Jordan Hall
software, crypto, math
https://oighty.eth.limo

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What is a Dollar?

It might seem like a simple question. However, it's difficult to give a definition that doesn't reference itself and is at the same time concrete. The dollar has changed over time. Originally, the U.S. dollar was based on the Spanish milled dollar, also known as Pieces of Eight since they were worth 8 reales. At the time, a dollar was standardized as 24-25 grams of silver (depending on the century). In modern times, the dollar is not tied to a quantity of a commodity and the answer to this question has become more complex.

The question has been asked several times to prominent economists and officials, such as Alan Greenspan and Ben Bernanke. The answer is generally something along the lines of "a dollar is what it can buy". Meaning, it is a substitute for a quantity of property, goods, or services that others will give you in exchange for it. To give them credit, this is not self-referential, but it is not exactly concrete. Even if you took one type of service or good, the quantity you could receive varies depending on where you are and who you are trying to buy it from. While I generally agree with them, I will try to provide a more concrete and perhaps less politically evasive answer. Perhaps in thinking through this with me, you gain new insights into how to think about the world's most popular currency.

Not all "dollars" are equal

Consider a related question: In what ways is a dollar represented?

Coinage

The simplest version is coinage. The United States Mint produces coins in a variety of denominations, including $1, that are legal tender. The coin (or combination of coins) is a physical manifestation of a dollar. The metal in the coin has a commodity value, which in some sense provides an intrinsic value to the coin outside of its face value. The Mint must purchase the raw materials and incurs costs to make the coins. In general, the Mint makes money by issuing coins on net whose face value is greater than the cost incurred in making them. This is called seignorage. However, over time the intrinsic value of the metal may change relative to the face value of the coin. When this happens, the coins typically move out of circulation. The most common recent examples were in the 1960s when the silver value of half dollars, quarters, and dimes made them more valuable. The Mint changed the composition of these coins starting in 1965, and the silver-containing ones began to dissapear from circulation. Savvy consumers recognized the increased value of the older coins and preferred to hold those over the newer debased coins, pushing them out of circulation.

Cash (Federal Reserve Notes)

Next, consider cash. In the United States, the only banknotes currently issued and accepted are Federal Reserve Notes. These notes are legal tender by law, liabilities of the Federal Reserve Banks, and are direct obligations of the United States government. Aside from being a piece of paper, Federal Reserve Notes are backed by debt securities held by the Federal Reserve Banks, including Treasury bonds and mortgage-backed securities created by government agencies like Fannie Mae and Freddie Mac. Originally, they were convertible into gold, silver, or Treasury notes at the United States Treasury, but this was stopped in the 1930s. Today, you cannot directly convert a Federal Reserve Note into the securities that back them with the Federal Reserve. However, since the notes are accepted by all banks as legal tender, you could exchange them with a commercial bank or brokerage for similar securities, which is effectively the same thing. Therefore, in a broad sense they are backed by promises of the government to pay back its debt (also in these notes, i.e. infinite loop) or the value of the property for which mortgages were taken out to purchase in addition to buyer's promise to pay and guarantees by the government agencies to backstop the loans (also in these notes). What?!?! This may seem convoluted, and it's true that it makes less sense the closer you get to the Federal Reserve reality distortion field, but bear with me.

Digital "Dollars"

In the modern financial system, most dollars are not represented by the physical manifestations discussed above. Instead, these exist in digital form, that is to say on the ledgers of banks. There are roughly three tiers to this system.

The first tier is Federal Reserve Deposits. These are accounts that the Treasury, foreign governments, and commercial (federal and state charted) banks have with Federal Reserve banks. These entities deposit Treasury bills with a Federal Reserve bank and their account balance is increased by the value of the bills. This "Federal Reserve Deposit" is equivalent to Federal Reserve Notes as a representation of the dollar. If the entities wish to withdraw from their deposit account, they can receive Federal Reserve Notes. Similarly, if they have an excess of physical Federal Reserve Notes, they can deposit them into their account.

