Wednesday, September 5, 2007


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.

Origin of money

To understand what money is and how it evolved, 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. A barter economy is characterized by direct exchange. If Jones the baker wants an apple, he will trade with the grocer by offering the grocer a loaf of bread. They both agree on how many apples each loaf is worth and make an exchange. Easy enough, but what if Smith the economics professor wants to get a haircut? He needs to find a barber willing to trade him a haircut in return for an economics lesson. This may prove quite hard to do. This problem in the barter economy is known as the double coincidence of wants -- both Smith and the barber must be looking for each others services in order for an exchange to take place. As is evident, this greatly reduces the ease with which people can trade and thus undermines the division of labor.

Suppose, instead of Smith, that Jones the baker had wanted to get a haircut. Do you think it would be easier or harder for him to find a barber willing to trade him a haircut for a loaf of bread? Intuitively, it should be apparent that it would be much easier. What about Davis the shoemaker? Presumably he would have an easier time than Smith, but probably have to look a little longer then Jones. This difference in how readily certain goods are accepted in trade is what Menger termed their saleability (marketability, liquidity).

Smith, if he was any good as an economics professor, understands this concept and also that his services are not very saleable. Therefore, in order to satisfy his daily needs, he realizes that he needs to have a reserve of highly saleable goods on hand. If he wants a haircut, instead of looking for a barber that wants an economics lesson, which can be costly in time and effort, he need only dip into his stock of highly saleable goods and get himself a haircut from the closest barber. Further, whenever he gives someone an economics lesson, he can request as payment highly saleable goods and thus build his reserve. By acting in this manner what he is doing is using highly saleable goods not for personal consumption, but rather as a means to facilitate trade in the future. He is using them as a medium of exchange.

In order for something to be effective as a medium of exchange it needs to be
  1. Highly saleable: as we have already discussed.
  2. Portable: so it can be carried to the place of exchange, or just on someone's person in anticipation of an exchange.
  3. Durable: probably wouldn't work to keep it under ones mattress to find it has perished a week later.
  4. Divisible: so exactly as much as needed can be exchanged.
It should be apparent that there are many goods that fit these criteria and are therefore in competition with each other to be used as the preferred medium of exchange. Eventually as more people catch on to Smiths idea, they will exercise their discretion in selecting which highly saleable goods they prefer to use as the medium of exchange. Many people acting on their own independant valuations will have the effect of the market selecting a good (or a few goods) that is most widely used as the medium of exchange. It is at this point that we refer to this good(s) as money.

The definition of money is precisely that good (or goods) which serves as the medium of exchange. At different times and places many goods have been used as the medium of exchange, including lumber, tobacco, and even cell phone airtime in some parts of Africa today. However, the market has selected one good in particular, gold, to be the universally preferred medium of exchange. There are very important reasons for this that will be discussed at length in the article on sound money. The current system, however, is based on government fiat paper money that is not backed by gold, silver, or anything for that matter. It would appear that this undermines our discussion, but it does not for reasons that will become clear shortly.

As one particular good becomes widely accepted as the preferred medium of exchange, it's demand rises. People now value it for whatever reason they valued it earlier, as well as because it has become money. It has its original non-monetary value (industrial or aesthetic), as well as its monetary value (can be readily traded). In the process of gaining monetary value, the good assumes further saleability as people are more likely to accept it in trade because they know still others are more likely to accept it in trade, and so on. This is self-reinforcing, and the end result is that money often gains much more monetary value than non-monetary value. This has been the case with gold; it has become much more valuable after it was widely accepted as money. Even today the major driver of the price of gold is investment demand. Also think about what the most saleable good is today. It is precisely federal reserve notes, what we call money. Remember they are backed by nothing, they are merely pieces of paper, but everyone will readily trade for them because they have monetary value -- can be exchanged for goods and services at a future date.

It should be clear at this point that a good cannot naturally arise in the market as money unless it is already highly saleable (for whatever reason). That is, it must have some original value to form a starting point. This is the essence of Mises' regression theorem. Even the current monetary system does not escape this need. When the federal reserve notes that we use as money today were first issued, they were redeemable in gold. Once they gained monetary value to offset the fact that they are nothing but pieces of paper, Nixon was able to close the gold window and sever any ties they had with gold. They did not fail because they had become saleable on account of acquiring monetary value. However, it is important to realize that they are an "unnatural" phenomenon because they required government force (legal tender laws and false demand in terms of income taxes only payable in federal reserve notes). It is impossible for fiat money to arise in a free market. If a critical mass of people realizes this, fiat money may very well be rejected (it is, in the economic sense, a bubble) and society will return to a commodity based money, such as the gold standard.


We will look at fiat money versus gold in more detail when we discuss sound money. For now it should be clear money is a commodity that naturally arises in the free market as the preferred medium of exchange. Individuals vote by choosing to accept certain goods over others and eventually one is selected as the best. Historically, this has been gold, and to a lesser extent silver. Although fiat money is unnatural, once it has gained monetary value, it is no different than gold in that regard. However, there are other important differences.

Some people will claim that money is a store of value and a unit of account. With the caveat that value is purely subjective and cannot be "stored", this is true. Money tends to maintain its "value" (it's purchasing power). I say tends because there is always the threat of inflation. It is also a unit of account because the prices of all goods are expressed in the monetary unit. However, these are both consequences of it being the medium of exchange.

A final note: the theory of money and credit is one area where Austrian economics clearly differentiates itself mainstream economics. Important books include Mises' Theory of Money and Credit, and Jesus Huerta de Soto's Money, Bank Credit, and Economic Cycles.

Please read the next article on banking.


Must read article by Rothbard.
Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto.
Theory of Money and Credit by Ludwig von Mises.
Study guide to money.

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