Wednesday, May 23, 2012

The Value of Money

A couple weeks ago I wrote a post addressing the question 'why does money matter?'. I hope I laid out a clear explanation of the role of money in our economy and how many mainstream economists misunderstand just what it is at its most fundamental level.

The basic insight is that money is credit or an IOU, and not a commodity nor a representation of a commodity (or commodities). So if money is credit, then what gives it value?

The metallists, those who believe money is like a commodity or a 'fiat' representation of commodities, believe money gets its value from that commodity or commodities. That is, they believe money gets its value from gold or in more modern times, from the bundles of goods a currency area produces.

I wondered about this question long ago, why is gold so valuable? I just didn't get why a mostly useless shiny metal would be so coveted by the Egyptians, Romans, or Europeans. Then I took a money and banking course in college that provided me with an explanation. Gold and other precious metals were used as money because they were easily molded into small, transportable coins. And because of its moldability, it could be divided into larger and smaller coins with varying values with markings to protect against counterfeiting. This mostly satisfied my curiosity. I though, 'oh, the people of Egypt (or wherever) were smart enough to figure out that this commodity, of all the commodities available to them, would serve best as money because of its inherent properties'.

Later in the course, however, I learned of an alternative approach to money that completely flips this view on its head. This is the Chartalist view that regards money as credit. To them, all money is an IOU or credit and anyone can then create money as long as someone is willing to accept it. Monies fall into a sort of hierarchy of acceptance with the most worthy creditors (or debtors) at the top and the worst at the bottom.

And it is here were we find the key to money's value. It isn't anything based on intrinsic worth of the commodity used to represent the IOU, it is rather the acceptability of the IOU. The most acceptable IOUs have more value!

Systems of IOU record keeping have long been used to ease trade. They were needed because of the division of labor. Farmers needed a way to obtain other goods and the same was true for all occupations. Usually some sort of commodity was chosen to represent the debts and credits, in early societies grain was used, but others used seashells, tallies, cattle, precious metals, really all kinds of things. And most often, the governing body chose the commodity used as the record keeper. So gold may very well have been chosen for its unique properties, but its unique properties are not what gave it value as money, rather, it was the acceptability of the debtor issuing those IOUs that gave them value. The people accepted the governing body's money (IOUs) when they believed they could obtain the goods they needed to live with that money. In some cases, the state had a difficult time making this happen and had to enforce arbitrary IOUs on its people to force them to accept the money they issued.

These 'arbitrary' IOUs we call taxes. This means that taxes weren't issued so that the government could collect 'money' from the people, they were issued so that the government could take real goods and resources from the people. The people sometimes wouldn't offer the government real goods and services if they didn't have to pay taxes. And almost each and every case, it is then the tax that determines the money to be used. If the state taxes in grain, grain will likely be the money. If they tax in gold, gold is likely to be the money. If they tax in pieces of paper, then pieces of paper are likely to be the money.

So to bring it full circle, people accept U.S. dollars because they think they can get something with them, but they first have to be able to get something with those pieces of paper. The logical beginning of this process first required the state to issue the dollars to the people and then to make them acceptable to the people, they had to enforce the tax. Citizens then needed these pieces of paper to pay the tax to avoid penalties for tax evasion.

Dollars now have value regardless of whether there is a gold standard or not. Dollars are needed to extinguish a liability enforced on us.

In the hierarchy of money I talked about earlier, the state's money is at the top, ultimately because it has the power to govern its people, to enforce contracts and hand down penalties if necessary. It is really the governing body's power to tax and to enforce that tax that gives money its value.

This may not go over well with some of you who think the state already has too much power, but please consider this. There must be a governing body to provide societal order, even if it is democratic. That body must have goods and resources to carry out its purpose. In order to obtain those goods and resources, it must get them from the people it governs which it does through taxation. Whatever it taxes will be needed by the people to pay the tax. That then likely becomes the money used by that society. So long as government is responsible and carrying out the good of the people there is not a problem in this process.

So if you don't like big government, fine, but you can't take away its power to tax and expect it to remain effective. If it taxes, then there will likely be a state money which will have the greatest value because of the government's ability to enforce it. In this way, the state always has a monopoly over the money. It may abdicate this right, as governments have done by adopting a currency board, common currency, gold standard, international gold standard, etc., but doing so undermines its ability to provide for the common welfare of the people. This really is the topic for another post, so if you are more curious about this, I will be glad to write about it later.

The main point is that ACCEPTANCE is the key to the value of money (which is always an IOU), and the ability to tax and enforce that tax make the state's money the most acceptable.

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