I have written before about money*, not in the sense of macroeconomic policy or economic policy, not even in the sense of monetary theory, but simply discussing money as money, that is asking what money is, why we use money and how it works. Despite the seeming simplicity of the topic, it is one that, because it is fundamental, must be resolved if we are to understand many other economic questions, especially those related to banking, inflation and other topics where money itself plays a crucial role. And it is not as simple a topic as many assume, it is, if anything, deceptively complex, and prone to a number of common misunderstandings, most of which lead to dangerously wrong conclusions. If anything, the questions of "what is money?" and "how does money work?"are at the root of many of the most common economic fallacies.
Thus, though I have discussed the topic before, I hope you will be patient as we examine it one more time, this time not in such great details, but rather, looking at a few common mistakes. Normally, I would not bother addressing these errors, as it is so much easier to simply explain how things work in some detail, and in the process demonstrate the mistaken beliefs behind any number of common mistaken perceptions, but in this case, these beliefs are so common, so frequently espoused, that is seems worthwhile to dissect them, and to demonstrate why a few bits of "conventional wisdom" are simply wrong.
There are three common errors made in discussions of money, errors that we hear repeated from elementary school all the way through graduate school classes. For some reason they are both incredibly popular and equally mistaken. And, not coincidentally, all three deal with the issue of value. First, there is the claim that money has value simply because we agree it does. Second, there is the statement that money is a substitute, or some sort of evolutionary step away from, for barter. That is that money is, in one way or another, sui generis, something completely separate and apart from barter and other direct exchange. Finally, there is the statement made about specie --gold, silver and other commodities once used as money -- that its value also rests upon arbitrary agreement.
Now, before we begin, let me clarify one thing. If you want to be absolutely pedantic, the three statements are technically correct, since valuation is a human concept and all value assigned to any good is arbitrary. If I say I want food more than bits of lint from the drier, that is an arbitrary valuation in one sense, as, divorced from human beliefs about utility and desirability, there is no way to say one is of more value than another. On the other hand, I do not believe that is what these arguments are intended to mean. Almost always, for example, in discussions of gold, the conversation mentions the lack of a "need"** for gold, proposing its worth is arbitrary as gold has no "practical" uses. Thus, I believe they are not arguing that these values are arbitrary in any absolute sense, but rather that, unlike the values we assign to goods we consume or use, the values assigned to money are based in imaginary worth, not upon any utility we find in satisfying wants. Thus, I will not mention again the fact that all value is subjective and arbitrary in this sense, and limit myself to discussing it in terms of utility in satisfying wants.
I could probably offer a few more such caveats, as valuation and subjectivity are tricky concepts, especially when used in economics, but I am afraid if I did so I would fill several dozen paragraphs with preliminaries before we reached the argument proper, and so, rather than allowing ourselves to get lost in prelude, let us jump into the main body of the essay, and begin examining our three errors. Should any particularly vexing conceptual issues arise, we can deal with them along the way.
Actually, I may have spoken a bit too soon, as our very first error actually requires a bit of clarification if we are to examine it properly. That is the claim that the value assigned to money, the worth it has, is rooted in nothing more than collective agreement, that it is an entirely arbitrary construct.
This claim is, in one way, clearly of modern provenance. Until the birth of fiat currency, fully divorced from any commodity, in the 20th century, this claim would have been seen as absurd. Money had worth, at least in part, because it was convertible. Granted, what commodity backed the currency was often somewhat arbitrary, from Chinese warehouse receipts to tobacco receipts to gold, or silver or copper, countries varied in what they used to back their paper currency, but until very recent times that paper currency was convertible***. And, it was made even more clear in those nations which used specie, as gold and silver coins often traded alongside the paper notes, making it clear money was not an arbitrary construct, but was a certain quantity of precious metal, whether in the form of a gold coin or of a paper note convertible into the same.
Some might agree with this claim, but then ask whether, because of changes in the modern era, it is not right to say, while past currencies were commodity currency, with their value imparted, at least in part, by the commodity into which they were convertible, is not the present fiat currency, no longer redeemable in anything****, not accurately described as a system where value is defined by arbitrary agreement?
The answer is, sort of. On paper the system does fit that description perfectly. National currencies are not convertible into anything, their value is not defined in terms of any commodity, they are valued only because people are willing to exchange them for goods, and because the government accepts them as payment (and deems those refusing them as payment to have forfeited a debt).
But that is on paper, without any of the context.
