Failed monetary technology

Archaic and ignored monetary technologies can be very interesting, especially when they teach us about newer attempts to update our monetary system. I recently stumbled on a neat monetary innovation from the bimetallic debate of the late 1800s, Nicholas Veeder's Republic of Eutopia coin:

During the bimetallic debates of the late 1800s, one of the more interesting compromises put forward was Nicolas Veeder's cometallic standard. His model 'Republic of Eutopia' coins (1866) had a plug with 12.9 grains of gold and ring with 206¼ grains of silver. A good idea or no? pic.twitter.com/6eZN2YAq6o

— JP Koning (@jp_koning) May 28, 2018

If you've read this blog for a while, you'll know that I like to talk about monetary technology. Unlike financial technology, monetary tech involves a technological or sociological upgrade to the monetary system itself. And since we are all unavoidably users of the monetary system—we all think and calculate in terms of our nations unit of account—each of us is immediately affected by the change.

Veeder's Eutopia coin is an old monetary technology that was never adopted. More recent examples of unadopted (or as-yet not adopted) montech include Fedcoin, NGDP futures targeting, or Miles Kimball's technique for evading the zero-lower bound, which would decouple the value of paper money from electronic money. Examples of recent monetary tech that went on to be adopted include the switch from paper to plastic banknotes, the replacement of older end-of-day clearing systems to real time gross settlement systems, and inflation targeting.

Fintech is more limited in scope than monetary tech. Only that portion of the population that uses these innovations is affected—everyone else's financial habits continues on as before. Recent examples include bitcoin, p2p lending, and roboadvisors. (If bitcoin ever became the standard unit of account, it would have made the trek over to becoming monetary technology, and not just fintech.)

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To make sense of Veeder's Republic of Eutopia coin, we need to understand the problem that his monetary innovation was meant to solve. Most nations were on a gold standard by the 1870s, and with the price of gold rising, the world price level was generally falling. This development provided an unexpected boost to the creditor class, who were owed gold, while hurting the debtor class, who owed gold. A higher price for the yellow metal meant that the loan contract to which a debtor had signed their name now required them to work that much harder to pay it off.

In that context, a broad popular movement for the remonetization of silver emerged. Prior to being on gold standards, nations were generally on a pure silver standard or a bimetallic standard. On a gold standard the debtor class had only one way to settle the debt, by providing the proper amount of gold coins. But if silver coinage was reintroduced at the old rate of sixteen-to-one, debtors could instead sell their labour to buy cheap silver, have it minted into legal tender silver coins, and use those silver coins to pay off the debt. Paying their debts with silver rather than gold meant they'd have a bigger amount of wealth remaining in their pocket.

The movement to restore bimetallism wasn't purely a populist one. The smartest economists of the time--folks like Irving Fisher, Leon Walras, and Alfred Marshall--also preferred bimetallism. A bimetallic standard recruits more monetary material into service than a gold standard. This is advantageous because, as Fisher put it, it "spreads the effect of any single fluctuation over the combined gold and silver markets." In other words, the evolution of the price level under a bimetallic system should be more stable—and thus more fair—than under a monometallic system, since it can absorb larger shocks.

The problem with bimetallism is that it very quickly runs smack into Gresham's law. The traditional way to bring the two metals into service as monetary material was to offer to mint both high denomination gold coins and lower denomination silver coins. So if a merchant needed £20 worth of coins, he could bring either a chunk of raw gold to the mint, or an even bigger chunk of pure silver, and the mint would convert either chunk into £20 for him. The specified amounts of raw silver or raw gold that were required to get a certain number of £-denominated coins constituted the mint's official gold-to-silver exchange rate.

Inevitably the market's gold-to-silver exchange rate would diverge from the mint's official exchange rate, effectively over- or undervaluing one of the two metals. In this situation, no one would bring any of the overvalued metal to the mint to be turned into coins. After all, why bother minting a chunk of gold (assuming the yellow metal was the overvalued one) into £20 worth of coins if that same amount of gold has far more purchasing power overseas? The overvalued metal would thus disappear as it was hoarded and exported, leaving only the undervalued metal in circulation. A monometallic standard had accidentally emerged, and all the benefits of bimetallism were for not.

To prevent Gresham's law from being engaged, the mint had to constantly adjust its official rate so that it stayed in-line with the ever-evolving market rate. Not only would these changes have been politically costly, but they would required an expensive series of recoinages in order to ensure that coins always had the proper amount of silver or gold in them.

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Enter Veeder's Eutopia coin. Nicholas Veeder was no economist, but an executive at C.G. Hussey, a copper rolling mill in Pittsburgh. In 1885, he published a pamphlet with the wordy title Cometallism: A Plan for Combining Gold and Silver in Coinage, for Uniting and Blending their Values in Paper Money and For Establishing a Composite Single Standard Dollar of Account.

Rather than defining a dollar as simultaneously a fixed amount of gold OR a fixed amount of silver, Veeder's pamphlet suggested defining it as a fusion of the two together. Specifically, Veeder's dollar was to contain 12.9 grains of gold AND 206.25 grains of silver. It's worth noting that under a proposed cometallic standard, paper dollars needn't be redeemed with actual Eutopia coins, but could be converted into separate silver and gold bars or coins. The important rule was that each dollar's worth of debt had to be discharged with 12.9 grains of gold and 206.25 grain of silver.