The second tier is Commercial Bank Deposits. Consumers and businesses in the U.S. open accounts (checking, savings, etc.) at chartered banks in the U.S. They make deposits into this account by depositing coins, Federal Reserve Notes, or transferring their deposit from another bank (the settlement process here is a little complicated and is the purpose of various payment systems like ACH). In either case, the bank receives the equivalent of Federal Reserve Notes from the customer and gives "Commerical Bank Deposits" in exchange. It's important to distinguish the difference between these deposits and "Federal Reserve Deposits". Commercial Bank Deposits are not strictly speaking legal tender nor are they obligations of the U.S. government. They are obligations of a private entity (the bank) to pay you a certain amount of legal tender. If the bank has solvency issues, they may default on this obligation and not be able to pay you back. This fear is the direct cause of bank runs. In order to provide confidence in the banking system, the government requires banks to get deposit insurance from the Federal Deposit Insurance Corporation (FDIC) up to certain amount for each customer account. If the bank did become insolvent, the insurance will cover the deposit up to the limit (currently $250,000). Additionally, the Federal Reserve banks, acting in their capacity as the "lender of last resort" in the financial system, often steps in to help banks in certain situations to avoid widespread economic damage from a bank failure, including to its customers. The net result is that most people believe Commercial Bank Deposits to represent dollars, but this is not exactly true due to the credit risk. In fact, this belief is so widespread that the majority of commerce in the U.S. appears to take the form of transfers of Commercial Bank Deposits.

The third tier is what I call Non-bank Deposits. These include a variety of non-bank financial institutions like brokerages, payment services (such as Venmo and Paypal), and stablecoin issuers. These institutions have accounts of their own accounts at commercial banks. When a customer deposits funds at one of these institutions, they are effectively transferring a Commercial Bank Deposit from their account to the institutions account at the same or another bank. In return, the customer receives a "Non-bank Deposit" at the institution. Depending on the specific type of institution, there are a lot of nuances here, but a general rule is that these Non-bank Deposits have greater credit risk than Commercial Bank Deposits because there is no FDIC insurance and the institution is more removed from the Federal Reserve as a lender. Brokerages have their own protections for securities that you purchase through them called Securities Investor Protection Corporation (SIPC) insurance, but this is for the actual securities and doesn't cover any cash balance that you have with the brokerage. Interestingly, most people also believe that these Non-bank Deposits represent and are equivalent to dollars, but this is less true than with Commercial Bank Deposits due to the even greater credit risk.

I've introduced these different representations out in a rough continuum from "most reliable" to "most convenient". In short, when selecting a type of "dollar" you are making a decision on what your priorities are for a given purpose. If you wanted to hold "dollars" that are most likely to last over time and have a small amount of commodity backing, you could (after several discussions with confused bankers) convert all of your money to coins and keep them in your house. They would take up a lot of room and it would be fairly cumbersome to buy anything with it. However, the metal will last awhile and if something did happen to the currency, you could melt them down (illegally in certain cases) or trade them based on their specie value. Cash is next, having slightly less staying power and backing compared to metal coins, but is slightly easier to spend. However, you can't easily buy anything online or at a distance with cash. At the other end of the spectrum are Non-bank Deposits, which move at the speed of electricity, but have the most credit risk. In general, choose the form that suits your purposes best (skipping Federal Reserve Deposits since they aren't available to consumers, though a CBDC would be roughly equivalent to them).

While this doesn't directly answer our original question, it provides some insights into what dollars "look" like and how they are used. As it happens, Federal Reserve Notes (and their equivalent Deposits) are the fundamental representation of the dollar which the others are based on. Therefore, let's examine them more closely.

A Mystery Wrapped in an Enigma

As stated before, Federal Reserve Notes (and Deposits) are liabilities of the Federal Reserve and direct obligations of the Government. They are in theory backed by collateral held by the Federal Reserve Banks. The majority of this collateral is in Treasury Bills. Therefore, you could say that a dollar (at best) is currency backed by the Government's promises to pay more currency in the future. In that way, it's a perpetual machine or infinite loop. Fear not though, this essay is not about to devolve into a rousing endorsement to return to the gold standard or some other commodity-backed currency. There is a clever nuance here that bears thinking about. For people to hold their wealth in an asset, they must believe that it will be worth something in the future. By backing the dollar with future dollars, the Government is implicitly saying that they will continue to use the dollar as their standard of value into the future and pay their debts with it. If this mindtrick works, they can enact monetary policy at will to support the economy and have almost infinite resources to do so. What does this mean?

