Thursday, May 14, 2009

What is money? (Part II)

Last time we demonstrated that wealth is only created through production. That eliminated the possibility of money as wealth, but did not shed any further light on what the nature of money is. To continue our investigation we have to consider a new scenario.

The original scenario analyzed the economy of a single man isolated from others. What dynamic emerges when we introduce more people into the picture? There are two possibilites: either each man fends for himself and is responsible for producing all of his needs, from housing to food to health, or there is a division of labor. As society transitions from a single man to a village, each productive citizen specializes in a particular good or service. One man may become a fisherman, another may harvest wheat berries, still another may tailor clothes. This division of labor improves the quality and variety of goods for everyone.

Yet there still exists a logistical problem. How does the fisherman acquire his new trousers (because back then they didn't wear pants they only wore trousers)? He trades his fish directly to the tailor. This is known as barter exchange. This will solve the problem for some cases of exchange, but it soon becomes apparent that not everyone wants what the other party is offering. If the tailor has no taste for fish, then the fisherman will be pressed to find a new commodity that does suit the tailor's taste. So the fisherman finds out that the tailor wants butter, trades some of his fish with the dairy farmer for butter, returns to the tailor and exchanges his butter for the new threads. Problem solved. This process is called indirect exchange and in this case the butter is the medium of exchange.

Notice how the medium of exchange in this case was itself a useful commodity. This is an important point to remember.

An interesting question can be raised at this point. Are all mediums of exchange created equal? Is there any significant difference between the various possible mediums? In his book "What Has Government Done to Our Money?", Murray Rothbard says the answer is no. He explains that the commodities that are chosen as the medium of exchange are more marketable than other commodities. In other words, they are readily sold. He lists several categories that make one commodity more marketable than another: Divisibility, durability, and transportability.

In the example above, butter is used as a medium of exchange with excellent divisibility, poor durability, and fair transportability. A cow might be considered to have poor divisibility, but strong durability and transportability. It is clear that over time certain commodities will rise to the top, and those will be the ones with the greatest marketability. Rothbard argues that gold and other precious metals eventually become the most widely used commodity as a medium of exchange. Gold and other precious metals wind up becoming money. The truth is that all of these various commodities are money, but not all monies are created equal, because they are not all equally marketable.

To illustrate the properties of money lets examine one more scenario. Assume we live in a society where gold is the preferred medium of exchange. Lets say that a new technology emerges which confers a tremendous social benefit but must use gold. If the net effect of this new technology sufficiently damaged the marketability of gold, a different commodity would inevitably take its place. Perhaps platinum, or maybe tungsten carbide. In other words, the marketplace would choose a new medium of exchange to compete with gold. History does bear this out with the emergence of silver and copper coins.

To summarize: Money is always a commodity in itself, and the commodity that finds itself in greatest favor for use as the medium of exchange is one that is most marketable at that time. Money is not confined to one commodity, the marketplace will use whatever varieties of money necessary to expedite trade.

This is a satisfying account of the origin of money, but there are still questions. What is our money? How do we make the leap from commodity money to paper money? Lastly, we still haven't gotten any closer to understanding John Adams' statement. We will look further into these questions next time.

1 comment:

  1. This is a famous old paper I read for a class once -- definitely the most interesting thing I've read about the idea of money: