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There is no such thing as just money

By Lorenzo

I have been doing a fair bit of reading in the history of money and monetary theory to try and understand money, particularly its origin and use. A thing reveals its nature through history, to understand the history of something is to much better understand it.

I was aware that modern macroeconomics is bedevilled by a lack of a common analytical language in talking about money. But the problem goes deeper than that; money is a multi-dimensional phenomenon.

I am not talking here about debates over monetary base (coins, notes and bank reserves with the central bank) and the various monetary aggregates (M1, M2, M3 etc). These debates are even less interesting than they appear, not least because expectations matter so much.

Nor even that when economists talk of the “demand for money” they mean the demand to hold money, not the willingness to spend money (which, in a monetary exchange economy, is the demand for goods and services; and money actually spent on goods and services is aggregate demand). Though one way of thinking of money held is as a proportion of money passing through, and shifts in the proportion of money held rather than spent can be very important in its macroeconomic effects. Especially if the money supply does not adjust accordingly, because then an increase in the demand to hold money can lead to a fall in transactions and hence (since one person’s spending is another person’s income) a fall in incomes, spiralling down into those transaction crashes/goods-and-services gluts we call recessions or depressions.

The problem in talking about money qua money, is that there are so many institutional possibilities with money. Let us just consider the situation were notes exist, so cost of production is not an effective constraint (and ignoring coins and the history of money before notes).

A “theory of money” has to consider to following dimensions:

(1) Is there a monopoly supplier of local notes or are there competitive suppliers?

(2) Are the notes convertible into gold, silver or some other commodities?

(3) If not convertible, are the notes backed in some other way?

(4) If not, is the supply of notes limited in some other way beyond cost of production?

If (2) is true, then the price level (P) is determined by the ratio of monetised backing (for example, gold if a gold standard is operating) to output (y), since notes can always be “swapped out” for gold, so the level of monetised gold (mG) sets the swap value of notes for output. (So P = mG/y.) So, if monetised gold rises faster than output, prices rise. If monetised gold rises slower than output, prices fall.

Note that if (2) applies, then the swap value of the notes (in terms of gold) is set, but their supply is not.[i] This setting of the swap value by a fixed price in gold leads to considerable price stability, as the gold/output ratio generally changes fairly slowly.[ii]  Changes in the rate of turnover of notes (i.e. in the demand to hold money) can easily be accommodated by changes in the supply of notes.

This price stability tends to lead to low levels of fluctuations in the rate of turnover/proportion of notes held–in Sweden, for example, in its gold standard era from 1873 to 1914, there was a steady decline (pdf) in the proportion of notes held (so gentle increase in rate of turnover).

If (2) does not apply, then the above is not how things work. So convertible or not convertible becomes a vital issue for effective analysis.

If you have a monopoly supplier of notes that are not convertible nor backed nor otherwise supply limited–so (2), (3) and (4) do not apply–then you have hyperinflation, for the reasons explained nicely here (pdf) using the example of the German 1922-3 hyperinflation:

throughout the hyperinflation episode the Reichsbank’s president, Rudolf Havenstein, considered it his duty to supply the growing sums of money required to conduct real transactions at skyrocketing prices. Citing the real bills doctrine, he refused to believe that issuing money in favor of businessmen against genuine commercial bills could have an inflationary effect. He simply failed to understand that linking the money supply to a nominal variable that moves in step with prices is tantamount to creating an engine of inflation. That is, he succumbed to the fallacy of using one uncontrolled nominal variable (the money value of economic activity) to regulate another nominal variable (the money stock).

Putting it in terms of the Fisher-Friedman equation of exchange (money stock x rate of turnover of money for goods and services = prices x output: i.e. MV = Py) as, in this situation, notes are neither supply nor demand constrained, M increases exponentially. The swap value of notes for goods and services plummets. So money turnover increases towards maximum practicable as people unload notes as quickly as possible due to notes plummeting as a store of value and people generally cannot avoid being paid in the monopoly notes. If M and V are both increasing (the former at an accelerating rate), prices head towards infinity, as prices are much more upwardly flexible than output.

Can always add more zeroes

If all these conditions do not apply, then you do not get hyperinflation. Which is why worrying about the size of the monetary base in the US leading to hyperinflation is so much blather. There is no way the US Federal Reserve is going to issue an accelerating supply of notes if prices start rising. Indeed, it has shown that it is able to keep inflation down no matter how high the monetary base gets; markets are also expecting that inflation will remain low.

To put it another way, we have a monopoly supplier of local notes (check the signatures on your banknotes) which are not convertible (except in foreign exchange markets) but are backed (by the assets of the central bank).  The backing sets the supply of money. The notes issued are the intermediary between the asset backing and output. The ratio between output and the supply of money (adjusted for changes in rate of turnover; so what counts is money spent on goods and services) sets the price level.[iii]

Of course, if note issue is competitive, people can insist on the notes which are better stores of value. Indeed, it has been reasonably argued that competitive note issue would drive the issuers towards convertibility, for precisely that reason.

So, by changing which of conditions (1) to (4) apply, we get profoundly different outcomes.

