The Anchor

The volume has traced the value of money from its quantity, through the false promise of a tradeoff, through the catastrophe of its collapse, to the temptation that biases the power to set it. All of it converges on the question the author posed at the outset: who should hold the power to change the value of every price at once? To answer it, one must first see what the value of money actually rests on — and the answer, in the modern world, is startling. It rests on nothing physical at all. The worth of money is anchored only in belief, sustained by the credibility of the institution that governs it. Thomas Sargent, studying how the great inflations end, brought the principle to its sharpest form; this plate draws it out, and with it answers who should hold the awesome power the volume has been circling.

For most of history, the value of money had a physical anchor. A unit of currency was a claim on a fixed weight of gold or silver; the metal, scarce and tangible, gave money a worth independent of any government's word, and limited how much money could be made, since one needed the metal to back it. In the twentieth century the world cut that anchor. Step by step — through wars that forced the suspension of gold, through the Depression, and at last through the severing of the final gold link in the early 1970s — the major currencies became fiat money: money by decree, backed by nothing. A modern banknote is a claim on nothing whatever; it cannot be redeemed for gold or for any other thing; it is, in itself, a printed slip of paper or a digital entry in a ledger. And yet it has value — it buys goods, discharges debts, stores wealth across years. The fiat world thus forces into the open a question the gold standard had kept hidden: if money is backed by nothing, what gives it any value at all?¹

The value of fiat money rests on belief: a banknote is worth something because everyone believes it is worth something and trusts that others will take it in exchange. This is not a trick or a weakness to be embarrassed by; it is the nature of money in a developed economy. Money's worth is a social fact, like the meaning of a word or the force of a custom — entirely real, immensely powerful, consequential in every transaction, yet existing only because it is collectively sustained. What people believe money will be worth tomorrow governs what they will give for it today; expectations of its future value are its present value. And because its worth is a matter of belief, it can stand unshaken for generations, when the belief is secure, or dissolve in a matter of weeks, when the belief breaks — as the hyperinflations showed, money collapsing not because the paper changed but because the faith in it did. The value of money is not a property of the note but a state of collective confidence.²

Sargent gave this principle its sharpest empirical form. Studying the great hyperinflations and the way they ended, he found that they stopped not gradually, as the money supply was slowly reined in, but abruptly — often within days — at the moment the public became convinced that the monetary and fiscal regime had truly and credibly changed: the budget brought into balance, a new currency established, an independent central bank installed, a binding commitment made that the printing would cease. The instant people believed the regime had changed, the headlong flight from money reversed, velocity fell, and prices steadied, even before the quantity of money itself had much adjusted. The lesson is that the value of money is governed not mechanically by the quantity of money alone but by expectations of the regime that stands behind it — by whether people believe the authority will behave. Change the belief credibly, and you change the value of money, and change it fast. Money's worth lives in the future that people expect, and the regime's credibility is what shapes that future.³

If the value of money rests on expectations of the regime, then the central bank's fundamental task is not merely to set the quantity of money but to anchor expectations — to be a credible commitment that the value of money will be held steady. A central bank that is believed, whose promise of stable money the public trusts, gives money a stable value almost of itself, for the belief is self-fulfilling: if everyone expects prices to rise by some small, steady amount and trusts the bank to deliver it, they set wages and prices on that expectation, and that small, steady rise is what results. A central bank that is not believed cannot deliver stable money however hard it strains, for unanchored expectations drift, and drift becomes self-fulfilling in the wrong direction. The whole apparatus of modern central banking — the announced target for inflation, the independence from government, the painstaking communication, the rule-bound restraint — exists for one purpose above all: to make the bank credible, to make it a trustworthy anchor for the public's expectations. The bank's power over the value of money is, at bottom, the power to be believed.⁴

