Friday, October 10, 2008

Econ 101: Confidence and Money

All of this talk about a lack of confidence in the credit markets causing all of this turmoil makes me think of one of the most basic economic mechanisms that exists - fiat money. Fiat money is essentially money that is backed by the full faith an confidence of the government (and, by fiat, must be accepted as a means of exchange) but not backed by any real commodity, like gold. We take the solidity of the Dollar for granted in the United States. In fact, I am reasonably confident that I can take a wad of dollars almost any place on earth and it will be accepted for exchange (and usually much more happily accepted than the local currency) - far out of the reach of the US government. How on earth can a simple piece of printed paper be so valuable? Well, because we believe it is.

What I believe, and what most people in the world believe, is that I will always be able to exchange Dollars for stuff: goods, services, interest, etc. And the reason I believe it is because everyone else believes it too - the fact that others believe it is what makes them willing to exchange stuff for my dollars. This is what gives the Dollars its value. It is a confidence game.

The Dollar is still the international currency of choice, thanks in large part to the dominance and stability of the US economy and government. What would happen if this crisis shakes world confidence in the US so much that the Dollar and US Treasuries are no longer seen as safe harbors (in other words, what happens if people start to believe that the US could possibly default)? The Dollar could suddenly become essentially worthless for international transactions. I am not predicting this, in fact I predict that the Dollar will remain the currency of choice and perhaps even more so now that the world is watching Europe struggle to come up with a coordinated response to the crisis lowering slightly their confidence in the Euro.

What if I started worrying about the US government and the monetary system, I might prefer to take payment in kind for my services. If a lot of people felt this way pretty soon that piece of paper with George Washington's face on it, is just a nice memento. Again, I am not suggesting this is where we are headed, rather I wanted to use this amazing demonstration of a crisis in confidence to point out how something as fundamental as currency relies on confidence.

It is pretty amazing when you think of it. A bunch of carefully printed pieces of paper in my wallet allow me access to an amazing array of goods and services - simply because we all believe in them. So it is not "In God We Trust" it is really in each other that we trust.


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