Money
Money
ON THE ALLOCATION OF RESOURCES
NOTES ON GOLD AND OTHER METALS
PAPER MONIES, NEAR MONIES, AND THE MONEY SUPPLY
MONEY AND CREDIT AND THE QUANTITY THEORY
Money can only be defined adequately in the context of a dynamic economy with markets and other financial institutions existing in a society complete with its laws and customs. It is a network or system of public good of considerable complexity. Even if money is privately produced, in the sense that it always depends on network acceptance it is a public good.
A quick perusal of any standard textbook immediately specifies the key economic properties of money as: (1) a means of payment; (2) a store of value; and (3) a numeraire. There are also a host of physical properties that are desirable for an item that serves as money. A partial list includes: (1) transportability; (2) durability; and (3) cognizability.
Left off these two lists is the strategic and informational properties of money. In particular the rules of operation with money distinguish among economic agents. The powers of an individual with respect to the creation and destruction of money are different from those of commercial banks, the central bank, and the treasury.
Part of the basic financial control mechanism of any society is the ability of some institutions to control the money supply and influence the money rate of interest. Although it can be shown at a high level of abstraction that with a perfect clearing system all individuals could issue their own currencies, the degree of reputation, trust, and memory required for such a system to work is unreasonable. The financial institutions that have been invented have been designed to provide a viable system for imperfect individuals.
The informational aspects of the use of money are critical to a modern complex economy. Money is an information aggregating, disaggregating device. Given prices, any collection of diverse assets can be valued by a single number. Bets of almost any variety on the future deal not only with the changes in uncertain bundles of assets, but with how they will be evaluated in monetary terms.
Because people are almost always concerned with a dynamic economy in disequilibrium, money does not provide a constant standard of measure like a carefully measured standard meter. It is a somewhat flexible, crude, and changing store of value. The conditions required to guarantee that a unit of money is of the same value in each period are rarely if ever encountered. A strict specification of all of the conditions that must be specified to guarantee no inflation or deflation is such that it is rarely met in reality. However in a dynamic economy the fact is that money does not maintain a precise value throughout time but permits prices to change in a flexible manner. And, up to a point, this is a desirable property.
Given that there are many desirable properties for ideal money, the institutional manifestation of the ideal money is hard to come by as most actual financial instruments called money miss some of the properties.
ON THE ALLOCATION OF RESOURCES
Precisely when in history individuals switched over from direct trade, where commodity A was exchanged for commodity B with no intervening means of payment, is not known. The open market with prices is by no means the only way that society distributes its resources. Among the ways extant today are direct bargaining, bidding, the free market with a price system, the dictates of higher authority, force, fraud and deceit, custom including inheritance and other gifts, and last, but not least, chance. Most of these, like society itself, preceded the development of an organized law-enforcing economy utilizing money.
A dynamic economy is a living organism with many ways of achieving some of its goals. Even the most advanced economy will not transfer many of its resources only through markets. Government, alone, at its many levels will account for 20 to 40 percent of the reported monetary income of any society. Gifts will still be made; housewives, husbands, handymen, and gardeners will still produce a considerable nonmarket produce; bribes and theft are all present to contribute to the nonmarket or only obliquely market parts of the economy.
A BRIEF HISTORY OF MONEY
It is not clear whether the development of money preceded, succeeded, or happened simultaneously with the evolution of markets. Their functions are deeply intertwined. The knowledge of the existence of markets makes it easier for individuals to find what they want to buy and where they should go to sell. The existence of money and other financial instruments makes it easier for them to trade. Among the earliest known monies were barley and silver, both of which were used in Mesopotamia over four thousand years ago. A considerable variety of substances have been used as money. They can be usefully divided into storable consumables, such as barley, and durables such as silver. Consumable monies have included barley, rice, cocoa beans, salt, bricks of tea, and cigarettes. Durables have included cowrie shells, wampum, furs, and many metals, including gold, silver, copper, tin and platinum, as well as alloys.
Among the earliest portrayals of the use of a metal as money is a painting from the tomb of Mereruka at Saqqara, Egypt, dating around 2300 BCE, showing gold being weighed in a transaction. Before the invention of coinage, payments utilizing metals were made in dust or ingot form. The invention of coinage is attributed to King Andrys of Lydia around 630 BCE. When one views money and financial institutions it is helpful to adopt the viewpoint of an engineer. This dispels much of the mystery often associated with finance. In particular, the transactions technology is seen to be a part of the economic production process. The switch to coinage contrasts with using metal by weight as a means of exchange. Coinage provided standardization of both the weight and quality of the metal and came with the stamp of authority, providing for law and its enforcement.
