All Money is Debt

Foreword

What is money? What is debt? How are they related?

Some people get all twisted out of shape calling fiat money “debt”, and that only gold or bitcoin or silver or whatever is real “money”. But is that really right?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Debt

Let’s start with the easy one. What is debt?

The Cambridge dictionary defines debt as “something, especially money, that is owed to someone else, or the state of owing something“. That’s fairly clear, ain’nit?

Island adventure

Let’s do a little thought experiment. Let’s say a bunch of people, including you, are on a remote island. None of you know each other, none of you have reasons to trust each other. But for your little society to work, and for everyone’s lives to improve, you need to work together, because it simply isn’t feasible for one person to do everything well — division of labor generally tends to yield much better results for everyone.

One day, one of the strangers, Alex, did a favor for you — they built a little fire pit for you, out of rocks they carried down from a nearby mountain. Your specialty is foraging berries, but Alex already had their meals today, and berries don’t keep long. How can you repay Alex?

One way, is for you to give Alex a token, a symbol of the value you owe them, for their work in constructing the fire pit. This token can be a cowrie shell, a pretty rock, a piece of leaf you scribble a mathematical puzzle that only you can solve, etc., pretty much anything — Anything that both you and Alex agree to recognize as an accounting measure of what you owe Alex.

Now, let’s say you and Alex settle on using cowrie shells — they are hard enough to find that neither of you are concerned about the other using newly found cowrie shells to deceive the other, and the shells are pretty enough that you wouldn’t mind keeping them just for their own sake. Further, let’s say that the rest of the group of strangers feel the same — that cowrie shells are rare enough, and valuable enough in their own right, so that everyone starts offering, and accepting, cowrie shells for goods and services bought and rendered.

Well, congratulations, you’ve just invented money — the cowrie shells are, essentially, money.

As you can see, money is, at least in this case, just a means to measure how much each person is owed by the collective body — the rest of the island (world). It is a physical manifestation of the debt that the rest of the world owes you. Nothing more, nothing less.

Intrinsic value

“Hold on there!” someone will be shouting right about… now, “Cowrie shells have intrinsic value as you’ve said, that’s why they are money”. Yes, I did say that cowrie shells, at least on that island, has some intrinsic value — they are pretty enough that everybody wouldn’t mind keeping them around just to look at them.

But you see, that doesn’t make cowrie shells money. It just makes cowrie shells pretty. There are a lot of things that are pretty, yet are not used as money — a medium of exchange, a scoreboard for tracking how much you owe the world, or how much the world owes you.

Part of the reason why cowrie shells is money on your remote island, is because everyone agrees they are money, and everyone agrees to accept or offer them as representations of value transferred. The fact that they are pretty is mostly irrelevant — the prettiness is a useful property for bootstrapping the economy, but beyond that has no real relevance to the day to day use of cowrie shells.

Similarly, a fiat currency can be bootstrapped into money by, well, fiat — a government can decree that within the borders under its control, some currency needs to be accepted and offered as legal tender for goods and services offered or rendered. The currency need not be pretty in this case for the bootstrapping — the credibility of the government, and how much people believe the government is able to enforce its legal tender laws, is the criteria for bootstrapping the currency. And once the currency is in wide circulation, and everyone agrees to use it as money, then it will be money, and it will, as before, track debt owed to (or by) each individual person.

Hyperinflation

Now, let’s say that for whatever reason a large portion of the population of the island decide not to use cowrie shells anymore at any point in time. They stop accepting cowrie shells, and start using their existing cowrie shells to quickly buy up goods or services from those who still use cowrie shells.

In time, more and more people will recognize that cowrie shells cannot be used to buy certain goods and services, and even though the shells are just as pretty, their “value”, how much each cowrie shell can buy, will start to drop. As more and more people recognize this, they will be more and more willing to exchange cowrie shells for less and less, resulting, eventually, in hyperinflation — the value of money essentially drops to, or close to, 0.

