by Josh Sidman
July 13, 2008
As I have argued in previous articles, much of the recent tumult in the economy – from the mortgage crisis to skyrocketing food and energy prices – is due primarily not to imbalances in individual markets for goods and services but rather to instability in the value of money itself. For example, while we are told that the rising price of oil is due to increasing global demand, it is also true that a large part of the increase is due to a decline in the value of the currency used to purchase oil – i.e. the US dollar. Likewise, the current turmoil in the real estate market stems from causes having nothing to do with the specifics of the real estate market. In fact, both the boom and subsequent bust in real estate were both due primarily to monetary factors and not to anything specific to supply and demand for houses. The reason why prices went up so much in the first place wasn’t because there was a sudden increase in demand for housing but rather because the Federal Reserve, in order to avoid recession in 2000, reduced interest rates to unprecedentedly low levels, thereby enabling the speculative frenzy whereby every Tom, Dick, and Harry was getting rich by simply borrowing money, buying property and flipping it.
All economic values are relative and interdependent. It is just as legitimate to say that a barrel of oil is worth 200 packs of gum as it is to say that its worth a hundred dollars. There is no true standard measure of economic value. Over the course of human history, man has searched for the perfect monetary “measuring rod”, and at different times gold, silver, tobacco, cattle, and sea shells have been used to approximate this never-to-be-found ideal money. But no matter what item is chosen, the instruments themselves are subject to unpredictable and uncontrollable changes of value and are therefore highly imperfect in their roles as currency. Even though gold is often thought of as a rock solid store of value, it too has been subject to major upheavals throughout history. Economies based on gold have experienced havoc resulting from new discoveries of gold deposits or conquests of gold-rich countries. Any drastic change in the value of the measuring-rod itself will always lead to unintended (and potentially harmful) redistribution of wealth.
From the point of view of an industrial economy, large, unexpected variations in the unit of value are highly problematic. Movements in the value of money can create unexpected windfalls for some, while wiping others out. For example, high inflation is extremely beneficial for firms which carry large inventories or owe money, but it is catastrophic for retirees living on fixed incomes.
One necessary precondition for the proper functioning of large-scale industrial capitalism is predictability. If corporations cannot predict with reasonable accuracy the conditions of production and distribution of their products, they will be unwilling to commit large sums of capital to long-term productive processes. This is why a stable monetary unit is so important to the proper functioning of a modern economy. If the monetary unit cannot be relied upon, investment in industrial activity will dry up, jobs will be lost, consumer demand will fall, and the whole economy will grind to a catastrophic stand-still.
In our country the Federal Reserve is charged with the task of creating and regulating the money supply. The Fed’s role is often distilled down to the dual mandate of, a) maintaining a stable price level, and b) keeping unemployment to an acceptable level. However, these two directives often call for directly opposite courses of action, and the very difficult job of the monetary authorities is to strike a balance between the two. The problem is that the mechanisms whereby the Fed can influence prices and employment are imprecise and unpredictable. For example, while a cut in interest rates can usually be relied upon to increase economic activity and reduce unemployment, if people are convinced that a depression is imminent, no amount of interest rate cuts will convince them to spend and invest money. A perfect case study of this phenomenon was Japan in the ’90s. The Japanese central bank reduced interest rates to zero and still failed to lift the economy out of its rut. And, the important point to note is that the main reasons for these economic crises have little to do with the specifics of supply and demand for individual goods and services, but are rather due to problems with the system of money generally.
So, we come back again to the question of what money is and what it is supposed to be. Money is most commonly described by economists as either a “store of value” or a “medium of exchange”. The problem, however, is that these dual functions are not fully compatible, and when they work at cross-purposes the results can be problematic. Therefore, I would argue that, rather than content ourselves with the standard dual definition of money, we need to take another step backward and look at how and why money came into existence in the first place and whether money as it is presently constituted is actually suited to the purpose(s) it is supposed to serve.
The most convincing explanation I’ve come across for why money was originally invented is based on the principle of division-of-labor. As Adam Smith demonstrated in the 18th century, the benefits of collaboration between human beings for the purpose of economic production are not just additive, they are exponential. In other words, a group of people working together to provide for their collective needs will perform far better than the same group if each individual works only to provide for his or her own individual needs. However, in order to reap the benefits of collaborative production, it becomes necessary to trade – something that is not necessary at the level of small-scale, self-sufficient producers.
The most basic form of trade is barter. Person A has a dozen eggs, Person B has a gallon of milk, and both agree to an exchange. Unfortunately, barter places severe limitations on how far an economy can expand. This is due to the fact that all of the various types of goods and services that make up an economy are produced and consumed according to widely different patterns. For example, certain goods (like agricultural products) are produced infrequently and in large quantities, while others (like manufactured goods) are produced continually and in smaller quantities.
