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With the possible exception of international trade, no topic in
economics contains more myths than monetary theory. In the present article I
address four popular opinions concerning money that suffer from either
ambiguity or outright falsehood.
One: "Money represents a claim on goods and services." Although there
is a grain of truth in this view, it is quite simplistic and misconceives what
money really is. 1
Money is not a claim on goods and services, the way a bond is a legal claim to
(future) cash payments or the way a stock share is a claim on the net assets of
a company. On the contrary, money is a good unto itself. If you own a $20 bill,
no one is under any contractual obligation to give you anything for it. 2
Now of course, in all likelihood people will be willing to exchange all sorts
of things for your $20 bill; that's why you yourself performed labor (or sold
something else) to obtain it in the first place. Nonetheless, if we wish to
truly understand money, we must distinguish between credit liabilities on the
one hand, and a universally accepted medium of exchange (i.e., money) on the
other.
Two: "The purchasing power of money equals the supply of real output
divided by the supply of money." As with the first view, this one too has
a grain of truth. Specifically, if everything else is held equal, then the
"price level" (if we ignore the problems with measurement and
arbitrariness) will go up if the money supply grows by more than real output,
and will go down if real output grows by more than the stock of money. However,
other things need not be equal, in particular the demand to hold money. As with
every other good, the "price" of money (i.e., its purchasing
power—or how many units of radios, televisions, etc. people offer in order
to receive units of money) is determined by the supply of dollars and the
community's demand to hold dollars. A given stock of money can be consistent
with any price level you want, so long as you are allowed to change the demand
for money. For example, even if output and the stock of money stayed constant,
all prices could double if everyone in the community wanted to cut in half the
purchasing power of his or her cash balance. How is this possible? Initially
everyone thinks he or she is holding "too much" cash and so tries to
spend it. But since the merchants too think they are holding too much, they
agree to sell only at higher prices. (If this seems odd to you, consider: Even
if you are uncomfortable with $1000 in your wallet—maybe you just won big
at the casino—if someone walked up and offers you another $1000 for your
shoes, you'd probably accept.)
If we ignore all of the real world complications caused by timing issues, it's
easy to see that in the new equilibrium, where everyone is content with his or
her cash holdings, nothing "real" will have changed. Instead, the
unit price of everything (in terms of dollars) will have doubled, so that even
though the per capita quantity of dollar bills is still the same, now the
average person can only buy half as much real stuff with the money in his
wallet. Of course this type of example (which I picked up from Milton Friedman)
is very unrealistic, but it does serve to illustrate the point that prices are
not a mechanical function of physical stocks of goods and dollar bills. On the
contrary, people's subjective valuations are also critical.
Three: "Under a gold standard the money is backed by something real,
whereas under our present system dollar bills are backed up by faith in the
government." Again, I sympathize with this type of view, but when my
upper-level students write such things on their exams, I have to take off
points for imprecision. Strictly speaking, under a gold standard the money
isn't backed by anything; the money is the gold. Now if we have a government
that issues pieces of paper that are 100% redeemable claims on gold, I wouldn't
classify those derivative assets (i.e. the pieces of paper) as money, but
perhaps as money certificates. Yet this is a minor quibble. My real objection
to the view quoted above is that it denies that our current fiat currency is
really money.
Although (as a libertarian, Austrian economist) I fully condemn the monetary
history of the United States, and deplore the means by which the public was
forcibly weaned from the gold standard, nonetheless it is simply misleading and
inaccurate to deny that the green pieces of paper in our wallets and purses are
genuine money. They satisfy the textbook definition: They are a medium of
exchange accepted almost universally in a given region. No one is forcing you
to accept green pieces of paper when you sell things. (If you don't want anyone
foisting pictures of US presidents on you, then just charge a billion US
dollars for everything you sell.) The fact that government coercion (past and
present) is necessary to maintain this condition is irrelevant; cigarettes
really circulated as money in World War II P.O.W. camps, even though this
wouldn't have occurred without the artificial and coercive environment in which
those traders found themselves.
Four: "Deflation is undesirable because it cripples investment. If prices
in general are falling, no one will invest in real goods because he can earn a
higher return holding cash." Although this last myth is understandable
when espoused by the layperson, it is inexplicable that some trained economists
believe it. (For three examples: An NYU professor used it to "shoot
down" my Misesian friend in class, Wikipedia's entry on deflation mentions
this argument, and even Gottfried Haberler advances a version of it in this
essay.) For one thing, the argument overlooks the fact that there were many
years of actual deflation in industrial economies on gold or silver standards;
I don't think investment fell to zero in every single such year. So clearly
something must be wrong with the argument. Specifically the argument fails
because it carelessly assumes that the relevant data for an investor are the
spot prices of a particular good from one year to the next. But this is wrong.
For example, suppose someone is considering investing in bottles of fermenting
grapes that will be ready for sale as wine in exactly one year 3
The rate of return on this investment concerns the 2005 price of the grapes and
the 2006 price of wine. So let us further refine the example and suppose that
all prices fall 50% every year; i.e., there is massive deflation and presumably
no one should be willing to invest in wine or anything else. Yet there is no
reason to jump to this conclusion. For example, the 2005 price of the bottle of
fermenting grapes might be $100 and the 2005 price of a wine bottle might be
$400, while the 2006 price of the bottle of grapes will be $50 and the 2006
price of a wine bottle will be $200. (Notice that, as stipulated, all prices
have fallen by 50% per year.) Would our investor prefer to hold his cash, which
in a sense appreciates at a real rate of 100% per year? Not at all! With our
numbers, the investor would earn a 100% nominal (not just real) return on his
money if he invests in the wine industry: He pays $100 for a bottle of
fermenting grapes in 2005, then waits one year and sells the resulting bottle
of wine for $200. Had our investor sat on his $100 in cash in 2005, its
purchasing power would have risen from 1/4 of a bottle of wine (in 2005) to 1/2
of a bottle of wine (in 2006). But by investing the cash, his purchasing power
goes from 1/4 of a bottle in 2005 to 1 bottle in 2006. Once we allow for the
prices of capital goods and raw materials to adjust to expectations of
deflation, there is no reason for falling prices to hamper investment
whatsoever. 4
Conclusion:
Most of the myths concerning money are easily exposed when we consider what
money is. Some of the more subtle myths, especially those concerning price
deflation, are exposed once we consider the intertemporal price structure. On
both counts, the Austrian School of economics serves us well.
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