- Is the value of money more sensitive to changes in short-term expectations or long-term expectations? Is what happens in the economy today the key driver of the value of money and the price level, or are both the value of money and the price level driven primarily by confidence about the long-term economic future of society?
- In last week’s post, we explored the idea that “money is only as good as the society that issues it”. More specifically, the value of any given fiat currency depends primarily upon expectations regarding the future economic prospects of the society that issues it. But is the value of money more sensitive to expectations regarding the near-term economic prospects of society or the long-term economic prospects of society?
- We can state this question another way: “Is fiat money a short-duration or long-duration asset?” This may seem like a strange question to ask about money. After all, most people associate the concept of duration with fixed income securities, not “cash” (the monetary base).
- However, every financial instrument, including fiat money, can be considered to possess the property of “duration”. Moreover, the duration of an asset is a critical determinant of how that asset behaves in response to changes in expectations.
- The view of The Money Enigma is that fiat money is a financial instrument and a proportional claim on the future output of society. More specifically, fiat money is a long-duration instrument.
- While there are a couple of ways to demonstrate that money is a long-duration asset, the simplest method is to apply what I call the “benefits-cut-off” test, i.e. imagine if it was announced that money would be no longer accepted in exchange for goods and services in one year from now or five years from now, or twenty years from now etc. and imagine what would happen to the current value of money in each of those circumstances.
- Why does the duration of money matter? Well, if we understand the duration of fiat money, then we can create better models for the value of money and, consequently, the price level. More specifically, if money is long-duration asset, then we can argue that both the value of money and the price level are far more responsive to changes in confidence regarding the long-term economic future of society than they are to any change near-term economic conditions.
The Concept of Duration
The duration of an asset is the weighted average time that it will take to receive the present value of the benefits generated by that asset. The term is most commonly applied to fixed income securities. A 5-year, interest-bearing government bond is a “short-duration” asset, while a 30-year zero-coupon bond is a “long-duration” asset.
From a practical perspective, if an asset is a “short-duration asset”, then most of its value relates to benefits that will be received in the near future. Short-duration assets are highly sensitive to changes in current conditions and expectations regarding the near future, i.e. the next 2-3 years. However, short-duration assets are, as a general rule, completely insensitive to changes in long-term expectations.
In contrast, the value of a “long-duration asset” depends primarily on benefits to be received in the distant future, i.e. 10-20 years from now. The value of a long-duration asset is highly sensitive to changes in long-term expectations, but relatively insensitive to changes in expectations regarding short-term conditions.
While the concept of duration is most commonly applied to fixed income securities, it can be applied to any financial instrument. After all, the value of every financial instrument depends upon benefits that we expect to receive from that financial instrument in the future. “Duration” simply provides with a measure of the average time taken to receive the present value of those benefits.
Indeed, every financial instrument can be considered to possess the property of “duration”. For example, John Hussman often discusses the idea that equities are a very long-duration asset. In theory, the stock market should be far more sensitive to changes in expectations regarding long-term earnings growth than changes in current economic conditions and earnings.
If every financial instrument possesses the property of duration, then this raises two interesting question relating to the nature of money. Is fiat money a financial instrument? And if it is, then what is the duration of fiat money?
Fiat Money as a Financial Instrument
The view of The Money Enigma is that fiat money is a financial instrument. Every asset can be classified as either a real asset or a financial instrument. Fiat money is not a real asset and, therefore, must be a financial instrument.
The classification of assets into real assets and financial instruments is important because it relates to how an asset derives it value. Assets can only derive their value in two ways: either they derive their value from their physical properties or they derive their value from their contractual properties.
A real asset is an asset that is tangible or physical in nature. More importantly, it is an asset that derives its value from these tangible or physical properties.
In contrast, a financial instrument is, by definition, both an asset and a liability. A financial instrument derives its value as an asset from the liability that it represents to another. In this sense, the value of a financial instrument can be considered to be an artificial creation of a contract entered into by economic agents.
In simple terms, if something doesn’t derive any value from its natural or intrinsic properties, then the only way it can derive value is if it creates an obligation on a third party to deliver something of value. Indeed, this paradigm is so fundamental that it is used as the basis of classification of assets for accounting purposes.
So, where does fiat money fit in this simple paradigm? Does fiat money derive its value from its physical nature or does it derive its value from the liability that it represents to its issuer?
