I often see people express the idea that the production or destruction of money must necessarily cause problems for the economy because that money does not “represent new real wealth”. There are many variants of this notion, such as that “good money” must “represent” some real asset (like gold).
However, this notion is fundamentally confused.
First, notice that as method of economic reasoning “representation” not great; there is no deep economic notion of “representation”. At best it could be a heuristic, you notice that money is not connected to particular real projects and think “huh, that’s weird” and decide to investigate further.
Next, notice that financial assets in general do not derive their value from “representing” some project or another. A financial asset derives its value from another party’s credible promise that the holder of the financial asset may receive something of value at some point in the future. For example, a corporation may issue bonds to undertake a new project and these bonds will have value, but the value is not derived from the project, the value is derived from the promise the corporation gives that the bonds will be honored. Such corporate bonds would have the same value whether the corporation issued them for a new profitable project or an unprofitable project or because of a clerical error, and they would cease to have value if the corporation’s promise went away.
Financial assets are useful because they are useful to either the issuer or the holder. Bonds allow businesses to undertake projects or smooth out cash flows; stocks allow businesses to get initial capital and allow investors to store resources; money helps lower transactions costs for people.
Finally, note that a financial asset is an asset to one party (the holder) and a liability to another party (the issuer). The subjective value of the asset to the holder may be larger or smaller than the subjective value of the liability to the issuer.
The US dollar has value because there are implicit (but credible) promises that it can be exchanged for something of value. These promises come from two sources: 1) the general public because they currently accept money as payment for other things of value 2) the Federal Reserve because they implicitly promise that they will trade dollars for something else of value in order to make sure that dollars continue to be valuable. Like other financial assets, its value has nothing to do with whether it represents real assets or not, and whether the economy would be better off with more or less of it has nothing to do with whether it “represents” real projects.
This was an attempt to address a popular confusion. I’m not totally satisfied with it, so if you have suggestions on how to improve it or know an article that does it better, let me know.
Good Morning, Economics 
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January 29, 2011 at 10:38 am
washingtonfreeman
“corporate bonds would have the same value whether the corporation issued them for a new profitable project or an unprofitable projector or because of a clerical error”
This seems false. See: Enron. If the corporation isn’t profitable, wouldn’t that threaten their ability to repay the bonds?
“the general public because they currently accept money as payment for other things of value”
Yes, but that fluctuates with prices as the money supply changes. So this source of “value” is suspect.
“the Federal Reserve because they implicitly promise that they will trade dollars for something else of value”
They do? What will the federal reserve trade for dollars? Other financial instruments based on the value of the dollar? How is that a guarantee of the value of a dollar?
January 29, 2011 at 10:38 am
washingtonfreeman
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January 29, 2011 at 12:12 pm
jsalvati
To clarify, when I say ‘value’ I mean something like ‘marginal highest willingness to pay’, not some notion of ‘inherent value’. Notions of ‘inherent value’ are worse than useless.
1) Notice that the important fact is the credibility of their promise to repay, *not* how profitable their project is. The credibility of the promise and the profitability of the project are obviously related, but it’s an analytical mistake to conflate the two. The profitability of the project affects the value of the security only though its effect on the credibility of the promise. If you know the credibility of the promise, knowing
For example, a big corporation may issue bonds “for” undertaking some project. However, even if that projects makes no money whatsoever, the bonds can easily be worth their full value.
It’s important to make this distinction because lots of bad arguments you hear about money hinge on this point. For example, it’s common to claim that fiat money is “valueless”.
2-3) The way to answer both of these objections is with the notion of “current, local, stable equilibrium”.
The fact that businesses currently accept money in return for other things of value means that US dollars has value for people. It might not in vastly different circumstances (it’s a local property), but it does in the current circumstances (it’s a current property).
As a local property, the Fed promises that US dollars will continue to have value by exchanging them for something else of value when they become less desired.
To make this clearer, lets say that the dollar loses half its value overnight (say demand for money drops 1/2 and prices adjust unnaturally quickly this time). The Fed still has the ability to influence the value of money in either direction. People still value money normally and still value government bonds, though less than they used to. Decreasing the quantity of money by exchanging money for government bonds (at some price) makes money scarcer and increases the value of money. As long as the assets the Fed works with have *some* value they can be used to influence the value of US dollars in either direction.