The real convenience of money

By Lorenzo

I recently read Adam Fergusson’s history of the early 1920s hyperinflation in Weimar Germany–which also covers contemporary hyperinflations of Austria and Hungary. (Well-spotted if you noticed that they were the losing Powers of the Dynasts’ War–aka WWI; this was not a coincidence.) One of the striking things about the period is how misguided conventional wisdom typically was in the afflicted countries about what was causing the problem and how to solve it. People blamed almost everything except the actual cause–the flooding of the economies by the central banks with ever higher levels of currency. The rising flood of said currency having the consequence of rendering nugatory the war-debt incurred by patriotic citizens by inflating it into insignificance. (The losing-the-War reparations well in excess of the willingness to tax citizens were not, however, similarly eliminated: the history of the war reparations imposed on France in 1871 makes for an instructive comparison–the French paid theirs in full in gold before the due date.)

when money dies

Getting money wrong
But getting money wrong is a recurring feature of commentary on matters economic. That the Great Depression was overwhelmingly a monetary phenomena was not a much accepted view at the time, and is still disputed. Worse, much conventional wisdom during the 1930s revolved around fears of imminent inflation which were profoundly misguided then and seem unbelievably obtuse in retrospect.

In our own time, that the stagnation of the Japanese economy, the problems of the eurozone, US and UK economies, and the Great Recession more broadly, all have monetary causes is very much a minority view, even among economists, while the fears of imminent inflation which so disfigured 1930s commentary is very much in evidence. Fears based, as were the same fears in the 1930s, on a profound misreading of monetary conditions and the significance of surges in the monetary base. (In particular, not apparently grasping that money not being used in transactions has no effect on the price level, nor any necessary effect on future price levels.)

The myth of the real economy
The fundamental error threading through much of the above–leaving aside the misguided inflation fears–is the notion that the “real” economy–the economy of goods and services–is much more causally important than mere money. Money is merely a means of transacting, it is the exchange of goods and services which really matter and have real causal power. (And even the overblown fears of inflation typically massively discount the significance of income expectations on economic activity.)

This discounting of money having any “real” effects whatsoever is an odd claim. (To put it in economic speak, that money is not merely superneutral–changes in the rate of growth of the money stock have no significant long-run effects–but entirely neutral–changes in the money stock have no short-run effects at all. Though I am generally much more concerned with expectations than monetary quantities on their own.)

If we take the analogy of an engine being like a car engine, then money becomes like the oil which allow the parts of the engine to interact smoothly. And engines do not work too well if the oil is lacking, or if it floods the engine. In a monetary-exchange economy, money is half of almost all transactions. Surely something that is one side of almost all transactions might matter for the level of transacting? Adam Fergusson’s above-mentioned history When Money Dies is full of very real effects from hyperinflation.

The underlying mistake is to assume that money does not affect either the level or nature of transactions. That the “real economy” is basic and money is just a convenient epiphenomena. But not so convenient as to have serious effects on that “real” economy of goods and services. Convenient, but not “really” convenient.

This is profoundly wrong-headed. A monetary-exchange economy is dominated by transactions that would not take place if it were not for money. That being so, shifts in the willingness to transact because of shifts in the willingness to spend money can profoundly affect the level of transactions. This without entering into the bizarre world of hyperinflation.

Wrong origins
Getting the role of money wrong is connected to getting the nature and significance of barter wrong. If we look as the standard “just so” story as set out by economist Carl Menger about how money evolved out of barter, we can see there is an underlying assumption that the self-contained (often one-off) transactions between otherwise unconnected individuals which are so much the stuff of exchange in monetised economies is the “basic”, the “original”, form of economic transactions. So transactions are either monetised or barter.

This is flatly wrong. If we look at the origins of human society (and so economic activity) in foraging (that is hunter-gatherer) bands, they were not barter economies. Barter was something that one did on the rare occasions that one traded with people you did not have on-going connections with. The overwhelming majority of transactions were embedded transactions. That is, transactions embedded in a web of personal connections and which were typically ways of fulfilling explicit or implicit obligations that were so much the stuff of said connections.

