"worthless" paper - how taxation makes money worth something

Many people think that paper currency is intrinsically worthless, but here's what they don't understand:
Currency derives it's value, in large part, from taxation.

Here is a very simplistic example that may help you understand:

There are 1000 houses.
There is an annual tax of 1% on the market value of each house.
There are 1000 units of currency in circulation.

That essentially means that each house owner has to give up 1/100th of his house every year.
Altogether, all the homeowners have to essentially give up 10 houses every year (or rather the equivalent of 10 houses in currency).
Since people only need the currency to pay the tax, the entire amount of currency in circulation is only worth 10 houses.
This means that 1 unit of currency is worth 1/100th of a house, and that the market price for 1 house will become 100 units of currency.

The currency becomes worth something because people need it to pay taxes.

 

idiocy:
1) currency has more uses than paying taxes
2) without taxes currency would still have value

 

Without taxation, and without any type of backing, the dollar would be a pure fiat currency, kind of like those giant stone wheels found on the island of Yap. Primitive tribes also used strings of seashells as money.

 

dear, you said without taxes, now when you realize how mistaken that was you added to it without any type of backing. Next time think before you you hit post. Why not just ask questions rather than pretend you are an economist. Its not something you can fake.

 

An interesting thing about currency:

A particular unit of currency has no intrinsic value. External pegs, such as pegs to commodities or pegs to other currencies, do not change this. My dollar is 'backed' by gold; I can exchange dollars for gold at the market price. My dollar is 'backed' by oil; I can exchange dollars for oil at the market price. My dollar is backed by carrots; I can exchange my dollars for carrots at the market price.

All the gold-standard does is enable you to buy gold at a predetermined price rather than the market rate. It does not mean your currency is 'gold backed.'

It is the 'pegged' nature of the gold standard that forced every major nation to abandon it. It was not feasible over the long term.

 

there are many possible rules to a gold standard currency and economy but when you can exchange your money for a fixed amount of gold it is a gold back currency.

Why not address op rather than start new and silly subjects??

 

You yourself remarked on the significance of the 'backed' nature of currency. I am responding that pegging a currency does not establish its value. The value of tea will rise and fall even with a so-called backed currency.

Under the current system, all values are determined on the market - including the value of the currency itself.

 

the value of the currency is largely determined by how much of it the govt prints

 

Only in a partial sense. Money created is just one input (currency printed is misleading, since that is a very small percentage of new money created).

On the positive side of the ledger we have money created through the standard channels. This includes money spent by the federal government and money lent by private banks. Monetary adjustments like QE create a very small increase in money supply - their main effect is to change the maturity of instruments held by the Fed.

On the negative side of the ledger is money destroyed or removed from circulation. Money is destroyed by taxation, private deleveraging, private debt writedowns, and physical currency destroyed (burned) by the Fed.

The difference between these two is the net money creation, which may be positive or negative. Net money creation can be positive without creating inflation, so long as the GDP increases by a similar percentage. In recessions it's common to have a net negative money creation, as demand from qualified borrowers drops sharply.

So the printing presses can run in reverse as well.

The bottom line is that their should be a stable relation between net money creation and GDP, so that every dollar represents a constant amount of goods and services.

 

Our subject isn't inputs but rather what determines the value of money. Value is determined by Fed which controls the money supply. Their mandate is no inflation or deflation so value of money stays the same.

 

This is commonly held, but mistaken, view.

The BIS, Fed, and BoE have made similar statements confirming that the money supply is a market driven variable, not a government established quantity.

 

What determines value is the market. Quantity theory of money, multiple variables can effect inflation/deflation. The Fed does not control the money supply. They can try to effect the money supply through their manipulation of interest rates but studies have shown this does not correlate. The money supply is largely driven by demand for credit and in some occasions large deficit spending.

 

yes and the Fed controls the market for money. 1+1=2

- - - Updated - - -

actually that's what it exists for!!!!

- - - Updated - - -

If they didn't you might expect to see inflation or deflation of 20,000% but oddly it stays at 1-2% exactly where the Fed wants it!!

