Money is one human institution that is so ubiquitous that we do not often step back and try to understand exactly how it works and why. After all, when one thinks about it, it is somewhat strange that a customer can walk into a store, hand over a piece of paper with ink on it, or just transfer some bytes of information over a computer, and walk out with merchandise worth much more than the ink and paper or the bytes. How has it come to be that we engage in this massive network of trust that we call monetary exchange? What exactly makes something money, and what role does money play in the economy and in generating economic growth and preserving economic freedom?
Money, like many other economic institutions, is not the product of human design. No one invented money. Rather, money is a classic example of a spontaneous, or unplanned, order.
Prior to the system of monetary exchange, people had to barter their goods and services for the goods and services of others. But the problem with a barter economy is that it can be very difficult to find someone who both has what you want and wants what you have. Frustrated in their ability to make exchanges, people began to hold stocks of goods that they thought other people really wanted as a way to make it easier to exchange with them. This so-called “indirect exchange” (e.g., exchanging eggs for corn and then corn for meat) involved two steps rather than one, but it was still easier than direct exchange. Eventually, people discovered that certain goods fulfilled that intermediary role particularly well, and these indirect exchanges converged upon one or two such goods, giving us money. Consequently, money is often defined as a generally accepted medium of exchange. Which goods worked best was often culturally specific—some societies adopted things like shells, stones, or even cattle—but precious metals became standard because they had a commodity value of their own and had physical properties that enabled them to be stored and divided easily.
The use of money means that we no longer have to worry about finding someone who both wants what we have and has what we want. We only need to find someone who has what we want because we know people will accept money for their goods or services. Thus, money makes it much easier for people to engage in exchange, and this, in turn, improves economic well-being by getting goods into the hands of the people who value them most.
The spontaneous order view of money also implies that governments cannot declare as money anything they wish. Money is what money does; it is whatever market traders converge on as a generally accepted medium of exchange. Even when governments create “fiat money”—money that they declare to be money using the law—they will have to somehow link the new money to the one the market has already decided upon. Money must always have a contemporary or historical relationship to an actual commodity that the public has chosen to use as a medium of exchange.
The most important consequence of the use of money is that it makes it possible for each good or service to have a unique price assigned to it in terms of that money. When all prices in a country are stated in terms of the national currency it is very easy to compare the values of the goods and services in that economy. The act of exchanging money for goods is a form of communication that enables the prices that emerge from those exchanges to be signals to producers and consumers about value. When prices are stated in terms of money, consumers can formulate budgets and determine the wisdom of their various expenditure choices. Perhaps more importantly, producers can determine which goods will be the most cost-efficient to produce, and they can know, based on profits and losses, whether the choices they have made in the past were good ones. They can also use current prices to inform any changes in behaviour that they think may be necessary in the future. Money prices make it possible for producers and consumers to engage in the crucial task of economic calculation, without which economies would not progress. The more extensive an economy’s use of money, the easier it is to improve the well-being of all who take part in it.
Initially, money was produced by private actors. Money first came in the form of gold coins, which were originally produced by private minters and stored by goldsmiths. But governments quickly realized that they could profit by monopolizing coin production, particularly if they spent them into circulation by purchasing goods and services for the king or queen to use. Paper money was also pioneered by the private sector, as banks discovered that they could give customers paper “receipts” for gold held in vaults and that those receipts could then be traded in the marketplace instead of the gold itself. As long as banks were required to keep their promise to redeem the paper notes in gold, this system worked quite well. However, here, too, governments realized that by intervening in this process, or by claiming a monopoly over the production of currency, they could use this money to acquire resources. The central banking systems that we have around the world today exist not because the private production of money failed, but because governments saw control over money production as a way to fund their activities, especially the military, without having to raise taxes.
In a modern economy, a variety of financial instruments are used as money or money substitutes. We still use paper bills and coins, but we also use cheques and, more recently, debit cards to make payments. Both cheques and debit cards are ways of conveniently accessing the funds that people keep in banks. Rather than withdrawing money every time we need it, cheques and debit cards offer us a way to order our bank to transfer funds to the bank account of the person from whom we wish to purchase. Credit cards, by contrast, are not technically a form of money but are unsecured lines of credit. Credit cards eventually have to be paid off using money in one form or another.
Other financial instruments can work like money by enabling people to write cheques from them. One good example is money market mutual funds, where small savers’ funds are pooled by a bank to purchase interest-bearing financial instruments, with the bank paying a slightly lower interest rate to their customers than they earn on the instruments. Most of these funds allow their owners to write cheques, usually with a high minimum amount, from their accounts, and those cheques are, in essence, orders to the bank to sell off some of their funds to pay the recipient’s bank.
