John Maynard Keynes famously said that “the market can stay irrational longer than you can stay solvent.” But the converse is also true: the market can become rational suddenly, and sooner than you expect. When people come to expect irrationality as a matter of course, then they are vulnerable to a sudden onset of rationality. Crashes and hyperinflationary events can be treated as events caused by a society that has gradually become complacent in its irrationality. A crash happens when people become too committed to particular enterprises and there is no one left to help out with a mistake. Hyperinflations happen when people begin to accept lower levels of inflation as a matter of course.

Understanding these phenomena is a matter of understanding when people prefer to hold cash or buy investments, the effect that this decision has on the economy, and how inflation of the money supply changes the incentives of the decision. That is what this article is about, and here are my definitions of the concepts I’ll be discussing.

Money: Money is an abstract concept that applies to whatever good is the most liquid. The value of having money, from the standpoint of an investor, is that it is the easiest good to get rid of in the market, which is what it means to be the most liquid. This means that if there is something especially good for sale, the person with ready cash on hands gets first dibs on it.

Cash: Different goods can be money at different times. Because I want to talk about the process by which a good loses its status as money, I will use cash to refer to a good that is money now, but in the future might no longer be money. If that happens, the status of money would switch to some other good, and cash would become worthless paper or worthless numbers in a computer. Whereas money is an abstract concept, cash is a specific good.

Savings: the portion of an investor’s portfolio held in cash.

Investment: goods other than cash which are bought because of an expected future benefit rather than for immediate consumption. This could be because it provides income, like a bond or a stock with a dividend, or because you expect its price to go up eventually. I don’t distinguish between different kinds of investments because the difference is not relevant to the issues I am discussing. If I use a company stock as an example, I could just as easily be talking about a bond, or commodity future, or a baseball card, or anything. When I say ‘stock market,’ I’m talking about the market for all investments, not a literal stock market.

This article is entirely about cash versus any other investment and why someone would prefer one over the other, so that is why cash is not considered an investment for the purposes of this article. However, cash can be an investment in the sense that someone might buy it because he anticipates it becoming more expensive later. If he expect a stock market crash, he can go into cash with the expectation that you’ll be able to buy stocks again more cheaply once the crash happens. One can also hold cash without investing because cash has a present benefit, which is its liquidity. This is discussed in more detail below.

Inflation: Inflation here refers to an increase in the money supply rather than an increase of prices. The reason is that if an investor knows the money supply is increasing, then he will anticipate his cash growing less valuable relative to what it would have been if the supply had not grown. He will do this even if there is no apparent price inflation yet. In general, investors learn to react to causes in anticipation of price changes because if they wait around for price changes to actually happen, then they have missed an opportunity.

This article presents an idealized picture of the economy in which it is objective what is money and what isn’t, and in which the money is managed by the issuer in a very simple way, that is, by issuing more. Our economy is a lot more complicated, but I would contend (without defending here) that the way to understand the real world is to unravel the mess and find this idealized scenario within. I don’t think that the real-world national currencies work in a fundamentally different way from what I have described.

I recently wrote an article on the growth of money called “It’s Not About the Technology, It’s About the Money”. This article can be seen as a continuation of that one, but it can be read independently. That article is mostly about a positive-feedback between the use of money and its value. That is, as more people use a good as money, it becomes more useful as money, as a result of becoming more liquid. This article is about how money interacts with the rest of the economy after it has matured and about how mismanagement by an issuer can cause it to fail.

The Value of Money

One thing that confused people a lot about Bitcoin in the very early days was how could it possibly be valuable, given that it’s nothing but a bunch of numbers in computers. It’s not that people were foolish to think that Bitcoin wasn’t valuable back then; actually they were foolish for not asking the same question about all forms of money. For already at that time people were paying real dollars for numbers in a computer (World of Warcraft gold or Farmville upgrades), and most real dollars were by that time also nothing more than numbers in a computer. Thus, there was nothing special about Bitcoin as a form of money.

What prevents us all from just throwing our dollar bills on the ground and saying, “These were all just pieces of paper all along! Why did I ever think they were valuable?” Seemingly not a likely scenario, but no currency lasts forever. I will argue that money serves a valuable function in investment, and the benefits which accrue to those who invest successfully in money explains why people are willing to hold on to it.

