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3: The Various Kinds of Money

When an exchange is made that involves money, it is not necessary for the money to be physically tendered: a secured claim to an equivalent sum can be transferred instead of actual coinage. (EN: this text was originally written decades before the emergence of credit cards, and even paper money was rare, so it was a more unfamiliar and interesting concept at the time.)

Money is especially well suited to such transactions. Direct exchange depends on the acceptability of the goods being tendered, such that a seller might be reluctant to accept the value of goods he cannot inspect. Also, there is the difficulty for the acceptor to transfer to others (i.e., to spend) until the physical items have been received.

The acceptability of money substitutes, specifically checks and banknotes, depends on some legal underpinnings: the issuer must accept the item without further proof of claim such that it can be paid to any bearer; no action may be taken by the previous holder to invalidate the item's value; and the item itself must be recognized as a method of debt settlement, such that the acceptance of the item is the legal equivalent of accepting money.

(EN: My sense is that it is not so much a legal requirement as a cultural one. Specifically, it is not the letter of the law that makes these items "work" as money, but the trust of the acceptor that their claim will be honored. The phenomenon of "bad checks" underscores this point, as no bank is legally required to honor a false check, nor is any seller under any legal requirement to accept a check as a method of payment. So while the premises are essentially correct, the notion that money substitutes are a creation of government is incorrect.)

From a perspective of economics, the goal is to consider the exchange ratio between money and other economic goods, and given that money substitutes are locked to a one-to-one ration in their exchange for physical money, it should make no difference from an economic standpoint whether an exchange involves physical money or a money substitute.

Some consideration can be given to the fact that claims are not goods; hence a money substitute is not actual money, merely a means to obtain it or have command over its disposal. As such, the value of a claim to a good is based not only on the value of the good, but must also consider the likelihood that the good can actually be claimed.

This is of particular interest to the futures market: when one purchases the right to claim some quantity of oranges a year from the time at which the transaction is made, the valuation of such a contract considers the value of the oranges, but that value is reduced by the risk involved (should the guarantor be unable to produce the oranges a year from now). A further reduction may also be made based on the acceptor's expectation of the cost of redemption (if the oranges are to be tendered at the orchard, the acceptor will bear the cost of shipping them).

These same "reductions" are applicable to money, though they tend to be lesser in degree. The acceptance of a banknote is discounted by any suspicion that the bank itself will be solvent when the note is redeemed, and further discounted by the need of the acceptor to undertake expense to travel to the bank to redeem the note for money.

In order to have a perfect one-to-one correspondence to money, a substitute must be absolute secure and there must be no cost to redeem it. This ideal cannot be accomplished perfectly in reality, hence the value of any money substitute is slightly less than one-to-one.

(EN: A note of interest to the current economy is the merchants accept money substitutes, such as debit and credit cards, as a one-to-one substitute. While the likelihood of the issuer becoming insolvent is very low, there are fees for merchants to accept payment cards - and it's rare that merchants charge a mark-up for credit card payment, and customers object to such.)

(EN: Another note of interest to the current economy is that the situation is entirely reversed. Individuals and companies alike desire to have money substitutes - a balance in their bank account to cover check and card payments - and tendering physical cash imposes upon the acceptor the inconvenience and risk of having to deposit it to turn it into "usable" funds.)

Another significant difference is that claims to money can be held indefinitely. In the previous example, the claim to oranges from next year's harvest must be redeemed at harvest-time, or else it becomes worthless. A claim to a sum of money held in a secure reserve is not perishable, and does not necessarily need to be liquidated (so long as the money is accepted as valid).

The longevity of money also makes it susceptible to counterfeit. If the claims are to be redeemed in the short term, the issuer must have sufficient stock of a commodity on hand to satisfy those claims. But if the claims remain in circulation, the issuer can get away with issuing notes the exceed the amount of money he has on hand, keeping in reserve only as much money as is needed to redeem notes that are tendered. This results in increasing money substitutes in circulation without increasing the actual supply of money.

Peculiarities of Money Substitutes

State-issued currency ("token coinage") is not the same as money, but it is a claim to money as it can be exchanged for precious metals in the state treasury. Examples are given of state-issued currencies that were accepted by the market s a medium of exchange (because they were redeemable), and others were the currency was rejected by the market when the state failed to redeem it.

Historically, token coinage has been issued as a means to facilitate trade of small volumes of little value. These small coins were minted in a quantity sufficient to the requirements of commerce, and were held in a fixed ratio to the money used in larger transactions.

Banknotes are similar in nature, in that they represent a claim to money held in reserve, which could be redeemed upon demand for a certain quantity of a commodity (typically, precious metals) held in either a private bank or the state treasury.

It's suggested that token coinage and banknotes function as money in domestic commerce, and that they are seldom in practice exchanged for actual money, the exception being in international commerce. And while countries issued a myriad of currencies, this was largely immaterial, and the actual money of European countries, was gold.

