Our Autistic Money — The Role of Collateral in Fiat-money
Fiat money, like the Dollar or Euro, is completely autistic. As they can be created indefinitely, the question arises of how they can hold value. Collateral is crucial in establishing a relationship between our money and the physical world.
Today’s money systems all operate on the same template organized by a central bank. While central banks can create additional amounts of money indefinitely, private banks can also inflate the circulating currency by creating credit. When money can be created effortlessly, and further supply is always around the corner, why should anyone seriously care about Fiat money and ascribe value to it?
How is our money autistic?
Fiat money is, in a sense, autistic because there is no proper relation between creating new amounts of money and an underlying physical process. Money is like an autistic person who is entirely disconnected from the world, which isn’t necessarily true for all kinds of money. Think about gold, for example: In the past, gold was the predominant money of choice. The terminology of inflation and today’s target of most central banks of 1 to 2 percent of inflation only arises from the background of our golden past.
Inflation is a voluminous term. When something inflates, it means that its volume increases. Living under a gold standard means that inflation is just the increase of the base amount of gold that can serve as money. Gold has a long track record of a couple of thousands of years of an average inflation rate of 0,5 to 2 percent with relatively low variance for most of the time.
To inflate gold, somebody must put in the effort to mine it first. Creating new money is intrinsically connected to a concrete process in the physical world, as somebody must buy proper tools or machinery and start building a mining facility. Since all this is only possible if somebody invests time, effort, and resources, the creation of gold cannot be inflated indefinitely. The creation of new amounts of gold is dictated by market demand, as the amount of money somebody can invest in mining new amounts of gold is connected to the market value of gold itself. If somebody can mine gold for cheaper than its market value, the mine makes money and can continue operating; otherwise, it loses money and will pause mining or go broke and cease to exist entirely.
As gold physically has to be extracted from the ground, the inflation of gold is directly connected to economic processes dictated by physical reality. Fiat money lacks this connection as it can be created indefinitely by decree.
What is the role of collateral in Fiat money?
Everyone will die sometime, so everyone’s time is scarce. This is why we value our time. The German Philosopher Martin Heidegger goes even so far in his magnum opus, Time and Being, that things only mean something to us because of our temporal finiteness. We spend significant amounts of our time working. Most of us live and work in modern economic structures with a division of labor organization. That usually translates to: We work for money. When all is said and done, we basically exchange our time for money with our work. And we can then use this money to exchange for the time of others.
As we consider our time valuable because of its scarcity and our desire to live, we should only accept something in exchange for our work that is at least equally scarce and desirable. As we are being paid in fiat money, like Dollars or Euros, and it can be inflated by simple decree, the question arises: Why is it tolerated as a means of payment for our work? As it can be created at will, it can hardly be considered scarce, and as it can hardly be considered scarce, it can hardly be considered valuable and desirable. Still, we accept it. Even more, we long for it. Money plays a vital role in many decisions, even beyond economic considerations.
To understand why we even care about fiat money, it is crucial to understand the role of collateral. It is essentially what connects autistic fiat money with physical reality. The idea of collateral is simple, and most people will be familiar with it to some degree: When credit is being created, the one who receives the money will designate something of value in case one cannot pay back the owed money. Collateral functions as a security for the lender. Otherwise, why should someone ever pay back what is owed?
The intertwining of credit and collateral infuses fiat money with value.
Think about it like that: Credit is debt. Every time someone benefits from credit creation, debt is created. If credit creation is stimulated, the amount of credit can easily grow beyond the amount of money. In other words: there would be more debt than money.
This is how fiat money can become scarce. On the merit of itself, it can have no desirable property of scarcity as it can be indefinitely created. But with the addition of credit, money can be scarce in relation to the amount of money owed. The scarcity of fiat money is not absolute, like in the case of gold or Bitcoin, but relative in terms of the relation of existing base layer money and the total volume of the credit system.
Okay, through this trick, it can be managed to make money scarce. But a low-quality piece of art is also scarce, and still, nobody wants it. How is fiat made desirable, then?
The core idea is to employ collateral. Credit makes money scarce. Through collateral, credit is connected to the physical world. Suppose someone takes up a loan to buy a new machine to increase one’s production capacity. A potential lender will want insurance if the money is not paid back in due time. This could, for example, be a house or something else of value. While money can be created by simple decree, the house cannot. That is why the house is desirable in the first place. As the credit is now connected to the house, the clearing of the debt inherits the property of desirability from the house.
To put it more simply: You want money to pay back your debt, even if it can be created indefinitely by decree. And if you don’t pay back your debt, you lose your house. So: You want money because you want to keep your house.
Collateral is the core concept in fiat money that connects autistic money with physical reality. Without collateral, there would be no incentive to pay back the debt; without debt, there would be no scarcity of fiat money.
Ultimately, it is of absolute importance to understand the core idea that fiat money is basically infused with value through collateral.
Sources/Further Reading
[1] Lewis, Parker (2019): Bitcoin is not Backed by Nothing
[2] North, Gary (2021): Dancing on the Grave of Keynesianism
[3] Rothbard, Murray (1976): The Austrian Theory of Money
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