First I wish briefly to dispel the notion that money’s value derives from its use as a medium-of-exchange. Money is useful as a medium-of-exchange because it is valuable, not the other way around. This can be seen to be true by the fact that you can use money as a medium-of-exchange without adding to its demand. If you earn a bunch of money and then spend it again almost immediately after, you’ve used the money as a medium-of-exchange but you got rid of it so quickly that you have immediately negated the effect of demanding it.

In order for the value of money to go up, people have to want to hold more of it at a time or hold it for longer periods of time. In other words, the value of money is caused by its demand for use as savings instead. Someone can live hand-to-mouth and have only an amount of money they need on hand for the immediate future. Other people can have a large savings but still spend roughly same amount that they earn. Other people can spend less or more than what they earn in order to increase or decrease their savings. The value of money can be understood in terms of the reasons that make people want a lot of savings or a little, and changes to the value of money, both slow and rapid, can be explained in terms of reasons that change how much people value their savings.

A Function of Savings

Here is a very real benefit of holding cash. People with cash are able to remain agnostic as to what they want to buy until the very last moment. They are more prepared for unexpected expenses and opportunities, and therefore free from the need to plan. A person with savings can treat as ordinary expenses things that would be disasters for people who didn’t have savings. Most people, if they have a big enough income, would choose to buy insurance for their car, home, or health. But someone with a lot of savings doesn’t need as much help from other people.

He is also more in a position to help other people who have been struck with disaster. Not only is he in a position to be nice if people should need help, but he is also in a position to profit from doing so. A business has certain expenses that it must make regularly or go out of business. It must make payroll, for example. There is always some risk that the company will not have enough revenue for some time. The company could reduce this risk by holding extra cash, or it could use the cash to buy more capital and attempt to expand its future production. It is difficult to maintain the right balance because circumstances are constantly changing and uncertain, so even fundamentally sound businesses sometimes end up in an immediate need for cash. When that happens the business’s stock price goes down because their risk of insolvency goes up. They may also be willing to take out a loan at a very favorable rate for the lender. An investor with cash on hand can help an otherwise worthwhile business survive by taking care of their immediate expenses and in return can buy the stock at a good value or earn a good rate of interest off a bond.

However, this kind of opportunity does not last forever. Investors who have cash get first dibs on it. When one is in cash, one is uncommitted and ready for opportunity. By contrast, a lot of the potential value of an investment depends on being able to choose when to sell it. A given investment can always go down for a while, even if the investor ultimately is able to sell it at a profit. An investment has a much better chance of being valuable if the investor can expect to hold it long enough that a good selling opportunity will have occurred. Furthermore, although on ordinary days it may seem as if a stock will be easy to sell at any time, there are days when most investments other than cash drop at the same time. During these days it may not be possible to sell investments fast enough and it is much better to have cash on hand in the first place.

Thus, a cash-holder benefits himself by being prepared to take advantage of the best deals, and provides the corresponding benefit to the economy of being prepared to jump in where help is needed. The cash-holders benefit the economy by deciding which troubled businesses can be redeemed and then providing the necessary cash.

Of course, it is not the cash itself that fixes the troubled business. The cash is used to buy the necessary resources to do so. For example, it could be used to pay employees to keep them working until some new revenue comes in. Thus, the existence of cash-holders in an economy can be thought of as meaning that some fraction of the economy’s production is reserved to be diverted to error correction.

The Problem of Overinvestment

A cash-holder can live idly and can avoid making investments. It would be a mistake to look at this person and say that he is not contributing anything. The ability to live idly is also an ability to become committed at any time, to whatever has the greatest need. People depend on this service because it is impossible to avoid error, and insofar as everyone in the economy depends on everyone else, we are all subject to one another's’ errors.

A person who is uncommitted cannot step in to fix every problem that might arise. Eventually he will be committed himself and can take on no additional projects. Therefore, if there is a lot of money held in cash, then there is a lot of tolerance for error in the economy, whereas if there is little, then the economy is much less error-tolerant. Thus, the problem of overinvestment is a reduced capacity for error-correction. If everyone decides to put their money to work now, then theoretically more can be accomplished at once, but at a much greater risk of failure. If a lot of cash-holders remain on the sidelines, then less can be ventured, but at a greater probability of success.

Because an error in one business can affect the businesses that depend on it, then when people are overinvested, not only is there a greater risk of error, but the consequences of errors are more severe. For example, suppose that two businesses, A and B, both make short-term errors that require correction. In a healthy economy, maybe one or the other would have failed, but the other would have been rescued, whereas in an overinvested economy, both fail. Now suppose that business C can tolerate either A or B failing to follow through on a deal, but not both. Then C also needs to be rescued. However, it too evidently fails as well.

