Austrian Economics Part Six – Money


Matthew John Hayden

Economics is the human response to scarcity, a response which takes the form of bidding prices, which are just exchange rates – or ratios – of one good against another. This means the value of one good is stated in units of another. Certain goods undergo a mutation to become a generally accepted medium of exchange, which we now call money. The origins of money and the reasons people value it are already explained by the guys at the Mises Institute, but let’s lift the lid here also. It’s a vital linchpin to contemporary economics, and a paramount prerequisite to studying applied economics.

Money is a medium of exchange. From the previous description of exchange it is apparent that exchanges without money are subject to what economists call the problem of the double coincidence of wants which can easily scupper potential exchange in a moneyless environment. This is because the chances of both parties to a potential exchange having something the other wants can be very low. If Person A offers a pillow and wants a birdcage while Person B offers a birdcage but wants a heap of sea shells, then no trade will take place, as only one party can get want they want.

Prices have been described as ratios of one good against another. What if one good becomes treated as a commodity – something that is fairly uniform like wood or stone – such as, say, shells, or precious metals? This leads to one or more of these commodities being accepted in more and more exchanges, gradually becoming accepted more for its usefulness as a medium of exchange than for its other possible uses. This regression from uniquely useful good to medium of exchange explains how, historically, it was gold and silver that became the standard money in trade throughout Europe, Africa and Asia.

Money is wonderful in its chameleonic grace. Whatever you want, at whatever time, and from pretty much whatever place, it just works, as many a smug developer will say about their latest app. But money has just worked for thousands of years already. And long may it last, because social evolution has led to money as our way to understand the costs of our actions. Whether attending a festival, buying a skinny latte, or driving across country, prices in festival tickets, cafe or store lattes, and gasoline for that darned automobile tell us what we will have to forego to enjoy these things. Money makes prices easier to understand. This is, simply, because all prices are expressed in units of the commodity that has been accepted as money. So whatever wins as money is valued by all those who engage in exchange. Why?

Because money can retain its value to its users. There are features all moneys have in common. Being commodities, they are divisible and fungible, which means that a given weight or quantity of these monies always has – ceteris paribus – the same purchasing power. It also means any coin of a given denomination can be exchanged for another coin of that same denomination without any loss of value on either side of the exchange. Monies must be durable, since a fast-spoiling commodity like butter can’t reasonably be expected to store value for very long. They are portable, so you can carry around enough of the stuff to exchange for substantial goods and services. And they are limited, so that only so many coins or tokens exist to be exchanged for goods and services at any given time.

It’s clear that the subjectivity of human experience makes economic value subjective, so the value or purchasing power of money will be a function of its use over time in lots of exchanges. It is just a commodity like any other, it’s just been discovered over a long time to be useful as a store of value from one exchange to another later one. Its initial subjective value – not intrinsic value, nothing has intrinsic economic value – will derive from the commodity’s price in barter-style exchanges, before shifting to represent the regression of the commodity in question away from its other uses. This regression is rarely universal to all examples of a commodity; plenty of gold has always been used in things other than money even through the pre-20th Century era of gold and silver monies.

Money in the modern world is quite different from the commodities of days past, being neither a commodity itself nor backed by a commodity. Instead it is backed purely by force of law. This means that it lacks two of the vital qualities of money enumerated above, because it is not limited in the way a commodity money is, and because it is not durable. Therefore this fiat money will be subject to a constant problem arising from the incentives facing its issuers at the government central bank. This problem is inflation.

Inflation is an increase in the supply of money. People often use the term incorrectly to mean rises in prices, but this is a silly use because all sorts of factors can affect a price and cause it to go up in the short term. If there is a long term increase in prices, say over a century, then calling the price rise itself inflation is identifying the symptom rather than the real economic process. This is a problem that comes up repeatedly in empirical positivist economics, whether the positivist is of a New Keynesian or New Classical persuasion. No, if prices are rising steadily over a century or more then it is because the supply of money relative to the goods and services it can be exchanged for is increasing.

