The Evolution of Money

by David Orrell

  If there has been one dominant monetary theme since money went virtual in the 1970s, it is debt. Public or private, in developed countries or emerging markets, debt has been on a steady upward climb, nourished by an expanding financial sector and interrupted only briefly by the recent crisis. Never since the time of its invention have people become so familiar with the concept of negative numbers. In the United States, according to Pew, eight out of ten Americans carry debt, and seven out of ten said debt was a necessity in their lives, with mortgages the most common form, even though they preferred not to carry any debt.50 Debt is the engine of economic growth, but its now-overpowering presence—for a Shanghai stock investor trading on margin, a Vancouver homeowner with a borrowed down payment, an American graduate saddled with a student loan and a car loan, an overleveraged hedge fund, or a bankrupt nation—has stretched the distance between debtors and creditors, the many and the few, to breaking point. The gap dividing money’s two sides fills the financial air with a crackling electromagnetic tension; the loaded calm before the next storm.

  Only to a completely linear mind-set, which sees money as neutral, debits as canceled by positive credits, and prices at stable equilibrium, could such levels of debt appear benign. So in the next chapter, we turn to another kind of power that is central to the topic of money—the power of economic ideas. We begin with the development of neoclassical economics in the Victorian era. This highly rational theory, with its emphasis on stability and efficiency, still forms the basis of the mainstream theory taught in universities today. It is also informative about our attitudes toward money—not for what it includes, but for what it leaves out. It might seem ridiculous, in our money-obsessed society, to say that we are as squeamish about money as the Victorians were about sex. But as we’ll see, the subject of money has been sterilized to a point where it seems that we are in denial about its true nature.

  7

  Solid Gold Economics

  Let me issue and control a nation’s money and I care not who writes the laws.

  MAYER AMSCHEL ROTHSCHILD, FOUNDER OF THE HOUSE OF ROTHSCHILD

  I don’t care who writes a nation’s laws—or crafts its advanced treatises—if I can write its economics textbooks.

  PAUL SAMUELSON, AS QUOTED IN MICHAEL M. WEINSTEIN, “PAUL A. SAMUELSON, ECONOMIST, DIES AT 94”

  In economics, money has traditionally been viewed as static, neutral, inert substance, rather like gold (which is an inert metal). Models of the economy don’t usually include things like banks—which makes it hard to predict events such as banking crises. This chapter traces the development of economics from Adam Smith to the present day, asks where the money went, and shows how new ideas from areas such as complexity science and psychology are reshaping the field. The shift is from seeing the financial system as a kind of utility-optimizing machine, to seeing it as one part of a living system. Different forms of money are like biologically active agents that can work to help or hinder the health of the system. In the future, the new currencies discussed in the final chapters will play an important role in reconfiguring the economy.

  Anthropologists say that a good way to understand a society is to listen to its myths. The central myths of economics are the stories, discussed in chapters 1 and 2, that money emerged naturally as a means for facilitating barter and is nothing more than a medium of exchange. While economists clearly agree that money is an intriguing subject and have produced a voluminous literature about it, one manifestation of these underlying beliefs is that money, as a thing in itself rather than an accounting metric, is largely excluded from macroeconomic models, which is one reason the GFC of 2007/2008 was not predicted (it involved money). To the general reader, untrained in the ways of orthodox economics, this will seem a remarkable situation. How can money be both central to economics and somehow excluded where it really counts? Why are its mysterious properties left unfathomed in both the textbooks presented to students and the models used by policy makers? Our aim in the first part of this chapter is not to give a survey of economic thought but to address these specific questions. The reason, as we’ll see, is that mainstream economics is based on a belief set in which money can only be allowed a very limited and repressed role.

  Beginning with Adam Smith—who is considered the founding father of economics—the aim of economists has been to build a kind of Newtonian cosmology for the economy, one that, as Thomas Pownall wrote to Smith in 1776, “might become Principia to the knowledge of political operations; as Mathematics are to Mechanics, Astronomy, and the other Sciences.”1 Just as we can compute the motion of the moon around the earth, so economists have attempted to model and predict interactions in the economy. The topic of money, however, was glossed over from the start.

  In his Wealth of Nations, Smith first of all asserted that the value of money was determined only by its weight in precious metal, with the numerical stamp playing no role other than proof of inspection: “By the money-price of goods, it is to be observed, I understand always the quantity of pure gold or silver for which they are sold, without any regard to the denomination of the coin. Six shillings and eightpence, for example, in the time of Edward I, I consider as the same money-price with a pound sterling in the present times; because it contained, as nearly as we can judge, the same quantity of pure silver.” So money is metal, a commodity like any other, and the denomination is not important. This approach was consistent with the story, discussed in chapter 1, that metal money emerged as a replacement for barter.

