Sunday, July 27, 2014

With My Mind On My Money And My Money On My Mind

Why is money valuable? Usual theories of value involve scarcity or labor (I want to be inclusive), but the dominant form of money for decades now has required no labor to make and has no real scarcity. Instead it has existed by government decree - "fiat money". So why is money valuable?
A Smith
The first theory as to the origin of money comes from Adam Smith. In his chapter "On The Origin and Use of Money", Adam Smith sketches his theory as to the value of money:

"In the rude ages of society, cattle are said to have been the common instrument of commerce; and, though they must have been a most inconvenient one, yet in old times we find things were frequently valued according to the number of cattle which had been given in exchange for them. The armour of Diomede, says Homer, cost only nine oxen; but that of Glaucus cost an hundred oxen. Salt is said to be the common instrument of commerce and exchanges in Abyssinia; a species of shells in some parts of the coast of India; dried cod at Newfoundland; tobacco in Virginia; sugar in some of our West India colonies; hides or dressed leather in some other countries; and there is at this day a village in Scotland where it is not uncommon, I am told, for a workman to carry nails instead of money to the baker's shop or the alehouse.
In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity. Metals can not only be kept with as little loss as any other commodity, scarce anything being less perishable than they are, but they can likewise, without any loss, be divided into any number of parts, as by fusion those parts can easily be reunited again; a quality which no other equally durable commodities possess, and which more than any other quality renders them fit to be the instruments of commerce and circulation. The man who wanted to buy salt, for example, and had nothing but cattle to give in exchange for it, must have been obliged to buy salt to the value of a whole ox, or a whole sheep at a time. He could seldom buy less than this, because what he was to give for it could seldom be divided without loss; and if he had a mind to buy more, he must, for the same reasons, have been obliged to buy double or triple the quantity, the value, to wit, of two or three oxen, or of two or three sheep. If, on the contrary, instead of sheep or oxen, he had metals to give in exchange for it, he could easily proportion the quantity of the metal to the precise quantity of the commodity which he had immediate occasion for."

This theory gives a special place to metals, an empirical observation that is no longer of any relevance. People traded by their own nature since time immemorial and looked around for something to act well as a medium of exchange. In Smith's time, metals did the job (for many tasks), imperfectly because they were heavy and still not infinitely divisible. Since numbers are lighter, more durable and more divisible than metals, they have so replaced them. However, this doesn't explain the value of money, just its convenience. Why can't ten thousand flowers bloom? Why is there a ruling currency in the land?
W S Jevons

After the marginal revolution, the problem became more acute. Money was, except in its value as money, fairly worthless. Even though metal was scarce, it was not very useful, even on margin, except as money (though the other uses did sometimes matter, for instance, Newton's accidental placing of England on a gold standard). Jevons and Menger, two innovators of neo-classical methods, gave a historical story of the origin of money. From Menger:

"[W]e have to explain why it is that the economic man is ready to accept a certain kind of commodity, even if he does not need it, or if his need of it is already supplied, in exchange for all the goods he has brought to market, while it is none the less what he needs that he consults in the first instance, with respect to the goods he intends to acquire in thecourse of his transactions. ... Consider how seldom it is the case, that a commodity owned by somebody is of less value in use than another commodity owned by somebody else! And for the latter just the opposite relation is the case. But how much more seldom does it happen that these two bodies meet! Think, indeed, of the peculiar difficulties obstructing the immediate barter of goods in those cases, where supply and demand do not quantitatively coincide; where, e.g., an indivisible commodity is to be exchanged for a variety of goods in the possession of different person, or indeed for such commodities as are only in demand at different times and can be supplied only by different persons! Even in the relatively simple and so often recurring case, where an economic unit, A, requires a commodity possessed by B, and B requires one possessed by C, while C wants one that is owned by A -- even here, under a rule of mere barter, the exchange of the goods in question would as a rule be of necessity left undone."

This was termed by Jevons as the "Coincidence of Wants" theory of money's origin. It is obviously false. In society before money, people would happily trade for favors and future recompense. Trade was simplified through implicit conventions, rather than enforced institutional ones. There might be inconvenience in divisibility, but this was still not solved by Menger's time - a coin was still an individual coin and a piece of eight was still a unit.
F Hahn

The origin of the value of money was put into modern terms by the economist Frank Hahn. He had in mind a Walras-Arrow-Debreau-McKenzie model of an equilibrium economy. From whence then did money come? The auctioneer has no need for "coincidence of wants", he moves everybody's goods at once. The usual solution is that the auctioneer can demand a small amount of a particular good (tax some money) from the agents, this induces a small positive demand for money, then Gresham's law takes over and drives all other goods out of the means of exchange game. This solution was precursed by monetary theorist Ludwig von Mises, but his verbiage is out of date and his conclusions included presumptions about institutions that are not well supported by data (namely, he assumed that a bureaucracy would always and only have pressure to inflate. This was arguably well borne out by experience up to but not after his time).

All of these theories are well presented here, by the brilliant Katushito Iwai. Iwai's exposition could use some Englishing up, and that was the original point of this post. But then I let life get in the way. Some other time!

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