What makes paper money so valuable? After all, in contrast to commodity money like gold and silver which have been in use for centuries, these printed pieces of paper have very little intrinsic value. Yet they get exchanged for valuable goods every day. In fact, the sale of almost any good today involves money being accepted by the seller. The usual answer provided by economists to explain this paradox has to do with the coercive power of government. Since the government mandates that citizens must accept paper money issued by it in any transaction, they argue, paper money attains value.
This argument was famously proposed by German economist Georg Friedrich Knapp in his 1905 book The State Theory of Money . Paper money, according to this logic, must lose almost all its value if the government in power breaks down and ceases to exist. But does such a thing happen in the real world? “Positively Valued Fiat Money after the Sovereign Disappears”, a 2017 paper by William J. Luther and Lawrence H. White, looks at the example of Somalia’s currency to find an answer. The authors discover that Somalia’s currency, the shilling, continued to be exchanged for goods in the market, even as the Somalian government broke down and the country became stateless in 1991.
Based on this experience, Luther and White argue that the government’s coercive power is required only to create a paper currency standard, not to sustain it. They say people generally do not accept paper as currency, as it has very little intrinsic value. But once a paper currency is established as a money by the government, it can continue to perform its functions smoothly, even in the absence of the government that created it. This, they say, is because people have already accepted it as money.
It is noteworthy that other economists doubt whether people will accept paper currency as money, even if it is the government that forces them to use it. They argue that, historically, paper currencies became acceptable only because they were initially backed by commodities like gold and silver.
