THE ROLE OF MONEY
Many economies in the distant past functioned without money. People simply bartered their products and labor with one another. But these have usually been small, uncomplicated economies, with relatively few things to trade, because most people provided themselves with food, shelter and clothing, while trading with others for a limited range of implements, amenities or luxuries.
Barter is awkward. If you produce chairs and want some apples, you certainly are not likely to trade one chair for one apple, and you may not want enough apples to add up to the value of a chair. But if chairs and apples can both be exchanged for some third thing that can be subdivided into very small units, then more trades can take place using that intermediary means of exchange, benefitting both chair-makers and apple-growers, as well as everyone else. All that people have to do is to agree on what will be used as an intermediary means of exchange and that means of exchange becomes money.
Some societies have used sea shells as money, others have used gold or silver, and still others have used special pieces of paper printed by their governments. In colonial America, where hard currency was in short supply, warehouse receipts for tobacco circulated as money.{560} In the early colonial era in British West Africa, bottles and cases of gin were sometimes used as money, often passing from hand to hand for years without being consumed.{561} In a prisoner-of-war camp during the Second World War, cigarettes from Red Cross packages were used as money among the prisoners,{562} producing economic phenomena long associated with money, such as interest rates and Gresham’s Law.{xxvi} During the early, desperate and economically chaotic days of the Soviet Union, “goods such as flour, grain, and salt gradually assumed the role of money,” according to two Soviet economists who studied that era, and “salt or baked bread could be used to buy virtually anything a person might need.”{563}
In the Pacific islands of Yap, a part of Micronesia, doughnut-shaped rocks function as money, even though the largest of these rocks are 12 feet in diameter and obviously cannot circulate physically. What circulates is the ownership of these rocks, {564}so that this primitive system of money functions in this respect like the most modern systems today, in which ownership of money can change instantaneously by electronic transfers without any physical movement of currency or coins.
What made all these different things money was that people would accept them in payment for the goods and services which actually constituted real wealth. Money is equivalent to wealth for an individual only because other individuals will supply the real goods and services desired in exchange for that money. But, from the standpoint of the national economy as a whole, money is not wealth. It is just an artifact used to transfer wealth or to give people incentives to produce wealth.
While money facilitates the production of real wealth—greases the wheels, as it were—this is not to say that its role is inconsequential. Wheels work much better when they are greased. When a monetary system breaks down for one reason or another, and people are forced to resort to barter, the clumsiness of that method quickly becomes apparent to all. In 2002, for example, the monetary system in Argentina broke down, leading to a decline in economic activity and a resort to barter clubs called trueque:
This week, the bartering club pooled its resources to “buy” 220 pounds of bread from a local baker in exchange for half a ton of firewood the club had acquired in previous trades—the baker used the wood to fire his oven. . . .The affluent neighborhood of Palermo hosts a swanky trueque at which antique china might be traded for cuts of prime Argentine beef.{565}
Although money itself is not wealth, an absence of a well-functioning monetary system can cause losses of real wealth, when transactions are reduced to the crude level of barter. Argentina is not the only country to revert to barter or other expedients when the monetary system broke down. During the Great Depression of the 1930s, when the money supply contracted drastically, there were in the United States an estimated “150 barter and/or scrip systems in operation in thirty states.”{566}
Usually everyone seems to want money, but there have been particular times in particular countries when no one wanted money, because they considered it worthless. In reality, it was the fact that no one would accept money that made it worthless. When you can’t buy anything with money, it becomes just useless pieces of paper or useless little metal disks. In France during the 1790s, a desperate government passed a law prescribing the death penalty for anyone who refused to sell in exchange for money. What all this suggests is that the mere fact that the government prints money does not mean that it will automatically be accepted by people and actually function as money. We therefore need to understand how money functions, if only to avoid reaching the point where it malfunctions. Two of its most important malfunctions are inflation and deflation.
Inflation
Inflation is a general rise in prices. The national price level rises for the same reason that prices of particular goods and services rise—namely, that there is more demanded than supplied at a given price. When people have more money, they tend to spend more. Without a corresponding increase in the volume of output, the prices of existing goods and services simply rise because the quantity demanded exceeds the quantity supplied at current prices and either people bid against each other during the shortage or sellers realize the increased demand for their products at existing prices and raise their prices accordingly.
Whatever the money consists of—sea shells, gold, or whatever—more of it in the national economy means higher prices, unless there is a correspondingly larger supply of goods and services. This relationship between the total amount of money and the general price level has been seen for centuries. When Alexander the Great began spending the captured treasures of the Persians, prices rose in Greece. Similarly, when the Spaniards removed vast amounts of gold from their colonies in the Western Hemisphere, price levels rose not only in Spain, but across Europe, because the Spaniards used much of their wealth to buy imports from other European countries. Sending their gold to those countries to pay for these purchases added to the total money supply across the continent.