It can be seen that money is the lubricant of modern economics, that sound pricing arises when prices are denominated in a commodity money. This means money is vital to the creation and deepening of vital economic phenomena that we rely upon every day such as the division of labour, and the advent and development of the stock market. Long may we all continue to benefit from the ease afforded by media of exchange and glory in the escalating value creation we can all enjoy from our peaceful co-operation in trade!

10 thoughts on “Austrian Economics Part Six – Money

  1. Anyone readind this might conclude that this money somehow materialises out of thin air, They might be nearer to the truth than they would imagine. The real question is, where does all the money actually come from? Who manufactures it and to whose benefit?

    The function of a monetary policy ought to be one and one only … to keep an economy at or near its optimum productive potential. Too much money (taking velocity of circulation also into account), and we get a flood of inflation, too little and we get the dought of recession and depression.

    • Money is largely created out of fresh air – by banks when they make loans. The real question here is why governments throughout the world have handed over this vital function to private companies. Most people see money as a neutral medium that assists the real economy – It doesn’t, even though that is supposed to be its real purpose. More often than not, money determines economic activity and often prevents what is physically possible from being carried out.

      Anyone who doubts that should look at 1930s America. In that period America lacked nothing to provide most, if not all, that its people needed. Its industry had the potential to be highly productive with a skilled and willing workforce. It had fertile farm land with industrious and capable farming families in place to make full use of it. It lacked nothing in the way of transportation and communications for the time, and it was a nation largely at peace. What did it lack then? From a position of such strength why was the country in the grip of a Great Depression? The answer is quite simple – money. It lacked money, that is bits of paper with numbers on them. And it lacked money because banks – the only source – cut off the supply of the stuff.

      Most of this economics twaddle is just that – pure twaddle. Take away the power of banks to create money – at interest – and put that power back where it belongs and most of our ‘economic’ problems will solved – as someone once said, at a stroke.

  2. Frank Taylor and Albion.

    If you had actually read the post before commenting you would know that money did not originally come from “thin air”.

    As the post points out – the regression examination (by Carl Menger and others) shows that all money originally comes from a commodity that people valued BEFORE it was used as money. That state may take over later – but that is later (and normally the state, at first, pretends that its money is “backed” by the commodity that people used as money before the state got involved – before the state later just resorts to the naked violence of legal tender laws and tax demands).

    As for your historical points you are mistaken.

    There is nothing wrong with prices gradually falling over time as people find better ways to produce goods and services – gradual “deflation” is not to be feared, it was (after all) the normal state of affairs in the 19th century (a time of greatly improving living standards).

    As for 1930s America – the bust of 1929 (like all great busts) was caused by the credit money “boom” of the late 1920s. A “boom” pushed (every step of the way) by Benjamin Strong of the New York Federal Reserve – as part of his Irving Fisher desire to “maintain a stable price level” and prevent gradually falling prices.

    As for why America did not recover from the 1929 crash – this is naught to do with the government (or private banks) not producing more money.

    America did not recover in the 1930s because America was not ALLOWED to recover.

    The various interventions (most importantly desperately trying to keep up real wages – as part of the “demand” fallacy) of both Herbert “The Forgotten Progressive” Hoover (falsely presented as a supporter of the free market – he was nothing of the kind) and Franklin Roosevelt – Mr Roosevelt went from denouncing Mr Hoover as a “socialist” in the 1932 Presidential election campaign, to (when in office) following even more interventionist and wrong headed policies.

    In 1921 the United States faced a similar bust to that of 1929 – in the case of 1921 the bursting of the World War One credit-money expansion. The government did not intervene in 1921 and America was in recovery within six months.

    The same would have been true in 1929 – had Herbert The Forgotten Progressive Hoover not desperately intervened.

    I repeat – the United States did not recover in the 1930s, with mass unemployment being dealt with and so on, because the United States was not ALLOWED to recover – and it as naught to do with a lack of money.

    It you wish to engage in further reason start with Murray Rothbard America’s Great Depression.

