June 8, 2013

How Money Comes About

By In Economics

According to Ludwig von Mises, “Economics, as a branch of the more general theory of human action, deals with all human action, i.e., with man’s purposive aiming at the attainment of ends chosen, whatever these ends may be.”  This means that the topic of money and its role in a society has to be viewed independent of a government influence, which is a very hard thing to do in this contemporary world of government issued and manipulated currencies.  How does mankind act in a market without government to provide the economy with money and interest rates?

Investor Peter Schiff, who is known for his bearish views on the dollar due to his Austrian perspective on the economy, has written a large allegory which takes a look at how an economy grows from its most basic state as a barter economy and can over time reach a situation where a crash is unavoidable.  He points out that the idea of money is a result of the market rather than a cause of the market.  In other words, in his parable, money was something that was discovered out of the market process and is therefore a naturally occurring reality.

Rothbard starts even further back than a barter system and poses the question, “why do men exchange at all?”  He answers this question several sentences later, stating that “exchange occurs because both parties intend to benefit.”  This has been said in another way; that because there is a “coincidence of wants,” two individuals based on their personal desires can mutually benefit one another.  In order for this coincidence of wants to occur, person A must have what person B wants, and person B must have what person A wants.  Based on their individual desires, both parties work to satisfy their wants as they “barter” for the other person’s goods.  Assume for a moment that Jones grows wheat and has enough of it to feed himself and his family for years but he has no chicken.  His diet day in and day out would consist of wheat only, but he is willing to give away some of his wheat in exchange for chicken in order to balance his food intake.  Smith on the other hand has the opposite problem.  Because both Jones and Smith have a “coincidence of wants”, they can trade their surplus in order to maximize their satisfaction.  This form of bartering is called direct exchange.

However, this will soon prove to be problematic as Jones begins to need other goods.  In order to continue producing wheat, he will need a new plow.  However, the person who makes plows has no desire for wheat and wants something else instead.  In order to solve this problem, Jones will have to figure out what the plow maker wants (perhaps salt), go and find someone who both produces salt and wants wheat (because Jones has to trade what he has in order to receive the salt), and then Jones must take this salt that the plow maker wants and trade him for a plow.  This is where direct exchange turns into indirect exchange.  The salt is used, not to satisfy Jones, but rather to satisfy the plow maker.  But Jones must acquire salt in order to satisfy his desire for a plow.  As can be seen, the coincidence of wants becomes harder to satisfy the bigger an economy gets.  As time goes on, one type of commodity will begin to become more generally useful or marketable to many people and they will begin to have confidence that this commodity can usually be used to purchase goods.  Slowly, this commodity will become a widely used medium of exchange by which the economy measures worth.  “A commodity,” says Rothbard, “that is in general used as a medium, is defined as a money.”

It has thus been determined that real money is the unit or medium of exchange which arises from the free exchange of goods in a market.  It must be established that one of the most important parts of the definition of money is the emphasis on the naturally arising use of it.  Carl Menger, the founder of Austrian Economics, says it this way: “Money is not an invention of the state.  It is not the product of a legislative act.  The sanction of political authority is not necessary for its existence.”  What the Austrians are saying in their definition of money is that while the state can try to issue money, it is flawed because it has not arisen out of the market place.  All that it can create, rather than money itself, is money substitutes, including currency.  When the government tries to create something that the market does not ask for, it does damage to the market.  Free-market advocates can see this as accurate when they think of examples such as health care and government sponsored housing.  It is important that these advocates also see the principle as true for monies and currencies.

Written by C.Jay Engel

Editor and creator of The Reformed Libertarian. Living in Northern California with his wife, he writes on everything from politics to theology and from culture to economic theory. You can send an email to reformedlibertarian@gmail.com