Barter is awkward for all the reasons Menger and others have identified. As Menger states, in foraging and simple farming societies barter has the difficulty:

each man is intent to get by way of exchange just such goods as he directly needs, and to reject those of which he has no need at all, or with which he is already sufficiently provided. It is clear then, that in those circumstances the number of bargains actually concluded must lie within very narrow limits. 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.

Far too awkward to be the basis of any society, no matter how simple. Instead, people lived in a web of personal connections and obligations that dominated economic activity, since transacting outside said web of connections and obligations was so difficult and chancy.

The first step to expand transacting possibilities was to create units of account, as such formal precision greatly expanded the connection and transaction possibilities. Such units were generally based on weight (shekels, debens, drachmas and pounds are all originally weights), but cattle and slave girls (in Irish law codes) have also been used. That transactions could be formal rather than personal meant that they could be incurred outside existing webs of personal connections. This also allowed credit exchanges–barter exchanges without the time constraint of immediate exchange. Hence the use of tally sticks–the discharge of the obligation ended the transaction with the rejoining of the  tally stick. (Not coincidentally, tally sticks were also used in tax collection–taxes being a compulsory obligation.)


Tally sticks

It was entirely possible to create highly sophisticated economies based on formal and otherwise embedded connections. That is the way manorial economics work, for example. Landlord and peasants are connected by a web of ongoing obligations, often involving a basic exchange of protection-for-labour. To call such transactions “barter” merely because they were largely non-monetary is to profoundly mistake their nature.

Add in credit, and the mixture of embedded transactions, credit transactions and barter (often implicitly using units of account) plus commodity media of exchange (e.g. silver) is how societies from Pharaonic Egypt to the Khmer Empire operated for millennia. Merely having units of account greatly expanded transaction possibilities (and likely reduced conflict even for many embedded transactions because they could be made more precise and so determinant.) What means of transacting are available profoundly affect the level and form of transactions which become practical.

The next step was to create media of account; things that were a medium of exchange that also instantiated the unit of account. That is money–originally in the form of coins. Suddenly, the transaction possibilities expanded greatly. One-off transactions discharged on the spot with people you had no connections with became much easier. Rulers were no longer stuck with “use or lose it” labour service as their dominant income source. They could gain revenue now and spend it later. Not to mention that collecting coins takes a lot less administrative effort than organising labour service. And can be levied on any agent or transaction.

Coins make the world transact a lot more

Coins make the world transact a lot more

Once one grasps that money actually greatly expands transaction possibilities, and so the level of transactions, then the notion that money is some transparent epiphenomenon that cannot have “real” effects makes much less sense. The convenience of money is a “real” convenience affecting profoundly the level and nature of transactions.

That one can gain revenue now but spend it later also means that Say’s Law does not applysupply does not create its own demand That, in Say’s words:

it is production which opens a demand for products. . . . Thus the mere circumstance of the creation of one product immediately opens a vent for other products

is not correct (at least not in the same time period). So monetary causes can have “real” effects. Indeed, are much the most plausible culprit for the business cycle, of what used to be called “general gluts” (an overall fall in demand for goods and services; that is, in willingness to spend money to buy goods and services).

Monetary austerity–driving down income expectations–can and does affect the level of economic activity, the willingness to exchange in transactions. Particularly given that debt obligations are the ultimate “sticky” price, so adverse income expectations can drive people to cut back spending to service (or reduce) their debt while other “sticky” prices (notably wages) lead to spending having effects on quantities demanded that are not immediately “cleared” by price changes.

If central banks drive down income expectations, or fail to counteract a fall in income expectations, then the level and form of transactions will be affected. As the convenience of money is a real convenience, expectations about money income affects the level and form of transactions in a monetised economy. So money matters and can profoundly affect the “real” economy.


  1. Andrew Reynolds
    Posted March 29, 2013 at 11:47 am | Permalink

    Can you please never, ever repeat the Keynesian nonsense that Say’s Law is as formulated above. Say never said that and would have laughed at the very idea – as would every other economist that used the classical law of markets.
    Say put it as “it is production which opens a demand for products”. Horwitz has it more correct, and with a good explanation, here:
    Keynes used that ridiculous formulation to make it easy to refute – but it is a strawman.

    I would think this greatly undermines the analysis of the last part of the article. The first section is a very good history lesson and I enjoyed it a lot.

