Money and the theory of exchange

Evidence mounts that the global credit cycle has turned towards its perennial crisis stage. This time, the gathering forces appear to be on a scale greater than any in living memory and therefore the inflation of all major currencies to deal with it will be on an unprecedented scale. The potential collapse of the current monetary system as a consequence must be taken very seriously.

To understand the consequences of what is likely to unfold requires a proper understanding of what money is and of the purpose for its existence. It does not accord with any state theory of money. This article summarises the true economic role of money and how its use-value is derived. Only then can we apply the lessons of theory and empirical evidence to anticipate what lies ahead.

Introduction

Through a combination of economic theory and empirical evidence, it is easy to establish that changes in our economic condition will prove to turn negative in the next few years. We cannot with certainty establish the timing and scale; that is the province of informed speculation. But we do know that a cycle of credit always terminating in a periodic crisis exists and we can explain why. We know that it is a repetitive cycle of events, a new crisis is now due, and the misuse of money is at the centre of it.

This time, the negative forces are unquestionably more violent than last time, threatening not just a recession, but something considerably more vicious. And anticipating, which we can do with total certainty, the statists’ monetary response to what we now know to be a forthcoming event, we can also say it will be met with a new wave of monetary expansion. The precedent was set by the Lehman crisis, when the greatest coordinated injection of money in the history of central banking was undertaken by the major central banks to buy off the consequences of previous monetary expansions. This one threatens to be even larger.

Consequences begat other consequences. But, by and large, they have not materialised in the form widely expected. Following Lehman, monetarists expected the purchasing power of currencies to decline in unison, and to a degree they did. How much they have declined becomes debatable, because government statistics try to measure the unmeasurable and fail to produce satisfactory answers. With respect to both economics and money, the problem for the ordinary person is further compounded by governments and their agencies acting like the three wise monkeys. They see no evil, hear no evil, speak no evil. And hey presto! There is no evil.

For a long time, those that determine what is best for us have been inhabiting another planet. They pursue economic and monetary policies that become more destabilising with each turn of the credit cycle. By statistical method they supress evidence of the consequences. Government finances benefited from the Lehman experiment with their expanding debt financed by the expansion of money and credit, which escalated with the interest cost conveniently suppressed. Government is all right Jack, so the little people, its electors, must be as well.

The forthcoming tsunami of money and credit, which if recent history is any guide, will be through quantitative easing, providing finance for worsening government deficits and supporting the banks they licence. The little people might take a different view of the consequences for state-issued currencies, as the debasement unfolds. This article anticipates that alternative view by explaining what money is, its validity, and how a state-issued currency differs from true money, in order to inform readers ahead of events instead of learning the lesson in retrospect.

The economic role of money

For all governments the role of state-issued money is to provide themselves with funds by facilitating tax payments, provide seigniorage from its issue and to manage economic outcomes. This was not money’s original role and is not the way economic actors in the wider economy utilise it.

Money’s proper role is to facilitate the exchange of goods and services in a world that works through the division of labour. It is itself a commodity, but with a specific function and suitability. It must be commonly accepted by economic actors, and for the purpose of exchange have an objective value; that is to say any variations in price during an exchange for goods must be viewed by both buyer and seller as coming from the goods side. This is the subjectivity in a transaction, the difference of opinion in price between exchanging parties, which must always be confined to the good or service being exchanged. It brings in value as a concept, which is conventionally measured in money under the assumption that money is the constant and all variations in values are in the goods.

However, this common view is incorrect. With money acting as the facilitator for an exchange of goods the value of one good must be considered in relation to all the others an individual may desire. If you buy something, you are giving up the opportunity to buy something else, so personal preferences at any moment in time will set the value that an individual decides a good or service is worth, not its measurement in money. At that moment in time, if the individual values an item highly in his personal schedule of needs and wants, then he may pay the price asked or he may haggle for a lower price. But it must be understood he nearly always values it because he wants it, not because of the money-price. If price was the principal motivation for exchange, we’d all end up with useless items.

Our needs and wants are therefore entirely personal and a medium of exchange must allow us to realise them by being objective in terms of its value for all transactions. It is what gives money its purchasing power. But that is for the purpose of transactions only; for other purposes, money is subjective in its value, its subjectivity wholly derived from its objective role as a medium of exchange.

Understanding that money can be objective for the purpose of transactions while subjective for other purposes allows us to accept an apparent contradiction, that money has no price while having a price. It is also why people can hold different views on the value of money relative to goods while accepting it in return for goods. Some are content to hold it in quantity, while others dispose of it rapidly.

If the public subjectively changes its general level of relative preference between money and goods, money’s purchasing power alters materially. If preferences for money increase, then its purchasing power will rise, which is expressed in falling prices for goods and services. If preferences for money decline, then its purchasing power also declines, leading to higher prices for goods and services. If all preference for holding a currency evaporates, it loses its objective role as money in transactions altogether.

How money derives its objective value

Money does not arrive at an objective value by accident. For everyone in a community, and for those that trade with it from outside, to accept it as money requires them to refer to their experience of it as money. Its subjective value, in this case the value ascribed to money prior to every transaction, must coincide with its objective value when an exchange takes place. Money’s subjective value is therefore drawn from experience of its recent history as money, which in turn is drawn from the more distant past.

