What makes currency valuable? A common answer to that question, one that I used to give, is that trust is what gives money its value 1. We all – society – have a shared belief in the stability of the United States Dollar and the institutions that control it, and therefore it is valuable. The logic follows that if everyone were to stop trusting the full faith and credit of the Federal Reserve or the US government then the dollar would collapse in value and society would fall apart.
This "trust theory of money" is so common that it feels like it has been around forever. But to the best of my knowledge, it is only a little more than a hundred years old. After all, fiat currency is a relatively new invention. One of the earliest instances of it comes from a German economist, Georg Knapp, who was active at the turn of the 19th and 20th centuries. "Money is a creature of the law", Knapp argued 2 in 1905, and the law requires the trust and cooperation of society. Without that trust and cooperation, money must be inherently valueless.
From this "trust theory of money" flow two other ideas: cryptocurrency and Modern Monetary Theory (MMT). Advocates of cryptocurrency worry that central banks and other institutions that control the money supply are not trustworthy or not always going to be trustworthy. They want money to be backed by an institution that is more deserving of trust and less susceptible to manipulation, namely, mathematics and cryptography 3. This belief is similar to those held by advocates of Sound Money or “metalists” – people who believe that money should only ever be backed by gold, silver, or other precious metals. Yet it is also more ambitious and more inclusive, in that a well-designed cryptocurrency system could allow more people to participate in the global economy than what the bank-dependent fiat current system allows 4. Cryptocurrency advocates, in essence, say "there's nothing wrong with the way we use money, though money should be something different" 5.
Modern Monetary Theorists are at the opposite end of the spectrum. They don't have trouble trusting the Federal Reserve or US Government, in fact, they take the "trust theory of money" to its logical conclusions: money is only a legal entity and nothing more. In fact, money can easily be created if the institutions we trust just make more of it. This happens not by banks lending more money, but by the government spending more of it. The value of this newly created money comes from the demand generated for it by taxes. That demand is generated because we all trust that the government will use its monopoly on the threat of violence to enforce its tax laws that require us to pay the government in the same currency it spends. Modern Monetary Theorists say that we need to exploit this property of money to stimulate more economic activity simply by increasing government spending without worrying about the resulting deficits 6. Modern Monetary Theorists say "there's nothing wrong with what money is, though we should be using it differently" 7.
But how do these two ideas hold up if money is more than just "a creature of the law"? What if money is actually a commodity or something else with inherent value in and of itself?
The labor theory of money
This alternative idea of money that we will explore begins with Marx 8. and turns into something slightly different. The connection to Marx is ironic, as advocates of MMT like Bernie Sander's economic adviser Stephanie Kelton, are often accused of being Marxist by their political detractors 9. The idea is that money, in any form (gold, fiat, or anything else) is just a commodity like anything else traded in a market. A particular commodity becomes money because society has agreed to use it as such. Its value comes not from us trusting it, but from it being a commodity in and of itself. If we wanted something else to become money then that thing first must itself be a commodity.
So how does something become a commodity? It must have a "use value" and an "exchange value". The "use value" part is easy. A "use value" is a qualitative thing; something has a particular "use value" if it fulfills some human want or need. "Exchange value", on the other hand, is a quantitative idea. It is essentially how much "congealed, socially-acceptable" human labor that was required to make it 10.
If I were to hand-craft a piece of furniture and persuade you to give me some of your fresh, home-baked bread in exchange for it, we are (according to Marx) implicitly agreeing that there is something in my furniture that is directly comparable to something in your bread. That something is "exchange value" and comes from the only two things that both items have in common: the labor we invested in making them and the fact that we are exchanging them. But what if I put in an extraordinary amount of time into making my furniture – either because I am clumsy or because I lacked the required tools? To answer this we have to pass from my own personal labor and to the average amount of labor time that our society would expect it to take to make such a piece of furniture 11. In fact, Marx believed that a good or service only becomes a commodity (and thus only takes on its “exchange value”) when it is actually exchanged, though that value originates in the labor invested into the commodity. This is analogous to Newton’s laws; Work only happens when an object moves regardless of how much Force was applied to it. Once it does move, Work is proportional to that Force. Exchange value only happens when items are exchanged, but the value itself is proportional to the labor invested in the commodities. 12 This is what is meant by "congealed, socially-acceptable" human labor.
Marx goes on to argue that gold – which has a lot of "exchange value" because of the human labor that went into mining it – is especially useful as a money commodity because of its weight, divisibility, et cetera. It is not that money is always gold, but that gold makes a particularly good form of money. And this made perfect sense in 1867 when Capital was first published 13. But today's currencies – the dollar, the euro, et cetera – are freely floating fiat currencies; they have no obvious connection to gold or other precious metals. Yet this is a recent invention. The dollar was a symbol for gold while the "Gold Standard" lasted (as were other currencies.) The dollar was used for convenience, but gold was still the thing. It was technically convertible to a specific quantity of gold up until the "Nixon shock" of 1971.