Monetary Policy and the Dollar

Economies go through cycles of expansion. The Federal Reserve attempts to adjust monetary policy so that the expansions and slow downs are moderated. The basic formula is:

By changing their monetary policy, the Federal Reserve influences the expansion (or contraction) rate of the money supply. Econ 101 tells us that supply increases with constant demand cause prices to go down, and supply decreases with constant demand cause prices to go up. In this case, the price is the value of the dollar. A decreasing dollar price means that assets, goods, and services increase in terms of dollars, and vice versa. This is an oversimplification to be sure, but the overarching concept is clear.

Let's compare how this looks in a fiat-backed vs. commodity-backed currency regime.

In the fiat system, they have at least one lever in each case they can pull to a near-infinite level (raising interest rates or injecting liquidity). Liquidity injection (aka quantative easing) is the most controversial. It is a recent development (as of the 2008 financial crisis) and is hard to calibrate (see post-COVID inflation).

In a commodity-backed system, they are limited in the amount of monetary expansion by a requirement to acquire the commodity to back the currency with. Price stability would be derived from the commodity value, not a value assigned to the currency, and their monetary policy would be much less effective. This sounds appealing from a wealth preservation perspective (they can't just print more money), but there are costs and external market dynamics to consider with acquiring and managing the commodity. Not to mention that economic downturns would be more severe and growth could be hampered by lack of liquidity.

Now, I can already here the skeptics shouting: "Remember Weimar!", "What the f&%k!?", "Look at Argentina!". They aren't wrong. Inflation can have a devastating effect on individuals' wealth and on a national economy, especially hyperinflation. If a currency is routinely losing purchasing power, then people stop trusting it. If they don't trust it, they are afraid to hold it and "sell" it for other assets as soon as they can. On a large scale, this exacerbates the problem. Therefore, the government as a whole must ensure that the trust in the value isn't lost.

The specific monetary goals of the Federal Government are to target maximum employment of the country's labor force and an annual inflation figure around 2%.

Let's consider the recent example of the COVID shock in 2020. Due to Government-mandated lockdowns and according to official figures, the unemployment rate jumped from historic lows around 3.5% to 14.8% in a single month. The expected impact of the lockdowns on economic activity were enormous, with many companies unable to operate. The immediate focus of policy shifted to easing the economy to combat this shock. Interest rate targets were dropped to 0% immediately and large amounts of liquidity were injected into markets via open market operations to prevent a cascading economic impact from asset prices crashing. This increased the expansion rate of the money supply. Erring on the side of doing too much, rather than too little, their actions went a little overboard. During this period, loans were extremely cheap and many people leveraged up to consume and invest more. Asset prices increased dramatically from the initial fall, and two years later official inflation numbers reached 8% YoY increases, with certain categories and unofficial values much higher. The net result of this was an accelerating decrease in the dollar's purchasing power.

Once unemployment recovered post-COVID and in response to the increased inflation, the Federal Reserve pivoted and began contracting the expansion of the money supply by increasing interest rates fairly quickly and removing liquidity from the system via open market operations. Asset prices stopped increasing as much and fewer loans were being taken. These actions shored up the dollar and reduced inflation to the current official value of 2.4% YoY increase.

Individual vs. National Interest

It should be obvious at this point that the goal of the Government isn't to preserve the wealth of individuals. They do strive to make the nation collectively wealthy, but this is more a result of growing the gross domestic product and the relative purchasing power of the nation globally. They want a relatively stable currency that allows citizens to grow wealth by engaging in positive economic activity, such as working and investing idle capital. A person who is investing that money back into new businesses, lending it to others who are growing businesses, etc. is contributing economic value. On the other hand, a person who simply holds cash isn't contributing anything to the economy. From the perspective of trying to grow the economy, those funds are misallocated and it's ok if they are diluted of purchasing power.

Let's unpack the Federal Reserve's inflation goal a bit more. Why is the target 2%? Why not 0%? If you're holding dollars, then you generally want no or negative inflation to preserve or grow your wealth. Negative inflation (deflation) is bad because it is a barrier to economic activity, which will ultimately hurt the currency. The reason this is the case is that no one wants to borrow in a currency that is increasing in value over time. They prefer to borrow an asset that is inflating so they can pay it back with less purchasing power in the future. For this reason, a small amount of inflation stimulates economic activity because it induces people to borrow. In the other direction, if inflation is too high, it affects people's daily lives more. A 2% annual increase is hardly noticeable on a month to month basis, but higher values would impact their ability to pay daily expenses. Therefore, this 2% value is viewed as a good middle ground.