The challenge facing central banks today is knowing how much money to supply and then which actions of theirs will supply that exact amount at the correct time so as to avoid the artificial inflation of the prices of goods and services. If the central bank issues too much money, the public will spend those extra funds on more goods and services, causing their prices to rise (“inflate”) above the levels justified by the real factors in the economy. Inflation not only reduces the value of money (and the value of people’s financial assets, such as savings accounts, that are denominated in terms of that money), but it also undermines the ability of prices to provide reliable information for economic calculation. Persistent inflation reduces economic growth and can even trigger a depression by making it harder for producers and consumers to disentangle the influence of inflation on prices from that of changes in the real economy.
Severe or “hyper” inflation can ultimately destroy an entire economy by making its money worthless. Such a scenario demonstrates one of money’s most important roles: it makes possible a society based on voluntary consent, contract, and exchange. When money is destroyed, our ability to interact on the basis of exchange is also destroyed, leaving force and coercion as the only option for human interaction. In this way, money is not just a symbol of economic freedom, but is also one of its most fundamental institutions. Not only does money allow us as individuals to turn our labour or assets into whatever purchases we desire, but it also enables us as a society to live by consent and exchange, rather than by brute force. Money makes us better off and it civilizes and humanizes us.
Join us for a live discussion of this topic with the Professor on Thursday, April 23 at 11 am (Pacific). Post your comment or question now to get in the queue, and it will appear during the live chat when Horwitz responds. You can even post a follow-up question or comment during the real-time discussion to contribute to the live chat!
Courtenay email -
Hey everyone! Go ahead and get your MONEY questions in the line-up. They will appear along with Dr. Horwitz's answers during the live discussion on Thursday, April 23rd.
See you there!
Courtenay email -
Welcome to Ask the Professor. We are pleased to have with us Dr. Steven Horwitz, Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY. Please remember to refresh your browser regularly to see the new comments.
Ikaterina Nikolaenko email -
Today, the U.S. dollar continues to hold its position as the dominant reserve currency. Do you feel that this will prevail into the future or will a change occur? Is there a possibility that Special Drawing Rights (SDRs) will gain popularity? Or will the Euro or another major currency overtake the U.S. dollar? Under what conditions would these changes take place?
Dr. Horwitz writes:
These things are hard to predict. I think that with the increase in the US debt taken on with the Bush-Obama bailouts, stimulus, and budget package, there's somewhat more concern about what might happen to the dollar. However, I'm not sure I see another candidate out there to take the place of the dollar as the dominant reserve currency. At least not yet.
Karen H. email -
You mention that "money prices make it possible for producers and consumers to engage in the crucial task of economic calculation, without which economies would not progress," - why is that?
Dr. Horwitz writes:
Great question Karen! One way to think of money prices is that they are condensations or crystalizations of the preferences and knowledge of both producers and consumers. They give us information about how valuable things are and they do so in a condensed form in a number that we can then manipulate. This enables producers and consumers to formulate budgets and lets producers in particular imagine how costly alternative production processes might be. After market activity unfolds, the changes in those prices tell us, after the fact, how well we guessed about how best to produce things. Prices enable us to calculate profits and losses, which tell us if we did (in the past) use resources wisely. So prices guide our future actions and inform us about our past actions. That is what we call "economic calculation." Without prices, we'd have no way of knowing those things - we'd be stumbling around in the dark trying to figure out how to produce things. I covered this in more detail in an earlier chat here: http://www.fraserinstitute.org/education_programs/forstudents/ask_professor/archive/Archive_2008_06_01.asp.
Shari email -
Can you explain the difference between current and constant dollars? Thanks.
Dr. Horwitz writes:
I just covered this in class the other day! The idea is simply this: when we measure various economic data over time and those data are measured in prices (like GDP), we want to take out the effects of inflation so that what we're measuring in two different years is really growth and not a change in the value of the dollar. The best analogy is imagine trying to use a rule to measure two pieces of wood and in between measuring the two pieces, the markings on the rule get a little closer together. Your second piece of wood will "measure" longer, not because it's really longer but because your ruler "shrank." The shrinking ruler is like the inflated dollar.
So what we try to do is to pick one year as a "base year" and then measure GDP (or other variables) in terms of the value of the dollar that year. The value of GDP in THIS year's dollar is "current dollar" and its value in terms of the base year's dollar is "constant dollars." This enables us to distinguish real growth from those changes in the value of the thing with which we measure growth.
Harry Sandler email -
What do you think about the gold standard? Is it good or bad for economic growth? Or does it even matter?