Now, I want to be clear here — hyperinflation and inflation are not the same thing. Inflation is just the regular ebb and flow of the value of money vs goods and services. Hyperinflation, on the other hand, is a loss in confidence in the value of money by a large portion of the populace, which then feeds on itself, becoming a death spiral for the value of money (1). The former is a measure of relative supply and relative demand, while the latter is a loss in confidence of money — two very different things.

You can have very, very high inflation (say 10-20% a year), without actually getting hyperinflation. There are countries with poorly managed currencies with such high inflation numbers for prolonged periods of time, but because enough people still believe in the currency (even if that belief means mentally adjusting by 10-20% a year), that hyperinflation simply does not set in.

In short, high inflation is a crisis of relative supply vs relative demand. Hyperinflation is a crisis of confidence in money.

Another way of looking at it, is that hyperinflation is one way how money stops being money.

Forgeries

Let’s say instead of losing confidence in the cowrie shells, someone stumbled upon a little cove on a remote part of the remote island, where cowrie shells are just all over. They secretly take these cowrie shells and start using them to buy things, and entirely stop working. If they do this at a small scale, most people may not notice, and while inflation may set in (prices will go up a bit to reflect the relative value of money vs goods and services has shifted), confidence in cowrie shells won’t be loss, and life goes on without hyperinflation. If, however, they do it on a large enough scale, effectively introducing a level of supply of money that’s so large that society (the rest of the island) can never repay the debt as symbolized by the new supply cowrie shells, then things will likely go haywire and hyperinflation will likely set in.

To counter the demise of cowrie shells, you found something else, a shiny yellow rock, that is, again, very rare, but because it wasn’t money, nobody has been really collecting it, and so you are the only person with a lot of it. Can you just unilaterally demand everyone use the yellow rock as money? Maybe! Obviously everyone else will be at a severe disadvantage to you, and clearly they won’t like that very much. Some other people can probably find other things, maybe a leaf scribbled with an arcane math problem only they managed to solve, or a series of auditable numbers carved on a giant stone, things that are also hard to forge, but that they themselves have a lot more of than the rest of the island. Those people will also make the same demand that their thing is the new money.

So why yours and not theirs?

Ultimately, the choice of what to use as money depends on the interplay of 2 things:

1. Who has the clout, the ability (by persuasion or by force) to convince more people to accept their choice
2. What is the thing most people agree to use

Essentially, being hard to forge, even impossible to forge, does not automatically make something money. Humanity has known for decades about cryptography and how to make essentially unforgeable artifacts. Yet none of these have become money in and of themselves — instead, they are used to secure existing money, by encrypting transactions made in USD, EUR, GBP, etc.

Summary

To become money, having the properties that are necessary for being money is not enough. You also need that bootstrap, and you need that bootstrap to morph into popular support by the populace. Finally, to prevent your money from stopping being money, you also need to maintain the people’s confidence in your money, essentially in perpetuity.

But underlying all of these, is the basic premise, that money is, simply, debt. Money represents debt owed, and is the unit of accounting so that society can decouple the 2 parts of a barter trade — instead of you and Alex trading a fire pit for berries, you get the fire pit now, and Alex gets the berries later, with money acting as a measurement of the debt you owe Alex in between.

Edit:

The key, then, to remember, is that the value of money does not come from within — it comes from without. Money is money not because it has intrinsic value. Instead, money is money because it has extrinsic value — its value is entirely bestowed by the willingness of others to take that money as payment for their goods and services. Claiming something is hard to forge or highly divisible is necessary, but not sufficient. Claiming something has intrinsic value because it can be used in industries, or looks pretty, is mostly irrelevant. Claiming something is backed by something else, is irrelevant, unless that backing is either a form of widely accepted money, or that backing involves the ability to persuade others (again, either by persuasion or force) to accept the backed asset as money.

Footnotes

1. Wikipedia defines hyperinflation here, which includes a mathematical definition of hyperinflation, which is basically 50% increase in prices of general goods and services on a month over month basis, over a prolonged period of time, essentially the death spiral mentioned above. On a year over year basis, 50% month over month translates to roughly 129x increase in prices per year.