None of this is hard to understand. Complications and confusion come in when we start thinking about such mystical and fallacious things as the “intrinsic value” of money or believe that gold somehow “backs up” our money or in some mysterious way gives it value.
For much of history, gold has been used as money by many countries. Sometimes the gold was used directly in coins or (for large purchases) in nuggets, gold bars or other forms. Even more convenient for carrying around were pieces of paper money printed by the government that were redeemable in gold whenever you wanted it redeemed. It was not only more convenient to carry around paper money, it was also safer than carrying large sums of money as metal that jingled in your pockets or was conspicuous in bags, attracting the attention of criminals.
The big problem with money created by the government is that those who run the government always face the temptation to create more money and spend it. Whether among ancient kings or modern politicians, this has happened again and again over the centuries, leading to inflation and the many economic and social problems that follow from inflation. For this reason, many countries have preferred using gold, silver, or some other material that is inherently limited in supply, as money. It is a way of depriving governments of the power to expand the money supply to inflationary levels.
Gold has long been considered ideal for this purpose, since the supply of gold in the world usually cannot be increased rapidly. When paper money is convertible into gold whenever the individual chooses to do so, then the money is said to be “backed up” by gold. This expression is misleading only if we imagine that the value of the gold is somehow transferred to the paper money, when in fact the real point is that the gold simply limits the amount of paper money that can be issued.
The American dollar was once redeemable in gold on demand, but that was ended back in 1933. Since then, the United States
has simply had paper money, limited in supply only by what officials thought they could or could not get away with politically. Many economists have pointed out what a dangerous power this gives to government officials. John Maynard Keynes, for example, wrote: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”{567}
As an example of the cumulative effects of inflation, in 2013 Investor’s Business Daily pointed out that in 1960, “you could buy six times more stuff for a dollar than you can buy today.”{568} Among other things, this means that people who saved money in 1960 had more than four-fifths of its value silently stolen from them.
Sobering as such inflation may be in the United States, it pales alongside levels of inflation reached in some other countries. “Double-digit inflation” during a given year in the United States creates political alarms, but various countries in Latin America and Eastern Europe have had periods when the annual rate of inflation was in four digits.
Since money is whatever we accept as money in payment for real goods and services, there are a variety of other things that function in a way very similar to the official money issued by the government. Credit cards, debit cards, and checks are obvious examples. Mere promises may also function as money, serving to acquire real goods and services, when the person who makes the promises is highly trusted. IOUs from reliable merchants were once passed from hand to hand as money. As noted in Chapter 5, more purchases were made in 2003 by credit cards or debit cards than by cash.
What this means is that aggregate demand is created not only by the money issued by the government but also by credits originating in a variety of other sources. What this also means is that a liquidation of credits, for whatever reason, reduces aggregate demand, just as if the official money supply had contracted.
Some banks used to issue their own currency, which had no legal standing, but which was nevertheless widely accepted in payment when the particular bank was regarded as sufficiently reliable and willing to redeem their currency in gold. Back in the 1780s, currency issued by the Bank of North America was more widely accepted than the official government currency of that time.{569}
Sometimes money issued by some other country is preferred to money issued by one’s own. Beginning in the late tenth century, Chinese money was preferred to Japanese money in Japan.{570} In twentieth century Bolivia, most of the savings accounts were in dollars in 1985, during a period of runaway inflation of the Bolivian peso.{571} In 2007, the New York Times reported: “South Africa’s rand has replaced Zimbabwe’s essentially worthless dollar as the currency of choice.”{572} During the later stages of the American Civil War, Southerners tended to use the currency issued in Washington, rather than the currency of their own Confederate government.{573}
Gold continues to be preferred to many national currencies, even though gold earns no interest, while money in the bank does. The fluctuating price of gold reflects not only the changing demands for it for making jewelry—the source of about 80 percent of the demand for gold{574}—or in some industrial uses but also, and more fundamentally, these fluctuations reflect the degree of worry about the possibility of inflation that could erode the purchasing power of official currencies. That is why a major political or military crisis can send the price of gold shooting up, as people dump their holdings of the currencies that might be affected and begin bidding against each other to buy gold, as a more reliable way to hold their existing wealth, even if it does not earn any interest or dividends.
