Our Dysfunctional Money System Poses Serious Risks, Dangers

Look to ancient Romans, imperial Chinese for monetary lessons
August 29, 2018 Updated: August 30, 2018

Money is something everyone thinks he or she knows something about, and most people think they know precisely what it is. Economists will tell you, however, that the question “what is money?” is one of the trickiest in economics.

They say that monetary policy is one of the slipperiest and most troublesome areas of economic policy; unrealistic expectations are regularly disappointed on all ideological sides.

Because this is such a difficult topic, and because the effects of money and monetary policy are so difficult to capture in mathematical models, it’s seriously undertaught and understudied in university courses.

For most students, thinking about money means trying to understand the macroeconomic effects of interest rates on demand, while areas such as the quantity and circulation of money, the demand for it and where it comes from, are largely ignored.

This state of affairs has a number of sources (one, for example, is the obsessive focus on things that can be modeled, often with spurious claims to accuracy). A basic cause, however, is a lack of historical perspective and understanding on the part of many (although not all) economists.

Most economists have a “just-so” story about the origins of money, first set out by Carl Menger. According to this, money appears as a neutral medium of exchange that resolves difficulties in barter due to mismatched wants: If you have a surplus of shoes, and I have a surplus of corn, but neither of us wants what the other has, then trade becomes difficult.

However, if both of us are prepared to take a particular commodity that can be exchanged for anything (money), then everything works smoothly.

This is an intriguing story, but there is one problem: Empirical evidence doesn’t support it. All of the evidence we have suggests that money arose as circulating debt claims, as a number of anthropologists have pointed out.

The Functions of Money

Economists argue that money has four functions: as a medium of exchange, a store of value, a unit of account (the measure in which prices are calculated) and a promise of future payment.

The story recounted above makes medium of exchange the original and, in some sense, the primary purpose of money, whereas anthropologists argue that it actually was a promise of future payment that came first. Be that as it may, the real problem is this: The assumption is that money has four functions; the problem is that historical evidence contradicts this.

In many historical instances, we have had different kinds of money for each function. Very often, one of these will meet more than one function, and there are always similarities between the various kinds of money. However, they are still distinct in their own ways.

In imperial China, for example, the medium of exchange money was “cash,” small copper coins of little or no intrinsic value that were minted in huge quantities (several billion a year, at times), while the store-of-value money was taels, small silver ingots issued by private silversmiths with an assay stamp on them.

Cash was used as the unit of account in the form of “strings” of cash. A string was 1,000 copper coins on a piece of string threaded through the square hole in the center of the coins. Prices were expressed in multiples or fractions of strings. In addition, at various times there was paper or “flying” money. These were circulating promissory notes, sometimes issued by wealthy individuals, often by the government. These were a circulating form of promises of future payment and were a way of monetizing the credit of private individuals or of the state.

Similar stories exist about the later Roman Empire, where there was a gold store of value currency (the solidus) and a medium of exchange (the denarius), and prices were often calculated in sesterces (the sestertius had originally been a small denomination coin but was used this way after it was no longer minted).

This happened because the different functions required money with different qualities. With medium of exchange money, the main concern was that it was easy to produce to a standard quality, easy to use and widely accepted. The latter took place mainly because of “network effects”—the more people that accept a medium of exchange money, the more useful it is.

Store of Value

Once a kind of money has risen above a critical level of acceptance, it will be widely adopted for this purpose. It doesn’t matter for most people if the exchange money experiences mild inflation (the rate at which exchanges for goods depreciates), because people seldom hold on to it for long. Inflation only becomes a problem if it is high and, above all, accelerating.

Store-of-value money, however, is different. Even mild inflation undermines the whole purpose of this kind of money. It is held for long periods of time and used to purchase investment goods or to pay off large liabilities. In the first case, a steady decline in the rate at which the money exchanges for goods is a serious matter.

For this reason, store-of-value money has typically taken the form of specie, precious metals. These last physically and retain a constant—or even improving rate—of exchange for goods. In systems such as the Roman or Chinese, where exchange money that has been accumulated can be converted into store-of-value money, the rate at which this is done depends on the inflation rate of the exchange currency.

Additionally, the quantity of store-of-value money tends to grow slowly (because of the difficulties of mining precious metals) and often in line with the growth of productive activity as a whole. It is often difficult to combine the two functions into one currency: if the exchange function is paramount, the currency will be subject to inflation, while if the store-of-value function is paramount, the currency will be “hard” and often won’t grow rapidly enough to meet demand for money, hence deflating the economy and reducing economic activity.

Credit Circulation

In the modern world, however, it is the fourth kind of money circulating—promise of future payment—that has become predominant. This is known as credit.

The value of promise-of-payment money depends on people’s expectations about the future and about the creditworthiness of issuers. If you believe that growth in the future will be sufficiently high that enough wealth will be produced for the promise of payment to be cashed out ultimately in goods, then people will accept it. This makes future-payment money (credit) enormously powerful and very fragile.

Credit is powerful because it works as a time machine. If a bank advances credit, it creates money based on the promise of future redemption. In recent years, a lot of investment has been done this way, rather than forgoing consumption (saving up exchange money) and converting it into store-of-value money or capital goods.

Credit has enabled an accelerated rate of growth and much higher levels of investment.

However, the problem is that the future is uncertain, and people can become unreasonably bullish and optimistic about the future. Even worse, governments can manipulate the way that the risk of the future not working out as expected is calculated: that is, they can keep interest rates artificially low. In those cases, too much future-payment money will be created, and when the expected growth is lower than anticipated—or even nonexistent—much of it will become worthless.

Moreover, while creating future-payment money for investment can be beneficial, doing so for consumption is even more risky. This can also be beneficial, but the chances of having too much created are high. In that event, you will have many consumers burdened by debt, which they took on thinking their incomes would rise or their assets would increase in value. They now can’t service if these things haven’t occurred.

Types of Money

The conclusion from history is that today, we should think seriously about emulating the ancient Romans and imperial Chinese and have different kinds of money. One type would be a circulating medium that eases exchange and economic activity. Another would be a store-of-value money that retains its value and is somehow tied into the growth of productive activity as a whole (GDP growth, perhaps).

There would be a way to easily convert accumulated exchange money into store-of-value money, but the rate at which this happens would reflect the inflation of any of the exchange money. This would be a unit of account, which could be either of the first two or an independent unit that is imply used for accounting purposes, to calculate relative prices.

We would still have future payment or “flying” money, but the supply of this wouldn’t expand as much as it has recently. Most of it would be interest-bearing, and the interest would reflect people’s collective expectations about the future. These could still be wrong, but would be much less likely to be wrong than the expert consensus or the views of politicians.

Right now, we have a dysfunctional money system. This poses acute risks and dangers that—because of the nature of money—can have system-wide effects. We should look at how monetary systems have been reformed in previous times and rethink the way money is commonly taught and thought about.

Dr. Steve Davies is a senior fellow at the American Institute for Economic Research and the head of education at the Institute of Economic Affairs. This article was first published by AIER.org

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.