More fiatsplainin': let's play fiat-or-not

The (Great) Tower of Babel, 1563, Bruegel the Elder. "Therefore is the name of it called Babel; because the Lord did there confound the language of all the earth"

People bandy the term fiat currency around a lot, but what exactly does it mean? None of us wants to live in a Babel where people use fiat to indicate twenty different thing. So let's try to zero in on what most people mean by playing a game called fiat-or-not. I will describe a monetary system as it evolves away from a pure commodity arrangement and you will tell me when it has slipped into being a fiat system. (The technique I am using in this post cribs from a classic Nick Rowe post).

So let's start the game.

1) An economy in which gold coins circulate as the medium of exchange.

Fiat or not? I think we can all agree that there is nothing fiat at all here. (For simplicity's sake let's assume for the duration of this post that taxes can be paid with anything, and that there is no legal tender.)

2) A government-owned central bank begins to issue banknotes that are redeemable into a fixed amount of gold. Owners of banknotes need only line up at the central bank's redemption window to convert their $1 notes into 1 gram of the yellow metal. The central bank ensures that its vaults contain 100% gold backing for its notes.

Fiat or not? Some people associate fiat with the invention of paper money or IOUs, but in general I don't think very many of us would say that these banknotes qualify as fiat.

3) The central bank sells off a chunk of its gold and invests in safe bearer bonds. Its banknotes are no longer 100% backed by gold coins, but are backed 70% bonds/30% gold. The central bank continues to redeem notes on demand with gold at a rate of $1 to 1 gram.

Say the public suddenly wants to hold more coins. A lineup develops at the central bank's redemption window and eventually the central bank uses up its coin reserves as it meets redemption requests. To continue meeting additional requests, it need only sell some of the low-risk bonds from its vault and use the proceeds to buy additional gold coins.   

Fiat or not? Since low-risk bonds have now become part of the backing for the banknote issue, a few readers may choose step 3 banknotes as the entry point for fiat money. But this would be unconventional, since most note-issuing central banks in the 1800s were running this sort of 70%/30% system, and we usually call the monetary system that prevailed in the 1800s a gold standard, not a fiat standard.

4) The central bank announces that it  will undergo extensive renovations. As a result, its redemption window will have to be shut for two months. People can no longer redeem their $1 for 1 gram of gold on demand, but will have to wait until the renovations are over.

Fiat or not? Two months is a long time. But it could be that the central bank already closes its doors on the weekends anyways, banknotes being inconvertible for 48-hours. I doubt many of us would describe the weekend as a fiat currency episode. Should we think of the renovation closure as an extended weekend, or is it long enough that it generates fiat money?

5) Unfortunately the central bank chose an incompetent construction company. Renovations will take another two years!

To make up for the inconvenience of the redemption window being closed for such a long time, the central bank promises to send agents to the local gold market who will ensure that the market rate stays fixed at $1/gram. These agents will buy & sell whatever amount of gold is necessary to maintain the peg (by selling and buying banknotes).

Fiat or not? Thanks to the strategy of buying and selling in the local gold market, the $1/gram price holds just as well as it did in steps 2 and 3. So the public notices no difference in the purchasing power of the money in their wallets. On the other hand, two years without a redemption window at the central bank may be long enough for many readers to tick the fiat money box.    

6) The central bank is still undergoing renovations, but instead of dispatching agents to the market to buy and sell gold to enforce the peg, they go with bonds in hand.

If the market price for gold threatens to rise from $1/gram to $1.01/gram, because there is too much money chasing too few goods, the agents sell bonds and withdraw banknotes, thus reducing pressure on the exchange rate and bringing it back to $1/gram. And when the exchange rate threatens to fall below $1/gram to $0.99/gram, because there is too little money chasing goods, agents buy bonds with banknotes.

Fiat or not? Not only are notes not redeemable in gold, but now the central bank no longer operates directly in the gold market. With this step we are getting a bit closer to modern central bank money. The Federal Reserve, the Bank of Canada, and other major central banks all regulate the purchasing power of money by purchases and sales of bonds. The $1/gram peg still holds thanks to bond purchases and sales, so step 6 money does almost everything that step 2 and 3 money does.

