Wednesday, August 28, 2013

What Is Money?

"Money is not an invention of the state.  It is not the product of a legislative act."

Carl Menger (1840 - 1921)
Founder of the Austrian School of Economics

What is money?  We all know that the classic definition of money is something used as a medium of exchange, such as coin and paper.

But those coins and paper can only be used when they are accepted by both parties in the transaction.  If I write "$ One Dollar $ " on a piece of paper and try to spend it, it could act as money only if it was to be accepted by the other party.

In addition to his recognition as the founder of the Austrian School of Economics, he is also known for two other contributions.

First, he developed the "marginal utility of goods" theory.  This is how he resolved Adam Smith's paradox of water and diamonds.  What bothered Smith was why diamonds have greater value than water when water is obviously necessary for life and diamonds are not?

This is where Menger's "subjective theory of value" comes into play.  When water is needed, say to water a garden, the first buckets are more valuable than subsequent buckets.  The more buckets that come into play successively reduces the value of each one.  A thousand buckets will not have equal value as the last many hundreds might not be needed.

Diamonds have value because of what economists call "derived demand."  Diamonds are valuable because of the degree of importance of wants they satisfy.  The derived satisfaction from a beautiful diamond creates value and demand.

Menger used this "subjective theory of value" to propone one of the most valuable insights in economics:  that both sides benefit from an exchange.  People will exchange something of lesser value for something they consider to be of more value.

This led Menger to his second big contribution in money and banking to explain how money came into being.

A man on the corner with a sign that reads, "Will work for food," is offering himself as money to pay for a meal.  He might clean a garage or rake a yard and is fed for his work.  That is a form of money.  It could be considered barter.

But why, considered Menger, does not barter simply become the accepted exchange we call money? 

My wife has a lot of shoes.  You shake your head yes, of course.  But it is unlikely she could trade those shoes straight up for a car.  She might be able to barter those shoes for something else, and that again for something else.  Over time, conceivably she might, after lots of exchanges, actually derive the ability to trade for a car.  But this is tedious!  It is uncertain!  It is very cumbersome, much more so than selling them for a more acceptable means of exchange, like paper money.  If she had enough shoes to sell, perhaps, she could buy that car more easily!

The value of those shoes is "subjective."  What is a car worth?  What someone is willing to pay for it, and what a seller is willing to let it go for.


My wife's shoes, LOTS of shoes, become a form of money, insofar as she can sell them for a medium of exchange.

Any good that is widely accepted can become money.  Roman soldiers were paid in salt.  We derive the word "SALary" from the Latin word for salt.  A blog on this concept can be read here:  The Salt Of The Earth.  Indeed, our word "pecuniary," which means relating to money, comes from the Latin word "pecus," meaning "cattle."  In some societies, cattle, for a time, served as money (and accepted as marriage dowries).

What is not money? 

Banks and lending institutions create money through lending.  They have money available to lend and advertise an interest rate which is charged to borrow.  The bank is required to retain a percentage in "reserve" to back the amount being lent.  As this lent money is paid back, more is returned to the bank than was originally lent, and more money has been created over time in the transaction.

Is money created when a central bank pumps huge amounts of money into a stock and bond market?  

When conventional monetary policy became ineffective an idea was created and implemented.  Disingenuously called "quantitative easing," this policy "injects" electronic transfers into the system through the purchase of stocks and bonds.  This has sent the stock market to historic highs.  But it's a house of cards.  As it does so existing stocks and bonds in retirement policies, and the value of the currency itself, are devalued.  It is a back door way of doing to the economy what the government of Greece tried to do front door when they announced their desire to tax bank accounts.  The subsequent uproar forced them to back down.  Quantitative easing does pretty much the same thing, but it is not so in the face and accepted by an economically-ignorant populace.

Remember Menger's quote above - money is not the creation of the state. 

Notice how the stock market has reacted in the past few weeks to the "news" that a "tapering" of such central bank quantitative easing is imminent.

Is money created when the gubment spends itself broke (again and again) and decides, with back door "continuing resolutions," to increase its "ability" to spend outside of any Constitutionally-required budgetary process?
Does this "legislative" act to borrow more actually create money?  Or does it simply create more debt which will have to be repaid by future generations via higher taxes and a lower standard of living?  The answer to that is obvious.  Peter is not paying Paul, in this case Peter is robbing Paul.  And of course it's unsustainable.  And intentional.

Remember Menger's quote above - money is not the product of a legislative act.

There would be subjective value to this should both sides benefit from the action.  But they do not.



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