Now the author's question can be answered: who should hold the power to change the value of every price at once? The inconsistency argument already showed that the power cannot safely be left to free discretion, for the freedom to inflate breeds the inflation bias. The credibility principle deepens the answer. Since the value of money rests on belief in the regime's commitment, the power must be held by an institution that can credibly commit — one insulated from the pressures that would otherwise break the commitment and unanchor expectations: the cycle of elections, the temptation to inflate away the state's debts, the standing demand to quicken the economy for short-run advantage. This is why the power over the value of money has been given, across the democratic world, to independent central banks — unelected officials with long terms, a narrow mandate for stable prices, and insulation from the politics of the day. The answer to who should hold the power is, paradoxically, an institution deliberately placed beyond the direct reach of those who hold every other power, precisely so that it can credibly resist the temptations they could not. The insulation is not a defect of democracy but a considered act of it: a society binding its own hands, because it knows it cannot trust them.⁵

This is the strange and awesome power the author named, and it rewards a moment's dwelling on how strange it is. A handful of unelected officials, by adjusting an interest rate or the quantity of money, move a single number — the value of money — that reprices everything in the economy at once: every wage, every debt, every pension, every savings account, the cost of every loan and the weight of every mortgage. By that one lever they can transfer real wealth from creditors to debtors or back again, levy a silent tax on all who hold cash, and lift or sink the fortunes of savers and borrowers across the whole of society — and they can do it without passing a law or facing a vote. No other power in a democracy is at once so vast in its reach and so insulated from accountability. The justification is the credibility argument: the power must be insulated to be trusted, and trusted to work at all. But the danger is no less real for being justified — that a power so great and so unaccountable will be turned to ends the public would not choose, will come to serve interests other than the public's, or will simply err, in good faith, on a colossal scale. The independence of the central bank is a bargain, and an uneasy one: insulation buys credibility, but at the price of democratic control over a power that reaches into every life.⁶

The power, vast as it is, has limits, and they are the limits of belief itself. Credibility, once lost, is hard to rebuild — a central bank that breaks its promise, or is forced to, may find expectations unanchored and not easily anchored again, as the painful disinflations of the past attest, where breaking an entrenched inflation demanded a deep and costly recession, the price of restoring a credibility once squandered. Nor is the bank in truth all-powerful. It depends on the government's fiscal restraint, for a state that runs vast and unfinanced deficits can force the bank's hand in the end, as the hyperinflations showed; it depends on the public's continued willingness to hold the currency at all; and it is buffeted by shocks it does not command. The anchor holds only so long as it is believed to hold, and belief, durable though it is, is not unconditional. The value of money is a confidence that must be continually earned — by a fiscal and monetary regime that conducts itself so as to deserve it — and that can, like any confidence, be lost. The power to set the value of money is real, but it is contingent: it is the power to sustain a belief, and it lasts exactly as long as the belief is warranted.⁷

The level, then, is the third of the aggregates, and it completes a picture the family has been assembling. Growth is the long upward trend of real output; the cycle is the fluctuation of that output around the trend; and the level is the value of the money in which all of it is counted — the changing worth of the very unit by which growth and the cycle, wages and debts and savings, are measured. The three are deeply entwined. The cycle's booms and slumps push the price level up and down, inflation swelling in the boom and threatening deflation in the slump, which is why the same central bank that manages the value of money also, through the very same lever, works to steady the cycle. And growth, by steadily adding to the stock of goods, tends to push prices down, so that the value of money would rise with prosperity were money not added to keep pace. One motion of the aggregate yet remains. The level governs the worth of the money in which the national product is reckoned; but how is that product divided — between those who labor and those who own? That is the share. The level is the worth of the measure; the share is the splitting of what the measure counts.⁸

Money, in the modern world, is backed by nothing — a paper claim on no metal, an entry in a ledger, worth something only because all believe it is. Its value is therefore not a fact of nature but a shared confidence, sustained by the credibility of the institution that governs it; and Sargent showed that this confidence, not the quantity of money alone, is what rules money's worth, for the great inflations end the very moment the regime is credibly changed. The central bank's deepest task is thus to be the anchor of that confidence, which is why the power to set the value of money is given to an institution insulated and committed enough to be believed — the paradox of an unaccountable power at the heart of a democracy, justified because it must be insulated in order to be trusted. Who should hold the power to change the value of every price at once? An anchor: a credibly committed, independent institution, bound by a clear mandate and set beyond the reach of the temptations that would unmoor it — held there by a society that knows the power too great, and too dangerous, to be exercised by a show of hands. The next and last motion of the aggregate is the share.