Money 101 — part 3

The Nature and Origin of Money

[To read the first section, click on its section-header above.]

The Equation of Exchange and the Price Level

[To read the second section, click on its section-header above.]

The Inflationary Process

[To read the third section, click on its section-header above.]

Commodity-Based Money

In order for someone to be willing to accept a thing as money, he or she must have a sense that someone else will later accept it in trade. In our case of Aya, Gus, and Tor, only Aya accepted something as money; Tor and Gus simply got an immediately desired commodity in their first-and-only trade. Gus had no plans to use the okra in further trade; if Gus had accepted it as money, then he would have been hoping to trade it in some further exchange. It's easier to start using something as money if no one much worries that the something won't be wanted. Indeed, if one knew that there would come a time when the something wouldn't be wanted, participating in the use of the thing as money would at best be like playing a game of musical chairs. Knowing that the something is itself desired as a commodity provides some assurance that it will be wanted by some next trader; which is why the things first things used as money were commodities.

Because money that results in relatively stable prices serves well enough as a store of value and best as a unit of account, there are pressures to settle upon a money whose supply changes in a manner to keep prices generally stable. Without change of monetary velocity (ν), the money supply would have to grow in an economy that grew, shrink in an economy that were shrinking, and stay unchanged in an economy that neither grew nor shrank; the change in the size of the money supply would have to be within some range, or prices would generally rise or generally fall, instead of being generally stable. So, in the context of a long-run tendency of economic betterment, and of velocity whose trend line wasn't decreasing, the commodities used tended to be those whose over-all supply grew, but not at greater rates than the supplies of other commodities.

When a commodity is used as money, there are stabilization mechanisms that are not widely recognized, even amongst economists.

Specifically, the commodity is put to its underlying uses up to the point at which the value of further such use would be less than that of its use as money, and (to say essentially the same thing) to uses as money up to the point at which the value would be less than that of its other use. So, if prices are generally falling, then the commodity is withdrawn from use as money and put to other use; and, if prices are generally rising, then the commodity is taken from other use and put to use as money. In each case, the effect on the money supply works to counter an over-all rise or fall in prices.

Additionally, to the extent that the monetary commodity can harvested from natural resources, it will be harvested up to a point that rising costs of doing so make this no longer a profitable activity, which will work to counter a rise in the relative value of the commodity. This process is somewhat asymmetrical, in that the event of a lowering relative value of money does not provide great incentive to somehow return the commodity to its natural state (as in the salting of mines), though one might imagine more of it being allowed to escape possession.[11] But, in generally improving economies, the problem of a fall in the relative value of money is less often much felt.

None-the-less, these sorts of shifts cannot be expected fully to off-set other things affecting the money supply (such as a discovery of large, easily mined deposits of a metal used as money), nor other significant changes that affect prices by affecting productive capacity.[12]

The physical location of a commodity might be largely disconnected from who has claim against it, so that the commodity can move without its ownership changing, or its ownership may change without the commodity being moved. This point is true of monetary commodities as well. The ownership of a specific commodity might be expressed by way of a promissory note, or a claim to some specific amount of that commodity might be expressed by way of such a note. When such notes themselves begin to be actual media of exchange, the money is based upon a commodity, but is not exclusively that commodity.

A trusted party might specifically go into the business of issuing such notes, accepting amounts of the monetary commodity, and providing promissory notes for something less than that amount, the difference being paid for the convenience of the note. Trusted parties might also accept the notes of other trusted parties in exchange for notes of their own.

Sometimes the notes will be redeemed for the promised quantity of the monetary commodity. But, if the issuer is trusted, many of the promissory notes may circulate indefinitely, without redemption. This creates an interesting opportunity for the issuer. If he or she feels assured that some share of the deposited money will not be withdrawn in the foreseeable future, then he or she may put it to other use; thus maintaining only a partial reserve (AKA fractional reserve) against the issued obligations. If some of the use to which he or she puts deposits returns it to circulation as money (which would happen if it were lent), then the money supply will have been increased.