In return for the services rendered by coinage the king took a payment termed a seignorage fee estimated at 3 percent. As is evinced by the association of Croesus with wealth, coinage by the king was a source of revenue. In the subsequent history of coinage permission for the operation of mints has often been granted to private entities, although the government has always played a role. The technology of the production of coins has progressed from slow crude hand striking to vast automation where machines can produce coins at the rate of 45,000 per hour. Coining is still a profitable occupation as is evinced by the profits that the U.S. Mint turns over to the U.S. Treasury. It is also an art form as is illustrated by the design by the renowned sculptor Saint-Gaudens of the double eagle gold coin.
Within a few hundred years the use of coinage stretched from England to China. Although historians are not certain, it appears that the Chinese might have invented coinage independently a little later than the West. The mere fact that coinage was quickly and broadly accepted, providing many services that payment in bullion did not provide, does not imply that all coins are accepted even if the issuer is trusted. Mixtures of law, custom, and even aesthetic appeal all come into play. An example is provided by the livre tournois in the thirteenth century, which dominated the use of the livre parisis of Paris, the official coin of the central government.
NOTES ON GOLD AND OTHER METALS
Gold is malleable, ornamental, inert, and easily alloyed. It is estimated that at the end of 2005, the stock of mined gold was approximately 171,000 tons, of which 64 percent had been mined since 1950. World production in 2005 was 2,770 tons. There is a considerable amount of gold in the ocean, but retrieval costs are prohibitive.
Various countries have employed gold, silver, and copper as currency simultaneously. A reason for doing so is to provide a fit for different levels of consumption: coppers for a glass of beer or newspaper; silver for a pair of shoes; and gold to buy a house. The size of a gold coin to buy a beer is too small and as Sweden’s experiment with a copper currency demonstrated, buying a house with copper currency required cartloads of copper.
When one country bases its currency on gold and another on silver, any attempt by a country to fix an internal price between gold and silver will cause an influx or outflow of one of the metals. When the English physicist and mathematician Sir Isaac Newton (1642–1727) was master of the mint, in 1717 he overvalued gold in terms of silver sufficiently that silver went out of circulation as it could be sold for gold and the proceeds repatriated and converted at a profit.
PAPER MONIES, NEAR MONIES, AND THE MONEY SUPPLY
From the late seventeenth century onward starting with the formation of the Bank of England in 1694, the world switched more and more to the use of paper currencies. Each currency represents a claim by a national government that it can use its monetary strategic powers to help to control its economy. Monetary consolidations such as the introduction of the euro must be viewed in terms of politics as well as economics. Viewed purely from economics the currency union offers a considerable saving in transactions costs, but from the viewpoint of international politics it marks a considerable change in the strategic powers of individual nation-states.
The mixture of law, custom, and logic that produces a viable monetary system is sufficiently subtle that it is extremely difficult to produce formal models that adequately reflect the many functions of money and near monies. The phrase “near money” refers to an instrument that has many but not all of the properties of a money. For example, confining the observations to the transactions use of money, it should be acceptable in all markets. Nevertheless there may be financial instruments in existence, such as bank checks, which are accepted in almost all markets. For many purposes of analysis it makes sense to lump bank money with the issue of the government.
Because other financial instruments and real assets may have some, but not all, of the properties of money there is a considerable problem in defining a single simple measure of the amount of money there exists in any country. For example the property of being a store of value is present for assets such as land or houses as well as gold.
If a single number is required to measure the amount of money, the United States produces three different measures with many components. The three measures are aggregations called M1, M2, and M3. M1 is the sum of paper currency and coin that is held outside banks, traveler’s checks, and checking accounts (but not demand deposits), minus the amount of money in the Federal Reserve float. M2 is the sum of M1, plus savings deposits, including money market accounts from which no checks can be written, time deposits less than $100,000, and retirement accounts. M3 is the sum of M2 plus the large time deposits, Eurodollar deposits, dollars held at foreign offices of U.S. banks, and institutional money market funds.
In the twenty-first century with the proliferation of computers and cheap communication together with data banks on credit evaluation, many new forms of payment, credit cards, debit cards, and e-money are coming into being. Groups of individuals who trade frequently and are well known to each other can set up their own clearing and credit systems without using banks.
