In this piece, I take “Macroeconomics” by Greg Mankiw, the bestselling undergraduate textbook, as the source for this story.
A history of money
In the beginning, there was barter…
and a rudimentary economy was based on it. This is extremely inefficient as you have to walk around all day carrying lots of goods, hoping you bump into someone who has something you need who at the same time wants something of yours and will trade you for it.
Efficiency demanded the use of commodities….
Given how poorly organised this world would have been, “it is not surprising that in any society, no matter how primitive, some form of commodity money arises to facilitate exchange”. “Most societies in the past have used a commodity with some intrinsic value for money”. We can see this because archaeologists have found lots of gold, silver and copper coins from previous civilisations.
A really nice example of recent commodity money is the use of cigarettes for currency in a POW camp in WW2. This is an excellent example of why commodity currencies existed and how they operate.
As society evolved thus did “fiat money”….
A modern development in the history of money is the development of “fiat money” which is “money that has no intrinsic value”. This occurs via a process of “evolution from commodity to fiat money”. The process by which this happens is rather mysterious but “in the end the use of money in exchange is a social convention: everyone values fiat money because they expect everyone else to value it.”
“Money is the stock of assets that can be readily used to make transactions” and it can be defined by its uses which are:
- Store of value
- Unit of account
- Medium of exchange
Between history and mythology
Unfortunately, as so often is the case with creation myths, none of this is actually true. Understanding what money is and why economists are taught its history in such a strange way is important. In fact, I would say it is central to understanding current economic policy and also how best to invest.
Myth #1 In the beginning there was barter
There is no evidence of any society has ever used barter as their primary means of exchange. This should be unsurprising as it would be horrifically inefficient.
Myth #2 Commodity money was the primary form of money for most of history
This myth is more serious and way more pervasive.
However the evidence from the existence of coins far from backs it up, I think it is good evidence of the opposite.
Imagine we are in ancient Rome and we have a Denarius coin in front of us
(Deni from Latin “containing ten” originally was the value of 10 asses)
It has a nice picture of Hadrian on it, “he” of the wall.
It was made of silver and so has an intrinsic value from its weight in silver
(there are examples of use of gold in coins too – the history is interchangeable)
Consider this, let:
A= intrinsic melt-down value of the coin
B= face value on the coin
Then scenarios are:
A > B the coin would not exist, it would be melted down.
A = B why mint it in first place? Why bother calling it a Denarius at all and put the Emperor’s face on it? It would be simpler just to weigh it. There is no benefit for the government to go to the trouble and expense of minting these things.
B > A Now there is a reason to mint it – a profit! The difference (B–A) is known as “seignorage”. We know this was a main source of income for monarchs for centuries from records. But if B>A then there is no strong link between the intrinsic value of the metal and the value of the money. It sets a lower limit but nothing more.
So what is the difference to fiat money? Not much. History indeed has little evidence for a prevalence of commodity money.
But what about the example of cigarettes in the POW camp?
I love this example because it is correct, and utterly misleading. There is an important reason why a commodity currency was used. It is because there was no way to enforce an obligation as the members of the economy were not in control of their society (see below for why this matters).
Myth #3 Money is an asset
Money is not a thing, or an asset like any other asset in the economy. It is much more special than that. It is a ledger item which always consists of an asset and a liability which come into existence at the same time. There is nothing else like it and it is central to the functioning of the economy. I will delve into this in the following posts.
A common error when struggling with such an abstract concept, it is often much easier and more natural to think in tangible terms. An analogy for this is units of measurement. It is now “obvious” that the concept of measurement is conceptually separate from any physical object. I can separate the concept of “1 metre” from the physical reality of a “piece of metal 1 metre long”. Although it is hard to imagine than this was not always obvious for humans, it was certainly not the case in ancient societies. In fact, it is striking how well these societies were able to operate, before the concept of number being separable from their physical objects, allowed formal arithmetic.
Myth #4 Money can be defined by its uses
This myth is again common but is a non-unique definition for money. There are many, many assets which could be used for the functions:
- Store of value
- Unit of account
- Medium of exchange
For example: dollars, gold, bitcoin, cigarettes, diamonds, canned food, oil etc.
In fact, anything non-perishable as bananas would not store well. The concept that in a mainstream economics they assume that anything can be used for money is important. Economic theories have developed from it, often containing the hidden assumption that money is not special and can largely be ignored. It is an asset like any other asset, is priced in the same way as any other asset. Therefore we should not be surprised that all the output from these models show no important role for money in the economy. I would have hoped the financial crisis would have exposed this as a myth.
Myth 5 Fiat money is a modern development
In fact, it is the oldest form of money.
I would prefer to say that “fiat money” means “money” and that “commodity money” is best defined simply as a “commodity”.
The story of money taught to economics students contains many a myth.
Next, I will tell an alternative story of money. The ideas I will present are not difficult.
But as Keynes said, “The difficulty lies not so much in developing new ideas as in escaping from old ones.”