  Smith then defined the exchange value of a good as being “equal to the quantity of labour which it enables [a person] to purchase or command.” Just as John Locke associated property rights with the labor needed to obtain it, so Smith associated a property’s value with the labor for which it could be swapped: “If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” In a market economy, this value would be discovered by the quasi-spiritual “invisible hand” that was the centerpiece of Smith’s theory (though the term was only later popularized by Paul Samuelson).2 If the price (relative to other goods) were too high, more suppliers would enter the market, driving the price down; and conversely, if the price were too low, suppliers would cut back, thus restoring the price.

  Smith’s theory was in part a response to the mercantilist economists who had confused value with bullion. According to Smith, money might be metal, but value is the energy-like quantity of work. There was furthermore a distinction to be made between what Smith called the “real” and “nominal” prices of goods. Like any other commodity, the cost of gold or silver depended on the labor needed to produce it, which in turn depended on factors such as the “fertility or barrenness” of mines. An excess of money therefore translated into higher nominal prices. But the role of the economist was to focus on real prices, which stripped out such distracting effects. In psychological terms, we may care about numerical prices, but in mathematical terms, what counts is relative prices. Smith therefore interpreted the economy in terms of ideas such as the division of labor and the mechanics of exchange, rather than of money, which dropped out of the equation like an unneeded variable: “The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.” Value is labor, and the real price is labor, so they are one and the same. Money is just a medium of exchange. The economist Jean-Baptiste Say, who popularized Smith’s work in France, summed this up in his statement that “money is a veil.”

  Smith’s chain of reasoning was not backed by empirical evidence: for example, he did not check whether the price of gold actually reflected the labor required to obtain it, or explore the fact that much of the bullion in existence had been produced by slave labor. And it neatly sidestepped the difficult question about what it means for money to assign number to fuzzy qualities such as value or labor in the first place. In both respects,
his work set a precedent that would be followed by future economists. Karl Marx’s own labor theory of value, for example, was heavily influenced by Smith (he added the capitalist’s markup). And when Victorian economists such as William Stanley Jevons, Leon Walras, and Carl Menger attempted to put economics on a sound mathematical footing, they similarly focused on the exchange of goods in idealized markets. But instead of relating value with labor, they related it to the subjective quality of utility—defined by Jeremy Bentham, the English philosopher and social reformer, as that which appears to “augment or diminish the happiness of the party whose interest is in question.” As Jevons put it in the second paragraph of The Theory of Political Economy (1871): “Repeated reflection and inquiry have led me to the somewhat novel opinion, that value depends entirely upon utility” (his emphasis). More precisely, according to this theory, exchange prices are determined by marginal utility, which takes into account whether you already have what is being offered—you will pay less for a loaf of bread if you already have as much as you can eat.

  According to these neoclassical economists, as they became known, the purpose of exchange—and of the market economy as a whole—was to maximize overall happiness. People trade what they have for what they want, and everyone involved becomes happier. While utility was highly subjective and could not be measured directly, Jevons argued that it could be inferred from prices: “Just as we measure gravity by its effects in the motion of a pendulum, so we may estimate the equality or inequality of feelings by the decisions of the human mind. The will is our pendulum, and its oscillations are minutely registered in the price lists of the markets.” His theory was therefore similar to Smith’s, with the difference that the quantity revealed by the market was utility rather than labor. Explicitly inspired like Smith by Newton’s rational mechanics, the aim was to reduce the economy to a set of elegant laws and equations. As Jevons put it, these laws were to be considered “as sure and demonstrative as that of kinematics or statics, nay, almost as self-evident as are the elements of Euclid, when the real meaning of the formulae is fully seized.”3

  Just as the economy was based on the Newtonian gold standard, so economics was to be based on a version of Newtonian physics. To make their program consistent, though, economists had to make multiple further assumptions, none of which were based on empirical observations. These included:

  • Agents make decisions on a purely rational basis (no shows of emotion).

  • Their aim is to optimize their own utility, as described by a utility function that reflects their fixed preferences (no one can change their minds).

  • Agents act independently of one another (no talking allowed).

  • Agents are of equal power and have access to the same information (no powerful banking networks).

  • Variations in behavior are assumed to average themselves out over a large number of people, so what counts is the opinion of the “average man.”

  • Economic forces are transmitted in a mechanical way courtesy of Smith’s invisible hand, which acts like an economic force of gravity and gently guides prices to their natural place.

  • The result is that markets tend toward a self-regulated and stable equilibrium that balances supply and demand (Walras attempted to demonstrate this using a mathematical model of an idealized economy).