Imagine that a community has 100 tons of silver that it uses as money. Imagine that various of its members deposit 50 of those tons with Eustace, who issues notes redeemable for 50 tons. (In our simple example, we will ignore service charges.) Eustace notices that, while people make subsequent withdrawals, others make further deposits, and there's never less than 35 tons in the vault, doing nothing. So when people asks if Eustace can loan them money, he does so, and loans-out those 35 tons. (If Eustace has already been in the process of brokering loans, then little may be thought of his increased lending.) The community now has at least 85 tons of the silver circulating as money, and notes promising 35-to-50 tons circulating as money; there is money equivalent to at least 120 tons! If the borrowers deposit some of the borrowed money, and always leave some of those deposits with Eustace, then he may find that he can even loan-out some of the money created by his loaning-out money! This cycle can be repeated many times, expanding the supply of money; but it doesn't go on forever, so long as people don't deposit all of the money creäted back with Eustace (or someone else in the same business), or so long as Eustace is compelled to keep some of the commodity available for withdrawals.

Of course, if Eustace has miscalculated, then at some point there may be an attempt to redeem his notes for more silver than he has on hand. If this ever occurs, his notes will lose some or all of their value, so that people holding them are suddenly worse-off (perhaps financially ruined). Further, even if it hasn't happened, if people fear that it may happen, then they may be moved to present their notes before it happens.

The term run is used for situations in which those with claims against money held in reserve are moved to redeem those claims for fear that they are about to lose value. A run reduces reserves of money held to honor claims; if that reduction itself exhausts reserves before claims cease to be presented, then the run may cause the claims to lose value. Fear of a run may therefore provoke a run, and claims may thus become worthless as a result of the fear of their becoming worthless.

Although partial-reserve issuance literally creätes money, the money that it creätes is founded on that money with which the issuer has promised redemption; and, while that base may be subject to variation of some sort, it is not subject to variation through the same process as the money creäted by partial-reserve issuance. The base itself might somehow be destroyed, but it would not be reduced by runs against those promising to redeem notes for it.

(In a section below, we will examine the proposition that it is fraud for those who safe-keep money to hold only partial reserves.)

Commodity-based money provided more price-stability than some of its severe critics have insisted, but it did not provide the wonderful sort of price-stability that is often claimed. One can find two distant points in time such that a certain mass of gold could be used to buy exactly the same basket of goods at each time; but, between those two points there may have been great oscillation, and the basket of goods may not be particularly representative.

The Nationalization of Money and Fiat Money

Because money becomes a tool by which almost anything that is traded may be acquired, rulers have long seen regulation of money as an important source of power. (And support for rulers having this power comes from those who believe that an extensive state can provide improvements upon what would otherwise result from choices made by people of differing values and expectations.)

The state may penalize the use of some things as money, and encourage the use of others. It may attempt to creäte an oligopoly or monopoly in the generation of money; it may claim such a monopoly for itself. It can define monetary standards — or redefine them, thereby rewriting contracts across many transactions.

Legal tender is that which is made money by law. A legal tender law may mandate that some quantity of what it establishes as money be taken as equivalent to some amount of something else previously recognized as money, or may require that the thing that it establishes as money be everywhere substituted for what was previously recognized as money. So, for example, in a community in which silver is recognized as money, gold may be made legal tender by requiring that anyone owed an amount of silver accept some specified amount of gold as payment; or the law might go further, to prohibit payment with silver.

While it would be meaningful to use the word standard in reference to a commodity that became popular as money without legal tender laws, often the reference is to a standard established by law.[13] For example, the United States went onto a gold standard as a result of laws and measures that caused a previously established silver standard to be replaced.[14]

(I think that, if money were denationalized, the market would move beyond monetary standards of the familiar sorts. Consider, for example, an order within which there are no legal tender laws, and what serves as money are notes issued by private institutions. Each institution would promise to redeem its notes for some specific basket over some interval. As the interval approached its end, a new interval would begin with some over-lap, and some basket would be offered over that new interval; it might be the same basket or it might be a new basket. Potential customers would be drawn to use the notes of institutions which chose their baskets so that their notes offered a great deal of stability in what else might be purchased with them. I do not think that baskets with a constant measure of one commodity would work particularly well, but this would be a possibility; I do not think that empty baskets would work at all, but this would be a possibility. The market could decide what were the prevailing money or monies of the economy.)

