Chapter 3: Money
The author makes the case that money is "perhaps the most important invention of all time." It gets little credit, because physical money doesn't do anything on its own and it often is not even a physical object, but the existence of money has facilitated production and trade of all kinds, and without it we would likely still be in medieval times, with isolated communities that are self- supporting and do not interact with one another.
The main value of money to society is facilitating trade. Direct barter is only useful when two parties have exactly what the other needs, but this is a coincidence. It also allows value to be transported long distances over time in which physical goods would decay - and by the same virtue to enable value created in the present to be stored for many years before it is used. There's a "day in the life" example that suggests the number of transactions we undergo on a daily basis that would be very difficult without money to serve as a medium of exchange for all things.
It is the ability of money to command goods and services that makes it desirable. Those who have great sums of money can use it to induce others to give them things and do things for them, and this gives them considerable power over others in society. (EN: This is often overestimated, however - money has the power to buy only what is for sale.)
He then touches upon the commodity and uniformity of money. How much wheat is considered a "fair trade" for a pound of meat depends on the quality of both goods and the subjective desire of each party, so it's impossible to predict what the wheat-price of meat will be on any given day. Money creates a universal standard and eliminates a lot of inspection and haggling.
There's a brief consideration of commodity money - societies in which wheat or salt or seashells served as money - along with the various reasons most societies gravitated toward the use of rare metals for currency (nonperishable, uniform, divisible, high value to weight, etc.). Then a rather swift consideration of how paper currency came to be (a note that gave ownership of a good was considered equal in value) and how eventually currency became divorced from having any basis in any physical commodity. (EN: These are covered in greater detail in other sources.)
The Importance of a Stable Currency
The price of a good in barter depends on the scarcity of that good. Where people desire more wheat than is available, those who hold wheat can demand more in exchange for it. Where the desire for wheat is less than is available, it is the wheat-holder who must give more in exchange because his wheat is worth less. So the prices of other goods can fluctuate depending on the supply of wheat. The same can be said of prices and money: it is the desire for money that causes prices to rise and fall, and a shortage or surplus of money in a market can increase or decrease its value.
This also applies to fiat currencies, whose value is entirely arbitrary. Where a government merely spins up the printing presses and turns out more paper money, this creates a surplus of money (against a fixed pool of goods and services) and decreases its value. A common example of this is the German government after the first world war, which merely printed up loads of money for itself - and the response was that the price of goods skyrocketed to the point where it took a handful, then a bundle, then a wheelbarrow full of money to purchase a loaf of bread. Workers collected their wages daily and ran as fast as they could to the market to spend them before they became worthless. This is an extreme example, but the same thing happens in slow motion where a government debases its currency over time.
He then meanders into another example to illustrate this: the use of cigarettes as currency in prisons - having not enough or too many cigarettes in prison populations has historically caused violence among prisoners and even riots.
He uses the example of cigarettes to point out a few other useful/necessary qualities of money:
- It has to be difficult to make and even more difficult to forge or debase
- It has to be a commodity, sufficiently uniform in quality that there is no haggling over the value of a unit
- It has to have sufficient value-to-weight that it doesn't take a physical bulk of money to purchase everyday items
- It has to be divisible or unitary, to the point that the smallest unit is useful to purchase something
- It has to maintain its value for a reasonable amount of time
He also mentions the problem of having a consumable commodity to serve as a medium of currency. Because wheat is eaten and cigarettes are smoked, the money supply is constantly fluctuating by the consumption of the money commodity, so it is difficult to regulate supply of money to the market.
Commodity, Credit, and Fiat Money
The author mentions that there are various bases of money, which is sometimes described as an evolution - but the author does not go that far. Credit and fiat monies are merely different to commodity money, and they are both quite fragile. There are those who maintain that commodity money is the only certain form of money and that the others are bound to fail - it's largely a political argument, but there is good reason for this perspective. But to skirt all of that, let's just consider the three to be different and attempt to understand their nature.
- Commodity money is based on the value of a good that is in existence. Whether buyers hand over the good itself or a piece of paper that can be exchanged for the good in a storage location, the good is what is being traded.
- Credit money is based on a value that will be delivered in the future. It is always a note or token because the good for which it can be exchanged does not yet exist, but allegedly will on a certain future date. The right to have that good in the future is what is being traded.
