sovereign” crypto currency.
Now if it were me and I were seriously considering the possibility of those types of disaster scenarios (i.e. ones involving the potential collapse of my nation-state), I would rather go with guns, bunkers or perhaps a second passport — my choice would be Australia — as better hedges. Just to be clear, to date I have not “invested” in any of these.
Another large use for fiat money is in the context of foreign reserves, which are somewhat analogous to checking accounts for a nation-state. For example, the majority of foreign reserves held by China are denominated in U.S. dollars. Some of this corresponds to direct trade between the two economic zones, but part of it also corresponds to trade with other countries where the U.S. dollar is merely being used as a reference currency due to its status as the world’s reserve currency.
The reason that China holds so many U.S. dollars is because a large amount of economic trade is denominated in U.S. dollars. But as I will argue later in part three, Bitcoin may have some advantages as a payment mechanism in international trade and to the extent Bitcoin becomes a more efficient payment rail, it could theoretically start to chip away at fiat currency’s role in foreign reserve accounts.
Indeed, some of the more interesting arguments being made for Bitcoin to replace gold and possibly fiat currencies held in foreign reserves revolves around the idea that countries like China and Russia may chafe at the being tied into a global economic system that is so reliant on the U.S. Dollar as the reserve currency and eager to find alternatives.
This was originally published on Quora in January 2018.
Source: Wikipedia: Money
The use of barter-like methods may date back to at least 100,000 years ago, though there is no evidence of a society or economy that relied primarily on barter. Instead, non-monetary societies operated largely along the principles of gift economy and debt. When barter did in fact occur, it was usually between either complete strangers or potential enemies.
Many cultures around the world eventually developed the use of commodity money. The Mesopotamian shekel was a unit of weight, and relied on the mass of something like 160 grains of barley.[16] The first usage of the term came from Mesopotamia circa 3000 BC. Societies in the Americas, Asia, Africa and Australia used shell money – often, the shells of the cowry. According to Herodotus, the Lydians were the first people to introduce the use of gold and silver coins. It is thought by modern scholars that these first stamped coins were minted around 650–600 BC.
Source: Wikipedia: Medium of exchange.
There are several features that are important to money being an attractive medium of exchange:
Value common assets
Common and accessible
Constant utility
Low cost of preservation
Transportability
Divisibility
High market value in relation to volume and weight
Recognisability
Resistance to counterfeiting
With limited exception. Certain very small nation-states find it more efficient to adopt a major currency zone as their own, simply because they do not have enough scale to manage their own currency. Other states (e.g. Hong Kong with the U.S. Dollar) will peg their currency to another country’s currency particularly in cases where there is significant economic trade.
For more on this general topic, you can read up on what economists refer to as an “Optimum currency area”.