A model of a cometallic gold certificate, from page 60 of Veeder's pamphlet on cometallism

Veeder's cometallic scheme was a neat way to keep all the benefits of bimetallism with none of its drawbacks. Cometallism would draw on the combined supplies of the gold and silver markets, so that the system would be much more elastic than a pure gold standard, and thus fairer to both creditors and debtors. At the same time, Gresham's law would be avoided. Under traditional bimetallic coin systems, the mint established an exchange rate between the two metals. This rate inevitably became the system's undoing when it diverged from the true rate.

But a mint that was operating under a cometallic standard would only accept fixed quantities of silver AND gold before it would mint a $1 coin, and so it would no longer be setting an exchange rate between the two precious metals. The undervaluation of one of the metals, a key ingredient for Gresham's law, could never emerge under cometallism.

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A year after Veeder published his pamphlet, Alfred Marshall—one of the world's leading economists—described a remarkably similar system. Here is part of his response to the Royal Commission on the Depression in Trade and Industry in 1886, which had been convened to address the Long Depression:

"I propose that currency should be exchangeable at the Mint or Issue Department not for gold, but for gold and silver, at the rate of not £1 for 113 grains of gold, but £1 for 56^ grains of gold, together with, say, twenty times as many grains of silver. I would make up the gold and silver bars in gramme weights, so as to be useful for international trade. A gold bar of 100 grammes, together with a silver bar, say, twenty * times as heavy, would be exchangeable at the Issue Department for an amount of the currency which would be calcalated and fixed once for all when the scheme was introduced. (It would be about .€28 or .€30 according to the basis of calculation)."

Marshall's proposal was later dubbed symmetallism. (I wrote about it here.) If you study monetary systems, you'll run into the gold & silver basket idea sooner or later. The concept is invariably refereed to as symmetallism (and not cometallism) and attributed to Marshall (not Veeder). In the 1800s academics were not required to provide references, and from what I understand plagiarism was rampant. Did Marshall develop his idea separately from Veeder, or did he rip it off? Whatever the case, Veeder was an unknown executive at a small manufacturing concern, whereas Marshall a world famous academic. Celebrity carried the day.

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Interestingly, Veeder himself probably borrowed the idea, or at least part of it, from someone else. Almost a decade earlier, William Wheeler Hubbell had tried to get the U.S. congress to adopt the so-called "goloid dollar," a coin containing silver and gold alloyed together.

Another proposed fix was William Hubbell's "goloid" metric dollar (1878). This specimen is 1 part gold, 16.1 parts silver, and 1.9 parts copper. Whereas Vedeer's dollars kept the metals apart, Hubbel's intermingled them. https://t.co/qXpE7EbQrk pic.twitter.com/csNahz1Hhq

— JP Koning (@jp_koning) May 29, 2018

Hubbell owned the patent to the goloid alloy, so he would have made a good profit if the goloid dollar had been adopted by the U.S. Treasury. Unlike Veeder, Hubbell doesn't seem to have been a very good monetary economist, and the case he makes for goloid misses much of nuances of the benefits of bimetallism and the hazards of Gresham's law. He lists a number of advantages for his proposed coin, including: superior durability to gold and silver coins; not susceptible to oxidization (unlike silver); a goloid dollar was smaller than a silver dollar and thus more convenient for consumers to carry around; the mint would be able to make more goloid dollars than silver dollars with its existing capacity; and goloid coins could not be easily melted down for usage in the arts as was the case with gold and silver coins.

Hubbell's idea foundered on the fact that a goloid coin, despite containing gold, has almost the exact same colour as a silver coin. Hubbell's critics believed this set the coin up to be widely counterfeited. A counterfeiter could make a replica with lower gold content, this alteration unlikely to be noticed by the public since the colour of a genuine goloid coin and the fake would be the same.

The difficulties that Hubbell experienced alloying gold and silver were not lost on Veeder. In has pamphlet he mentions that "my first approach, as with many other persons, was to combine the two metals as an alloy for coinage, but, owing to certain difficulties... this idea was soon considered impracticable and abandoned." To avoid Hubbell's color problem, Veeder ended up mechanically wedding the two metals rather than chemically combining them, the Eutopia coin being comprised of a ring of silver and a gold plug embedded inside.

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The topic of goloid and Eutopia dollars seem a bit obscure, but the issues of stability and fairness that concerned monetary technologists in the late 1800s remain relevant today.

Today, most western central banks define the national currency in terms of a basket of consumer goods and services rather than a fixed amount of gold (gold monometallism) or a basket of gold & silver (cometallism, symmetallism). This makes a lot of sense. If we want to create a stable monetary standard, one that provides creditors and debtors with an even playing field, better to use a broad basket of stuff that regular people buy than a narrow basket of metals. That way all parties to a contract know many years ahead of time exactly how much consumer goods they will get (if they are creditors) or give up (if they are debtors). Knowing how much gold and silver baskets they will owe or be owed is less relevant to the average person, since gold and silver are a very small part of most people's day-to-day consumption profiles.

There is an important debate going on today about whether to continue defining national currencies in terms of a consumer goods & services basket, or whether to move to something more fluid like a nominal gross domestic product (NGDP), or output. One problem with using a consumer goods basket is that, in the event of a large economic shock that leads to significant loss of jobs, debtors take on all the macroeconomic risk. After all, they owe just as many CPI baskets as before, but have less capacity to meet that obligation because they might not have a job. This doesn't seem like a fair splitting up of risks and rewards.