In practice, most people don't hold huge balances of "dollars" anyway. They keep a minimum amount to fund their living expenses, and if able, invest the rest in savings accounts, bonds, stocks, etc. If they don't, they are making a tradeoff (whether conscious or not) of accepting some dilution in return for not taking on any credit or value risk.

Hazarding an Answer

Therefore, my definition of the dollar is:

A dollar is a unit of currency managed by the U.S. Government to steer economic activity towards their overarching goals, which they believe provide the most overall benefit to United States as a nation. Its value is derived from a combination of the Government's legal tender mandate, the size of the U.S. economy and foreign trade conducted in dollars, and the liquidity of the dollar in the financial system, facilitated by the Federal Reserve's monetary policy.

Whew, probably not perfect, but I think it reasonably captures the Government's intent and major dynamics in the financial system. I'll let you decide whether you believe it or not.

Trouble in Paradise

Up to this point, this should seem fairly reasonable. The idea of uncontrolled monetary expansion may be concerning, but simple economic factors don't create situations where this is necessary except in extreme cases (e.g. the COVID shock). While it's a little disappointing as an individual that the Government currency is not prioritizing the purchasing power of individual dollars, there are various other assets and financial instruments that can help individuals do this.

However, problems can begin when fiat-based monetary policy intersects with uncontrolled fiscal policy. Fiscal policy is the management of the Government's budget and overall debt. It's no secret that in the last ~20 years, the Government went from a mostly balanced budget and seemingly "reasonable" debt levels to large spending deficits and a ballooning debt figure. Large defense spending, multiple market crashes, and rising entitlements costs have combined to make the total debt greater than the national GDP. In recent years, the interest rate increases needed to control monetary policy have increased the borrowing costs for the Government in line and caused the deficit to grow just from financing costs. The idea that the nation can balance its budget, run a surplus, and begin paying down the debt is viewed skeptically by many. My personal opinion is that we have to reckon with longstanding problems and then grow ourselves out of the current hole, but that is easier said than done. It would require a new technology wave, perhaps fueled by AI, to get the growth we need. Entitlement reform and fiscal austerity are not popular in either political party. Both parties see the writing on the wall, but they won't risk the resulting hardships being pinned on them. I digress here, but the point is that the Government's fiscal position has worsened over time, and it's unclear that it will get better anytime soon. The question is then "when is this a problem?" and, since this is an article about money, "what does it mean for the dollar?".

A large factor in the ability of the dollar to maintain its position, aside from domestic monetary policy, is its status as the global reserve currency. Other countries hold more dollars as foreign reserves than any other currency or commodity. Major markets, such as oil, have their prices denominated in dollars, and many nations settle trade in dollars. This creates a continual demand for dollars from the rest of the world. As they grow and require more dollars, we indirectly benefit from this since there is addtional demand for dollars, which supports its purchasing power.

A bad, but possible outcome, of irresponsible fiscal policy is that these other countries may try to find another currency to replace the dollar for settling trade and holding as reserves. If they believe the United States cannot pay back the Treasury bills that they buy without issuing many new dollars to do so (and therefore inflating the money supply and reducing its value), then they may stop holding dollars and buying Treasury bills. This would result in lower demand for new Treasury issuances, which would then require monetary policy expansion to support the Government's fiscal requirements.

Wait, what does monetary policy have to do with this? Isn't this a fiscal problem? Unfortunately, the two are inextricably linked. Imagine that the Treasury needs to borrow $1T to fund a given year's budget deficit. They can auction to raise the amount, but the interest rate is higher than expected. The Government ends up paying more interest and future deficits increase. Perhaps the credit rating of the Government is downgraded by ratings agencies. At the next auction, the same thing happens, and they start paying a higher rate. The increasing debt raises remove liquidity from the system, acting as a depressant on the market (though a good amount is paid back out to government contractors, employees, and entitlment recipients). Meanwhile, the Federal Reserve is holding a large amount of T-bills, which are ostensible collateral for Federal Reserve Notes. The Federal Reserve would be put in a tough position to lower interest rates or provide liquidity to the market, but this risks increasing inflation.

It's unclear how this will play out and if monetary policy ends up being effected by fiscal policy to a large degree. If so, it will be a reckoning for everyone and undercut the goals of the Federal Reserve in managing the dollar.