The Federal Reserve and the institutions that control the supply of the dollar, however, still hold a considerable supply of gold 14, as well as US Treasury bonds, corporate bonds, foreign currency, and other securities. The value of gold, as we discussed, still comes from human labor. But these bonds have value because we trust the US Treasury department, or other issuers, to repay them. But this is not blind trust! These treasury bonds are financed via taxes 15 on the exchange of commodities (such as the sale of a physical commodity in the case of a sales tax, or the sale of a person's services in the case of an income tax.) Corporate revenues are financed by future labor for which that corporation holds some claim. So while these institutions no longer have a legal requirement to exchange the dollar for gold, the value of the dollar is still backed by other symbols of human labor.
In other words, gold was money because it was a symbol of a unit of human labor, and it was that human labor that made money valuable. The dollar used to be a symbol for gold, and thus for human labor. It has changed since then, but now it a symbol for a combination of other securities all of which are symbols in the end for human labor. The "labor theory of money" says that money, even in the form of a freely-floating fiat currency, has inherent value as a representation of a unit of human labor; money has value because it is what you get in exchange for work.
This "labor theory of money" feels more correct than the former "trust theory of money". If you work all day and get a paycheck for it then that paycheck certainly feels like a symbol for your labor. Even so, I am not advocating this idea as the one true idea behind money. Rather I want to return to evaluating those other two ideas, cryptocurrency and MMT, from the lens of this "labor theory of money".
Cryptocurrency and the labor theory of money
Cryptocurrency advocates are keenly aware that their cryptocurrencies are not yet legitimate forms of money 16. This is because it fails to live up to the 3 "use values" of money: a medium of exchange, a unit of measure, and a store of value. Naively, one might conclude that cryptocurrencies might remedy this by encouraging more people to use their platform. But our "labor theory of money" says otherwise. Cryptocurrency is a poor medium of exchange of human labor, it is not a great unit of measuring human labor, and it doesn't store the value of human labor because cryptocurrency neither lays claim to nor contains any human labor. Whereas the dollar "contains" human labor in the form of reserves of precious metals, bonds, taxes, et cetera, the best that can be said of cryptocurrency is that it embodies the labor of the programmers who work on it plus the labor of the utility workers who generated the electricity that powers the computers on which the cryptocurrency platform runs. While I haven't proposed a way to measure the amount of human labor contained within the dollar or any other item 17, I think it is fair to say that a national government can claim to represent a much broader base of human labor activity than any cryptocurrency can. Cryptocurrency advocates might do better to advance their cause by paying their programmers in cryptocurrencies rather than fiat currencies – though this would create other obvious problems for the advancement of cryptocurrency.
Cryptocurrencies by definition require cryptography 18, in other words, mathematical facts. And mathematical facts might as well be a part of nature. So if cryptocurrency were to have any type of inherent value (different from "use value" or "exchange value") it would have to be of a similar sort of value to that of raw, unrefined elements of nature. The difference is that gold, wood, coal, et cetera all require some human labor to extract, whereas cryptocurrency only requires electricity and a computer program to "mine" its elements of nature. Indeed, some have argued 19 that the market for cryptocurrencies behaves like that for physical commodities, especially precious metals, relative to fiat currencies.
Another similarity between cryptocurrencies and precious metals is the motivations of those who wish them to be used as money. Cryptocurrency advocates, like "metalists", seek to rid money of its manager, the central bank, whom they view with suspicious and as someone opposed to liberty and economic equality 20. This "labor theory of money" suggests that a currency would benefit from "active management", id est, from some entity that can grow or contract the supply of money when the value of labor itself changes.
Human labor in 1867 is not worth the same as human labor in 2020. We know that – through education, or its neglect; innovation, or lack thereof; technological advances, or regressions – the productivity of the average human laborer goes up or down over time. So if money is to fulfill the "use values" we require, especially a store of value, it must also go up and down. The amount of labor represented by a single dollar must change. Cryptocurrency advocates – and advocates of the gold standard – point to the erosion of the dollar's value by inflation caused by the banking system. By one estimates 21 today's dollar is worth about 3% of the 1860's US dollar. But if you were to pay someone $15/hr to complete a certain task today, how much would that same labor be in 1860? Considering that today's workers – with the tools and education available to them – can do so much more with much less labor, I do not think that 3% figure is all that much off. One hour of work from today's workers might produce some commodity or service that would be worth $15, but if that same hour of work came from a worker from 1860 then perhaps the result would only be worth 3%, or 48 cents.
That is not to say that the "labor theory of money" does not imply that inflation is a risk. The danger posed by inflation, according to our theory, is that whatever item was chosen to be the money commodity would fall out of practical use. Even the tax requirement could become unfashionable; governments or whoever controlled the money supply, could create money so much faster than the productivity of labor is increasing that even the government would want taxes collected in a different form 22.