The nice thing about defining the national currency in terms of NGDP, or output, is that the risk of a large shock, and the associated loss of jobs, is shared between creditors and debtors. This is because if a recession occurs, debtors will owe a smaller amount of real wealth to creditors than they otherwise would. And during a boom, when the job offers are rolling in, creditors will owe more.

Cometallism was never adopted. Perhaps it was a bit too fancy. NGDP is a bit exotic too, but then again so were many forms of monetary technology, until they were actually adopted and became part of the background. We'll have to see what happens.

From ancient electrum to modern currency baskets (with a quick detour through symmetallism)

Electrum coins [source]

First proposed by economist Alfred Marshall in the late 19th century as an alternative metallic standard to the gold, silver and bimetallic standards, symmetallism was widely debated at the time but never adopted. Marshall's idea amounted to fusing together fixed quantities of silver and gold in the same coin rather than striking separate gold and/or silver coins. Symmetallism is actually one of the world's oldest monetary standards. In the seventh century B.C., the kingdom of Lydia struck the first coins out of electrum, a naturally occurring mix of gold and silver. Electrum coins are captured in the above photo.

While symmetallism is an archaic concept, it has at least some relevance to today's world. Modern currencies that are pegged to the dollar (like the Hong Kong dollar) act very much like currencies on a gold standard, the dollar filling in for the role of gold. A shift from a dollar peg to one involving a basket of other currencies amounts to the adoption of a modern version of Marshall's symmetallic standard, the euro/yen/etc playing the role of electrum.

The most recent of these shifts has occurred with China, which late last year said it would be measuring the renminbi against a trade-weighted basket of 13 currencies rather than just the U.S. dollar. Thus many of the same issues that were at stake back at the turn of the 19th century when Marshall dreamt up the idea of symmetallism are relevant today.

So what exactly is symmetallism? In the late 1800s, the dominant monetary debate concerned the relative merits of the gold standard and its alternatives, the best known of which was a bimetallic standard. The western world, which was mostly on a gold standard back then, had experienced a steady deflation in prices since 1875. This "cross of gold" was damaging to debtors; they had to settle with a higher real quantity of currency. The reintroduction of silver as legal tender would mean that debts could be paid off with a lower real amount of resources. No wonder the debtor class was a strong proponent of bimetallism.

There was more to the debate than mere class interests. As long as prices and wages were rigid, insufficient supplies of gold in the face of strong gold demand might aggravate business cycle downturns. For this reason, leading economists of the day like Alfred Marshall, Leon Walras, and Irving Fisher mostly agreed that a bimetallic standard was superior to either a silver standard or a gold standard. (And a hundred or so years later, Milton Friedman would come to the same conclusion.)

The advantage of a bimetallic standard is that the price level is held hostage to not just one precious metal but two; silver and gold. This means that bimetallism is likely to be less fickle than a monometallic standard. As Irving Fisher said: "Bimetallism spreads the effect of any single fluctuation over the combined gold and silver markets."  Thus if the late 1800s standard had been moved from a gold basis to a bimetallic one, the stock of monetary material would have grown to include silver, thus 'venting' deflationary pressures.

Despite these benefits, everyone admitted that classical bimetallism had a major weakness; eventually it ran into Gresham's law. Under bimetallism, the mint advertised how many coins that it would fabricate out of pound of silver or gold, in effect setting a rate between the two metals. If the mint's rate differed too much from the market rate, no one would bring the undervalued metal (say silver) to the mint, preferring to hoard it or export it overseas where it was properly valued. The result would be small denomination silver coin shortages, which complicated trade. What had started out as a bimetallic standard thus degenerated into an unofficial gold standard (or a silver one) so that once again the nation's price level was held hostage to just one metal.

The genius of Alfred Marshall's symmetallic standard was that it salvaged the benefits of a bimetallic standard from Gresham's law. Instead of defining the pound as either a fixed quantity of gold or silver, the pound was to be defined as a fixed quantity of gold twinned with a fixed quantity of silver, or as electrum. Thus a £1 note or token coin would be exchangeable at the Bank of England not for, say, 113 grains of gold, but for 56 grains of gold together with twenty or so times as many grains of silver. The number of silver and gold grains in each pound would be fixed indefinitely when the standard was introduced.

Because symmetallism fuses gold and silver into super-commodity, the monetary authority no longer sets the price ratio between the two metals. Gresham's law, which afflicts any bimetallic system when one of the two metals is artificially undervalued, was no longer free to operate. At the same time, the quantity of metal recruited into monetary purposes was much larger and more diverse than under a monometallic standard, thus reducing the effect of fluctuations in the precious metals market on aggregate demand.

While symmetallism was an elegant solution, Alfred Marshall was lukewarm to his own idea, noting that "it is with great diffidence that I suggest an alternative bimetallic scheme." To achieve a stable price level, Marshall preferred a complete separation of the unit of account, the pound, from the media of exchange, notes and coins. This was called a tabular standard, a system earlier proposed by William Stanley Jevons. The idea went nowhere, however; the only nation I know that has implemented such a standard is Chile. As for Fisher, he proposed his own compensated dollar standard plan, which I described here.

The urgency to adopt a new standard diminished as gold discoveries in South Africa and the Yukon spurred production higher, thus reducing deflationary pressures. None of these exotic plans—Marshall's symmetallism, Jevons tabular standard, or Fisher's compensated dollar—would ever be adopted. Rather, the world kept on limping forward under various forms of the gold standard. This standard would be progressively modified through the years in order to conserve on the necessity for gold, first by removing gold coin from circulation and substituting convertibility into gold bars (a gold bullion standard) and then having one (or two) nations take on the task of maintaining gold convertibility while the remaining nations pegged to that nation's currency (a gold exchange standard).