    What I would ask is what you believe should be done when the central bank thinks that an adverse outcome is likely. To me, the problem we’ve been having is not monetary austerity during the bad times – that is a consequence of carrying too much debt. The problem is the profligacy during the previous boom. If you look at the proper formulation of Say’s Law (if we use that term for it) then the reasons for downturns is clear – production of the wrong goods is occurring and investment has been misdirected. Central Bank manipulation of the currency is one possible cause of that by its attempts to set the price of money.
    I would argue that further attempts to set the price of money merely compounds the error.

  2. Posted March 29, 2013 at 1:48 pm | Permalink

    [email protected] I am not committed to any particular characterisation of Say’s Law, so I am happy to adjust, as I have done. (As DeLong points out in the useful short piece on the history of macroeconomics I linked to, Say changed his mind.)

    That the theory of the unsustainable boom is a good theory of the business cycle is something I profoundly disagree with. That somehow Australia missed out three recessions (only one of which involved a commodity boom–and even that included a dramatic drop in export income at the height of the Great Recession) because we got our goods and services production, and capital allocation, correct while the rest of the developed world did not makes little sense to me as an analysis. That the Reserve Bank managed to keep income expectations anchored makes much more sense.

  3. Andrew Reynolds
    Posted March 29, 2013 at 9:11 pm | Permalink

    Getting it correct is not necessary. Getting it more correct than others would do as a means of outperforming them. As many economists have noted in the past, there is no such thing as a correct number, as the number would be a constant, dynamic thing, as is any concept of value in any market.

    To me the answer in Australia is simple – we did not have an unsustainable boom. We had a government that paid down and eventually eliminated debt and ensured a reasonably open and flexible labour markets. Our regulatory authorities used comparatively light-touch regulation and the RBA followed its brief well.
    I’m not going to say they were perfect (I’d actually argue that reducing or eliminating them would be better) but to me the Australian experience is an object lesson in how the business cycle can be tamed. Australia experienced booms, to be sure, but none of them was caused by artificial amounts of spending, artificially low interest rates or enforced spending. We have been (and I believe continue to be) producing goods and services people want and are investing in producing more of them at better prices. People and goods are able to move where they are needed and, when there are shortages and bottlenecks we can mostly deal with them. Do that and there is no unsustainable boom – just measured, sensible growth.

  4. Posted March 30, 2013 at 9:31 pm | Permalink

    [email protected] Re-stating your thesis at greater length does not make it more plausible. Nor, as far as I can see, refutable. Whether the boom was unsustainable is apparently “proved” by not having a recession. But the business cycle is the thing to explain, not the proof.

    Yes, a more flexible economy is better than a less flexible one. But it is the change in monetary policy which seems to be crucial, as most of the major policy reforms were in place when we suffered the 1991-92 “recession we had to have”.

    Also, our housing and commercial land markets are pretty screwed up.

    Focusing on NGDP and monetary policy, on the other hand, seems to explain much more.

  5. derrida derider
    Posted April 2, 2013 at 12:29 pm | Permalink

    “A monetary-exchange economy is dominated by transactions that would not take place if it were not for money.”

    Something that should be forcibly tattooed on to every RBC theorist. Now of course money is not the only thing that can disturb those transactions, but it very commonly in practice is the thing.

  6. Posted April 2, 2013 at 3:09 pm | Permalink

    I would argue that further attempts to set the price of money merely compounds the error.

    It seems to me, if it’s done correctly, that it tends to counter the natural macroscopic errors inherent in the market.

    That somehow Australia missed out three recessions .. because we got our goods and services production, and capital allocation, correct … That the Reserve Bank managed to keep income expectations anchored makes much more sense.

    It seems to me that stable income and price expectations would greatly assist the getting correct levels of production and investment. This would dampen the feedback signals that arise from an initial bump (or fall) investment preventing the unrealistic optimism that might otherwise arise from such a feedback mechanism.

    Now of course money is not the only thing that can disturb those transactions…

    Which is why the RBA should not tie its monetary policy to a single measure such as NGDP as Lorenzo argues.

  7. Posted April 4, 2013 at 4:53 pm | Permalink

    [email protected] With you bruvver …

    [email protected] The point of NGDP targeting is that smoothing the path of income expectations allows other shocks to be better handled.

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