By Emanuel Derman
May 4, 2012

Thinking aloud:

As I understand it, all money is really an IOU created and issued by someone. When McDonald’s gives you coupons, you’re taking their credit; similarly with Frequent Flier Miles, and similarly with a bank that lends you U.S. dollars. All of these institutions are creating money, their own currency.

The question then is: what if they can’t fulfill their IOU?

In the case of McDonald’s, who cares?

With frequent flier miles, it’s irritating when they change the rules on you or impose blackout dates, but that’s what they do. They had given you a floor value for the miles, though you could trade them to someone for a fluctuating amount, and then they changed the value of the floor. Foul play.

The U.S. dollar is an IOU issued by the Treasury and backed by the full faith and credit etc. Which means what?

Under the gold standard, your dollar could be exchanged for any product in the world at a floating rate, as money, but there was a kind of put embedded in the dollar: you could always put it back to the U.S. Treasury for a fixed fraction of an ounce of gold. (Similarly, a Zimbabwean dollar can be put into a U.S. dollar.) The riskier the government’s policy, the more the put is worth.

Without a gold standard, the dollar has no embedded put at all, and therefore no floor.

It’s not so much the gold floor that matters, as the fact that there was a floor of some kind. It made the USD a collateralized IOU rather than one with limited (well, zero) liability.

It would be nice if all IOUs had embedded puts with floors to provide a realistic safety net. McDonald’s coupons could have a Burger King floor. Without a reasonable floor — the closer to at-the-money the better –  you have to keep evaluating the borrower’s business status, because you have no protection against default. If all IOUs had embedded slightly out-of-the-money puts into something of value that the the issuers actually possess and can be taken away from them, life would be simpler, though business would be slower.

What does a country that issues dollars actually possess that can be the underlier of the embedded put? Gold, or land. The value of land — if a dollar could be put into one square foot of land — varies too much depending on what people do with it. Gold is kind of useless but mysteriously valuable, so maybe it’s not such a bad underlier.



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