    Yes, even I praise Rothbard sometimes – on matters of economics, economic history and the history of economic thought (he was very good on these three subjects – but sadly awful on other things).

  3. By the way private banks do NOT “create money” – they create CREDIT (calling this credit “broad money” as some economics textbooks do – just adds to the confusion).

    Some bankers may indeed confuse money and credit – which is why such banks go bankrupt (and demand bailouts).

    If banks really could “create money” they would never get into financial difficulties – because they could create their own money (backed by legal tender laws and used to pay any tax demand).

    As for real money – fiat money (government money – “fiat” means “command” as in “by fiat”) rests partly on legal tender laws and tax demands and partly on habit – folk memory of when the government money actually represented a real commodity (such as gold or silver).

    Remember that these commodities were considered valuable by human beings BEFORE they were used as money.

    Money is not just a “medium of exchange” it is also a “store of value” – and economic value being subjective does not change this.

    The problem with something like “Bitcoin” is that it is not considered valuable apart from its monetary use (no one actually wants these “special numbers” in their own right), therefore it is not a “store of value” in the sense that gold and silver (and other commodities) can be.

    • ‘If you had actually read the post before commenting you would know that money did not originally come from “thin air”.’

      If you had actually read my reply (to Frank Taylor) properly before commenting you would know that I used the present tense in my comment – as in, ‘Money *is* largely created out of fresh air’. I wasn’t talking about where it originally came from, neither is it pertinent to the point I was making.

      Banks do indeed create money – out of fresh air – well around 97% of it they do. Call it bank credit, book money, or whatever you want, it amounts to the same thing. And when they create it they create interest bearing debt at the same time. When banks create money they only create the principal, and the interest can only be paid by further loans – which is the main reason why we are where we are at the present time. If you disagree with that, then please tell us where do you think our money comes from?

      ‘If banks really could “create money” they would never get into financial difficulties – because they could create their own money (backed by legal tender laws and used to pay any tax demand).’

      They can’t create central bank reserves, which is where and why they run into trouble. At the end of every day the clearing banks must settle they transactions with each other. Those that have a shortfall must borrow central bank reserve from banks that have a surplus. If they overstretch themselves too much the other banks will either refuse or be unable to lend them sufficient reserves – this is what happened to Northern Rock.

      ‘I repeat – the United States did not recover in the 1930s, with mass unemployment being dealt with and so on, because the United States was not ALLOWED to recover – and it as naught to do with a lack of money.’

      Really? Do please tell us then who, or what, did not allow the US to recover in the 1930s?

  4. Albion I have already explained – at my age I have no desire to repeat myself to people who are too lazy to read what I have already written.

    • “Albion I have already explained – at my age I have no desire to repeat myself to people who are too lazy to read what I have already written.” Paul Marks.

      What an arrogant so-and-so you are. You have explained nothing, and you are clearly unable to answer the straightforward question I put to you. You clearly imagine that whatever you assert is beyond challenge. No wonder most people now ignore your posts, something I shall do myself from now on.

  5. For the record, real wages were not allowed to fall (to get in line with the economy and eliminate mass unemployment) in the United States till World War II – then under the cover of pretending that official prices were real prices (in reality, of course, the “black market” prices were the real prices) real wages were allowed to fall and mass unemployment eliminated.

    Of course it is possible for real wages to rise and no mass unemployment to result – but only if the rise is in line with real improvements in productivity, as was the case in the late 1940s (under the period of rolling back of statism by the “Do Nothing Congress”).

    In 1921 Warren Harding did not (as both Herbert “The Forgotten Progressive” and Franklin Roosevelt did in the 1930s) intervene to back unions and prevent (actively prevent) real wages adjusting to the economic bust of 1921.

    That is why the consequences of the credit-money bubble bust of 1921 were so different from the consequences of the credit-money bubble bust of 1929.

    And NO the Federal Reserve did NOT follow a policy of monetary expansionism in 1921 – that came later (the terrible let-us-keep-the-price-level Irving Fisher style policy of Benjamin Strong in the late 1920s).

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