I originally wrote this for RevoluTimes on December 8, 2011
How do green sheets of paper denote wealth? You might think it obvious that money is a representation of wealth and wealth is needed to purchase goods and services for our survival. But does money necessarily represent wealth? Are there different types of money and if so can anything be money? To answer these questions we must first understand where money comes from.
In primitive economies where societies are only beginning to form, the first stage of economic growth arises from barter. Imagine that I have a dairy cow that produces more milk than I can consume while my neighbor has an extra pair of shoes. Suppose I need a pair of shoes and my neighbor needs fresh milk; by exchanging these goods we’ve satisfied the want or need of the other. This is often referred to as the “double coincidence of wants.” While this does result in some economic growth and can increase the standard of living to a degree, barter economies can only develop to a certain point.
As Austrian economist Joe Salerno has indicated, the double coincidence of wants is a very rare occasion. While there certainly may be those who can meet your demands of a particular good or service, in a barter economy, it’s far less likely to find someone who is willing to exchange that good or service for what you have to offer. If my neighbor has no need or use for milk, and I have nothing else to trade for his extra pair of shoes, I’ll be forced to go without. This lack of coincidental wants creates the need for a good that is universally recognized and accepted as having value.
Another hindrance of a barter society Salerno points out is the inability for such a society to have mass production for a few reasons. First, Dr. Salerno invites you to imagine a supermarket in a barter society. According to Salerno, the average supermarket has around 27,000 different products. Using only barter, it would be impossible to calculate a system of pricing as there would almost be an infinite amount of exchange rates for each individual product.
Secondly, most goods are also indivisible in the sense that their value is not maintained if they’re not intact. If my neighbor wished to trade a bundle of firewood for my dairy cow, I’d likely turn him down. The cow far exceeds the value of the firewood, but the cow is not divisible; in other words if I cut the cow into pieces, it loses its value. And lastly, in a barter economy, what would a business pay its workers? Would a plant that manufactures cell phones pay its workers with cell phones? These limitations prevent such societies from further developing beyond a primitive economy. It is due to the need of a universally acceptable good that money comes about in the first place.
Money is simply a good that is widely viewed as valuable and accepted as a medium of exchange. But there are different types of money. Here I want to discuss commodity money and fiat money.
Commodity money or sound money is a medium of exchange that has been chosen by the market to be money; in other words, a good that is voluntarily deemed valuable universally. Traditionally, gold and silver have outperformed other mediums of exchange over time; though various goods have been used throughout the centuries from salt, corn, and even cigarettesafter World War Two. Gold in particular has been chosen by the market because of its characteristics. Gold is very durable, (all of the gold ever mined is still in existence, although some may be under water from sunken ships) malleable, (which allows for it to be easily recognized), it’s very divisible, has scarcity and can be calculated to a very precise weight. While many other goods may share some or most of these traits, the only other commodity that comes close in terms of value in the market is silver.
All of these commodity based monies were derived from the market. When it was realized that a medium of exchange was necessary to facilitate an expansion of the economy, no government instituted these goods as a form of currency. There was no central planner that originally imposed salt, gold, silver or corn to be used as a medium of exchange. This is important to note because it brings to light a very crucial point: market-based money has value not because the State claims it does or that it must be used in transactions; but because individuals find it useful, reliable and trust it to maintain its worth over time. As I’ve discussed prior, the money you earn is a direct reflection of the amount of production created by your labor. The employer and employee are taking part in an act of voluntary exchange. Just as members of barter economies may trade one service for another, when money is developed it takes the place of one of the services rendered.
Despite that the U.S. used commodity-based money for much of its early history, today it uses, (like the rest of the world) what is called a fiat monetary system or a paper based currency. Fiat is Latin for decree or government order. As you may have guessed by the definition, no paper currency in the history of the world has ever come from the market. It may be second nature for us to reach for cash, but when do we ever take the time to consider why we value pieces of paper with such high regard?
This is because for much of American history, the currency was linked to some sort of commodity, (usually gold or silver) in which case the paper was nothing more than a promissory note from the State to be redeemable for a precise weight in gold or silver, (however, Nixon closed the gold window in 1971). But as has been the case throughout history, the fiat monetary system was abused and as too many bills of credit, (paper money) were chasing too few goods and services, the prices of those goods and services increased as the purchasing power of the currency dropped. This is called inflation. The French economist Frederic Bastiat gave a brilliant explanation of this phenomenon in his essay, “What is Money?” Bastiat describes a poker game in which ten men are playing with each having ten chips and each contributing $100 to the pot. But one man claims the more chips he has at the end of a round, the wealthier he is in proportion to those chips; so he suggests doubling the amount of chips amongst the players so as to increase everyone’s wealth. But the end of the next round only reveals that rather than more wealth being miraculously created, it only debased the value of their chips.
Author, blogger and host of Liberty and Production Radio, Shane Coley gives a real life example of inflation at work in his new book, Know Stealing, (which I highly recommend). Coley asks the question, “Who took your $68?” He describes a scenario in which the reader earned $2 in 1969 and was paid with paper currency. Today, those two dollar bills are only worth $2; but had you been paid with two American Eagle silver dollars, today you’d have $70 worth of silver. Coley’s point is significant as it demonstrates not only the economic effect of inflation but the immorality of fiat currencies.
It’s imperative we understand that money embodies wealth, not by some decree of the State, but only to the extent that it represents production from human labor when providing a good or service. As Bastiat illustrated, doubling the amount of chips on the table results in a corresponding loss of value for each chip. Similarly, flooding the market with paper currency without any new production does not create wealth, but diminishes it. In order to create a robust recovery from this recession we must ask where money comes from, and ask the State where our money went.
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