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.

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