7) With the renovation dragging on, the central bank decides that it doesn't need a redemption window after all. So what was initially a temporary suspension of convertibility becomes permanent. But the central bank continues to send agents to the market to buy or sell whatever quantity of bonds are necessary to maintain the $1/gram peg.

Fiat or not? You tell me. Perhaps permanent inconvertibility is the very definition of fiat. However, if steps 2-6 didn't qualify as fiat money, because gold stayed at $1/gram, why would step 7 be any different?

8) The central bank decides that, rather than fixing the market price of gold at $1/gram, it will set the market price of a typical consumer basket of goods and services (i.e. meat, car repairs, school, etc). 

This is a bit trickier to think about than the other steps. So for example, say that the central bank is currently setting the price of gold at $1/gram. And people can buy a consumer basket for $1000. But the price of that basket starts to rise to $1010, $1020, and then $1030. To stop this inflation, the central bank will announce its intention to reduce the price of gold to $0.99/gram. It does this by selling bonds and withdrawing money from the system, so that there is less money chasing goods. It keeps repeating gold price decreases/money withdrawals until it has successfully reigned in the inflation and brought the consumer price basket back to $1000. The net effect is that consumers are always guaranteed that the money in their pocket has constant purchasing power.

Fiat or not? This is pretty much the monetary system we have now in the U.S. and Canada where central banks target inflation. Well, there are a few small differences. Instead of temporarily setting the price of gold in order to regulate the value of a consumer price basket, the Fed and Bank of Canada temporarily set the price of a very short-term debt instrument to hit their target for the basket. And rather than shooting for constant consumer goods and services prices, these central banks prefer one that shrinks by 2% a year.

Given that step 8 describes something close to modern money, and it is common practice to refer to modern money as fiat, then it would only make sense that many readers raise their hands at this point. Complicating matters is that step 8 money isn't really that different from steps 2 to 7. After all, the central bank is establishing a fixed price for banknotes, the only difference being that the fix has been adjusted from gold to a basket of consumer goods and services. 

9) The central bank donates all of its assets to charity, closes its doors and shuts down for good. But it leaves all its banknotes outstanding. Money floats around the economy without a tether to reality. Or as Stephen Williamson says, money is a bubble.

Fiat or not? By this stage, everyone will probably have ticked the fiat money box. 

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Here is a collection of unconnected thoughts on the fiat-or-not game.

A) My guess it that readers will have chosen different stages as their preferred debut for fiat money. This is a bit tragic, since with no commonly-accepted definition for the term, most debates about fiat money have been and will continue to be meaningless.

B) We apply our definitions like cookie cutters to the real world. So if you chose step 7 (when banknotes became permanently irredeemable) as your flipping point, then 1971 would be a very important date in your scheme of the world since this is when the U.S. permanently removed gold convertibility.

But if you chose step 9 as your transition point to fiat, then the global monetary system is not currently on a fiat standard, since central banks have neither closed their doors nor donated their assets to charity. So 1971 really isn't an interesting date. I'm aware of only one country on a step 9 fiat standard: Somalia. Its central bank burned down yet Somali shilling banknotes continued to circulate. And ironically enough, if we choose to adopt a step 9 definition of fiat money, then bitcoin—which was designed to destroy central bank "fiat" money—is itself fiat, because it is unbacked, whereas most central bank money is not fiat.

What I've described is the Borges problem. Categories pre-digest the world for us. We get very different results depending on what definition we use and how we apply it to the world.