 

"Money" is backed by debt, but that debt is still denominated in Federal Reserve notes.
Over the long-term the "money supply" can just adjust to whatever the currency is worth, so the Fed does have direct control over what the inflation will be.
Long-term non-adjustable debt throws a debacle into that idea though, can make things more complicated.

Still, what many economists apparently fail to realize is that inflation is not simply determined by the quantity of money in circulation, but by what is backing it. As long as the backing increases in proportion to the increase in money supply, theoretically there will be no inflation. (although for large changes it is not entirely a linear relationship, but that would mostly only apply in the case of hyperinflation)

 

Actually, Zorroaster, I believe Ted is basically correct in this instance (Maybe the only time he has been correct).

The "money supply" becomes pretty much irrelevant if the underlying currency changes in value.
The one exception is in the case of a bubble where the market thinks there is more backing the "money" than there actually is. In that case it's not even "real" inflation but "apparent" inflation (or rather price inflation due to market irrationality).

It should also be mentioned that U.S. currency also gets its worth from the Reverse assets on the Federal Reserve Bank's balance sheet, but I did not want this to get too complicated. Basically these Reserve assets are intended to provide backing for the dollar (albeit in an indirect sort of way), but now we basically have an absurd situation where most of these "assets" are just government obligations to pay more dollars. Assets backed by debt backed by those same assets, kind of circular. But again, this is just another form in which taxation makes the dollar worth something!

All this terminology trying to describe money can get sort of confusing. Hope I didn't lose anybody!

 

Let me try to lay it all out for you:

Physical house backs bank mortgage.

U.S. dollar is Federal Reserve Bank note. Federal Reserve Bank note backed by Reserve assets. Reserve assets on the Fed's balance sheet at this time are about half residential mortgages and half U.S. Treasury bonds.

U.S. Treasury bonds are government debt.
Future obligation to pay dollars back government debt. Future obligation to pay dollars backed by future taxation and value of individual unit dollar.
Individual unit dollar backed by Reserve assets divided by the number of dollars in circulation (Federal Reserve Bank notes outstanding).

"Money" backed by bank promise to pay dollars.
Bank promise to pay dollars backed by bank mortgage and value of individual unit dollar.

So what do we see? Basically the entire money supply is essentially backed by physical property and taxation.

It's a little more complicated than just this of course, but I believe this pretty much sums up the system.

 

dear, you say it is backed by promise to pay and then you say it is backed by physical property and taxation.

You should think about it and come to a conclusion and then tell us why it matters? Why not tell us what you think Fed policy ought to be since that is an important subject. Do you understand now?

 

You still fail to understand what velocity is. You'll get there. Do you understand now?

 

Eliminate taxation and houses would become worthless/free?

But then without taxation, would money lack any value to acquire food, clothing, and other needs/wants?

Paper money has value relative to some labour performed to acquire it and then exchange it for the labour of another/others.

 

any reason to think I don't understand the velocity of money??

 

Yea, your comments clearly indicate you don't understand it at all.

 

idiocy:
1) currency has more uses than paying taxes
2) without taxes currency would still have value

 

why so afraid to show which comments exactly?????

 

Well I really didn't want to waste my time going back and reading your comments because you really don't know very much and should be asking questions instead of making comments.

Here's some just from this thread alone...

"Our subject isn't inputs but rather what determines the value of money. Value is determined by Fed which controls the money supply. Their mandate is no inflation or deflation so value of money stays the same."

-- That is not their mandate at all and the Fed does not determine value.

"If they didn't you might expect to see inflation or deflation of 20,000% but oddly it stays at 1-2% exactly where the Fed wants it!!"

-- This would not happen because the Fed doesn't control the money supply.

-------------------------

And in the other thread you say equally ludicrous comments about inflation. You can have inflation without increasing the money supply and you can have deflation while increasing the money supply. Those are the comments that lead me to believe you have no clue what you're talking about and you haven't taken velocity in to any consideration. Understand it now?

 

so then pick the best example of ignorance and tell us why you think it is ignorant.