Dr. Horwitz writes:
It matters a lot! I'd put the question just a little bit differently: central banks are the source of a great deal of macroeconomic disorder, including the current recession. I think we need to have an open and honest conversation about alternatives to central banking, one of which could be a gold standard. Government control over the production of money has caused many more problems than it's cured, not to mention enabling governments to grow to unprecedented size. In that way, central banks have been awful for growth, as they are sources of inflation and excessive government.
Whether "the gold standard" is a good solution is a complex question. What exactly is meant by "the gold standard" is part of the problem. If one means government created money redeemable in gold, that's a step in the right direction as redeemability would limit the inflationary tendencies of central banks. One could also mean demonopolizing/denationalizing money and having the privately produced money redeemable in gold, this would be even better in my view. But one could also mean a system where only gold coins or paper money fully backed by gold were used (as opposed to fractional reserve notes), which would be a problem in my view.
So depending on what one means by the gold standard, we get different answers. But it matters a lot. The bigger point is that central banks creating money unbacked by gold is the real problem.
Caralee email -
Why does it seem like some prices have gone up during the recession and some have gone down? Wouldn't you expect to see all prices go down since so many people are losing their jobs?
Dr. Horwtiz writes:
Not necessarily. All prices going down would result from a decline in the money supply relative to demand, and we have not seen that. In fact, we've seen central banks increasing the money supply pretty dramatically. What I would argue IS happening is that the economy is going through a process of correction. Think of it like a person who is fighting off an illness. The way economies do that is by reallocating resources to the places where they are now needed. The result is that some prices fall (like housing, where resources are leaving) and others rise, as people buy more of those things (think about things like Kraft Macaroni & Cheese - or Kraft Dinner to my Canadian friends - that are good when your income is lower). So as resources move around, some prices rise and others fall.
Dave email -
Do you think that it's possible that physical money (coins and paper) will become irrelevant?
Dr. Horwitz writes:
That's quite possible! One way of seeing the evolution of money over the long run is that we've gone from the concrete to the abstract. Money was ones just metal, then it became paper that represented the metal, then we got checks, which are even more abstract. Then came things like wire transfers then credit cards. Now with debit cards and various ways of paying for things online, the use of actual paper and coin has become more and more rare. The guy in front of me at the grocery store the other day used his debit card for like a $3 purchase. So yes, it's possible. However...
The problem with the other forms is that they are not anonymous. So long as people want to spend money on things that can't be traced (not just illegal stuff like drugs or prostitution, but think about a person having an affair who wants no traces of it), they'll be a demand for paper and coin. If we can solve the technological problem of creating electronic money that is also anonymous, then paper and coin might disappear.
Jason Kneely email -
If money production is not centrally planned by the government - what is the alternative? I am a believer in free markets, but I find it hard to conceive of a system where a competitive private sector printed money.
Dr. Horwitz writes:
It's not hard to conceive of - it was the norm across the world until the last 100 years or so. And in fact the private sector creates money right now. Your checking account dollars are the privately created liability of the bank you use. It's private money. Yes, it may be government insured and redeemable in government paper currency, but it's privately produced money. I can't make the whole argument for how such a system would work in a chat like this, but the short version is that banks that created their own paper currency (as banks did into the 20th century) would make them redeemable in some commodity (like gold). That legal obligation woudl limit how much tehy would find it profitable to produce as well as providing a profit incentive to produce a sufficient amount of money. Redeemability is the key of course.
Courtenay email -
Great chat so far everyone! We only have about 15 minutes left, so please get any remaining questions in the queue.
Harry Sandler email -
Doesn't having a gold standard limit the amount of wealth that can be created though? Or would that just mean that the scare amount of gold would just keep going up in price as more wealth was created in the economy?
Dr. Horwitz writes:
Not necessarily to both. It really only takes a very small amount of gold to have a functioning fractional reserve banking system. The advantage of such a system is that it can continually create more money in response to the increased demand for it that accompanies growth. And it can do so with very little need for more gold in the process. If you're thinking of a system of 100% reserves or pure gold coin standard, then your concerns could be a problem. But a competitive fractional reserve system does not face that problem.
Dave email -
So are you saying that the amount of privately created of money would simply be derived from demand? Would there be any incentive for a private institution to create a lot of money to increase inflation?