So let’s say that instead of the simple exchange described above, Person A now raises cattle and Person B makes shoes. What happens now if these two want to make an exchange? Well, since Person B probably doesn’t need a whole cow, and Person A probably doesn’t need a hundred pairs of shoes, if left to their own devices they will be unable to arrange for a mutually advantageous exchange.
This is where the need for money arises. Money allows for the dynamics of barter to be abstracted beyond the tangible and immediate exchange of specific goods. With money, Person A can say that he is willing to part with a pound of beef for a given quantity of money, and Person B can do likewise for a single pair of shoes. Each party is free to set his own price, and each is free to refuse a given transaction if he judges it to be disadvantageous. So the purity of a barter transaction is apparently maintained. However, the introduction of money as an intermediary between actual economic goods, in addition to allowing goods to be exchanged in convenient quantities, also introduces a time element into the equation that is not present in pure barter. This is where many of the complexities of a modern economy arise.
Let’s imagine that Person A and Person B agree that a pair of shoes is equal in value to ten pounds of beef, and each feels that it is in his own best interests to make such an exchange. However, due to the differing natures of their respective production processes, they decide to make the exchange by way of a monetary medium. (For example, let’s say that Person A has slaughtered his cow today, but Person B won’t be able to complete the pair of shoes until a month from today. Note that if pure barter was the only means of trade, both parties would be out of luck, since by the time the shoes were ready the beef would be rotten, and there would be no possibility of a mutually advantageous exchange.) So, because of the time element, the two agree that instead of trading ten pounds of beef for a pair of shoes, they will instead exchange the beef for money at one point in time and then money for shoes at a later point in time. If each person has accurately calculated his own needs and production costs, each can rest assured that he has made a bargain which is beneficial to himself.
But what happens if something changes during the time interval between the two transactions? Let’s imagine that after the first transaction the materials that Person B uses to make shoes double in price. Now, if Person B fulfills the bargain according to the original terms, he will end up incurring a loss. He might choose to deal with this by raising his prices, defaulting on the transaction, or completing the transaction at a loss. In addition, the value of the money itself could change in the interim. For example, in a gold-based economy a new gold mine might come online, thereby reducing the value of the currency. This will also cause the actual economic impact of the transaction on the two parties to be different from what was originally anticipated.
The point is that the interposition of money into the equation creates an element of uncertainty that is not present in the case of pure barter. John Maynard Keynes, arguably the greatest economist of the 20th Century, famously referred to this phenomenon as the “veil of money”. In other words, in a monetary economy, there exists a thin, almost imperceptible layer between all of the real goods and services that are exchanged. In ordinary times, the existence of this veil has little effect on the outcomes of the exchanges it facilitates, but when something happens to disturb the veil, it can have drastic consequences for the overall economy. In fact, Keynes believed that most modern economic crises were the results of problems arising from improper functioning of the monetary system.
Another economist (who almost nobody has ever heard of, yet who Keynes himself thought of as the best monetary theorist of his time) proposed an explanation for the chronic malfunctioning of the world’s monetary systems. This man was Silvio Gesell. (As fate would have it, Gesell was a German, and as a result of being on the losing side of both world wars, his ideas fell into obscurity. This despite the fact that Keynes enthusiastically predicted that “the future will learn more from the spirit of Gesell than from that of Marx.”)
Despite the current lack of appreciation for Gesell’s ideas in academic and policy circles, I believe he diagnosed the fundamental problem of monetary economics with more simplicity and precision than anyone before or since. According to Gesell, the malfunctioning of modern monetary systems is due to the dual definition of money described above. By asking money to serve as both a “medium of exchange” and a “store of value”, we are asking the impossible. And, by attempting to achieve both objectives, we sow the seeds of inevitable crises. Gesell argues that it is irrational to expect money to serve as both a store of value and a medium of exchange. He proposes that the proper role of money is only the latter and that it ought not to be used as a store of value.
To understand why, let’s imagine the following circumstances. The economy of a given country is stuck in a depression. Job growth is stagnant, leading to reduced consumer spending and falling corporate profits. As a result of falling profits, corporations have little ability or incentive to invest in additional productive capacity, so jobs are not created, and the vicious cycle feeds on itself to the detriment of all.
As Gesell observes, this is precisely the time when society would benefit most from having those with surplus money put it into circulation by spending and investing. But, he also explains that this is precisely the time when these people face the strongest disincentives to do so. If people observe economic stagnation and falling prices, they have every reason to postpone any act of spending or investment. If prices are falling, why would anyone buy something today instead of waiting for a chance to buy it tomorrow at a lower price? Likewise, if there is little prospect of near-term profits, why wouldn’t a corporation wait as long as possible to invest in new plant and equipment?