The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Money is an asset to one party because it is a liability to another. More specifically, money is a liability of society and represents a proportional claim on the future output of society.
In simple terms, the cash in your pocket has value to you today because you believe that you will be able to exchange that cash for goods and services in the future. The money in your pocket represents a claim against the future output of society. This is the essence of the social contract that fiat money represents.
So, if fiat money is a financial instrument and every financial instrument possesses the property of duration, then what is the duration of fiat money?
The Duration of Fiat Money
One of the aspects of fiat money that makes it rather unique as a financial instrument is that it doesn’t entitle us to a stream of future benefits. Rather, it entitles us to a slice of future benefits. In simple terms, we can only spend the dollar in our pocket once. We can spend it today, tomorrow, one year from now or twenty years from now.
Since most of us are in the habit of spending the dollars in our pocket within a week or two, this would suggest that money is a short-duration asset. However, this simplistic form of analysis is wrong. Just because we don’t typically hold the same cash in our pockets for a long period of time, doesn’t mean that fiat money is a short-duration asset.
There are two much better ways to think about the duration of money. The first is relatively simple and involves the application of a basic test. The second is more complex and requires an appreciation of the economic concept of “intertemporal equilibrium”.
Let’s begin by discussing the first, relatively simple approach.
There is an easy test for duration of any asset. For lack of a better term, we can call this test the “benefits cut-off test”.
As discussed, a financial instrument only has value because it creates an obligation on the issuer of that instrument to deliver something of value in the future.
The benefits cut-off test involves imagining a scenario in which the issuer of that financial instrument announces that it will not to honor the liability starting x years from now and thinking about the impact that announcement would have on the current value of the security.
For example, if the government announced that, starting five years from today, it would stop paying interest and principal on all government debt, what would be the impact on the value of its debt?
Clearly, it depends on the duration of the debt. The announcement should have no impact on one-year government debt, after all, the interest and principal will be repaid well before the government stops honoring its commitments.
But what about recently issued 30-year debt? Clearly, the value of such debt would collapse. Why? Because it is a long-duration asset: most of its value is associated with payments that will be made well beyond five years from now.
Now, let’s apply the benefits cut-off test to fiat money.
As mentioned, the view of The Money Enigma is that money is a financial instrument that represents a proportional claim on the output of society. In short, fiat money is a liability of society and its value depends on society honoring its obligation to deliver output in exchange for little pieces of paper.
Now, what would happen to the value of money and, conversely, the price level, if it were announced that society would not honor money’s claim on output starting one year from now?
Think about this for a moment. What would your immediate reaction be if the government announced that cash would no longer be accepted in commercial exchange one year from now? My guess is that you would try get rid of all your cash and cash-related securities, i.e. bank deposits, as fast as possible!
The problem is that everyone else would try to do the same thing. What would happen to the value of money if everyone wants to get rid of it and no one wants to accept it? It would collapse.
If the government announced that money would no longer be accepted one year from now, then it seems reasonable to believe that there would be panic and the value of money would collapse, not in one year, but today, right now. What would happen to prices in this scenario? Prices would soar. You can imagine the scene: people offering $100,000 for a jar of peanut butter and the grocer refusing to accept it.
Let’s try a different scenario. What if it was announced that the cut off was 5 years from now? In other words, what would be the reaction if everyone learnt that money would not be recognized as a claim on output starting five years from now?
In this scenario, there might not be panic, but there probably would be an immediate drop of in the demand for money. Again, money would lose a substantial portion of its value very quickly and prices, as expressed in money terms, would skyrocket.
What about if the cut off was 10 years from now? Maybe a smaller drop in value, but still a drop in value.
Now, apply a 30-year test. Would there be a significant drop in the value of money today? Probably not. Why? Well, 30 years is a long time from now. Arguably, money could function for at least another ten years before people really start to worry about the end point.
Clearly, this exercise involves a large degree of speculation, so we won’t belabor the point. Nevertheless, it does give some credence to the view that money is a long-duration asset. The value of money is highly dependent upon the expectation of benefits, in the form of goods and services, that can be claimed with money not just months but years from now.
So, how is it possible for money to be a long-duration asset? After all, we tend to think of money as something that we can spend now or at any time we wish.
The benefits cut-off test provides a hint as to the answer: the value of money today depends upon a long chain of expected future values.
