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Friday, December 7, 2012

The Nature and Origin of Money

The study of spontaneous orders—systems of coordination resulting from human action but not of human design—is one of the most important tasks facing economists. Austrian economist and Nobel laureate F. A. Hayek even claimed that understanding these phenomena was the single most important concern of the social sciences. 

With its evolving networks and patterns of exchange, the free-market economy is perhaps the best-known example of spontaneous order. However, the extensive division of labor common in advanced market economies (and thus often taken for granted) itself rests on another self-organizing and self-perpetuating system. You can find evidence of that system every time you open your wallet.

A commonly accepted medium of exchange, what we call “money,” is necessary for the division of labor in a given society to progress beyond the most rudimentary level. To see why, consider the limits to specialization and trade facing humans in an environment where use-goods trade directly for use-goods—that is, barter. In a barter economy, economic calculation is impossible because there is no common denominator that can be used for accounting purposes. Calculations of profit and loss are indispensable signals for entrepreneurs; without them they have no way of knowing which lines of production should be expanded and which should be abandoned.
In addition, without profit-and-loss accounting, there is no way to single out the economically efficient way of producing a good from the many technologically feasible ways to make that good. This means entrepreneurs cannot create the network of goods and services that are used to make goods for final consumption. The use of capital in a barter economy is severely curtailed. Without capital to facilitate the division of labor, labor productivity—and thus wages and living standards—remains abysmally low. Advanced, capital-intensive economies cannot exist without money serving as the standard that guides profit-seeking entrepreneurs.


Chartalism vs. Bottom-up Money

It’s obvious then that there are massive gains to be had from moving from a barter economy to an economy characterized by indirect exchange, or exchange via money. But how did this system come about? Some scholars attribute the creation of money to the State. This theory, called Chartalism, holds that the demand for money was created by governments imposing obligations on their citizens, and then requiring said citizens to pay these obligations (taxes) in the form of a particular commodity. This commodity then became widely desirable because it made discharging obligations to the government a simpler matter for both State and citizen. Lending weight to this theory is the significant role governments around the world have in supplying money, usually with the help of a central bank. 
However, that government has a role in money provision now does not mean this was always the case. The origins of money may have quite a different story, as we’ll see. Chartalism also cannot explain why some commodities that governments demanded—such as precious metals—almost universally emerged as money all around the world, while others—such as livestock—did not. We need a theory that can explain why some commodities appear to be “better” forms of money than others. Once again, the Austrian school of economics provides an answer, this time in a theory developed by the school’s founder, Carl Menger.


Menger and Money

Menger laid out his theory in an 1892 journal article titled “On the Origins of Money.” Menger described, starting from a system of barter, the economic forces that led to the emergence of a commonly accepted medium of exchange. The answer lies in the concept of salability—characteristics of a good that make it relatively more marketable than other goods. To be salable, a medium needs three things: homogeneity, divisibility, and low storage costs. Homogeneity means one unit of the commodity, whatever it is, is more or less the same as other units. Divisibility means the commodity can be split into smaller parts without damaging the resale value of the commodity. Low storage costs are self-explanatory. 
We can see from these criteria that precious metals are quite salable. An ounce of gold is identical to another ounce of gold; an ounce of gold can be split into a half-ounce without diminishing the ability of the gold to satisfy a want (say, to make jewelry); and gold is relatively cheap to store. Livestock, on the other hand, exhibits none of these qualities. One cow can be quite different from another; you cannot split a cow in two without killing it; and cows are costly to keep, since they must be fed and protected from predators and disease. 
So much for salability. But how do these salable commodities become money? In a barter economy there is an additional exchange friction relative to a money economy: Not only do you have to find someone who has something you want, but that someone also has to want what you have. This problem, known as the double coincidence of wants, greatly increases the costs of trading. Due to differences in salability across commodities, some traders are going to have their desires frustrated more often than others. However, given that the terms of an exchange are frequently visible to third parties, enterprising traders can engage in a bit of strategic behavior: Instead of only exchanging their commodity directly for the one they want, they will also offer to exchange their commodity for one that is more salable than the one they currently have. Traders have an incentive to do this since commodities that are more salable are by definition more marketable. By trading their less-salable commodity for a more salable one, they increase their chances of making the trade that was their desire all along. This strategic behavior makes the trader better off, since he is now able to satisfy his wants more easily. 
Other traders have an incentive to copy this behavior for the same reasons. As more and more salable commodities become desired for strategic trading purposes, demand for these commodities increases. The process repeats itself until the most salable commodities are almost universally demanded for their exchange value rather than their consumption value. Eventually the process terminates with one commodity (or sometimes a few) serving as the generally accepted medium of exchange. The money economy has been created—not by any social planner or State, but as the result of the behavior of many, many individuals pursuing their own interests. It is the quintessential example of spontaneous order. 


The State of Money

How money economies are created and sustained has important implications for economic policy. If the State is the prime mover behind money, it is much more likely that policy can shape its development than if money is the spontaneous result of decentralized market behavior. This is why the debate on the origins of money is not limited to academic publications but also features in today’s most prominent periodicals, such as The Economist. While the debate has been going on for more than a century—Chartalists and Mengerians have a poor track record of changing one another’s minds—it is crucial that students of society actively engage in this debate. In light of the recent financial crisis and the uncertain fate of both the dollar and the euro, money is too important a phenomenon to be misunderstood.