Dr. Horwitz writes:
That's exactly what I'm saying - or at least what economists like me who have made these arguments say. The theoretical work argues that no such incentive would exist. If a bank tried to inflate in that way, it would see its dollars coming back to it, forcing it to pay out its reserves (a commodity like gold or the balances it holds at other banks), which would in turn mean it was risking default, which would lead it to then reduce its outstanding amount of money to regain the proper ratio between its liabilities and its reserves. There's historical evidence that systems like this can work, especially when the government keeps it free of other regulations that can cause trouble. The Canadian system before the early 20th century actually was fairly close to such a system and worked quite well, better than the US system which was more burdened by regulations prior to the Fed (and after, of course).
Courtenay email -
Thanks to Professor Steven Horwitz and to all participants for a great chat today. Next time, economics professor Danny LeRoy from the University of Lethbridge, will be joining us to discuss Value on Thursday, May 28 at 11:00 am Pacific. See you then!
Courtenay email -
Welcome again to Ask the Professor. We are pleased to have with us Dr. Steven Horwitz, Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY. Please remember to refresh your browser regularly to see the new comments.
Anonymous email -
In what way might having a gold standard have deterred the current market crisis?
Dr. Horwitz writes:
Short question with a potentially long answer! The key is that a gold standard would make it much more difficult for a central bank to inflate, even if the central bank is the only producer of money. With a gold standard, when the supply of money becomes too big, it will eventually flow back to the issuer and drain it of gold. Since it has to keep some gold on hand to keep its money redeemable, it will be forced to shrink the money supply back down. And that, of course, is a good reason not to expand in the first place.
With a gold standard, it would have been harder for the Fed to have generated the inflation that fueled the boom of the last few years that, in turn, caused the current recession.
Anonymous email -
Other than the gold standard, what are the other alternatives to central banking? Should it all be privately produced?
Dr. Horwitz writes:
Well, the gold standard isn't necessarily an "alternative" to central banking. All a "gold standard" means is that the various forms of money are ultimately redeemable in gold. One can, as the US did to some degree or another for most of the 20th century, have a central bank and a gold standard at the same time. It's probably better than the status quo, but it still has weaknesses.
Alternatives to central banking mostly revolve around private money production of one sort or another. Many of those proposals include gold or other commodity standards, but they don't have to. Some writers have proposed freezing the stock of Federal Reserve Notes in the US and then allowing banks to create their own money redeemable in FRNs. That might or might not work, but it would be a real alternative to central banking that wasn't a gold standard.
There are some other more exotic proposals around, but the main alternative to central banking is to simply let private banks produce not just checking account dollars but currency as well.
John email -
What would happen if the entire world used only one currency? Would there be any negative consequences?
Dr. Horwitz writes:
There would be some obvious benefits as we'd eliminate all the hassles and transaction costs of switching among currencies. The costs are less obvious, but important. With one currency, especially if it were produced by one world-wide central bank, there would be NO check whatsoever on inflation. Even with each country or region having its own central bank, we still have the ability to substitute a more stable currency for one that gets devalued by inflation. If the US dollar gets inflated down to nothing, we could switch to the Euro or the Canadian dollar or others. With a world-currency, we wouldn't have that option. As it stands, with substitutes available, there's pressure on central banks not to inflate. A world central bank would have no such pressure and we'd be risking massive inflation.
Courtenay email -
There is only 15 minutes remaining in the chat - please post the last of your questions now.
David Gossler email -
What policy changes would you recommend for the Fed to inhibit abuse of their power to inflate the money supply?
Dr. Horwitz writes:
Well given the existence of a central bank, there's not many ideal options. One would be to constitutionally mandate a specific growth rule in the money supply. That isn't perfect and it might be hard to enforce. Another would be to mandate a specific macro target for the Fed (e.g, nominal GDP) which would have the side effect of stabilizing monetary policy. A third would be to link the dollar back to gold.
All of these are less effective than doing away with central banks, but all of them would also be improvement on the status quo.
Courtenay email -
Thanks to Professor Steven Horwitz and to all participants for a great chat today. Next time, economics professor Danny LeRoy from the University of Lethbridge, will be joining us to discuss Value on Thursday, May 28 at 11:00 am Pacific. See you then!
Courtenay email -
We have on last question in the queue...
Nach email -
Some have advocated privatizing the whole Fed system. Do you think this is wise? And what of the considerations of sovereignty?
Dr. Horwitz writes:
I do think it's a good idea. The Fed has caused way more problems than it solved. I'm not sure what the sovereignty issues are. There's no economic reason why each country has to have its own currency. The Euro shows us that. One concern might be that countries can't use their central bank to inflate as a way to gain resources for crises, especially war. I don't see that as a problem but an advantage of moving away from central banking! So other than those, I'm not sure what the sovereignty concern is.
Courtenay email -
Thanks again Dr. Horwitz!