So, just when the economy needs those who have the most to increase their spending and investment, they are faced with a strong incentive to do just the opposite. And, this is precisely due to the fact that money is designed to function as a store of value.
The notion that money ought to be a store of value is so ingrained in our understanding of economics that most people would be shocked to hear it ever questioned. But there is a very strong case to be made that designing money with this function in mind puts holders of money at an unfair advantage over producers of real goods and services. After all, as Gesell observes, if a producer of milk brings his product to the market and discovers that prices are unfavorable, he has no choice but to sell, even if doing so results in a loss. The alternative would be to hold onto his milk which would become worthless in a short period of time. The holder of money, on the other hand, is subject to no such pressure. He can walk away from a proposed exchange if he doesn’t like the terms and wait for a more favorable time without suffering any loss as a result of waiting.
(Gesell’s proposed solution to this problem is to completely overhaul the monetary system so that money is no longer capable of being used as a store of value and functions solely as a medium of exchange. He suggested accomplishing this by creating currency that loses value according to a predetermined schedule of depreciation. In other words, anyone who held onto a dollar for a year would have to purchase a stamp for, say, 5 cents in order to keep it at face value. Such a monetary system would eliminate the aforementioned advantage that holders of money enjoy over producers of real goods and services. Furthermore, it would eliminate the disincentive to spend and invest that holders of money face during economic downturns.)
To return to our current economic predicament, I believe that the “veil of money” is a perfect metaphor for understanding the unique and perilous nature of the challenges we currently face. Ever since money was divorced from any underlying object of value (e.g. the gold standard), its value is derived solely by virtue of the fact that the government decrees it “legal tender” and promises to regulate its supply in such a way as to ensure a stable price level.
In recent years, our government has completely lost sight of the vital importance of responsibly managing the money supply. These days every new crisis we face brings about the same response on the part of government – i.e. “Let’s just print more money!” We are in the midst of a war that will end up costing trillions of dollars, yet taxes have been lowered. How do we make up the shortfall? Just print more money. The American public is heavily indebted and can’t continue to buy flat-screen TVs and SUVs. How do we prevent a contraction in consumer spending? Just print more money. Bear Stearns goes bankrupt due to the greed and negligence of its managers, and the failure of such a large institution threatens to set off a chain reaction of bank failures. How do we prevent disaster? Just print more money. Fannie Mae and Freddie Mac are threatened with insolvency without tens of billions of dollars of additional capital. How do we prevent this from causing the already weak real estate market to go into freefall? Just print more money.
The problem, though, is that every deviation from a straightforward monetary policy aimed at price stability causes a disturbance to the veil of money. Rather than functioning as a neutral medium of exchange, the veil starts flapping around in the wind and causing unintended consequences. And, the more violent the disturbances become, the more the veil twists and turns and becomes anything but a neutral medium of exchange. When taken to an extreme, the outcomes of real economic processes become so uncertain due to the agitated veil that it becomes impossible to pursue rational, prudent business strategies. Instead, the whole system devolves into a virtual casino, and this is exactly what has happened in our country during the past decade. People quit productive enterprises in order to try to make a quick buck by purely financial maneuvers. Just think, prior to the last decade, how many people did you know who flipped real estate? And how many do you know now?
As Phil Gramm so impoliticly (yet accurately) observed recently, our economic problems are largely psychological. But, what he didn’t say is that the government is largely to blame for our psychological problems. Since money has no “intrinsic value”, the only way for it to function properly is for the government to act in a disciplined and responsible manner. This means that when imprudent companies collapse we don’t just print more money and bail them out, we let them deal with the consequences of their actions. Unfortunately, in our political system it is easier to tell people what they want to hear and keep the printing presses rolling. However, with every passing episode that is dealt with by printing more money, the basis of our whole monetary system is undermined. Eventually, as the veil becomes more and more disturbed, mass psychology shifts, and people lose the trust they once had in the almighty dollar. This process is already well under way. The dollar has collapsed versus other world currencies and real economic goods. How far this process might go is anybody’s guess, but recent history demonstrates just how far it could go. In Germany after World War I, due to the impractical reparation payments dictated by the Treaty of Versailles, the government had no choice but to print more and more money. Eventually the German mark lost so much value that it took over one trillion marks to buy the same amount of goods as one mark bought prior to the war. As a result, Germany had no choice but to start from scratch and create a whole new currency. Of course, anyone who had spent their lives accumulating savings denominated in marks lost everything they had. I can’t help but wonder if we might be headed for exactly the same fate.