Thus, it is possible, in an overinvested economy, for a small error to turn into a big error because there is no one prepared to fix it while it is small. This is an economic crash. When too many people become invested and not enough remain uncommitted, then everyone in the economy must move in lock-step with one another. In a healthy economy, there is a lot more room for everybody screw up.

Why Money Persists

I am now in a position to talk about why money persists, despite the fact that it is merely a shared hallucination. Why don’t people, so to speak, wake up and throw their money on the ground? In my previous article I explained the growth of money as a step-by-step process in which a good becomes monetized as one investor after another comes to treat it like money.

One might also suppose that the opposite process is possible, in which investors lose confidence in their money as they successively dump it, one by one. In order to explain the persistence of money, we would need a reason for someone to want to buy cash that another person wanted to dump.

Let us suppose that an investor was actually worried about his cash losing all value. This person would prefer to hold investments over cash under circumstances in which someone else would prefer to hold cash. Or, conversely, let us suppose that he loves stocks so much and doesn’t understand the value of cash very well that he sells everything so as to be fully invested. Either way, the effect is the same. When he sells cash for investments, he very slightly increases the price of the stock market relative to the supply of cash. He has therefore very slightly increased the demonetization risk of cash and simultaneously the risk of a crash in the stock market.

The other investors may respond to his move by judging the demonetization risk or the stock market crash risk to be greater. If they judge the crash risk to be greater, then they will sell off stocks for additional cash, thus opposing the first investor’s action. If they judge the demonetization risk to be greater, then they will follow him and dump their cash themselves.

An old and consequently well-established currency will tend to be perceived as secure because the investors have a lot of experience seeing one another rely on cash as a safe haven. Thus, they will tend to (correctly) perceive the stock market as more risky than cash. On the other hand, if there is reason to believe that other investors are losing confidence in their money, then it is possible for other investors to prefer the stock market risk to the currency risk. If enough of them do this, then the currency is demonetized, just as they had feared.

The persistence of money, therefore, is explained by the fact that there is a more immediate need to reduce risk from investments rather than from demonetization. There is even a natural price for money. It is not like an ordinary price, which is the ratio by which two goods are exchanged. But you can think of the price of money as being the ratio of the total supply of money to some measure of the value of all investments in the economy. (In the real world, there are many different numbers that one could use to represent this price because people can disagree about how to correctly measure each of these.)

Changes to the Supply of Money

This section is about how changes to the money supply change investors’ incentives about whether to hold cash or to be invested. Deflation is when the supply decreases, and inflation is when it increases. The most important thing about changes to the money supply is that they happen at specific places as a result of specific actions. Whenever there is deflation, there is a deflator. Whenever there is inflation, there is an inflator. In other words, money doesn’t generate or disappear evenly—some specific person holds it.

Deflation is true charity because the deflator works or invests to earn money and then destroys it rather than demanding anything back. Therefore, people don’t do it very much. Inflation is the one you need to worry about because the person who does it gets money for nothing. That means everyone would do it if they could get away with it. Someone who can just print up money has a big advantage over someone who actually saves money because he can print up more whenever he wants. He can take advantage of good deals immediately rather than putting in the work of collecting a sum of cash in the first place. Therefore, someone who can print money discourages everyone else from holding cash. They are incentivized to invest instead.

Of course, the inflator does not actually do anything to cause more resources to come into existence to match the new money he creates. He drives people away from their saving and into investments. Prices rise because they are all buying. There is no one left to who is prepared to correct errors. The investors cannot because they have reduced their savings. The inflator cannot because prices have risen and production cannot be diverted as easily as before. Thus, although the inflator appears, to the rest of the economy, like an investor with a lot of cash on hand, the economy is not safe. It is overinvested.

Failure to Remain a Safe Haven

A crash occurs when an unstable market sustains an error that spreads throughout like a row of dominos and investors flee back into cash. In order for a demonetization event to occur, the currency risk must remain greater than the stock market risk, even as more and more investors pile into stocks. The scenario I described above is possible, but it is kind of weird because it describes a demonetization event with no cause other than one lone investor with very infectious paranoia.