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Let's bring this back to the present. In the same way that conditions in the gold market caused deflation among gold standard countries in the late 1800s, the huge rise in the U.S. dollar over the last few years has tightened monetary conditions in all those nations that peg their currency to the dollar. To cope, many of these countries have devalued their currencies, a development that Lars Christensen has called an 'unraveling of the dollar bloc.'

A more lasting alternative to re-rating a U.S. dollar peg might be to create a fiat version of electrum; mix the U.S. dollar with other currencies like the euro and yen to create a currency basket and peg to this basket. China, which has been the most important member of the dollar bloc, has turned to the modern version of symmetallism by placing less emphasis on pegging to the U.S. dollar and more emphasis on measuring the yuan against a trade-weighted basket of currencies. This means that where before China had a strictly made-in-the U.S. monetary policy, its price level is now determined by more diverse forces. Better to put your eggs in two or three baskets than just one.

Bahrain, Oman, Qatar, Saudi Arabia and United Arab Emirates are also members of the dollar bloc. Kuwait, however, links its dinar to a basket of currencies, a policy it adopted in 2007 to cope with the inflationary fallout from the weakening U.S. dollar. In an FT article from April entitled Kuwaiti currency basket yield benefits, the point is made that Kuwait has enjoyed a more flexible monetary policy than its neighbours over the recent period of U.S. dollar strength. Look for the other GCC countries to mull over Kuwaiti-style electrum if the U.S. dollar, currently in holding pattern, starts to rise again.

Modern day electrum can get downright exotic. Jeffrey Frankel, for instance, has suggested including commodities among the basket of fiat currencies, specifically oil in the case of the GCC nations. Such a basket would allow oil producing countries to better weather commodity shocks than if they remained on their dollar pegs. If you want to pursue these ideas further, wander over to Lars Christensen's blog where Frankel's peg the export price plan is a regular subject of conversation.

Yap stones and the myth of fiat money

At first glance, the large circular discs that circulated on the island of Yap in the South Pacific certainly seem quite odd. Too big to be easily transported, the stones are often seen in photos resting against their owner's houses. So much for velocity. Yap stones have been considered significant enough that they have become a recurring motif in monetary economics. Macroeconomics textbooks, including Baumol & Blinder, Miles & Scott (pdf), Stonecash/Gans/King/Mankiw, Williamson, and Taylor all have stories about Yap stone money.

Why this fascination? Part of it is probably due to the profession's obsession with the categorical divide between "money" and "non-money". In dividing the universe of goods into these two bins, only a few select goods end up in the money bin. That an object so odd and unwieldy as a three meter wide stone could join slim US dollar bills and easily portable silver coins in the category of money is pleasantly counterintuitive  – and economists love the counterintuitive. I'll talk about this divide and on which side to place Yap stones later (see part 3 below).

Another reason that Yap stones attract attention is their seeming "fiat" nature. In serving no useful purpose other than money, Yap stones seem to be historic ancestors to our modern "fiat" central bank money. I'll be discussing this idea in the current post.

The discussion on Yap stones will be split into three parts:

1. Yap stones and the myth of fiat money
2. Yap stones and chartalism
3. Yap stones and moneyness

I recently finished reading The Stone Money of Yap: A Numismatic Survey (pdf) by Cora Lee Gillilland (1975), which provides a historical summarization of all appearances of Yap stone money in the accounts of travelers, administrators, and anthropologists over the centuries. Having little to do over Christmas, I also picked up The island of stone money: Uap of the Carolines (1910) by W.H. Furness. Furness spent a year living on Yap and recorded his observations.

Here are some interesting facts gleaned from Gillilland and Furness which will be useful for all three parts:

1. Yap is an Island in the South Pacific. Denizens of Yap, the Yapese, valued circular stones called rai, or fei. A certain type of mineral called aragonite was prized by the Yapese in making rai. Aragonite, a white limestone that glistens, was only found on the island of Palau some 250 miles away, necessitating a long and arduous journey by canoe with a heavy rock in tow (see map below). The stones were quarried in the mountains of Palau and shaped into discs with holes in the centre. The holes allowed the stones to be carried on long poles, facilitating transportation. The poles can be seen in the photo above.

2. One of the earliest European accounts of these stones (in Gillilland) refers to a trader named Andrew Cheyne, who in 1843 wrote this about his arrival at Yap from Palau with a delegation of Palua traders.

At 9 A.M., the premier and chiefs of Tomal [Yap] came on board to receive their present, sent by Abba Thule [one of the chiefs of Palau], for their king, which consisted of nothing more or less than a round stone, with a hole in the centre, similar to a small upper millstone. These stones are very rare, and consequently highly prized, being only found in the mountains of the Pallou Islands. 

This particular stone was sent to the king of Yap to secure permission for Palau traders to barter with the Yapese for bêche-de-mer, otherwise known as sea cucumber.

3. We know from Gillilland that Yap exchanged not only bêche-de-mer with Palau traders, but also turmeric root. Nor was this the only exchange good. Accounts in the late 1800s describe Yapese traders traveling to Palau and exchanging their labour for the right to quarry stones. They gathered firewood for the Palau, carried, water, and according to one account, constructed the paved streets of the island of Koror in Palau.

