Sunday, July 01, 2007

Why does fiat money seemingly work?

Imagine that you live on a small island mining the local salt mine, together with Pete the fisherman and Tom the apple grower. You'd exchange your salt for Pete's fishes and Tom's apples, while they would exchange fishes and apples between them.

One day Pete says: "Instead of fish, from now on I will give you pieces of papyrus with numbers marked on them. (Papyrus grows in near unlimited quantities nearby, to the obvious benefit of Pete)." Pete continues "One papyrus mark will represent 1 fish or 5 apples or 2 bags of salt (equivalent to current barter exchange rates). This will make it easier for us to trade among ourselves . We won't have to lug fishes, apples and salt around all the time. Instead, we simply present the papyrus for exchange on demand."

In short, Pete wants to modernize your little island economy by introducing money - and he already has one of those $1 papyrus notes with him, which he's eager to exchange for salt.

You'd laugh him out of the room, since you would realize that the papyrus per se is not of any value. If you were all to agree on using the papyrus, its value would rest on a promise alone - Pete's promise that papyrus he issues is actually backed by fish. Since the stuff grows everywhere, he could easily issue it by the bucket load. In fact, it's unlikely that any of the islanders would ever come up with such an absurd idea.

More likely they would use another good for which there is an actual demand (for instance, a rare type of sea-shell that is prized as an ornament and only seldom found on the island) as their medium of exchange.

In short, a free market medium of exchange/store of value can only be something with an already established demand. No worthless object would ever emerge to function as money in a free market.

So how did it happen?

How did essentially worthless objects come into widespread acceptance as money? To answer that question, we need to take a brief look at history.
Take a look.