- Fiat money is based on no physical good. In essence, it is to be used in exchange because the government says so. It is accepted on faith that it can be exchanged for other goods, but it can never be directly redeemed for anything.
The benefit of commodity money is the certainty of its value - when one accepts a silver coin, one takes possession of the silver. It exists. Or when it is a note, it can be redeemed immediately, or at any rate soon enough that if it is found to be false, the seller can still get hold of the buyer (or the authority issuing the paper certificate) and make them deliver what was promised. The drawbacks, as mentioned previously, is the limited supply of commodity money - unless more silver is produced, there can only be so many silver coins or silver bars in storage to back paper money.
The benefit of credit money is that it enables people to have access to value that will not be created until the future. A farmer can borrow money to buy supplies and pay laborers to plant, tend, and harvest a crop that will pay back these costs when it is sold at market. The obvious drawback is that if the crop fails, the credit cannot be repaid, and all those who have hold the notes are no longer able to collect.
(EN: This presently ignores intermediaries. Very often one of the services of the money-issuing intermediary is in guaranteeing the value of its money so that even if the crop fails, the people holding notes of credit will be paid, but the issuer of the notes must find the means to pay them.)
Both credit and commodity money are based on productivity, whether past or present. The amount of money, hence the exchange value of each unit of money, depends on the quantity of a physical good that exists (or will exist). The more of the physical good that exists, the less value it has, and the less value each unit of money based on the value of the underlying good.
Fiat money is created at the whim of government and valued for its exchange value. It is valued because it is presumed that the government will force sellers to accept it, and loses its value when the faith of the people in its willingness to force its acceptance wavers. Because it can be created or destroyed at a whim (and is not locked to the value of a good), governments can control the stability of their currency - but this is not always done well, which causes currency to be debased or become worthless when there is too much of it.
Special attention is given to credit money whose value is based on the ability of another party to repay a debt. It is essentially the same as the farmer scenario, but instead of paying the loan from the proceeds of production, credit money can be repaid by any means (which was always the case, because the farmer whose crop failed may purchase crops from other farmers to meet his commitment).
The dysfunction of banking is also mentioned: bankers discovered they only needed a small amount of money on deposit to satisfy its' customers demand to withdraw funds, and that most money remained it its vaults. This gave banks the opportunity to loan out the depositors' money and, so long as it collected it by the time depositors wanted to withdraw it, no-one would be the wiser. This greatly increases the money supply but at times causes financial upheavals when loans are not repaid or depositors panic and make a run on the bank to withdraw cash the bank does not have. Rather than punishing the bankers, government entities such as the Federal Reserve and the Federal Deposit Insurance Corporation were created so that banks could carry on loaning out their depositors' money.
It's also noted that fiat money is possible because commodity money is seldom redeemed. As the bankers observed, most people carry around paper notes indicating that there is gold in the bank, but never redeem the notes. Instead, this paper money passes from one hand to another and remains in circulation indefinitely. So unless/until it is redeemed there is no practical reason for there o be gold to back money - and this generally proves true until loans go unpaid and depositors want their gold back.
So long as people are willing to accept paper money and never redeem it, then it makes no difference: money is valued because it can be exchanged for goods even if there is nothing for which it can be redeemed.
Measuring the Money Supply
If there were only commodity money, measuring the total amount of money in a market would be a matter of estimating the amount of that commodity that exists - but because there is credit and fiat currency, measuring the money supply is no easy task and must begin with considering what kind of money is being measured.
- M0 or "the monetary base" considers currency (bills and coins in circulation) plus the amount banks have on deposit with the Federal Reserve
- M1 adds the amount of travelers' checks and demand deposits (checking and savings accounts, which can be withdrawn at any time)
- M2 adds the balance of money market accounts (which can be withdrawn) as well as time deposits (such as CDs, which may be surrendered early)
- M3 adds institutional time deposits, money market mutual find balances, repurchase agreements, Eurodollars (dollars held by banks outside the US), and other redeemable instruments
There are various reasons that certain of these items are included or excluded from one of the "levels" of money based on the needs of any given analysis (whether a decision would be impacted just by cash in circulation, or if things that can be quickly converted to cash may be affected or have influence). There are also various methods of estimating these amounts, some quick methods that provide a loose estimate and other laborious methods that provide a more precise one. Again, it depends on what is relevant to the analysis being conducted.