4. Early rai were small, usually no more than eight hand spans across according to Gillilland. They were also rare. The difficulty of transporting stones by raft from distant Palau was certainly a limiting factor. The appearance of European traders allowed the Yapese to transport larger stones back from Palau and in greater quantities. There are accounts of stones weighing a ton and spanning over three metres in diameter. The stereotypical Yap stone we are accustomed to seeing in photos like the above are probably post-European stones. Cheyne described the stones as "very rare" in the 1840s, but they numbered 13,281 in 1929 according to a Japanese survey.

5. Other forms of "money" were used on Yap, including pearl shells (yar), pearl shell bead necklaces (gau), ceremonial pestles (ma), and woven mats (mbul).

6. David Sean O'Keefe, an Irish American adventure, cornered the market in Yap stone transportation from 1872 to 1901. The Yapese were allowed to transport the stones they'd mined on Palau on O'Keefe's schooner. Upon arrival at Yap, they were required to pay O'Keepe in copra to have the stones released. Copra is the dried meat of coconuts, and it was useful in lamp oil. Because most Yapese didn't have a copra supply, they could also pay by working on O'Keefe's coconut plantations.

7. Rai had exchange value on Yap. Furness reports that a rai spanning a length of three hands and

of good whiteness and shape ought to purchase fifty 'baskets'; of food - a basket is about eighteen inches long and ten inches deep, and the food is taro roots, husked coconuts, yams, and bananas;- or, it is worth an eighty or a hundred pound pig, or a thousand coconuts, or a pearl shell measuring the length of the hand plus the width of three fingers up the wrist. I exchanged a small short handled axe for a good white rai, fifty centimeters in diameter. For another rai, a little larger, I gave a fifty pound bag of rise... I was told that a well-finished rai, about four feet in diameter, is the price usually paid either to the parents or to the headman of the village as a compensation of the theft of a mispil [a woman].

Gillilland lists rai as capable of purchasing fishing equipment, canoes, and housing materials. There is record of a dance group being paid in rai for their performance. War indemnities and funeral expenses of chiefs were paid in rai, as was the assistance in war of a neutral tribe. Normally a family was self-sufficient in food, but when necessary rai could be used to purchase fish, yams, or taro.

8. Rai needn't be exchanged directly, especially the larger variety. Rather, Yapese were often content to transfer mental ownership of a Yap stone, leaving the stone sitting in place. Wrote Furness:

it is not necessary for its owner to reduce it to possession. After concluding a bargain which involves the price of a rai too large to be conveniently moved, its new owner is quite content to accept the bare acknowledgment of ownership and without so much as a mark to indicate the exchange, the coin remains undisturbed on the former owner's premises.

9. An extreme example of this is provided by Furness. According to local legend, two or three generations before Furness's arrival a large stone in transit was lost at sea during a storm. The claim to this stone continued to have value, even though the stone itself was unrecoverable.

10. According to Furness, the Germans bought control of Yap from the Spanish in 1899. In order to motivate Yapese to work on improving the island's road system, the Germans marked a certain number of rai with black crosses, indicating that the government now claimed these stones. To regain control of their rai, people had to labour on the road system. It was in this way that Yap got its first roads. Gillilland confirms this account, noting only that the intials B.A. (Berzirks-Amt or District Office) was painted on the stones, not a cross.

There are many more facts and anecdotes worth reading about in Gillilland and Furness, as well as this shorter article from the Smithsonian. I'm going to turn away from the anthropological evidence and investigate how economists have used Yap money in their theorizing.

Yap stones used by economists as examples of fiat money

One of the earliest expositions of Yap stones is in Volume II of J.M. Keynes's Treatise on Money (1930). When he mentions the stones, Keynes is in the process of writing about the emergence of "representative" money from commodity money. According to Keynes, a representative money can be either fiat or "managed". Representative money has "relatively little or no intrinsic value apart from the law or practice of the State." As gold had ceased to be used privately in the west, it was increasingly concentrated in the vaults of central banks. Keynes noted that even central banks had ceased transferring gold to each other's vaults, preferring instead to have their gold "ear-marked" – have its ownership changed without changing location. In this context, Keynes mused that money was on the verge of becoming fiat, which he felt was comparable to the status of Yap stones:

The earliest example of "ear-marking" is in the case of the stone money of Rossel Island, which, being too heavy to move without difficulty, could be conveniently dealt with in no other way. One of the largest and most valuable of these stones lay at the bottom of the sea, the boat which was importing it having capsized. But there being no doubt that the stone was there, these civilized islands saw no objection to including it as part of their stock of currency—its lawful owner at any time being, in fact, thereby established as the richest man in the island—or to changing its ownership by "ear-marking". (Pg 292, Vol II)

Note that Keynes's facts are wrong, since it was Yap Island, and not Rossel Island, thousands of miles to the southeast of Yap, that used stone money.

In an article called Money for the New Palgrave, James Tobin also provides an account of Yap Stones, closely mirroring Keynes by comparing the stones to gold:

On the island of Yap debts were settled by changing the ownership of large immovable stone wheels. The practice continued after the sea flooded their site and the stones were invisible at the bottom of a lagoon. (Similarly when gold was international money in the twentieth century title to it often changed while the gold itself, safe in underground vaults, never moved.) (Pg 3)

Tobin either makes an error or an embellishment, since neither Furness nor Gillilland mention the sea flooding the site where stones were held, only that one stone was lost at sea during a storm.