In truth, money is still sort of valued in gold. Why else would currency have varying exchange rates? Why else would countries maintain massive gold reserves? Why else would nations continue to fret over the price of gold in terms of the national currency?
The fact is, when the gold window began to close in 1934, people expected it might open again, or at least, because some people could still convert money to gold, they imagined they could get gold if they wished. And even as the window closed more and more, finally shutting entirely between 1971 and 1973, people still thought gold redemption may one day return, and so money still traded as it were redeemable in gold. (And when the holding of monetary gold was made legal in the US once again in 1977, people became even more optimistic about this, for a time.) Even now, when there is little hope that money will ever be convertible into gold, it is still valued, at least in part, based on national reserves.
Thus, while on paper money may appear to be arbitrary, in truth the value of money continues to persist based upon its history as a commodity currency, with a value based on that commodity, not an arbitrary value at all.
Which brings us logically to the third error (we shall skip the second for a moment), the claim that precious metals are, themselves, valued on an arbitrary basis, and that their worth is entirely based upon a collective decision, that, but for their use as money, they would be considered much differently.
The arguments against this are many, and should be obvious, but I have heard this argument frequently enough I can tell they must not be as obvious as I think. So, allow me to off er a few of the most convincing, in hopes of dispelling this mistaken belief.
I suppose the first argument is the most obvious, that being that claims these metals have no uses are simply wrong. Silver, because it is toxic to most organism, has a long medicinal history continuing through the present. Likewise, because it both resists corrosion and is easily shaped, gold has found uses throughout history, even bore the discovery of many modern applications in electronics. And that completely ignores the widespread use of both in decorative functions, even in lands that never used them for currency, even lands that never developed a currency. Gold, because it is so soft and easily shaped, does not tarnish and is a bright and attractive metal, was used in many civilizations for jewelry, objects d'art and other functions. Silver, being less easily shaped and more prone to tarnishing, was not adopted quite as early in our history, but it too was a popular decorative metal.
Thus the value assigned was hardly simply an arbitrary choice made by those seeking to create a currency. In fact, it is certain these metals were valuable before they became currency, as their value is what made them attractive as money.
Allow me to explain.
A good money must have several traits. First, it must be durable, which is why most agricultural products are unpopular (though tobacco receipts were used at one time in the colonies, and the more impoverished among the ancient Egyptians sometimes used loaves of bread). Second, it must be easily divisible, but not only that, it must retain its value when divided. The reason for the first should be obvious. If I am to make change, or join together smaller amounts, it is useful to have a currency which can be split or joined with ease. Things that must be kept in discreet units (such as the goods represented by Chinese warehouse receipts) are not as attractive, as one must constantly deal with the full value, being unable to split it apart. The second bit of that argument, that it must retain its value, is less obvious, but becomes clear if we think of an example. Gems, for instance, are a good possibility for a currency, except that they cannot be subdivided. Oh, they can be cut apart, but their value changes greatly. A 1 carat diamond is not worth twice as much as two half carat ones. Thus, gems are not a good choice since subdivision alters the value. The third rule is also one that demonstrates a shortcoming of gems. A good currency must be uniform. If each unit has a different value (as is the case with gems) it becomes too difficult to appraise the worth of each unit, and exchange becomes cumbersome, more like barter than currency.
It is the final rule that demonstrates why gold and silver were thought valuable before they were used as money. To be useful, money must have a high value per unit volume and weight. Since currency needs to be transported, especially in eras before bank notes, the commodity chosen must have a fairly high value per weight and volume, or else it becomes difficult or impossible to carry large sums. Thus, when gold and silver were selected to be used as currency, they must already have been considered quite valuable, as otherwise there would be no sense in selecting them, since until their value rose from being used as currency, one would need to carry massive quantities.
Thus I would argue gold and silver were not simply arbitrarily selected as currency and thus assigned a high value by popular acclaim. No, they were already valuable because of their uses, both practical and decorative, as well as their relative scarcity. It was this high value, along with uniformity, divisibility and durability that made them good choices for becoming the basis of a monetary system. All of which demonstrates they were not valued arbitrarily, but were in demand already, making them a good fit for use as money.
Which brings me to the final mistaken belief, the idea that there is some dividing line distinguishing the use of money from barter.
Before going ahead, let us agree on a few points. Yes, once money is well established, and banking and bank notes and all the rest are in regular use, there are manipulations possible with currency that would be difficult in a system of direct exchange. Fractional reserve banking, inflationary expansion of money supplies and other practices do rely upon money, and would not be available in a purely barter economy were it not for the acceptance of a single currency. However, I would argue that does not prove money is in any way separate from barter. After all, those particular aspects apply only if we have both money and the use of bank notes with reserve backed banking. Were we to use currency but never develop banking those practices would be impossible as well. Thus, while they seem to distinguish money from barter, in truth they simply demonstrate one specific type of money economy allows a number of unsound economic policies.