C) I think many readers associate fiat with hyperinflatable. For instance, here is Dror Golberg:

Was Canada ground zero for fiat money? This paper claims that fiat money was independently invented by French Canadians in 1685, copied by Massachusetts in 1690, adopted in Europe, and diffused to the rest of the world: https://t.co/bSXyYLYzwp pic.twitter.com/kWVWbi43hH

— JP Koning (@jp_koning) March 14, 2018

Readers who conflate fiat and hyperinflatable will probably have played the fiat-or-not game by gauging each step to see if it introduced (or removed) a set of features perceived to be conducive (inhibitory) to high inflation. They probably toggled the fiat button somewhere in the murk of temporary inconvertibility (step 4) and permanent inconvertibility (step 7). The thinking here is that convertibility into specie imposes a more imposing restriction on a central bank than a mere promise to hold gold's value at $1/gram by using open market operations (step 6). With the removal of convertibility, hyperinflatability is activated and thus money has become fiat.

There are certainly some good historical reasons for assuming that inconvertibility leads to hyperinflatability. Some of the most famous hyperinflations occurred after redemption was removed, including John Law's paper money scheme, the American Greenback episode, and the Wiemar inflation. But there is no inherent reason that these systems must lead to hyperinflation, or that step 1 (coin-based systems) and step 2 (fully convertible) systems aren't themselves hyperinflatable. In the case of coin-based systems, all that it takes is a rapid series of reductions in the silver content of coins to set off inflation, Henry VIII's consistent debasement of the English coinage being one example. And there is no reason that a fully convertible step 2 banknote system can't undergo a series of large devaluations leading to hyperinflation. 

D) Fiatness, fiatish? If we can't agree on what constitutes fiat-or-not, maybe we can agree that there might be a fiat scale, from pure fiat to not fiat at all, with most monetary systems existing somewhere in between. I am already on record advocating moneyness over money, so this fits with the general them of the blog. On the other hand, fiatness seems a bit of a cop-out.

E) We don't need gobbledygook like fiat. The term carries too much baggage. Let's select a more precise set of words, then apply them to the real world in order to understand what our monetary systems were like, how they are now, and where we are going. Until we settle on these words, let's avoid all conversations with the term fiat in them.

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P.S. I have a recent post about the desirability of coin debasements at the Sound Money Project and another post on money as a measuring stick at Bullionstar. 

Settlers of Catan... the monetary version

I've been playing the game of Settlers of Catan for ages. Over time I've gotten less cutthroat and more philosophical about the game. What I've come to realize is that Settlers is a great tool for both thinking about monetary phenomena and building different sorts of monetary economies. In this post I'll assume a basic knowledge of Settlers—if you haven't played the game by now, you're living on the moon.

1. Catan isn't a barter economy

The first thing worth noting is that Catan is not a barter economy—it's a monetary economy. This might seem like an odd thing to say. After all, the trades that we see in a typical Settlers game are all commodity-for-commodity trades.

To see why it's a monetary economy, imagine the case of autarky, or a Catan in which trade is prohibited. Here, players can only build structures using cards earned from tiles on which they have a settlement. The value of a lumber card in an autarkical economy is derived solely from its use-value, or its ability to help build settlements and roads.

The moment autarky is lifted and players are allowed to trade resources amongst each other, resource cards provide their owners with a whole new range of services. Not only is a lumber card valuable for the settlements and roads it yields, but also for its ability to purchase things from others. It has become a medium-of-exchange. Given the unpredictability of dice rolls, owning a stock of readily-tradeable exchange media provides players with wiggle room, or monetary optionality. Because an option is valuable, resources that provide optionality earn liquidity premia. The more liquid the resource card, the broader the option it provides and the larger its premium.

Monetary phenomena like monetary optionality begin to emerge the moment we exit from autarky—we don't have to wait till some hypothetical item called "money" appears on the scene in Catan, nor for so-called barter to disappear. All media-of-exchange, whether they exist in our simple Catan economy or the real economy, have money-like properties. In fact, I'll show later that there is no such thing as "money" in our modern economy, only a universe of media-of-exchange that differ along a spectrum of liquidity.

2. Patterns of resource monetization in a Catan economy

The Catan universe is a well-balanced monetary economy. By well-balanced, I mean that we tend to observe an even distribution of trade. Put differently, since Catan's five resources are all equally marketable, none of them earns a superior liquidity premia.