If people do not specify clearly what conditions they are talking about in analysing money, then folk will misunderstand, talk past each other and generally get involved in debates which never get satisfactorily resolved.  For example, disagreeing or agreeing with the quantity theory of money without specifying whether, for example, (2) applies is unhelpful. Money matters, but it is also a multi-dimensional phenomenon. There is no such thing as “just money”.


[i] So any analysis which is predicated on the proposition that the gold standard controls the money supply is mistaken. There may be a legally imposed “cover ratio” (a, usually minimum, ratio of gold held to notes issued) which, if followed, affects money supply, but that is not an inherent feature of the gold standard.

[ii] Unless you are the Bank of France and the US Federal Reserve in the 1928-1932 period and you are treating an international monetary regime as a game of “who can suck more gold out of the monetary system”, so causing the Great Depression (pdf) by reducing the supply of monetised gold, so driving down prices (since monetised gold shrank dramatically compared to output) causing a massive transactions crash/goods-and-services glut.

[iii] I am agreeing with Nick Rowe and disagreeing with Mike Sproul (pdf) on the law of reflux (the proposition that notes issued in excess of the demand to hold notes reflux straight back to the issuer). Also, backing strikes me as fundamentally different from convertibility since, with convertibility, the swap value of notes for gold is a set quantity per unit; the price is set as an external (exogenous) anchor. (A currency board uses a set exchange rate as such an anchor.)  In the case of backing without such convertibility, the backing assets generally do not have a set external (exogenous) price.  But I found Mike Sproul’s papers very helpful.


  1. Posted July 12, 2012 at 1:53 pm | Permalink

    Amused, wryly, at the equivalent of anthropologists not being able to define “man” or physicists not being able to define “matter” and “energy” … The difference being that economists aren’t looking at something tricky and grey created and obscured by the complications of nature like the anthropologists and physicists, but having difficulty defining something entirely artificial, arising from human volition and agreement.

    Aaaah, perhaps this explains why economics is not so much the “dismal science”, but resembles more a dismal theology. And yet … so much social policy is determined by estimates of angels dancing on the heads of pins, not able to agree on what pins or angels or both are!

  2. JC
    Posted July 12, 2012 at 2:14 pm | Permalink

    Which is why worrying about the size of the monetary base in the US leading to hyperinflation is so much blather. There is no way the US Federal Reserve is going to issue an accelerating supply of notes if prices start rising. Indeed, it has shown that it is able to keep inflation down no matter how high the monetary base gets; markets are also expecting that inflation will remain low.

    I’m not sure I share your optimism that in this setting- the state of the US debt/deficit position and the large increase in the monetary base things could not end in hyperinflation.

    How about this scenario.

    The market begins to reject US debt/bonds and yields spike. The spike in yields put the US in a situation where it is perceived to be in a debt/unsustainable position by the market. What does the Fed then do? If it buys the debt there could be an uncontrollable spiral. If it doesn’t, the US goes into a deflationary debt default.

    Don’t forget that hyperinflation is basically a complete loss of confidence in the currency.

    I’m not suggesting it is going to happen although funnily enough I see the likelihood increasing while the Fed continues to refuses to move to NGDP targeting which may therefore allow deflationary forces to corrode the econom

  3. Posted July 12, 2012 at 2:45 pm | Permalink

    DB@1 Money is a notoriously difficult area because of the complexities. Trying to study something where the agents you are studying can react to your conclusions is fun too (hence Goodhart’s law).

    There is a much wider area of agreement in economics than there appears to be because folk don’t argue over what they agree on.


    Don’t forget that hyperinflation is basically a complete loss of confidence in the currency.

    Well yes, but why does that loss occur? If you are the Confederacy and folk believe you are about to disappear so all C$ have to be spent as soon as possible, then you get hyperinflation as the value spirals down to inconvenient wallpaper.

    But the market rejecting US debt/bonds is not even close to happening. If the UK can cope with public debt being 200-250% of GDP and taxes being 10% of GDP in 1815, then the US must be a long way from the sort of scenario you are mooting.

    Indeed, if the Eurozone collapses, US debt/bonds are going to look even better.

  4. JC
    Posted July 12, 2012 at 3:06 pm | Permalink

    . If the UK can cope with public debt being 200-250% of GDP and taxes being 10% of GDP in 1815, then the US must be a long way from the sort of scenario you are mooting.

    Well, you can’t always compare unless you know the economic setting. Greece is broke with less debt. Japan isn’t and has more debt. If there was a lot of confidence the UK could repay the debt then that’s okay. Also keep in mind the tax level was 10% and therefore it may have been perceived there was scope to increase it from that level.

    You shouldn’t totally discount the level of risk and you shouldn’t rely on the misery of others (EZ collapse) to look more attractive.

    A couple of studies suggest that the return from the never never is debt around 90% of GDP.

  5. kvd
    Posted July 12, 2012 at 4:32 pm | Permalink

    To put it another way, we have a monopoly supplier of local notes (check the signatures on your banknotes) which are not convertible (except in foreign exchange markets) but are backed (by the assets of the central bank).