So, what is it that distinguishes money from barter? Supposedly money casts a "veil" over transactions, abstracting from direct exchange, but, in truth, monetary exchanges are nothing but barter. Granted, they are a barter system where everyone sues the same intermediate step of converting goods into a single commodity, but they are still barter.
If you doubt this, stop thinking of money as something special and look at how the market reacts to various changes. If money increases, be it from an influx of precious metal or the printing of currency, how does the market respond? As it would to a glut of any good, that good trades at a discount against other goods. Likewise, when a shortage of a good arises, it trades at a premium. Money, especially when commodity money, trades like any other good. There is no real distinction from barter, monetary exchange is just a barter system where everyone trades for the same good.
So, what does all this tell us? Why is it important to keep these ideas in mind?
Well, first because they provide a good remedy against silly monetarist beliefs. There is, for instance, no way we can have "too little" money. Nor is there any need to keep increasing the amount of currency, as some claim. If currency is in short supply, it will be revalued, and things will proceed. There is no need for "managed money" or continued government inflation. Do you need someone to keep adding goats to a barter economy for it to work? Then we do not need an influx of new currency either.
Secondly, it should eliminate the idea that adding money is beneficial. Increasing the money supply lowers the value of currency already in hand, that is it erodes the value of savings, of fixed incomes and other possessions valued in cash. In short, it is a drain on the economy. Nor does it help increase wealth or end unemployment or any of that other nonsense. All it does is making accounting inaccurate and savings a dangerous folly.
There are many other follies justified by mistaken views of currency, more than I could reasonably list. So, rather than continuing to go on drawing out this essay to absurd lengths, I will leave it here and let my readers discover how many absurd claims can be demolished simply by recalling money is just a form of barter, and the value of money comes from the value of a commodity. It really does make it difficult to believe in many of the concepts of macroeconomics.
* See "Monetary Issues Made Simple Part I", "Monetary Issues Made Simple Part II", "Inflation and Uncertainty", "Bad Economics Part 7", "Bad Economics Part 8", "What Is Money? ", "What Is A Dollar?", "The Gold Question, Not "Why?" But "When?"", "Counter-Strike and Currency", "Bad Economics Part 19","Fiscal Discipline", "Putting the Bull in Bull Market" and "Why Gold?".
** I have many problems with the use of the word "need", but this is not a good place to discuss such topics. Those interested can read about my arguments against that word and similar, largely meaningless terms in "The Most Misleading Word", "Luxury and Necessity", "Res Ipsa Loquitur", "A Question of Fairness", "Protean Terminology", "One More Meaningless Word and Its Consequences", "Confucius, Aedes Aegypti, Pluto, Sub-Species, Conservatives and Republicans", "Misunderstanding Arbitrary Definitions", "Weasel Words and Hollow Words", "Semantic Games", "Misleading Terminology", "Smoking Versus Sex -- Want and Need Take Two", "Can We Ban the Word 'Scarce'?", "Government by Emotion" and "Selfishness as Reason - 'Wants', 'Needs', 'Fairness' and Other Guises for Arbitrary Decisions".
*** The colonial experiments with land banks in some ways
presaged modern fiat currency. The money was nominally backed by land of
a certain value, and note issue was limited by the quantity of land,
but since money was not directly convertible into land, and oversight
was weak or nonexistent, these banks became sources of uncontrolled
inflation and routinely resulted in economic chaos. Some states even
recognized this fact and used land banks to effectively inflate their
way out of debt, by using land bank notes to export debt and consequent
inflation to other colonies. Since notes were not really convertible,
they did not have to worry about out of state holders trying to redeem
them, as did the "wild cat" banks used for the same purpose.But that was
the only real example of nonconvertible currency before modern times.
**** In "What Is Money? " and "What Is A Dollar?" I point out that at present a dollar is defined as the amount of money that is worth a dollar, normally in the form of paper notes or metallic token coinage which is convertible into more paper notes or token coinage having the same dollar value. In other words, a dollar is defined in terms of a dollar, making it a meaningless term, and because it is only convertible into more paper currency, it cannot even be expressed in terms of other commodities, it is truly a meaningless term since 1973. (Well, almost, as we shall see very shortly.)