MONEY AND CREDIT AND THE QUANTITY THEORY
One of the mysteries of fiat money and national income accounting is what backs fiat or paper money. Is it custom, the power of government, trust in the government, gold reserves and other government assets, the presence of taxation, expectations, the negative incentives of default punishment, or factors associated with insurance and inheritance? A tentative answer is all of the above, in part. The mix may vary through time and place. The ideal money is a symbol that serves as a substitute for trust. It is an abstract “trust pill.” This ideal currency does not exist, but the currency of a stable noninflationary economy is hopefully an approximation to this trust pill. Fiat money is an asset like gold but it is an artificial or societally created virtual gold. Treating it as an asset has some paradoxical features. What does one receive on surrendering a one dollar bill to the Federal Reserve? One gets another new bill. Currently the average life of a dollar bill is estimated at twenty-two months; hence this activity is not merely symbolic but relevant. In their work Money in a Theory of Finance (1960), Jack Gurley and Edward Shaw made a distinction between “outside money” and inside money that stresses the role of government. Outside money is government fiat money against which a government debt exists. Inside money is fiat money held as an unencumbered asset by a private individual. A way in which the government can adjust the overall supply of fiat money held by private individuals is by selling to or buying from them, public debt. The basic difference between fiat money and credit is that money is a virtual commodity. It is a fictitious gold. It is the only financial instrument for which there is no operationally meaningful offsetting instrument on the other side of the balance sheet. The government maintains a fiction that it owes something to the individual who owns a dollar bill, but apart from obtaining a newer piece of paper from the bank it has no operational meaning. From the mid-eighteenth century until today there has been considerable interest in what has become known as the quantity theory of money. In his essay “Of Interest” (1752) the Scottish philosopher and historian David Hume (1711–1776) noted, “All augmentation has no other effect than to heighten the price of labor and commodities; and even this variation is little more than that of a name.... Money having chiefly a fictitious value, the greater or less plenty of it is of no consequence if we consider a nation within itself” ([1752] 1985, pp. 296–297).
In the modern terminology of Don Patinkin, Hume’s concept of money shows a classical dichotomy illustrating that the amount of money does not matter. More money merely raises the level of prices. The classical dichotomy means that the structure of real economy in equilibrium is independent of the amount of money in the system. The latter only fixes the price level.
The conditions for the classical dichotomy between money and other goods are that there are absolutely no frictions in the speed of adjustment of the economy to the introduction of more money. This is counterfactual as can be seen by trying to build a playable game of the system.
EQUILIBRIUM OR DISEQUILIBRIUM
In the 2000s there are at least two major schools of thought, one deriving from Hume, the monetarists, exemplified by Milton Friedman and the other modern followers, and modifiers of the work of the English economist John Maynard Keynes. Both schools have skilled analysts. The key distinctions lie in basic assumptions and different interpretations of unclear evidence. Those following variants of the quantity theory appear to stress long-run equilibrium conditions playing down the influence of short-term adjustments and coordination problems as well as ignoring nonsymmetries in wealth, expertise, and decision-making abilities. The neo-Keynesians are more concerned with the influence of monetary policy on short-run adjustments and on problems in economic coordination. They tend to be more concerned with non-symmetries among industry, the workforce, consumers, and government. More than the monetarists they appreciate the constant disequilibrium in the economic system.
A strategic and more biological view of money and financial institutions is that they represent the neural network and control system over the economic body of society. The government and the private financial establishment form a considerable segment of the economy. They are large enough to have considerable influence on the overall supply of money and credit. This alone places an upper bound on prices. The presence of default penalties and bankruptcy laws places a lower bound on prices. If there is enough deflation it pays a debtor to default unless the bankruptcy laws are changed at the same speed as the money supply. The laws of contract and the bankruptcy laws reflect a society’s attitude toward risk. In a highly innovative society in constant disequilibrium, the laws of default and bankruptcy control the innovation rate or the speed of mutation of that society. Furthermore the ability of the government and banks to create money and the other parts of the financial system to direct where credit goes gives government and the financial system considerable control in directing the disequilibrium dynamics of a modern economy. In this structure money matters considerably. In a static equilibrium of a society without innovation the classic dichotomy appears and the importance of money and financial institutions is diminished.
The financial system and money provide the interfacing mechanisms between the economy and the polity. Human society, like an individual’s body, is not an undifferentiated mass of independent individuals or cells. There is a complex organization, which in both instances requires a flow of information, control instructions, and nourishment to differentiated organisms that require coordination. The financial system provides for the flow of information and control and the economy provides the various physical forms of nourishment needed by the society.
SEE ALSO Balance of Payments; Currency; Divisia Monetary Index; Exchange Rates; Monetary Theory; Money, Endogenous; Money, Exogenous; Policy, Monetary; Quantity Theory of Money; Trade
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Martin Shubik