There are ways to tilt the rules of Settlers so that trade patterns get more skewed. One way to do this is to penalize trade in certain goods. For instance, say we institute a rule that continues to allow for full trade in sheep, brick, ore, and wheat but only permits lumber to be traded when a six has been rolled (limited autarky in lumber markets). This inhibits lumber cards from serving as full media of exchange. As a result, lumber loses some of its optionality and will trade at a discount to its prior price. The distribution of trade will now be skewed away from lumber towards the other four resources. If we penalize all resources but one, we would skew the pattern of trade dramatically in this resource's favor.

Another way to affect the distribution of trade is to endow certain resources with unique properties. Let's say that ore is more storeable than the other commodities. The rule in Settlers is that when a 7 is rolled, any player with eight or more cards must lose half their hand. If ore cards don't count to the total when a 7 is rolled (they are storable, after all) then players will be able to hold larger hands as long as they cushion their hand with ore. Players will begin to trade for ore not because they wish to build a city with it, but to protect their hands from 7s. This could increase the incidence of ore cards in trade relative to other cards. The more liquid ore cards become, the more will their monetary optionality increase, as will their liquidity premium.

There are all sorts of ways to tilt the distribution of monetary trade. Be creative.

3. Let's try Settlers chartalism

The idea behind chartalism is that some external monopolizer, say a gang or a king, sets an obligation upon citizens that can only be discharged with a certain type of settlement media. This media doesn't have to be a commodity. It might be an intrinsically useless token.

Let's imagine that the robber in Settlers requires a bribe from all players whenever a 7 is rolled. If a player doesn't pay the bribe, then they must sacrifice two cards. Say that the bribe must be paid in the form of an intrinsically useless $100 Monopoly bill. Players can only purchase the Monopoly bills from the robber on their turn for one resource card. Presumably players will purchase $100 bills since the 1 card cost exceeds the potential loss of 2 cards.


A player who has already bought enough Monopoly money to satisfy the robber should a 7 come up may wish to sell excess bills to players desperate for protection. Monopoly paper bills thereby join the five existing resources as a media of exchange in Catan. We might be able to tilt the distribution of trade in favour of the chartal medium if we encourage its marketability through rule changes discussed in section two.

4. Credit-based settlers

The existing rules of Settlers prohibit credit transactions. Relaxing these rules allows us to introduce a whole new range of resources that can be used in trade—each player's future earnings power.

There are infinite ways to structure credit transactions in Catan. Informal verbal promises are one way. I tell my trading partner that I'll buy a lumber from them now for an IOU of two sheep in the future. Due to their informality, these promises are unlikely to become liquid.

To really tilt the distribution of trade towards credit, we probably want to create standardized paper credit contracts. Standardization allows for quick appraisal, and this lowers transaction costs. Transcribing the promise onto paper will encourage its negotiability, or exchangeability from player to player. The more we streamline the process, the more likely that credit will become Catan's most liquid traded resource. The simplest IOU I can think of is a one-time paper promise to pay out all production from a 6 or 8 tile. The issuer can easily satisfy this obligation since they don't have to trade away for the media to settle it—they produce the media themselves.

When we allow for credit, players are acting simultaneously as bankers. The player that succeeds in getting his or her credit to circulate from player to player has effectively increased their purchasing power relative to everyone else and will be able to advance through the game much quicker. Players that push too close to the sun will find themselves unable to meet their outstanding promises and will default. They'll lose the trust of fellow players and will find it difficult to issue credit again, their advancement in the game slowing.

5. The social contrivance of a fiat Catan dollar

Paul Samuelson famously described how the contrivance of fiat money would allow members of an economy to efficiently solve the problem of passing on savings over time. Through a "grand consensus," worthless "oblongs of paper" would be accepted into circulation. This sort of paper is different from chartal Monopoly paper since the latter discharges a particular obligation. Samuelson's oblongs are merely bits of paper. They have no non-monetary use whatsoever.