    I’m understanding this as a para about Australia, so just wondering as a first step – what actually are “the assets of the central bank” that you’re referring to?

    Separate note: One of the pdfs refers to the Swedish experience of the gold standard; the other day I was busily reading the Swedish (present) move towards a cashless society; and there was another ‘Swedish’ which escapes me for the moment (something to do with banks I think). So, for economists, is Sweden basically an economic lab rat? And is this because of a fairly small, closed, and homogenous society – or some other reason?

  6. kvd
    Posted July 12, 2012 at 4:54 pm | Permalink

    Update: after googling “Swedish Models” but rapidly backing off in case Mr Conroy was watching, I tried “swedish economic case study” – and there are about a zillion. So I’m thinking that economics is the preferred discipline of choice in Sweden? Or do they just keep very good records?

  7. Posted July 12, 2012 at 6:20 pm | Permalink

    kvd@5 In the words of Wikipedia, central bank assets are:

    government bonds, foreign exchange, gold, and other financial assets

    kvd@5,6 Sweden is an extremely well documented society with a history of being over-endowed with economic talent: figures such as Knut Wicksell, Gustav Cassel, Gunnar Myrdal, Bertil Ohlin, Lars Svensson.

  8. Posted July 12, 2012 at 6:25 pm | Permalink

    kvd@6 How many countries have former Ministers of Trade and Opposition Leaders who win Nobel Prizes? (Let’s ignore the question of who hands out the Nobel memorial prize in economics …)

    JC@4 10% of GDP in taxes was regarded as an extremely high tax burden. And Greece is stuffed because their supply-side is stuffed, their revenue collection is stuffed and the ECB is their central banker.

    That 90% figure seems to be in great violation of historical experience.

  9. kvd
    Posted July 12, 2012 at 6:28 pm | Permalink

    Thanks Lorenzo, so that would be gold then. And you forgot to mention Stieg Larsson – who actually made a profit.

  10. JC
    Posted July 12, 2012 at 7:22 pm | Permalink


    I raised Greece because I wanted to show that we need to understand the economic conditions of Britain in 1815 as we just can’t make general comments without delving deeper.

    10% may have been high by standards experienced then.

    That 90% figure seems to be in great violation of historical experience.

    Dunno. Forget who wrote the research. They suggested that at 90% interest begins to so big it hastens the compounding effects.

    The point I’m really trying to make is that you end up in default when the bond markets basically say that’s enough debt and we’re not buying anymore. No one can predict when that point is reached.

    However if we get to that situation in the US the final result will be hyperinflation. In other words they won’t default in the traditional sense. I wouldn’t be as dismissive if I were you. I’m not suggesting it will happen, but the odds are no longer low enough to laugh it off.

  11. Posted July 12, 2012 at 9:23 pm | Permalink

    JC@10 I have another post popping up tomorrow on just those points.

  12. Posted July 13, 2012 at 6:51 am | Permalink

    JC@10 I have held said post over until Monday.

  13. derrida derider
    Posted July 13, 2012 at 2:48 pm | Permalink

    Nice post. For a similar disquisition on the nature of money and how the Austrians misunderstand it try Brad deLong’s attempt

  14. JC
    Posted July 13, 2012 at 3:28 pm | Permalink


    Brad De Short is an “expert” on money that you listen to? Wow! Still, I think you really didn’t understand De Short’s silly essay. De short’s wasn’t a discussion about money, it was a critique on Austrian monetary policy. Of course these things aren’t the same thing, as you ought to know.

    De Short doesn’t seem to understand monetary policy himself. Not long ago he was suggesting that NGDP targeting was simply a method to raise the inflation rate totally confusing NGDP targeting with the simplistic and crude Keynesian model.

  15. JC
    Posted July 13, 2012 at 3:43 pm | Permalink

    Found the thread where in fact Brad shows he has no understanding of monetary policy other than crude Keynesian.

  16. Posted July 13, 2012 at 4:15 pm | Permalink

    DD@13 Being implicitly ranked with Brad DeLong, I’ll take it ;) (My GradDipEc with his PhD…)


    JC@14 I disagree with him on various issues too, but DeLong also wrote what I still think is the most informative single post on macroeconomics I have ever read.

  17. JC
    Posted July 13, 2012 at 6:23 pm | Permalink


    Like Krugman, De short is actually an excellent economist except when they aren’t pushing their politics and Keyniesian bullshit.

    Krugman is fabulous when he’s actually defending economics and stops being a partisan hack.

    However their support of the stimulus and suggesting it was a success are just lies and they know it.

    My point was that DD linked to a De Short piece that had nothing to do with what he thought it meant.. money. It was about monetary policy- not money.

    In any event De Short was peddling bullshit keynesian stuff in that link.

  18. JC
    Posted July 13, 2012 at 7:06 pm | Permalink

    Not your link, lorenzo, DD’s.

  19. Posted July 14, 2012 at 2:10 am | Permalink

    You can better answer this:

  20. Posted July 14, 2012 at 7:12 am | Permalink

    Marcus, I have posted a response at the bubbles and busts blog and done a response post here.

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