Milton Friedman also jumped into the Yap stone fray in the first two chapters of his book Money Mischief. Like Keynes and Tobin, Friedman compares the earmarking of gold among central banks to the use of transferable claim on the famous submerged Yap stone. In the second chapter of the same book, Friedman goes on to question whether the stones had any nonmonetary value whatsoever:

When most money consisted of silver or gold or some other item that had a nonmonetary use, or of an enforceable promise to pay a specified amount of such an item, the "metallist" fallacy arose that "it is logically essential for money to consist of, or be 'covered' by, some commodity so that the logical source of the exchange value or purchasing power of money is the exchange value or purchasing power of that commodity, considered independently of its monetary role" (Schumpeter 1954, p. 288). The examples of the stone money of Yap, of cigarettes in Germany after World War II, and of paper money currently make clear that this "metallist" view is a fallacy. The usefulness of items for consumption or other nonmonetary purposes may have played a role in their acquiring the status of money (though the example of the stone money of Yap indicates that this has not always been the case). [My emphasis]

Greg Mankiw invokes Keynes's line between commodity and representative money when he writes in his textbook Macroeconomics that "Yap, a small island in the Pacific, once had a type of money that was something between commodity and fiat money."  Yap therefore illustrated an economy with circulating paper redeemable in a commodity on the threshold of becoming an economy in which the circulating paper's claim to the original commodity has been lost. Mankiw also repeats the famous story of the lost Yap stone:

Eventually, it became common practice for the new owner of the fei not to bother to take physical possession of the stone. Instead, the new owner accepted a claim to the fei without moving it. In future bargains, he traded this claim for goods that he wanted. Having physical possession of the stone became less important than having legal claim to it. This practice was put to a test when a valuable stone was lost at sea during a storm. Because the owner lost his money by accident rather than through negligence, everyone agreed that his claim to the fei remained valid. Even generations later, when no one alive had ever seen this stone, the claim to this fei was still valued in exchange.

Gary Smith's textbook Money and Banking (1984) goes even further than Mankiw in attributing to Yap stones not merely intermediate status between fiat and commodity money, but status as a purely fiat money:

The stone money of Yap is superficially a commodity money. And yet is has no real value as a commodity. A Yap stone is eagerly accepted in exchange for useful goods and services solely because its recipients are confident that they will also be able to exchange the stone for goods and services. Its acceptance as a medium of exchange rests on simple faith, nothing more. This is an example of fiat money, something that has little value as a commodity but, because of law or tradition, is accepted as a medium of exchange.

We see modern use of the motif in Willem Buiter in Helicopter Money (2004, pdf). Like Smith, Buiter doesn't bother with the idea that Yap money might be somewhat intermediate between commodity and fiat money:

Some commodity monies have intrinsic, that is, non-monetary, value as a consumption, intermediate or capital good. Gold, salt, cattle and cigarettes are historical examples. I do not consider this kind of intrinsically valuable strong outside money. There is, however, a partial resemblance between the government-issued fiat base money considered in this paper and commodity money that does not have any intrinsic value. Pet rocks, the candy wrappers that are part of many first expositions of Samuelson’s pure consumption loans model (Samuelson (1958)), or the stone money used on the Micronesian island state of Yap are examples.

On the blogosphere, Nick Rowe had this to say about Yap stones a few years ago:

My point is that both Yap stones and cowrie shells (the Yap stones especially) look totally useless except as money. Even if they did have some value apart from their use as money, that "industrial value" would be a small proportion of their value as money.

So as you can see, there is a long line of economists who have attributed a pure fiat nature to Yap stones.

Yap stones not fiat - Dror Goldberg's response

Dror Goldberg penned an interesting paper in 2005 called Famous Myths of Fiat Money. I'm in debt to him for providing some clues to the whereabouts of the above references to Yap stones.

Goldberg defines fiat money as an object that has no intrinsic value and is not convertible into anything. It is neither legal tender, not is its use forced on anyone. Insofar as money can be thought of as having a kernel of fundamental value plus some extra marginal use as a medium of exchange, a fiat money is something without any fundamental value whatsoever. It is a purely speculative object valued only for its exchangeability.

Goldberg points out that most monetary economists believe that their concept of fiat money is not merely fictional but exists in reality. One justification for their belief is the supposed existence of fiat monies in primitive societies. However, in investigating the phenomenon of Yap stones, Goldberg finds that scholars have ignored laws, customs, and religion in according to rai the label "fiat". To begin with, the stones were valued for their aesthetic value:

For Pacific islanders who knew no metals or precious stones, it was reasonable to attach high value to semi-precious stones. Another proof for the high esthetic value is that the largest stones were “entirely beyond price” (Einzig 1966, p.40). Small specimens may have been used in jewelry, but the stones became more popular as big statues in the shape of a full moon (Gillilland 1975, pp.19-20). In fact, these stones were Yap’s version of gold. Just as gold could barely be used for any practical purpose (it is too soft), and one of the few things one could do with it was sit on a throne made of it, the Yap stones were also used as thrones (Gillilland 1975, p.3)

Goldberg also points out that Yap stones had religious value:

One local legend says that the bodies of the islanders’ ancestors, which were half-human and half-divine, have become the oldest stones (Gillilland 1975, p.19). Another legend says that the Fairy Godmother of Yap chose which stones would become money, and the stones’ shape was also approved by her (Christian 1899, p.300). Regardless of the latter legend, it is known that the full moon shape had a religious significance.