Could we get players to accept mere paper? Our first guinea pig will only do so if they know for sure that the next player will accept it. Absent a significant amount of negotiation and coordination ahead of time, its difficult to imagine why the first player will ever trust the future negotiability of paper. Far safer for him or her to just refuse any fiat paper trades. Might players spontaneously negotiate a set of rules to encourage the circulation of Samuelsonian paper? Perhaps, but if the game already allows people several trading technologies—trade in resources, trade in chartal Monopoly money, and trade in credit—will players want to devote resources negotiating an expensive institution like fiat paper? I doubt it.

6. Catan Money?

Can the rules of Settlers be manipulated so that Catan approximates our modern world in which there seems to be one universal medium-of-exchange called money? Could we get ore to appear in all of Catan's trades, or Monopoly money, or the circulating credit of one trustworthy player?

As I pointed out earlier, we don't have to. In the real world, there's no such thing as a universal medium of exchange. Rather, we have an almost an infinite range of media that vary in terms of liquidity. The "dollar", for instance, refers to a number of different exchange media: paper dollars printed by the Fed, electronic dollars created by the Fed, private savings account dollars, chequing account dollars, eurodollars, traveller's cheques, credit card dollars, and more. Private chequing account dollars can be broken down into Bank of America dollars, Wells Fargo dollars, Citi dollars etc. The fact that these various media are denominated in the same unit should not confuse us into consolidating them into one universal medium-of-exchange. A US paper dollar, for instance, is a far more liquid instrument than a hamburger patty, but it still only appears in a small percentage of total US trades. As long as we can manipulate a game of Settlers to show a skewed distribution of trades, then we've sufficiently approximated the real world.

7. Catan economics vs. modern economics

Setting up a stylized Catan environment in order to explore monetary phenomena is akin to the approach taken by modern monetary economists. Economists realized long ago that exchange media simply had no role to play in a stylized Walrasian environment. In a world with an omniscient auctioneer who calculates the prices and quantities of all trades, and in which all trades are cleared at a central clearing house, there's no room for monetary phenomena like media of exchange or liquidity premia to arise.

To get "money" into an economy, modern economists start by introducing various refinements into a Walrasian environment. Rather than have individuals meet at a centralized market, Kiyotaki and Wright (1993) have traders meeting randomly and pairwise. Wright, Trejos, and Shi (1995) replace the auctioneer with traders who are capable of negotiating prices bilaterally. Our simple Settlers environment easily captures decentralized search and bargaining.

Some environments created by modern monetary economists are downright odd. The modern work-horse Lagos/Wright model sets up an environment with day and night markets. Day markets are bilateral and anonymous while night markets are centralized. Dror Goldberg imagines different cities which specialize in a certain good. Traders must trek between cities to secure a consumption good. Settlers, of course, will appear odd to anyone seeing it for the first time. Manipulating the rules of Settlers to see how we can generate monetary patterns is very much like letting rational agents loose in an Lagos/Wright sci-fi environment. The advantage of the former is that it's fun and real people are testing out the model, not imaginary agents.

Try experimenting with some of these rule changes the next time you play Settlers and tell me what happens. Even if you don't get around to it, hopefully I've convinced you that Settlers provides a great model for thinking about monetary economic phenomena.

Legal tender 101

The trillion dollar coin debate has inspired a lot of chatter about legal tender, not all of it correct. The best source on the meaning of legal tender is Dror Goldberg (the same Dror Goldberg from my Yap Stone post). His paper, Legal Tender is short and concise. Give it a read. This post is largely based off his work.

First off. If someone offers to pay you in legal tender, say a US platinum coin, are you obligated to accept it? The answer is no.

When a medium-of-exchange is denoted as legal tender, that means that it must be accepted in the discharge of certain types of debt. If you are engaged in an exchange with someone that doesn't involve the settling of debts, then legal tender laws don't apply. For example, say you walk into a corner store and offer to pay for cigarettes using legal tender platinum coins. The store owner can legally refuse to accept the coins. After all, the two of you are not settling debts—you're engaging in a spot transaction. The owner is on the right side of the law in requiring payment in, say, peanuts. Either pay him in peanuts or walk out of the store without your smokes.