When the state has claimed for itself the right to determine the monetary standard and to control who may generate money, it becomes thinkable for the state to remove the requirement that notes and ledger entries that serve as money be redeemable for some commodity. This is especially true if people have been using notes and ledger entries as money, if partial reserve banking has been practiced, and if redeemability has previously been suspended (perhaps on an ostensibly temporary basis).

The term fiat money is used to identify money that is neither a commodity nor redeemable for a commodity. (A fiat is a decree.) The term is more loosely used for money whose redemption is suspended, especially when the suspension is long-standing or indefinite, or redemption is expected to be cancelled before the suspension ends.

In a context in which the prices of all commodities are unregulated, it is difficult to explain why fiat money should have any value — that is, why people should expect to be able to spend it in exchange it for some specific amount of this or that other commodity and therefore be willing to provide something in exchange for an amount of fiat money. Even if the legal price of some commodity is held within some bounds, unless sellers may be compelled to produce that commodity, it is hard to see why potential possessors of money should be able to value it positively. (And if sellers of a commodity are compelled to produce a commodity and sell it at some price, then that commodity is actually a monetary base.) However, as noted above and elsewhere, some of the value of commodity money and of commodity-based money also seems somewhat mysterious.

When the state issues fiat money, it may be that other institutions continue to intermediate transactions, such that stocks of fiat money held by private individuals and associations are deposited with the intermediating institutions for safe-keeping or to broker loans to others. If, instead of withdrawing money for transactions, people are able to transfer their claims to others by instruments such as checks, then the intermediating institution may hold only partial reserves against such claims, increasing the amount of money beyond the fiat base, just as it might have increased the amount of money beyond a commodity base.

It is useful to have a general term for money belonging to the base, as opposed to money creäted by partial-reserve issuance. With fiat money, one can no longer refer to a share of the commodity serving as the base. The most popular term seems to be high-powered money.

[To continue reading, click on one of the section headings below.]

Partial-Reserve Issuance — the Charge of Fraud

[Read more.]

The Effects of Inequality in the Accumulation of Money

[Read more.]

[11] I very much expect that there will eventually be a struggle over land-fill deposits of what has been garbage, with some attempting to acquire them as private property and to mine them for what will be valuable substances, others insisting that these substances are communally owned, and archæologists attempting to play Science cards to claim thereby the deposits for those who have their interests.

[12] I have encountered at least one article in a respected journal of economics, in which the authors rejected the applicability of a quantity theory of money to commodity-based money, declaring that instead the value of a unit of the monetary commodity would be determined by its other uses. It should have given them pause that the quantity theory arose when money was based upon commodities.

In any case, the equation M · ν = Σ (pi · qi) must still hold; velocity ν should be no more variable with commodity-based money; and the various quantities of other commodities bought-and-sold shouldn't typically be much more responsive to changes in the supply of money when the money is a commodity.

What the authors seem to have missed are that the nominal price of the monetary unit in terms of itself doesn't vary no matter what is used as money, and (especially) that the relative prices of the monetary commodity in terms of other goods and services varies (like that of every other commodity!) as it becomes more or less scarce.

The remainder of their article may have been in some ways brilliant and insightful, but I lost heart and quit reading.

[13] The term de jure (under law) is frequently used to make explicit that a standard is intentionally declared by law, as in de jure silver standard. The term de facto (in fact), is typically used to identify the standard in practice, as in de facto gold standard. (But note that de facto standard may be a consequence of law, and that a de jure standard may be something of a legal fiction.)

[14] The word dollar is used in the US Constitution without definition because it was wasn't an invention of US or British law. Dollars were silver coins, of a particular size (when minted), produced in various parts of the world. Most of those circulating in America were minted by the Spanish Empire in its colonies. The United States began minting dollars as silver coins based upon the mean weight of dollars sampled from those circulating within America. (These had experienced a significant amount of wear or of shaving by the time that they reached America.) The transition to a gold standard in the United States was a messy business stretching across many decades, and set political and legal precedents that facilitated the later transition to money that was not based upon any commodity (which transition was also a messy business stretching across many decades).