The Pizza Theory of Fiat Money
To Really Understand Fiat, You Must Learn Fractions
Fiat money is created by governments, it can’t be directly converted into gold or other commodities.
In modern financial systems, fiat money is created when people, businesses, or governments, borrow from a government sponsored “Central bank”.
Because government designs and controls fiat money systems, it doesn’t borrow from the central bank because it “has no money”. Instead, the government tasks the central bank with keeping track of all the money that is issued, and what is promised in return.
It’s just like the board game monopoly. One player is assigned to be the “banker” and keep track of the money, but that doesn’t mean they own all the money. They still have to follow the rules like everyone else.
Because we can issue as much money as we like, the problem is not having enough money, but whether the money being issued matches what is promised in return.
Money is lent out through the banking system based on credit worthiness. Banks are tasked with evaluating whether people will be able to “repay” loans, or provide value that matches the money they are lent, thus preserving the value of our currency.
To prove they delivered enough value to match the money they were lent, borrowers must repay loans, potentially with interest, to try to offset inflation and other risks. In that way, the value of the currency is maintained(and the individual lending institutions remain solvent).
If borrowers cannot repay what they owe, they are insolvent. Insolvency triggers a legal process called bankruptcy. The person who is insolvent must use their existing assets to repay their lenders, to the extent they can, according to legal rules.
If, on the other hand, your assets exceed your liabilities, you are said to have equity:
- Equity = Assets - Liabilities
Because of these legal financial concepts like credit, debt, equity, solvency, and bankruptcy, we are trained to think about money using addition and subtraction.
When you earn $10 you add it to the “asset” side of the scale, and when you spend $10 on your credit card, you add it to the “liability” side of the scale.
But to really understand fiat, and what makes it go up and down in value, you have to git rid of this notion of trying to balance a scale.
Instead of using addition and subtraction, we must use addition and division, or fractions. This may sound complicated, but we can make it relatable to your average person if we turn it into pizza. Yummy!
Every month you and your friends get together and make a giant pizza. One friend buys the dough, another gets the pepperoni, another one buys the cheese, and so forth. You then cook it together and share. Everybody’s happy.
But one of your friends is a cheapskate. Every month he just gets onions. For one thing, onions are pretty cheap. For another, not everyone wants onions on their pizza.
So you decide to create a system. Depending on which ingredients you bring, you get more or fewer slices of pizza:
However big the pizza turns out, you simply count up all the slices people earned, and divide the pizza in that many slices.
You could even issue tokens representing claims to slices of the pizza:
This system gives us a fraction for the size of each pizza slice:
So instead of adding assets and subtracting liabilities, you are adding assets and dividing by liabilities.
This is much more sustainable. It’s not like the scale where too much on one side breaks the system. To create an effective fiat money system, we just need to make sure that the top and bottom of the fraction are in proportions we find acceptable, so that our individual portions are sufficient. We need to have enough real resources, and make rules to encourage developing resources and dividing them up fairly and effectively.
This is just a metaphor, but I think it can help us understand how our fiat money systems work.