According to Goldberg, legal tender laws start with non-spot transaction—those transactions in which goods & services are provided prior to final settlement, thereby creating a debt. Legal tender laws require that a creditor accept legal tender as settlement for most types of debt contracts (not all, see next paragraph). What qualifies as legal tender? In the US this includes all United States coins and currency, as well as Federal Reserve notes. In Canada, coins produced by the Royal Mint and notes issued by the Bank of Canada are legal tender (see the Currency Act). Private bank deposits are not legal tender in the US or Canada, nor are traveler's cheques or credit cards. Creditors needn't accept cheques or credit cards.

Creditors can structure contracts to avoid the obligation of accepting legal tender. All it takes is that both parties to a debt contract agree ahead of time that some alternative medium will be used to settle the debt. Say a debtor and creditor have agreed to settle three months from now in bitcoin. If after three months have passed the debtor offers to settle with a legal tender platinum coin, the creditor can refuse to accept the coin since the contract specifies BTC. Private agreement trumps legal tender laws.

Even if no alternative media has been chosen to discharge a debt, in certain situations a creditor can still refuse legal tender. In Canada, for instance, the Currency Act specifies that while $2 coins (toonies) are legal tender, they need not be accepted in the settlement of debts over $40. If a debt is larger than $25, the creditor can refuse twenty-five $1 coins (loonies). In India, a half rupee coin is only legal tender for debts less than ten rupees, which means that a creditor can refuse to accept more than twenty half-rupee coins. (See this RBI page.)

Over the years, governments have set some odd commodities to serve as legal tender. In his book Legal Tender (1903) Samuel Breckenridge notes that in 1631, the governor of Massachusetts declared that corn was to pass in payment for all debts at the market rate, unless money or beaver had been stipulated in the contract. Breckenridge goes on to write:

A little later bullets were ordered to be taken, being rated as equal each to a farthing, though no man was to be forced to take more than 12d in any one payment in this form. In 1643, likewise in Massachusetts, wampum [shell money] was given the debt-paying quality within the value of 40s at the rate of four pieces of black or eight pieces of white to a penny. Similar legislation was enacted in Connecticut and Rhode Island. In Virgina and Maryland tobacco was the commodity most universally desired, and so, in 1633, Virginia enacted that, while contracts, judgements, etc., should be reckoned in English money, they should be paid in tobacco. And a century later Maryland made tobacco a legal tender at a penny a pound, and corn at twenty cents a bushel. In North Carolina corn, pitch, tar, pork were also used at specified rates. Thus, in 1715 any one of seventeen commodities named might be used as a legal tender or in payment of taxes. (Pg 53).

Here I'm obligated to present the alternative view to Goldberg, of which Breckenridge himself provides a decent example. In his book, Breckenridge adopts the common view that legal tender laws applies to all transactions, whether these be time (credit) or cash (spot) transactions. Writes Breckenridge:

in general, it may be said that both gold and silver coins were a lawful tender; that in cash transactions the buyer, in time transactions the debtor, had the right to select the form of money to be employed. In the case of cash transactions it was found necessary to supplement this law by penal legislation and by legislation regulating prices. But in the case of time transactions, the civil power of the courts was an adequate sanction.

Who is right? Here's a quote from the Richmond Fed that settles the matter, at least in its modern US context:

However, no federal law mandates that a person or an organization must accept currency or coins as payment for goods or services not yet provided. For example, a bus line may prohibit payment of fares in pennies or dollar bills. Some movie theaters, convenience stores and gas stations as a matter of policy may refuse to accept currency of a large denomination, such as notes above $20, and as long as notice is posted and a transaction giving rise to a debt has not already been completed, these organizations have not violated the legal tender law.

It would seem that Goldberg is correct. In spot transactions—those in which a debt hasn't been created—legal tender laws don't apply. No one needs to accept your trillion dollar coin or Federal Reserve note. At least not over the counter.