In very simple terms, I accept money from you because I think I will be able to acquire goods of value from the next person. In turn, the person who accepts that money from me does so because they think that the next person will accept it as something of value. And so a chain develops: money has value now because we believe it will have value to each successive person in the chain.
Fiat Money and Intertemporal Equilibrium
What our very basic example highlights is that the equilibrium value of money incorporates a chain of expected future values for money. More specifically, the present value of money depends largely upon the expected variable entitlement of money in distant future periods. If, as in our example, the entitlement of money drops to zero in future periods, then this has a big impact on the current equilibrium value of money.
In theory, the economy should always be in or adjusting towards a state of intertemporal equilibrium. If it is announced that society will no longer recognize money as a claim on output beginning next year, then it will lose all, or nearly all, of its value today. In essence, a state of intertemporal equilibrium is disrupted by the announcement: everyone tries to spend the money today with the result that no one can spend the money, or only at a massively reduced value.
In our simple one-year cut-off example, equilibrium is only restored once the value of money has fallen to such a degree that someone is prepared to accept it in exchange for goods or services. The price level may well have to rise by a 1000% or more in order to restore a state of intertemporal equilibrium.
Interestingly, there is another way we can leverage the concept of intertemporal equilibrium to demonstrate that fiat money is a long-duration asset. More specifically, we can use the concept of intertemporal equilibrium to demonstrate that the expected value of money in distant future periods does impact the value that we put on money today.
This process starts by investigating one of the key differences between fiat money and shares of common stock.
One of the most obvious differences between money and a traditional equity instrument is that one unit of money provides its holder with a claim to a slice, not a stream, of future economic benefits. A share of common stock provides its holder with a proportional claim to a stream of future cash flows. In contrast, one unit of money provides its holder with a one-time claim on the output of society, or a “slice” of future output.
If a financial instrument entitles its holder to a stream of future benefits, then we can create a valuation model for that asset by simply adding the present value of each of the expected future benefits in that stream.
However, if a financial instrument entitles its holder to a slice of some set of possible future benefits, then we face a different challenge: the present value of that instrument could equal one future benefit or another or another.
In essence, we are left with a question of probability: what is the probability that the holder of that financial instrument will claim any one of n different future benefits? If we know the probability of each slice being claimed (i.e. the probability of when the money will be spent), then we can calculate the present value of the asset.
So, how do we create a probability function to weight each of the possible future values of money and, thereby, determine the current equilibrium value of money? The key to the answer lies in the question itself: the concept of “equilibrium”.
Equilibrium can be thought of in one period terms, “static equilibrium”, or in multi-period terms, “intertemporal equilibrium”. It is the view of The Enigma Series that in order for the economy to be in a state of intertemporal equilibrium, the marginal holder of money must be indifferent between spending the marginal unit of money at any point in their future-spending horizon.
Think about it this way: if you would much prefer to spend the marginal dollar you receive in five years, than spend it today, then you haven’t maximized your utility and the economy is not in a state of equilibrium. In simple terms, you have an incentive to act and, by definition, the economy is not a “state of rest”.
If you have n years remaining in your life, then technically, for the economy to be a state of general equilibrium, you should be indifferent between spending money now versus spending money in any one of those future n years. Moreover, you will also be indifferent as to which of those future periods you spend the money in. For example, you will be indifferent as to whether you spend the marginal dollar in 5 years, 10 years or 20 years.
[Geeks note: Mathematically, if you are indifferent between A (spending money now) and B (spending money in 5 years) and indifferent between A (now) and C (10 years), then you are also indifferent between B (5 years) and C (10 years)].
Now, we can use this idea to create our probability distribution. If the marginal holder of money must be indifferent between spending the marginal unit of money at any point in the future n period spending horizon, then the probability that the marginal unit of money is spent in any one of the future n periods is 1/n.
At least theoretically, the probability that we spend the marginal dollar twenty years from now is the same as the probability that we spend it one year from now. Therefore, the value we put on money today will incorporate not only expectations about the value of money one year from now, but the value of money thirty or even forty years from now.
This application of equilibrium theory casts new light on the duration of money. The value of money doesn’t just depend on what we expect we might get for it one or two years from now. Rather, the value of money also depends heavily on what we might expect to get for that money many years, if not decades, from now.
In summary, the value of money depends upon long-term expectations. Fiat money is a long-duration asset and the value of fiat money is highly sensitive to changes in expectations regarding the long-term (20-30 year) economic future of society.