Commodity Money, Credit Money, and Fiat Money

The legal distinctions between kinds of money are of little interest to economics. In essence, there are two things that can be used as money - physical commodities that can be used in direct exchange, and various objects (coins, notes, and checks) that represent a claim to physical commodities.

Quite some consideration has been given to state-issued notes and coins as money, but it is incidental: a note or coin issued by a state government is not essentially different from a note or coin issued by an independent organization or private individual.

And while it is within the power of the state to regulate the creation of notes and coins, it is beyond the power of the state for them to require such notes and coins to be accepted in commerce as a common medium of exchange. As such, sate-issued currency cannot become money by command of the state, but only because it is accepted by those who take part in commercial transactions.

As such, there are three distinctions among items used as money in commercial exchange:

  1. Commodity Money - Money that is an actual good, such as a coin whose value is the metal contained in the coin itself
  2. Fiat Money - Money that has no physical value in itself, but is backed by a commodity held in reserve
  3. Credit Money - Money that has no physical value in itself, and is backed by a commodity that is not presently in reserve but may be obtained or created in future

The latter two types are not money, but are money substitutes, which may be accepted as if they were money, given that the acceptor assumes the risk that they may not ultimately be redeemable for a physical commodity.

Some consideration has been given to the differences between the three kinds of money and money substitutes, but this remains purely academic: the value of money is as an object used in a commercial transaction, its intrinsic value being entirely incidental to that function.

Money: Past and Present

Historically, currency was issued in coinage that itself was a physical commodity - coins were minted of metal, and were valued by the purity and weight of the precious metals they contained. Trade was conducted in terms of the weight of the metal itself - an agreement to trade for five ounces of silver was satisfied by tendering five ounces of silver, in whatever coin. In effect, the coin was no different than any other piece of metal.

The currency of the present day, being fiat or credit monies, have a fixed redemption value as noted on the physical representation. The result is that, in current transactions, the unit of money is according to the indicated value of the currency, in which prices can be given. Trade is conducted in francs, marks, florins, or aught and an agreement to trade for ten francs can be satisfied by any combination of notes and coins representing that amount.

As such, the chief problem of monetary theory is finding a satisfactory explanation of the ratio of exchange between money and other economic goods.

The comparison of various forms of currency (determining how many florins can be exchanged for how many marks) as well as the exchange value of currency as opposed to the value of physical commodities (the Austrian "silver mark" fluctuates in value against the same quantity of metal it is purported to represent) is a distraction that is of little consequence to the economic activity of buyers and sellers in the marketplace.

However, it does obfuscate matters of international commerce, when there is no clear and consistent exchange rates in currencies, and the currencies themselves are based on different commodities in reserve. For example, if one currency is backed by a certain quantity of gold and another by a certain quantity of silver, the exchange rate between the metals is subject to constant fluctuation, hence the exchange rate between the currencies is subject to the same constant fluctuation.

Turning again to history, it is noted that the minting of coins by the state has led to the debasement of currency in a literal sense. Originally, a state-issued coin was taken as a guarantee that a coin contained a specific amount of metal. However, states that wished to spend a greater amount of funds than were available took to decreasing the amount of base metal in its coins, but expected the coins to be accepted at face value in commercial exchange by virtue of authority of the state.

In that way, price inflation in the market, which resulted as a consequence of debasement, was a rectification that asserted that state authority over currency was of less importance, when any coin is presented, that the actual value of the base metal contained within the coin. In effect, kings cannot create value by command.

It is noted that the units of money in countries - the mark, the pound, the dollar, and so on - originally referred to a specific weight of a specific metal. But as a result of debasement, the value of currency has declined against the value of money. If you wish to buy a pound of sterling silver, the price will be considerably higher than one "pound sterling" of currency issued by the English government.

A few examples are provided of organized markets in which the value of currencies were assessed, and prices in the market adjusted accordingly, hence a debased coin was considered to be worth less in exchange for goods by virtue of containing less metal, and a corresponding debasement occurred for checks and banknotes, on the rationale that they would be redeemed for the most recent coinage.

As a result, the opposing forces in the conflict were the integrity of the state (to declare the value of its currency) and the integrity of the marketplace (to declare the value of its goods as measured by currency). Historically, the latter has been the victor: governments and monetary systems have suffered complete collapse, but trade in the marketplace has continued.

It's also worth noting that trade on a large scale was conducted with commodity money. A merchant purchasing goods in bulk would pay with gold and silver ingots rather than physical currency. This enabled agreements to be made with confidence (an ounce of gold is an ounce of gold, regardless of currency exchange rates) and safeguarded the fortunes of wealthy individuals against the whim of the state (physical gold retains its value, whereas currencies can lose value when they are debased).