We may not consciously do this, but when you take a $50 bill or a £20 note from your wallet you know it is money and you know pretty much what it will buy. The subjective value of the money in your hand is central to its role for the exchange of goods, goods exchanged with a view to being consumed, while money is not. Money will continue to circulate for the purpose of future transactions and that is its sole purpose. If it lacks credibility as money it cannot perform this role, so that credibility, regarded subjectively in your hand, is vital to it. The Austrian economist von Mises called it a theorem of regression, whereby to prove its current validity to the user, its qualification as money theoretically links step by step back to the moment when the money became money.

In the cases of gold and silver their role as money evolved from their prior value as commodities for other purposes before they become money. They were accepted as money because they had and still have value for other uses and possess the enduring qualities that allowed them to survive as media for exchange long after other rival commodities for that role were abandoned. They were selected as money by an evolutionary process decided by economic actors dividing their labour and accumulating material wealth. Consequently, they have both been used as media of exchange for five or more millennia, sometimes individually and often together.

Silver lost out to gold in the ealy 1870s when Europe progressively moved onto a common gold standard, after the United Kingdom, the leading trading nation at that time, had set the gold sovereign as its monetary standard after the defeat of Napoleon. From 1873, silver’s price declined sharply following its general demonetisation in Europe and the gold standard reigned until the First World War.

A gold standard meant that physical gold was represented in transactions by local currencies, which were free to be exchanged for gold by the general public at any time. Whether it was marks, pounds, francs or dollars, these bank notes were proxy for gold and therefore drew their credibility from it. A user making a subjective assessment of a gold-backed currency saw in a bank note a regression to gold’s value. It lasted, in America at least, until 1933, when President Roosevelt forbade the ownership of gold coin, gold bullion and gold certificates in America. The link with gold at $20.67 remained but citizens were unable to exercise it. The following January Roosevelt devalued the dollar to $35.00 per ounce.

As money changed from gold through the medium of the dollar to just paper dollars, few saw anything amiss, because they were used to using paper dollars anyway. The government argued that gold confiscation was somehow necessary as an emergency measure in order to combat the depression, and it was only later that it became clear that far from gold convertibility returning after the crisis was over, it would be restricted to foreign governments and central banks.

The only money permitted to circulate in America was the paper dollar and the people had no option but to accept it. It must also be noted that the public is normally slow to understand that there has been a fundamental change in how they should view money. It had become an article of faith that a dollar was a dollar. Everyone accounted in dollars, paid their taxes in dollars and maintained bank balances in dollars. The history of the dollar’s circulation appeared to confirm its validity.

Now let us imagine that a government decides to introduce a new currency overnight. Without a measured regression to earlier values, the public would only accept it with difficulty. If the issuing government had good standing with its electors, that might help. But if the government is demonstrably not to be trusted with respect to monetary policy, the fact that it chooses to issue a new currency would be regarded by its citizens with disbelief.

This has been confirmed in the few cases where this has happened. When the assignat failed at the time of the French revolution, it was replaced by the mandats territorial. It was originally set at 30 assignats. The mandats lost all purchasing power within six months. Attempts to introduce new replacement currencies in Zimbabwe have met similar fates. When people are forced to use a new currency when an old one fails, even at gunpoint they know its worthlessness because there is no history of a new currency as money. In the event the current monetary system fails, a government-contrived reset will almost certainly fail as well for this reason.

For people in the eurozone the euro replaced national currencies on a ratio basis which were already circulating as money, so from Day One euros were accepted as money. The fact that its creation was planned long in advance and not born out of a crisis was also vital to its acceptability. In this respect euros were and still are different from instances where a completely new fiat currency replaces a failed predecessor.

However, with today’s dollar-based system of pure fiat currencies, regression to earlier values cannot not give us a convincing reason for current values. The only regression is an implied one to the dollar, which does not resolve our problem. Currencies only retain a purchasing power because people are naturally unwilling to accept the consequences of the regression logic. This puts state-issued unbacked currencies at permanent risk of an unexpected loss of their role as money.

The instance of a fiat currency collapse that people often refer to was that of the paper mark in 1923, but they are not usually aware of the sequence of events that led to it. In the nineteenth century, Bismarck unified all the German-speaking states, with the exception of Austria. Trading was under a gold standard and it was a remarkably successful exercise. But in 1905 Georg Knapp published his State Theory of Money, in which he argued that money should be a creation of the state, not private actors. It was an argument for a paper currency without the need for gold to back it; a licence for the state to fund itself through the expansion of the circulating medium.

Bismarck used this latitude to equip Germany with armaments before the First World War, and when Germany lost, in post-war years printing of unbacked currency accounted for roughly 90% of government income, only 10% coming from taxes and trade tariffs. Consequently, the purchasing power of the papiermark fell rapidly under the burden of its expansion, until about May 1923 when the general public became finally convinced it was worthless. It led to the phenomenon of the crack-up boom, when everyone furiously dumped worthless marks for anything they could buy.

The mark finally lost its ability to act as the objective value in transactions by November 1923, a process that only took that long because in Germany’s cash-based economy there was a perpetual shortage of paper notes to turn wages into goods.

The relevance to today’s monetary condition