However, with the right inflation schedule, an inflator can cause this to happen. The greater the rate of inflation, the more will investors prefer the risk of investment to the safety of cash. The economy can still function without an established form of money, or with an alternative money, so there is always some rate of inflation that is too high to be sustainable. All that must happen is for the inflator to be driven to bring the rate of inflation up to the level that it becomes preferable to stop holding cash.

As the inflation rate increases, and as investors more and more prefer to take on risk, the error-correcting function of cash-holding is reduced without, at first, being replaced by anything. Instead, the economy must change so that errors are less likely in the first place. Enterprises must become more self-sufficient, and less reliant on long-term profits. In other words, the economy becomes more primitive.

If the economy compensates more quickly than the inflator can spend his new money, then he can find that he must inflate at faster and faster rates in order to sustain the same level of consumption. If he is unwilling to reduce his level of consumption, then he can reach an unsustainable rate of inflation. That is when people start to think of their cash as paper or meaningless numbers rather than stores of value.


I think of this article as being the last of a trilogy, the first two being “Reciprocal Altruism in The Theory of Money”, and “It’s Not About The Technology, it’s About the Money”. The first article is an attempt to explain the use of money as a game. The second is about the growth of money, and this last one is about the death of money.

Because just about any good can be used as money, it is better to think of money as a behavior rather than as a thing. The money good is often something that is not very useful; it is something that is easy to count and difficult to reproduce. Money is rarely demanded to be consumed. Even something gold, which has important uses in industry or as jewelry, is more often just stored away. It is not, therefore, the nature of the specific good that is used which makes money useful. It is the way people treat it.

The way that people treat money is as a thing which is good for being liquid, or in other words, a thing that is always demanded everywhere. This is not an intrinsic property of any good. It is a property that is established by tradition. Every time people accept money, they are reinforcing that tradition. They are also making an investment in it, because there is no guarantee that the tradition will be as strong by the time they get around to spending the money. But as long as people continually make that investment, the tradition continues.

Despite the fact that people who acquire money do not necessarily have benevolent feelings about doing so, it makes sense to look at money as a form of altruism known to biologists as reciprocal altruism. In reciprocal altruism, one animal does something at its own expense which is immediately beneficial to another. The animal can afford to do this because it lives in a community of altruists, so it will eventually benefit from another animal’s altruism.

A necessary condition for reciprocal altruism to persist in a population is for non-altruists to be identified and excluded. Otherwise a group of moochers can live off the altruists and grow until altruism is unsustainable. This is accomplished in a money economy by the fact that people can’t have a negative balance. People must be altruists first (earn) and beneficiaries second (spend).

Altruism may at first appear to be a strange way to look at money because it is understood that people acquire money for selfish reasons. However, in biology, there is no such thing as true altruism, or at least if there were, they would soon be exploited to death. There is only apparent altruism. The theory of reciprocal altruism tells us that it is possible for an animal to appear to be altruistic in the short term, but later to receive help from others when it cannot help itself. If an alien came down to Earth, and observed a miser he might well see the miser’s behavior as altruistic because the miser appears to work hard at others’ bidding without receiving anything useful in return. Only after the alien observes that everyone else also attempts to acquire money would he understand the miser’s selfishness.

Because money being a social behavior, so its value depends on the society using it rather than the physical nature of the good being used. Because there can be more or fewer people using a kind of money and because they can demand more or less money, a kind of money can be more or less useful depending on the society in which a person finds himself. In other words, a person can find himself in a more or less altruistic society, and as a result, his money can be more or less valuable.

The network effect explains the initial growth of money out of a good which may have very little value initially. Because an initial investor in money will be rewarded much more than a late investor, initial investors have some incentive to take on additional risk and grab some when it is worthless. In doing so, they make it more immediately useful because they provide some initial demand that others can rely on. As money grows, there is a line of investors, begining with the most prescient, which leads money from its initial state to its central position in the economy.

The death of money follows the same process, in which the most prescient investors flee first, followed by more and more people until it no longer has value as money. This could theoretically happen on its own but one would expect it to be instigated by a superior competitor coming on the market or by an inflationary monetary policy which makes it a lot less useful.

The network effect explains why money grows and shrinks, but it does not explain why money would reach an equilibrium. It also does not explain why people hold more cash than they need immediately. The reason is that cash serves an investment function, so investors need to hold large amounts of it. The equilibrium value of money is the point where investors no longer prefer to hold more cash, and instead prefer to hold more stocks or bonds or other investments instead.

That is what I think of money. Now, for the good of society, earn as many bitcoins as you can!

Further Reading

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