  • Money is treated as a commodity like any other, that happens to also serve as a medium of exchange.4

  In the same way that the force of gravity exerted by an object depended on its mass but not its color or appearance, so money was just a distraction that could safely be ignored by the serious economist. As John Stuart Mill wrote in Principles of Political Economy, which served as a standard text for more than sixty years, “There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money.”5

  The Money Illusion

  Orthodox economists, according to Gilles Dostaler and Bernard Maris, “wanted to create a science that ignored money.”6 In particular, they wanted to draw attention away from the awkward incompatibility between exact number and fuzzy value (and therefore between economics and reality) that is at the beating heart of money, and focus purely on the math. Of course, this is not to say that mainstream economists neglected the subject of money completely—even Mill followed up his dismissal of money with a number of chapters about its mechanics—only that they treated it in a mechanical, sterilized way that deprived it of any kind of life or power.

  As discussed in chapter 1, speculation from economists including Smith, Jevons, and Menger on the emergence of money as an intermediary for barter was key to the subject’s self-mythologizing. During much of the twentieth century, the dominant theory about how money actually functioned in the economy was the quantity theory of money, as formulated by Irving Fisher. After receiving Yale University’s first doctorate in economics, Fisher went on to develop or popularize many of the key ideas of modern economics. The so-called Fisher identity, which reads MV = PT, states that the amount of money in circulation M, multiplied by the average rate (or velocity) at which the money changes hands V, is equal to the average transaction price P multiplied by the total volume of transactions T.7 The left-hand side, MV, represents the flow of money through the economy—if a dollar bill changes hands three times in a year, then it represents $3 in total transactions. The right-hand side, PT, aggregated over a country, amounts to what today is called the gross domestic product, or GDP. So the equation says that GDP equals money times velocity. A typical rate for velocity is about two, meaning that money changes hands about twice a year, but there is considerable fluctuation around that number, both in time and from place to place.8

  The Fisher identity has a clear analogue in Newtonian physics, where an object’s momentum P is equal to its mass M times its velocity V. Mercantilism saw wealth as being the sum of money (in the form of bullion), but the Fisher equation shows that what counts is the economy’s momentum. Money changes hands whenever an economic transaction takes place, and the faster the flow, the more the products and services being sold. “If the coin be locked up in chests,” observed David Hume in the eighteenth century, “it is the same thing with regard to prices, as if it were annihilated.”9 As Fisher pointed out in 1934, some of the scrip currencies that emerged in the Depression needed a stamp added once a week to remain valid, which had the effect of boosting the velocity of the money, since people tried to spend the notes before the stamp was due.10

  The equation is just an accounting statement, but Fisher applied it by arguing that velocity V and volume of transactions T are fixed with respect to the money supply, so if the supply of money is increased by, say, 5 percent, then prices will also increase by 5 percent. The money supply can therefore be used by the central bank as a lever: if it wants to reduce inflation, it can just trim back on the money supply. According to Fisher, inflation was harmful because of the “money illusion,” which was our tendency to think in terms of nominal values rather than “real” values. This made it hard to connect past costs with present costs (e.g., to understand whether selling your house for double what you paid was a great deal) or for businesses to raise prices without losing customers.

  Fisher’s equation later formed the basis of the theory known as monetarism, whose best known exponent was Milton Friedman. As Friedman said in 1970, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”11 Monetarism was essentially a more refined version of Copernicus’s observation that the value of money depends on its scarcity, so governments should try to keep the amount in circulation stable. As Friedman told EconTalk: “What you want—if possible—is a mechanical system.” He suggested that the quantity of so-called high-powered money—currency plus bank reserves—should simply be kept the same. “I would freeze that and hold it constant and have it as sort of a natural constant like gravity or something.”12 This doctrine was adopted by R
onald Reagan and Margaret Thatcher as a means to tackle inflation, with decidedly mixed results (Friedman later admitted the experiment had not been a success). In Britain, inflation hit 18 percent at one point. Its influence was also evident in the design of the European Union, with the central bank’s strict mandate on controlling inflation.

  Despite its enduring attractions, the theory is an example of the kind of linear, mechanistic thinking that so often leads us astray when thinking about complex systems. One problem is that terms such as velocity V are not constant, as assumed, but change along with other economic variables in a highly complex and unpredictable manner. For example, a major contributor to inflation is expectations of future inflation, which creates a nonlinear feedback loop: a worker who thinks prices will go up next year will (1) spend his money before it is devalued, which increases the velocity; and (2) demand a higher pay settlement, which in turn drives up prices of the firm’s products. These actions, when replicated over a large number of people, lead to more inflation, which creates the expectation that prices will go up in future, and so on. Conversely, in a depression, deflation may mean that people are afraid to spend and businesses are afraid to invest, and again this behavior exacerbates the situation.13 Such feedback loops are discussed in more detail later in the chapter.