Money

Folks,

Danny DeVito has a funny line in the David Mamet movie "Heist" in which his
character says to Gene Hackman "Of course you want money, everyone wants money,
that's why they call it money."

What is odd in popular economics is they have a hard time defining money,
probably for the same reason they have a hard time defining "free trade;"
probably because they are never really talking about "money." Something else.

The current USA President has thrown down the gauntlet to the Chinese over
"money," and the Chinese management of their money. If you want to learn about
money, get some definitions straight and think clearly about it, here is a
good starting place:

http://www.mises.org/fullstory.asp?control=1333


The Origin of Money and its Value


by Robert P. Murphy


[Posted September 29, 2003]


The importance of the Austrian school of economics is nowhere better

demonstrated than in the area of monetary theory. It is in this realm that

the simplifying assumptions of mainstream economic theory wreak the most

havoc. In contrast, the commonsensical, "verbal logic" of the Austrians is

entirely adequate to understand the nature of money and its valuation by

human actors.


Menger on the Origin of Money


The Austrian school has offered the most comprehensive explanation of the

historical origin of money. Everyone recognizes the benefits of a

universally accepted medium of exchange. But how could such a money come

into existence? After all, self-interested individuals would be very

reluctant to surrender real goods and services in exchange for intrinsically

worthless pieces of paper or even relatively useless metal discs. It's true,

once everyone else accepts money in exchange, then any individual is also

willing to do so. But how could human beings reach such a position in the

first place?


One possible explanation is that a powerful ruler realized, either on his

own or through wise counselors, that instituting money would benefit his

people. So he then ordered everyone to accept some particular thing as

money.


There are several problems with this theory. First, as Menger pointed out,

we have no historical record of such an important event, even though money

was used in all ancient civilizations. Second, there's the unlikelihood that

someone could have invented the idea of money without ever experiencing it.

And third, even if we did stipulate that a ruler could have discovered the

idea of money while living in a state of barter, it would not be sufficient

for him to simply designate the money good. He would also have to specify

the precise exchange ratios between the newly defined money and all other

goods. Otherwise, the people under his rule could evade his order to use the

newfangled "money" by charging ridiculously high prices in terms of that

good.


Menger's theory avoids all of these difficulties. According to Menger, money

emerged spontaneously through the self-interested actions of individuals. No

single person sat back and conceived of a universal medium of exchange, and

no government compulsion was necessary to effect the transition from a

condition of barter to a money economy.


In order to understand how this could have occurred, Menger pointed out that

even in a state of barter, goods would have different degrees of

saleableness or saleability. (Closely related terms would be marketability

or liquidity.) The more saleable a good, the more easily its owner could

exchange it for other goods at an "economic price." For example, someone

selling wheat is in a much stronger position than someone selling

astronomical instruments. The former commodity is more saleable than the

latter.


Notice that Menger is not claiming that the owner of a telescope will be

unable to sell it. If the seller sets his asking price (in terms of other

goods) low enough, someone will buy it. The point is that the seller of a

telescope will only be able to receive its true "economic price" if he

devotes a long time to searching for buyers. The seller of wheat, in

contrast, would not have to look very hard to find the best deal that he is

likely to get for his wares.


Already we have left the world of standard microeconomics. In typical

models, we can determine the equilibrium relative prices for various real

goods. For example, we might find that one telescope trades against 1,000

units of wheat. But Menger's insight is that this fact does not really mean

that someone going to market with a telescope can instantly walk away with

1,000 units of wheat.


Moreover, it is simply not the case that the owner of a telescope is in the

same position as the owner of 1,000 units of wheat when each enters the

market. Because the telescope is much less saleable, its owner will be at a

disadvantage when trying to acquire his desired goods from other sellers.


Because of this, owners of relatively less saleable goods will exchange

their products not only for those goods that they directly wish to consume,

but also for goods that they do not directly value, so long as the goods

received are more saleable than the goods given up. In short, astute traders

will begin to engage in indirect exchange. For example, the owner of a

telescope who desires fish does not need to wait until he finds a fisherman

who wants to look at the stars. Instead, the owner of the telescope can sell

it to any person who wants to stargaze, so long as the goods offered for it

would be more likely to tempt fishermen than the telescope.


Over time, Menger argued, the most saleable goods were desired by more and

more traders because of this advantage. But as more people accepted these

goods in exchange, the more saleable they became. Eventually, certain goods

outstripped all others in this respect, and became universally accepted in

exchange by the sellers of all other goods. At this point, money had emerged

on the market.


The Contribution of Mises


Even though Menger had provided a satisfactory account for the origin of

money, this process explanation alone was not a true economic theory of

money. (After all, to explain the exchange value of cows, economists don't

provide a story of the origin of cows.) It took Ludwig von Mises, in his

1912 The Theory of Money and Credit, to provide a coherent explanation of

the pricing of money units in terms of standard subjectivist value theory.


In contrast to Mises's approach, which as we shall see was

characteristically based on the individual and his subjective valuations,

most economists at that time clung to two separate theories. On the one

hand, relative prices were explained using the tools of marginal utility

analysis. But then, in order to explain the nominal money prices of goods,

economists resorted to some version of the quantity theory, relying on

aggregate variables and in particular, the equation MV = PQ.


Economists were certainly aware of this awkward position. But many felt that

a marginal utility explanation of money demand would simply be a circular

argument: We need to explain why money has a certain exchange value on the

market. It won't do (so these economists thought) to merely explain this by

saying people have a marginal utility for money because of its purchasing

power. After all, that's what we're trying to explain in the first place—why

can people buy things with money?


Mises eluded this apparent circularity by his regression theorem. In the

first place, yes, people trade away real goods for units of money, because

they have a higher marginal utility for the money units than for the other

commodities given away. It's also true that the economist cannot stop there;

he must explain why people have a marginal utility for money. (This is not

the case for other goods. The economist explains the exchange value for a

Picasso by saying that the buyer derives utility from the painting, and at

that point the explanation stops.)


People value units of money because of their expected purchasing power;

money will allow people to receive real goods and services in the future,

and hence people are willing to give up real goods and services now in order

to attain cash balances. Thus the expected future purchasing power of money

explains its current purchasing power.


But haven't we just run into the same problem of an alleged circularity?

Aren't we merely explaining the purchasing power of money by reference to

the purchasing power of money?


No, Mises pointed out, because of the time element. People today expect

money to have a certain purchasing power tomorrow, because of their memory

of its purchasing power yesterday. We then push the problem back one step.

People yesterday anticipated today's purchasing power, because they

remembered that money could be exchanged for other goods and services two

days ago. And so on.


So far, Mises's explanation still seems dubious; it appears to involve an

infinite regress. But this is not the case, because of Menger's explanation

of the origin of money. We can trace the purchasing power of money back

through time, until we reach the point at which people first emerged from a

state of barter. And at that point, the purchasing power of the money

commodity can be explained in just the same way that the exchange value of

any commodity is explained. People valued gold for its own sake before it

became a money, and thus a satisfactory theory of the current market value

of gold must trace back its development until the point when gold was not a

medium of exchange. *


The two great Austrian theorists Carl Menger and Ludwig von Mises provided

explanations for both the historical origin of money and its market price.

Their explanations were characteristically Austrian in that they respected

the principles of methodological individualism and subjectivism. Their

theories represented not only a substantial improvement over their rivals,

but to this day form the foundation for the economist who wishes to

successfully analyze money.



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Robert Murphy has been a summer fellow at the Mises Institute and now

teaches economics at Hillsdale College. robert_p_murphy@yahoo.com. See the

Study Guide on money. See the Murphy Archive.

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