Yap stones and chartalism

Rai at the Bank of Canada - part of Canada's foreign reserves

As I pointed out in my previous post, all sorts of economists have incorporated the example of Yap stones into their monetary discourse. One of the more peculiar uses of these stones can be found in neo-chartalist L. Randall Wray's Understanding Modern Money (1998).

In Chapter 4 of his book, Wray claims that an economy becomes monetized by the introduction of state-issued tokens (what I call coupon instruments). To provide empirical support for his claim, Wray repeats the story about German administrators marking all Yap stones with paint (see previous post, #9). The Germans did so in order to motivate the Yapese to build roads. After all, in order to get the state to remove these markings from their valuable stones, the Yapese were required to provide their labour. The implications of Wray's chapter are that instead of requiring labour, the German government could just as easily have required payment in government-issued paper coupons. Thus Yap, which up till then had never been a monetary economy, would have suddenly become monetized.

Wray is in some difficulty here since Yap stones already circulated as media of exchange (see Goldberg in previous post). Thus the emergence of a monetized economy came prior to any German state-inspired monetization. This possibility is particularly harmful to Wray since he has adopted throughout his book an extreme, or "vulgar", version of chartalism in which the only way to monetize an economy is to introduce a state-issued coupon instrument. In a note, Wray tries to wriggle out of his predicament, claiming that:

Furness, almost certainly in error, called these 'stone currency' and imagined that they were used as some sort of primitive 'medium of exchange'; however, his description uncovers no evidence that there were any markets. (73)

Wray is contradicted by the anthropological evidence provided by Gillilland and Furness, who list all sorts of examples of rai acting as media of exchange. Rai were used to purchase fish, housing materials, yams, labour, women, coconuts, and many other valuable items. Yap stones original circulation as commodity media-of-exchange therefore prove Wray wrong  in his extreme view that an economy can only be monetized via state-issued coupons.

Federal Reserve Bank of Cleveland's Michael Bryan wrote a paper called Island Money (2004) in which he adopts the chartalist idea that "money" is a marker, or a credit/debit, in order to explain rai. Owning a stone meant that one possessed a credit on the rest of the Yapese or, put differently, that Yap was in debt to the stone's owner. In this way rai functioned as "memory", a means by which to tabulate who owes whom. This is an old idea going back centuries but most popularly reincarnated in Narayana Kocherlakota's Money as Memory.

Now it is certainly true that credit IOUs have and continue to serve as some of society's most liquid instruments. Bank deposits are a great example. But to assume that only credit can qualify as "money" is to commit the same sin of monetary extremism that Wray commits. Bryan maintains that

rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money... Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established. Lacking intrinsic worth, Yap stones may be an especially useful object of study for students wishing to understand the significance of U.S. dollars, which, after all, have no value other than as a monetary unit; they’re what economists call an “fiat” money.

But as Goldberg has pointed out, Yap stones did have significant intrinsic value. There is no need, therefore, to accept Bryan's fallback view that within the so-called vacuum of intrinsic worthlessness, money could only earn value from its status as an IOU, or as so-called "memory".

The other problem with the Bryan's rai-as-credit story is their sheer size. Why choose something so awkward as a three meter wide stone to record an IOU? Any small token can be used to represent either smaller or larger debts. Casinos issue chips of the same size and shape representing amounts from $1 to $1000 — no casino deems it necessary to issue human-sized intrinsically valuable (gold plated?) $1000 casino chips. Rather than using huge stones as IOUs, the Yapese could have easily used verbal promises to record debts (see #8, previous post), or coconut shells emblazoned with markings. The simpler explanation for rai's value is Goldberg's: rai were intrinsically valuable for religious and aesthetic purposes.

I'm not saying that chartalism is wrong. I've pointed out before that I think the idea of coupon "money" makes some sense—even McDonald's could create chartal coupon instruments. So while you can count me in as a soft chartalist (I'm also a soft metallist, a soft monetarist, a soft Keynesian, a soft Austrian, etc), I'm not persuaded by the extreme versions of chartalism. The contortions its advocates are forced to undertake in order to explain monetary phenomena like Yap stones lead them astray.

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.