September 29, 2003

The Origin of Money and its Value

The importance of the Austrian school of economics is nowhere better demonstrated than in the area of monetary theory. It is in this realm that the simplifying assumptions of mainstream economic theory wreak the most havoc. In contrast, the commonsensical, "verbal logic" of the Austrians is entirely adequate to understand the nature of money and its valuation by human actors.

Menger on the Origin of Money

The Austrian school has offered the most comprehensive explanation of the historical origin of money. Everyone recognizes the benefits of a universally accepted medium of exchange. But how could such a money come into existence? After all, self-interested individuals would be very reluctant to surrender real goods and services in exchange for intrinsically worthless pieces of paper or even relatively useless metal discs. It's true, once everyone else accepts money in exchange, then any individual is also willing to do so. But how could human beings reach such a position in the first place?

One possible explanation is that a powerful ruler realized, either on his own or through wise counselors, that instituting money would benefit his people. So he then ordered everyone to accept some particular thing as money.

There are several problems with this theory. First, as Menger pointed out, we have no historical record of such an important event, even though money was used in all ancient civilizations. Second, there's the unlikelihood that someone could have invented the idea of money without ever experiencing it. And third, even if we did stipulate that a ruler could have discovered the idea of money while living in a state of barter, it would not be sufficient for him to simply designate the money good. He would also have to specify the precise exchange ratios between the newly defined money and all other goods. Otherwise, the people under his rule could evade his order to use the newfangled "money" by charging ridiculously high prices in terms of that good.

Menger's theory avoids all of these difficulties. According to Menger, money emerged spontaneously through the self-interested actions of individuals. No single person sat back and conceived of a universal medium of exchange, and no government compulsion was necessary to effect the transition from a condition of barter to a money economy.

In order to understand how this could have occurred, Menger pointed out that even in a state of barter, goods would have different degrees of saleableness or saleability. (Closely related terms would be marketability or liquidity.) The more saleable a good, the more easily its owner could exchange it for other goods at an "economic price." For example, someone selling wheat is in a much stronger position than someone selling astronomical instruments. The former commodity is more saleable than the latter.

Notice that Menger is not claiming that the owner of a telescope will be unable to sell it. If the seller sets his asking price (in terms of other goods) low enough, someone will buy it. The point is that the seller of a telescope will only be able to receive its true "economic price" if he devotes a long time to searching for buyers. The seller of wheat, in contrast, would not have to look very hard to find the best deal that he is likely to get for his wares.

Already we have left the world of standard microeconomics. In typical models, we can determine the equilibrium relative prices for various real goods. For example, we might find that one telescope trades against 1,000 units of wheat. But Menger's insight is that this fact does not really mean that someone going to market with a telescope can instantly walk away with 1,000 units of wheat.

Moreover, it is simply not the case that the owner of a telescope is in the same position as the owner of 1,000 units of wheat when each enters the market. Because the telescope is much less saleable, its owner will be at a disadvantage when trying to acquire his desired goods from other sellers.

Because of this, owners of relatively less saleable goods will exchange their products not only for those goods that they directly wish to consume, but also for goods that they do not directly value, so long as the goods received are more saleable than the goods given up. In short, astute traders will begin to engage in indirect exchange. For example, the owner of a telescope who desires fish does not need to wait until he finds a fisherman who wants to look at the stars. Instead, the owner of the telescope can sell it to any person who wants to stargaze, so long as the goods offered for it would be more likely to tempt fishermen than the telescope.

Over time, Menger argued, the most saleable goods were desired by more and more traders because of this advantage. But as more people accepted these goods in exchange, the more saleable they became. Eventually, certain goods outstripped all others in this respect, and became universally accepted in exchange by the sellers of all other goods. At this point, money had emerged on the market.

The Contribution of Mises

Even though Menger had provided a satisfactory account for the origin of money, this process explanation alone was not a true economic theory of money. (After all, to explain the exchange value of cows, economists don't provide a story of the origin of cows.) It took Ludwig von Mises, in his 1912 The Theory of Money and Credit, to provide a coherent explanation of the pricing of money units in terms of standard subjectivist value theory.

In contrast to Mises's approach, which as we shall see was characteristically based on the individual and his subjective valuations, most economists at that time clung to two separate theories. On the one hand, relative prices were explained using the tools of marginal utility analysis. But then, in order to explain the nominal money prices of goods, economists resorted to some version of the quantity theory, relying on aggregate variables and in particular, the equation MV = PQ.

Economists were certainly aware of this awkward position. But many felt that a marginal utility explanation of money demand would simply be a circular argument: We need to explain why money has a certain exchange value on the market. It won't do (so these economists thought) to merely explain this by saying people have a marginal utility for money because of its purchasing power. After all, that's what we're trying to explain in the first place—why can people buy things with money?

Mises eluded this apparent circularity by his regression theorem. In the first place, yes, people trade away real goods for units of money, because they have a higher marginal utility for the money units than for the other commodities given away. It's also true that the economist cannot stop there; he must explain why people have a marginal utility for money. (This is not the case for other goods. The economist explains the exchange value for a Picasso by saying that the buyer derives utility from the painting, and at that point the explanation stops.)

People value units of money because of their expected purchasing power; money will allow people to receive real goods and services in the future, and hence people are willing to give up real goods and services now in order to attain cash balances. Thus the expected future purchasing power of money explains its current purchasing power.

But haven't we just run into the same problem of an alleged circularity? Aren't we merely explaining the purchasing power of money by reference to the purchasing power of money?

No, Mises pointed out, because of the time element. People today expect money to have a certain purchasing power tomorrow, because of their memory of its purchasing power yesterday. We then push the problem back one step. People yesterday anticipated today's purchasing power, because they remembered that money could be exchanged for other goods and services two days ago. And so on.

So far, Mises's explanation still seems dubious; it appears to involve an infinite regress. But this is not the case, because of Menger's explanation of the origin of money. We can trace the purchasing power of money back through time, until we reach the point at which people first emerged from a state of barter. And at that point, the purchasing power of the money commodity can be explained in just the same way that the exchange value of any commodity is explained. People valued gold for its own sake before it became a money, and thus a satisfactory theory of the current market value of gold must trace back its development until the point when gold was not a medium of exchange. *

The two great Austrian theorists Carl Menger and Ludwig von Mises provided explanations for both the historical origin of money and its market price. Their explanations were characteristically Austrian in that they respected the principles of methodological individualism and subjectivism. Their theories represented not only a substantial improvement over their rivals, but to this day form the foundation for the economist who wishes to successfully analyze money.

Posted by graeme at September 29, 2003 09:16 AM | TrackBack

To jump from Money to (Free) Banking, try Kevin Dowd's

The Evolution of a Free Banking System

Posted by: Ian Grigg at September 29, 2003 09:28 AM

Good Article.

Question - Any ideas on how to convert desire or will into Money or directly into the object of desire? (e.g. I see a great meal on Food Network... That meal is in front of me.) Abstracly, Desire ----> Object

Posted by: John at December 17, 2003 04:09 AM