Money

For my first post I would like to look at one of the most important aspects of the market economy: money. In fact, I would go as far as to say that the prerequisites for a prosperous and stable society are precisely property rights and sound money. Nothing more, nothing less. I will talk about property rights at a later date once I have gotten the easy stuff out of the way. For now, I think the reader will agree that allowing theft is probably not a good idea if one wants to build a prosperous and stable society.What exactly is money?To understand what money is (and isn't) we need to look at the role it plays in the market economy. Without money, we would be living in what is called a barter economy. If you wanted to purchase an apple from the apple-dude, you would need to exchange something for it; he's probably not going to just give it to you. Let's say you're the bread-dude. You would need to give your loaf of bread to the apple-dude, who in return will give you 2 apples. We assume here that 1 loaf is worth 2 apples. This is the price of each. That is, the price of 1 loaf is 2 apples, and the price of an apple is 1/2 a loaf. We'll come back to this later.That's all well and good, but what if you are an economics professor and you want to get a haircut? Well, you will need to find a barber willing to trade you a haircut for an economics lesson. This could be really hard. This problem in the barter economy is known as the double coincidence of wants - both you and the barber need to be looking for each others goods/services in order for a trade to take place. As you can see this greatly reduces the ease with which people can trade and thus undermines the division of labor (article coming soon).While you are pondering how to get a haircut, the baker comes to you and asks you for an economics lesson and offers you a loaf of bread in return. Since you have already eaten that day, and the bread will go bad by the next day, it would appear that, again, there can be no exchange. However, being the smart economics professor that you are, you realize that while you may not have any use for the bread, the barber might. So you trade for the loaf and take it to the barber. Sure enough, he hasn't eaten that day and is happy to accept it in return for a haircut. Notice how you accepted the loaf in the expectation that you could give it to the barber. You clearly would not have accepted anything that you didn't expect the barber would want.In the above example, we can say that the loaf of bread has acted as money, not that it is money. There is a subtle, but important, distinction. Money is defined as the medium of exchange. When you traded for the loaf you used it to facilitate a 3 way exchange, between you, the barber, and the baker. It was the medium that allowed for there to be trades when it seemed like none could happen. Whenever a good works to facilitate trades as in the example above (or to higher degrees), we say that it is acting as the medium of exchange; or, as money. We say that something is the medium of exchange (is money) if it is commonly used as the medium of exchange.What makes good money?As a medium of exchange, the purpose money serves is to facilitate trade. It needs to be portable (so you can carry it to the place of exchange, or just on your person in anticipation of an exchange), durable (how would you like it if you put it under your mattress only to find it has perished a week later), and divisible (so you can exchange exactly how much of it you want). This is true even if you have banks and banknotes as will become clear when I discuss banking (article coming soon).Some people will argue that money needs to store value and is a unit of account. With the caveat that value is purely subjective (article coming soon) and cannot be "stored", we can say that this is, in fact, true, but these are both consequences of the one real purpose: as a medium of exchange. I am not going to elaborate here; you can refer to links below for more details on this.There is one final consideration that is somewhat of a thorny issue and ties into the topic we will look at next. Since money is accepted in trade with the expectation that it can be easily traded again, it clearly needs to be widely valued. If it was not widely valued then it is unlikely that you will be able to trade it for something you want in the future and you should not accept it in trade? In the example above, had you not known that most people (including the barber) eat bread to satisfy hunger, and hence value it, it could not have functioned as the medium of exchange. It is interesting to note that once a good is accepted as money we no longer have this problem because it is already widely valued as money.But how does a good become money? Well, it must have already been widely valued, else people would not have started using it as the medium of exchange. For example, suppose you live in a society by the beach where everyone really likes sea shells (assume for simplicity that there are only one kind and that they are rare enough that it takes a little looking to find one). You know this because everyone is always talking about sea shells and their collection. If someone wants something from you, would you not be likely to accept a sea shell in return? You know that a sea shell is highly valued because it is cannot be easily found, so it is quite likely that you can trade it along to someone else for something you desire. Once enough people catch on to this idea and begin to trade their sea shells for other goods, the sea shells become the money of the society.Once a good has become money it has monetary value (because it is valued as money), as well as its original value (either industrial or aesthetic (as with the sea shells)). It is quite possible that the monetary value will come to dominate (as is the case with gold today).The important lesson to take away from this discussion is that a good can become money in a free market if and only if it is already widely valued for some other characteristic it has.Historically, we see that many different types of goods have served as money, including lumber, tobacco, and of course, gold and silver. The important characteristic of all of these has been precisely that they cannot be arbitrarily created, but must be either discovered or manufactured, both with effort. There's no such thing as a free lunch!Fiat money is an invention of the 20th century. It will be discussed in detail when I talk about sound money.What makes sound money?This is a much much more interesting question that has many people disagreeing. I will address it in my next post.Here is a must read article by Rothbard.