This is an interesting lesson in monetary economics for a variety of reasons: Using Iraq as the primary example, it illustrates exchange value versus use value, it shows some of the properties that a medium of exchange must possess to circulate widely, and it shows the relationship between the supply of money and its value. It also explains the difference between fiat and commodity backed paper money, private versus government issued money, how speculation can affect the value of the medium of exchange, and other lessons. This is Hal Varian with an Economic Scene from January 2004:
Why Is That Dollar Bill in Your Pocket Worth Anything?, by Hal Varian, Economic Scene, NY Times: Why is that dollar bill in your pocket worth anything? One answer is that it's valuable because it says it is. To the left of the portrait of George Washington, the dollar proclaims: "This note is legal tender for all debts, public and private."
Dollar bills are "fiat" money - they are valuable because the government in power says so. People can, however, write contracts that specify payment in other currencies. If a contract specifies payment in euros, dollars will not fulfill the contract, despite what is printed on them.
A more profound, and perhaps slightly unsettling, reason that a dollar has value is simply that lots of people are willing to accept it as payment. In this view, the value of a dollar comes not so much from government mandate as from social convention.
In the jargon of economists, the value of a dollar is a result of "network effects." Just as a fax machine is valuable to you only if lots of other people you correspond with also have fax machines, a currency is valuable to you only if a lot of people you transact with are willing to accept it as payment.
Indeed, one can have currencies that have no government backing. Gold has been used for centuries as a medium of exchange; cigarettes were used for payment in prisoner-of-war camps in World War II; and countless other goods, including cowrie shells and peacock feathers, have functioned as money throughout history. They were money because people were willing to accept them as payment for debts, public and private. Gold, cigarettes, cowrie shells and peacock feathers all have "use value" in addition to their "exchange value." These items were originally valued for their utility or their beauty, and they became used as currency. It is rare to see a purely paper currency functioning as money without the backing of some government or financial institution.
Rare, perhaps, but not unheard of. Mervyn A. King, governor of the Bank of England, cited an interesting example - the Iraqi dinar - in the Ely Lecture delivered at the recent American Economics Association meeting in San Diego. (Mr. King's speech can be downloaded from http://www.bankofenglandco.uk/speeches/speech208.pdf.)
Here is the story Mr. King told:
After the gulf war of 1991, Iraq was divided in two: the south ruled by Saddam Hussein, the north governed by the local Kurds. Mr. Hussein needed money to finance government spending, and in the time-honored tradition of dictators, created it himself.
The government could not import more of the bank notes then in use, because of United Nations sanctions, so Mr. Hussein ordered the local printing of a new currency. In May 1993, the Central Bank of Iraq announced that citizens had three weeks to exchange their old 25-dinar notes for the new "Saddam dinars," which bore his portrait.
During the next few years, so many Saddam dinars were printed in southern Iraq that they became virtually worthless. The face value of cash in circulation rose from 22 billion dinars in 1991 to 584 billion in four years, and inflation averaged about 250 percent a year over that period.
Residents of northern Iraq could not exchange their notes. The 25-dinar notes continued to circulate and became known as the "Swiss dinars," because they were printed with plates made in Switzerland.
The fact that the Swiss dinars continued to be used at all speaks to the power of social conventions. The Kurds in the north despised the Baghdad government, and would have much preferred to have their own currency. But there was no government in place powerful enough to mandate a currency change, so they kept using the old Swiss dinars by default.
The Swiss dinar was in fixed supply, while the Saddam dinar was flying off the printing presses, so it is not surprising that the Swiss dinar quickly became more valuable. By spring 2003, it took 300 Saddam dinars to buy one Swiss dinar.
The more interesting economic effect was the behavior of the Swiss dinar against the dollar. In fall 2002, as it became more and more likely that the United States would invade, the Swiss dinar became more and more valuable.
This appreciation was driven by expectations. If the Kurds had expected that they would once again fall under Saddam's sway, the Swiss dinar would have quickly become worthless. As this became less likely, and the belief that future governments would accept the Swiss dinar became more widespread, the local currency became more valuable. Of course, every exchange rate movement can be interpreted in two ways: in the north, the Kurdish regional government initially interpreted the rise in the Swiss dinar against the dollar as a fall in the value of the dollar.
The government soon realized, however, that since the dollar was stable against other currencies, the correct explanation was that recounted above: the increasing belief that the Swiss dinars would, in fact, be honored by future governments.
The government was right. On July 7, 2003, the American occupation administrator, L. Paul Bremer III, announced the creation of a new Iraqi dinar that would be exchanged for the two existing currencies at a rate that implied that one Swiss dinar would be worth 150 Saddam dinars.
Interestingly, the currency markets valued the Swiss dinars somewhat higher than the official 150 exchange rate, primarily because many counterfeit 10,000-dinar Saddam notes were in circulation.
This story illustrates that paper currency can take on a life of its own, even in the absence of government backing. At the same time, it is clear that government backing makes a significant contribution to the value of paper currency: the more likely it became that the Swiss dinars would be valued by a subsequent government, the more valuable they became.