Thus to ascribe to Yap stones intrinsic uselessness is to ignore the very real value ascribed to them by the Yapese . While from the perspective of outsiders these stones may seem useless, within the context of the society in which they are used they have a very particular meaning and history.

As for the famous story of the lost stone that Keynes and Mankiw invoke in favor of fiat money, Goldberg points out that the stone in question remained in the possession of an ancestor of the family that had first brought it over from Palau. Thus Keynes, Tobin, and Mankiw are wrong to assume the claim to the lost stone continued to have exchange value, for there is no evidence that it was ever traded outside of the family who originally lost the stone. If the claim had been marked-to-market, would its so-called value have survived? We simply don't know. I suppose a graduate student could fly to Yap and try to locate the claim to the famous missing stone — after all, it should still be valuable if Keynes/Mankiw/Tobin are right. But until then, the story remains dubious.

This leads into the final question in this post.

So why is the existence of theoretical and/or actual fiat money so important to economists?

I suspect the answer to this is because fiat money makes theorizing easier. Goldberg, for instance, points out that the fiat money concept is "useful". He invokes Wallace and Zhu (2004), a quote worth providing in full:

The conception of money as fiat money, an intrinsically useless object, has been used in models for a long time. It was used in the classical-dichotomy model, even though that model was developed and used at a time when actual money was gold or silver. Ignoring the commodity aspect of money was convenient because it produced a simple and strong prediction: allocations are independent of the amount of money.

In other words, in assuming the existence of a fiat money, the analyst can neutralize the monetary sector and work purely with a real economy. This removes a number of thorny issues.

The great economist Alfred Marshall, for instance, noted in his example of an economy that used "shells of some certain extinct fish" as currency, that the simultaneous demand for those shells as useful ornaments would break the proportional relationship between the quantity of the shells and their value. This was the famous quantity theory of money. If it was the case that shells were desired as ornamentation, then an increase in demand for shells as ornaments would have monetary effects while an increase in demand for shells as money would have non-monetary effects. Gone is the useful dichotomy between the real and monetary economies.

Another reason that the myth continues to be sustained is the idea that fiat money saves resources. One of the oldest expressions of this idea comes from David Ricardo in The Principles of Political Economy and Taxation:

A currency is in its most perfect state when it consists wholly of paper money, but of paper money of an equal value with the gold which it professes to represent. The use of paper instead of gold substitutes the cheapest in place of the most expensive medium, and enables the country, without loss to any individual, to exchange all the gold which it before used for this purpose for raw materials, utensils, and food; by the use of which both its wealth and its enjoyments are increased.

This idea rings true in modern general equilibrium economics. Ostroy and Starr (1988) note that in a sequence economy (one which opens and closes, rather than an all-at-one-point-in-time Arrow Debreu economy)

goods are desired as objects of consumption and as carriers of value between trading opportunities. The second demand may interfere with the first. When it does so, the introduction of a fiduciary or fiat money with negligible transactions and storage costs can change the equilibrium allocation to one that is Pareto efficient... Since the opportunity cost of holding real goods in inventory will generally be non-negligible, there is an efficiency gain through the use of fiduciary (bank) or fiat money in place of commodity money. 

In other words, since intrinsically useful goods serving as money also have consumption value, the opportunity cost of using said goods as money is the lost consumption. Replacing these commodity monies with a non-real money good, something inherently valueless like a fiat token, will return a commodity money’s “lost consumption” to the economy, while ensuring that something still exists to perform the function of money. Fiat money is the most efficient solution. Given that in theory fiat money is the theoretically ideal money, it is no doubt tempting to assume the actual existence of such an object, even when the evidence is lacking. Otherwise we would be living in a world with a massive market failure.

Lastly, in observing the rise of central bank money, monetary economists going back to the days of David Ricardo have felt it their duty to create theories of fiat money. But central bank money is not necessarily fiat money. If there is no actual fiat money in the real world, why have economists spent so much time modeling a world as if it contained such an item? There needs to be fiat money to justify the effort.

Uncertainty and the demand for liquidity

In between my more practical posts, once every week or so I'll do something on the idea of moneyness. Economists have known for a long time that the concepts of uncertainty and money are intimately intertwined. George Costanza knows this too. He holds a bunch of cash to deal with all eventualities... until his wallet blows up. I'll show how we can just as easily replace money with moneyness in this two-step with uncertainty.

Uncertainty is an uncomfortable feeling one endures when thinking about an unforeseeable future. One of the ways to shield oneself from uncertainty is to devote a certain portion of one's portfolio to "money" – dollar bills, bank deposits, and such. Because these money items are liquid, it will be relatively easy for their holder to offload them in the future should some unanticipated eventuality arise. Holding money therefore alleviates discomfort about the future. This is the same sort of service that a fire extinguisher provides. Though someone may never need their extinguisher, it comforts its owner by its mere presence. On the margin, individuals are always comparing the present value of the stream of "security and comfort" that money provides to the consumption goods or durable assets that money can buy.

