Why does the dollar bill in one's pocket have value? The value of money is established, according to some experts, because the government in power says so. For some commentators the value of money is on account of social convention. What this implies is that money has value because it is accepted.
And why is it accepted? ...because it is accepted! Obviously this is not a good explanation of why money has value.
The Difference between Money and Other Goods
Let us try another approach. Demand for a good arises from its perceived benefit. For instance, people demand food because of the nourishment it offers them. Likewise, people demand money not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value—it is exchangeable in terms of other goods and services. Money is demanded, because it offers the benefit of its purchasing power, i.e., its price.
Consequently, for something to be accepted as money it must have a preexisting purchasing power, a price. So how does a thing that the government proclaims will become the medium of exchange acquire such purchasing power, a price?
We know that the law of supply and demand explains the price of a good. It would appear that the same law should explain the price of money. However, there is a problem with this way of thinking, since the demand for money arises because money has purchasing power, i.e., because money has a price. Yet if the demand for money depends on its preexistenting price, i.e., its purchasing power, how can this price be explained by demand?
We are seemingly caught here in a circular trap, for the purchasing power of money is explained by the demand for money while the demand for money is explained by its purchasing power. This circularity seems to provide credence to the view that the acceptance of money is the result of government decree and social convention.
Mises Explains How the Value of Money Is Established
In his writings, Mises had shown how money becomes accepted.2 He began his analysis by noting that today's demand for money is determined by money's purchasing power yesterday. Thus is today's purchasing power established for a given supply of money. Yesterday's demand for money, in turn, was fixed by the prior day's purchasing power of money, setting yesterday's price of money for a given supply of money.
The same procedure applies to past periods. By regressing through time, we will eventually arrive at a point in time when money was just an ordinary commodity whose price was set by supply and demand. The commodity had an exchange value in terms of other commodities, i.e., its exchange value was established in barter. To put it simply, on the day a commodity becomes money, it already has an established purchasing power, or a price in terms of other goods. This purchasing power generates the demand for this commodity as money. This demand in turn sets the commodity's purchasing power on the day it starts to function as money.
Once the price of money is fixed, it serves as an input for setting tomorrow's money price. It follows that without yesterday's information about the price of money, today's purchasing power of money cannot be established.
With regard to other goods and services, history is not required to ascertain present prices. A demand for these goods arises because of the perceived benefits of consuming them. The benefit that money provides is that it can be exchanged for goods and services. Consequently, one needs to know the past purchasing power of money in order to establish today's demand for it.
Using the Misesian framework, also known as the regression theorem, we can infer that it is not possible for money to have emerged as a result of government decree or endorsement or social convention. The theorem shows that money must emerge as a commodity.
On this Rothbard wrote in What Has Government Done to Our Money?,
In contrast to directly used consumers' or producers' goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold). Thus government is powerless to create money for the economy; the process of the free market can only develop it.
But how does all that we have said so far relate to the paper dollar? Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money. These certificates acquired purchasing power on account of the fact that they were seen as representing gold. (Note that according to the regression theorem, once the purchasing power of a certificate is established it can function as money regardless of gold, since the demand for money can then be established. Remember the demand for money is because of its purchasing power.)
Paper certificates that are accepted as the medium of exchange open the door to fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that are not covered by gold. However, in a free market economy, a bank that overissues paper certificates will quickly find that the exchange value of its certificates in terms of goods and services has declined. To protect their purchasing power, holders of the overissued certificates would most likely attempt to convert them back into gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market, then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold.
The government can, however, bypass the free market discipline. It can issue a decree that makes it legal for the overissued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that created incentives to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed creation of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.
To prevent such a breakdown, the supply of paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from overissuing paper certificates and bankrupting each other. This can be achieved by establishing a monopoly bank—i.e., a central bank—that manages the expansion of paper money.
To assert its authority, the central bank introduces its own paper certificates, which replace the certificates of the various banks. The central bank money's purchasing power is established on account of the fact that the various paper certificates, which carry purchasing power on account of their historical link to gold, are exchanged for the central bank money at a fixed rate. The central bank's paper certificates are fully backed by the bank certificates, which have the historical link to gold.