Since the price of gold depends on people’s expectations as regards the value of money, that price can rise or fall sharply, and reverse promptly, in response to changing economic and political conditions. The sharpest rate of increase in the price of gold in one year was 135 percent in 1979—and the sharpest fall in the price of gold was 32 percent just two years later.{575}
Existing or expected inflation usually leads to rising prices of gold, as people seek to shelter their wealth from the government’s silent confiscations by inflation. But long periods of prosperity with price stability are likely to see the price of gold fall, as people move their wealth out of gold and into other financial assets that earn interest or dividends and can therefore increase their wealth. When the economic crises of the late 1970s and early 1980s passed, and were followed by a long period of steady growth and low inflation, the price of gold fell over the years from about $800 an ounce to about $250 an ounce by 1999. Still later, after record-breaking federal deficits in the United States and similar problems in a number of European countries in the early years of the twenty-first century, the price of gold soared well over $1,000 an ounce.{576}
The great unspoken fear behind the demand for gold is the fear of inflation. Nor is this fear irrational, given how often governments of all types—from monarchies to democracies to dictatorships—have resorted to inflation, as a means of getting more wealth without having to directly confront the public with higher taxes.
Raising tax rates has always created political dangers to those who hold political power. Political careers can be destroyed when the voting public turns against those who raised their tax rates. Sometimes public reaction to higher taxes can range all the way up to armed revolts, such as those that led to the American war of independence from Britain. In addition to adverse political reactions to higher taxes, there can be adverse economic reactions. As tax rates reach ever higher levels, particular economic activities may be abandoned by those who do not find the net rate of return on these activities, after taxes, to be enough to justify their efforts. Thus many people abandoned agriculture and moved to the cities during the declining era of the Roman Empire, adding to the number of people needing to be taken care of by the government, at the very time when the food supply was declining because of those who had stopped farming.
In order to avoid the political dangers that raising tax rates can create, governments around the world have for thousands of years resorted to inflation instead. As John Maynard Keynes observed:
There is no record of a prolonged war or a great social upheaval which has not been accompanied by a change in the legal tender, but an almost unbroken chronicle in every country which has a history, back to the earliest dawn of economic record, of a progressive deterioration in the real value of the successive legal tenders which have represented money.{577}
If fighting a major war requires half the country’s annual output, then rather than raise tax rates to 50 percent of everyone’s earnings in order to pay for it, the government may choose instead to create more money for itself and spend that money buying war materiel. With half the country’s resources being used to produce military equipment and supplies, civilian goods will become more scarce just as money becomes more plentiful. This changed ratio of money to civilian goods will lead to inflation, as more money is bid for fewer goods, and prices rise as a result.
Not all inflation is caused by war, though inflation has often accompanied military conflicts. Even in peacetime, governments have found many things to spend money on, including luxurious living by kings or dictators and numerous showy projects that have been common under both democratic and undemocratic governments. To pay for such things, using the government’s power to create more money has often been considered easier and politically safer than raising tax rates. Put differently, inflation is in effect a hidden tax. The money that people have saved is robbed of part of its purchasing power, which is quietly transferred to the government that issues new money.
Inflation is not only a hidden tax, it is also a broad-based tax. A government may announce that it will not raise taxes, or will raise taxes only on “the rich”—however that is defined—but, by creating inflation, it in effect transfers some of the wealth of everyone who has money, which is to say, it siphons off wealth across the whole range of incomes and wealth, from the richest to the poorest. To the extent that the rich have their wealth invested in stocks, real estate or other tangible
assets that rise in value along with inflation, they escape some of this de facto taxation, which people in lower income brackets may not be able to escape.
In the modern era of paper money, increasing the money supply is a relatively simple matter of turning on the printing presses. However, long before there were printing presses, governments were able to create more money by the simple process of reducing the amount of gold or silver in coins of a given denomination. Thus a French franc or a British pound might begin by containing a certain amount of precious metal, but coins later issued by the French or British government would contain less and less of those metals, enabling these governments to issue more money from a given supply of gold or silver. Since the new coins had the same legal value as the old, the purchasing power of them all declined as coins became more abundant.
More sophisticated methods of increasing the quantity of money have been used in countries with government-controlled central banks, but the net result is still the same: An increase in the amount of money, without a corresponding increase in the supply of real goods, means that prices rise—which is to say, inflation. Conversely, when output increased during Britain’s industrial revolution in the nineteenth century, the country’s prices declined because its money supply did not increase correspondingly.
Doubling the money supply while the amount of goods remains the same may more than double the price level, as the speed with which the money circulates increases when people lose confidence in its retaining its value. During the drastic decline in the value of the Russian ruble in 1998, a Moscow correspondent reported: “Many are hurrying to spend their shrinking rubles as fast as possible while the currency still has some value.”{578}
Basic Economics Page 42