The link between uncertainty and the demand for money has a long heritage. We can find this idea early on in the Marshallian tradition, for instance. In 1917 Arthur Pigou, a student of Marshall, wrote that any person would be anxious to hold money "to secure him against unexpected demands, due to a sudden need, or to a rise in the price of something that he cannot easily dispense with." On the margin, people could either hold money, spend it on consumption, or exchange it for a capital asset. "These three uses," wrote Pigou, "the production of convenience and security, the production of commodities, and direct consumption, are rival to one another." (The Value of Money, 1917)

In 1921, Fred Lavington explicitly described this very same link between uncertainty and money.

the stock of money held by a business man serves not only to effect his current payments but also as a first line of defence against the uncertain events of the future. (The English Capital Market, 1921)

More explicitly, said Lavington, money provides its owner with a

return of convenience and security. His stock [of money] yields him an income of convenience, for it reduces the cost and trouble of effecting his current payments ; and it yields him an income of security, for it reduces his risks of not being able readily to make payments arising from contingencies which he cannot fully foresee. The investment of resources in the form of a stock of money which facilitates the making of payments is then in no way peculiar; it corresponds to the investment by a merchant in the office furniture which facilitates the dispatch of business, to the investment of the farmer in agricultural implements which facilitate the cultivation of his land, and indeed to investment generally. 

Like Pigou, Lavington emphasized the marginal choice between holding money, spending it on consumption, and investing it.

Resources devoted to consumption supply an income of immediate satisfaction; those held as a stock of currency yield a return of convenience and security; those devoted to investment in the narrower sense of the term yield a return in the form of interest. In so far therefore as his judgment gives effect to his self-interest, the quantity of resources which he holds in the form of money will be such that the unit of resources which is just and only just worth while holding in this form yields him a return of convenience and security equal to the yield of satisfaction derived from the marginal unit spent on consumables, and equal also to the net rate of interest.

The most famous adopter of this idea was Keynes, a friend of Pigou's and, oddly enough, Lavington's teacher.

Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future... The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude. (The General Theory of Unemployment, 1937)

The link between uncertainty and money isn't confined to the Marshallian and Keynesian traditions. Erich Streisler (1973) quotes Carl Menger in Geld:

The amount of money which is used in actual payments constitutes only a part, and indeed a relatively small part, of the cash necessary to a people, and . . . another part is held (in order that the economy may function without friction) in the form of various reserves as a security against uncertain payments, which in many cases in fact are never realized.

William Hutt, an Austrian "fellow traveler", described the prospective yield from money in a 1952 paper called the Yield from Money Held. According to Hutt, the value of money assets was "affected by reason of their being demanded for their 'liquidity,' i.e. for the medium of exchange services that they can perform." These monetary services that money assets provide are prospective – even though money isn't being used, much like a fire engine when there were no fires, it isn't lying idle. "The essence of all these services is availability," wrote Hutt.

Modern Austrian Hans Herman Hoppe provides a very sharp linkage between uncertainty and money holdings.

the investment in money balances must be conceived of as an investment in certainty or an investment in the reduction of subjectively felt uneasiness about uncertainty. ('The Yield from Money Held' Reconsidered, 2009)

Nor is the Auburn side of the Austrian school the only to note linkage. Steve Horwitz, a free-banking Austrian, also gives expression to the link between money and uncertainty:

The connection between Hutt and Menger lies in recognizing that the availability services that money provides flow from it being the most saleable good. To be available to be exchanged for anything at any time requires that the good have the degree of saleability that Menger describes. The nature of Hutt's availability services is that they are a subjective return to holding an item that others also subjectively value a great deal, thus permitting the item to be easily exchangeable. When one chooses to hold wealth in the form of money, one is simply purchasing these availability services. (A Subjectvist Approach to the Demand for Money, 1990)

We also find the link between uncertainty and money among monetarists. In their 1971 paper The Uses of Money, Brunner and Meltzer noted that in a world of perfect certainty, information is available for free. This effectively eliminates the main reasons for the existence of money. However, by relaxing the assumption of certainty, “transactors possess very incomplete information about the location and identity of other transactors, about the quality of the goods offered or demanded, or about the range of prices at which exchanges can be made.” Rather, they must acquire information about these characteristics. Because knowledge acquisition takes time and energy, individuals may alternatively:

search for those sequences of transactions, called transaction chains, that minimize the cost of acquiring information and transacting. The use of assets with peculiar technical properties and low marginal cost of acquiring information reduces these costs. Money is such an asset.

David Laidler, also a monetarist, describes the money as a "buffer against costly consequences of market uncertainty and inflexibility".

If money holding is a cheap and reliable buffer, then agents will find that it pays to remain relatively uninformed about the processes affecting the variability of their net receipts, and will be relativley unwilling to undertake any costly measures that might render them either more predictable or controllable. If, on the other hand, money holding itself is a costly or unreliable source of insulation from such uncertainty, then the expenditure necessary to acquire and utilise extra information is more likely to be made. (Taking Money Seriously, 1990)

It's clear from this wide variety of quotes that many economists have considered money holdings to be uncertainty-alleviating. It's not a big step to replace the concept of "money" with "moneyness". The idea here is that by selling less-liquid items for more-liquid items, individuals can increase their protection from uncertainty. All assets can be ranked on a scale according to their liquidity/moneyness, and as a corollary, by their ability to "lull our disquietude".

On the margin, people are constantly comparing the package of services provided by each asset in an economy, where each package consists of the real services the asset provides, its pecuniary returns (interest, capital gains, or dividends), and finally the extent to which that asset's moneyness shields the holder from uncertainty. This means that in trying to defray their worries about a cloudy future, people seek out the quality of moneyness rather than a specific instrument called money. This quality, or property, is never fully concentrated in one hypothetical asset called "money" but can be found unevenly distributed over the economy's entire range of goods.

To get up to speed, here are two previous posts dealing with the idea of moneyness
1. Why moneyness?
2. What is a non-monetary economy?