MMT and the labor theory of money
All this talk of inflation is taking us back to MMT, so let us see how the "labor theory of money" treats it. In fact, the "labor theory of money" is just as opposed to MMT as it is to cryptocurrency. Our theory starts with the axiom that money is a commodity – it fulfills certain specific use-values related to the function of money and is the embodiment of human labor. MMT, however, says that money is a legal creature created through government spending and killed off via taxes. When the government creates too much money, id est, spends too much, it acquires goods, resources, and labor, causing demand for them to rise and therefore prices to rise. MMT argues that this resulting inflation is the primary danger of government spending. It otherwise views government spending as benign or even a way to fight unemployment. Should unemployment rise too high, the government can create more money by spending more and cause the demand for goods and services to rise directly or indirectly. If the tax regime were thorough enough, that is, if all economic activities and exchanges were taxed, then a citizen would essentially be forced to collect some of the newly created money to pay his taxes. So this should cause unemployment to fall. Inflation is only a possibility when the economy is already near full employment.
So while these two theories are diametrically opposed, they do agree that there is a certain limit to money creation before inflation becomes a real threat. For the "labor theory of money" – it happens when money is created faster than the average productivity of labor is rising, but for MMT it happens when money is created while the economy is in full employment (this employment could be of low or high productivity.) But they do not agree on the increase in government spending to fight unemployment.
Mainstream economists argue that when a government wants to spend more than it takes in through taxes it must resort to issuing debt, and that doing too much of this will lead to skyrocketing inflation. Modern Monetary Theorists argue that new debt is not the only answer; a government can always print more currency (or create it digitally). The actual spending of that money distributes it through the economy, and the taxing of it is what gives it value. But in the "labor theory of money", this new government money (together with the resulting taxes) is a claim on the labor of the population, even a claim on the labor of the grandchildren of today's citizens. The danger of "too much spending" isn't just inflation, but it is also that future citizens would be unable to accumulate any wealth or otherwise hold on to any of the "exchange values" they create through their labor. It would all be taken away in taxes. In this way, the "labor theory of money" is more similar to arguments proposed by an advocate of Sound Money or cryptocurrency.
Monetary theories and the financial crash
So far we have not mentioned the reason MMT is worth thinking about at all: that it may better explain the macroeconomic situation following the Great Financial Crash. From one (naive) level, the initial crash was followed in the US by massive government bailouts of banks and other industries to prop-up the economy. Many people, myself included, thought that all this new cash being pumped into the economy would cause massive inflation 23. And when central bank interest rates went closer and closer to zero (which is the main form of increasing the money supply according to mainstream economic theories that are different to MMT or the "labor theory of money" explored here) this appeared to be more certain. But it never happened. Across most of the developed world interest rates were at record lows and inflation barely appeared. Some developed economies actually experienced deflation.
A slightly more sophisticated view saw that outside of the US money was being created via monetary policy (by this I mean low interest rates) but not at all through government spending. Most European countries embraced "austerity", a combination of lower government spending and higher taxes. The low interest rates should have meant that there was a flood of new money flowing into the economy, which would result in inflation. But, as we already said, this never happened.
This is where MMT takes the spotlight. The US never embraced austerity to the extent that European countries did, and the US economy experienced slightly more inflation than Europe. It also emerged from the recession more quickly and continued to grow more robustly until the 2020 pandemic 24. Recall that MMT argues that money is created through government spending – not bank interest rates. Since the US continued its rate of government spending it continued to create new money and fight off unemployment, according to MMT. Europe turned off the taps. So perhaps austerity was never great economics and Modern Monetary Theorists are on to something. Or maybe the paper that argued for austerity in the first place had an Excel error that invalidated the whole argument and that the authors tried to cover up 25.
So how does the "labor theory of money" explain this lack of inflation? The period before, during, and after the financial crash saw robust advances in education and technology 26. Many of these changes – broadband internet, smartphones, better telecommunications – had been available but were not yet realized in the workplace. The advances in productivity had yet to be "congealed" into the mass of human labor. When companies began to lay off people and ask the remaining employees to do the same work, those productivity gains started to be realized by shareholders, and the amount of labor reflected in a single unit of currency rose, preventing inflation. So we entered a period were fewer people could do more work and those exchange values were captured by a smaller group of people.
Cryptocurrencies and MMT both have technical frameworks for economists to work out the details of their claims, back them up with statistics and economic data, and demonstrate that their ideas do or do not reflect reality. Any theory needs to undergo the same scientific process of careful study and experimentation before it should be accepted. But as far as I am aware, no such technical framework exists for our "labor theory of money". These ideas are not precise and are hard to translate into something that can be compared with actual economic data. This is a shame, as there is probably another situation coming similar to that which followed the Great Recession. Artificial intelligence has advanced greatly in the past decade, and it is hard not to argue that workers so enabled would be several times more productive than workers without it. Yet many of these productivity gains have yet to be realized by the labor market. Our current economic situation also has rising unemployment and fewer workers being asked to do greater amounts of work, so those gains may soon be realized and a small group may capture all the excess value. If this is the case, we could all benefit from a theory that could recognize, predict, and remedy such situations.
Thank you to Gabriella Abraham, Lawrence Dallman, and Jagna Feierabend for reading earlier drafts of this essay.