Money and prices
andrea.parisi | Published: 25 Sep 2023, 11:19 a.m.
We are perfectly familiar with money: we use it every day to buy goods, and we get a bit of it every month through our work. It is essential to keep track of the balances of any company, family or individual, and it is at the heart of all aspects of our modern society. And yet, the definition of money is the most elusive in economic theory and it is rarely discussed. Money has taken many forms in history. The most well known historical form of money, especially in Europe and America, is gold, which was used in Europe since ancient times and adopted throughout the world. Other commodities have surged as a role of mean of exchange, thus money, in historical times: salt, cattle, shells, glass beads, stones. Paper money, which is what is used nowadays, was invented in China around the XIth century. Historically, the use of paper money has occurred regularly in the modern era around the world. However, any money system not based on gold always had a short life.
There are many books that touch either in passing or more in detail the origins and the role of money in economics. Here I would just like to recall that money has a crucial economic role as medium of exchange, as unit of account and as store of value. As medium of exchange, it provides to individuals an easy way to sell goods or services in order to buy other goods or services. In the absence of money, people should use barter which makes exchanging goods quite complicated. As a unit of account, it allows to keep track of incomes and expenses, and thus to make appropriate economic plans. As store of value, it allows to put aside purchasing power for the future.
Not all forms of money are equivalent: and they do not always maintain their characteristics through time. For instance, to be valuable as a store of value money must be "hard": its total amount should be stable through time. Gold had this feature as it is a rare material and historically has had a relatively stable annual increase limited to about 2%. Cowries, a kind of shell, was used until recent times in most of the Pacific and African areas. According to Saifedean Ammous, author of the book "The Bitcoin Standard", their disappearance was linked to the enormous quantities of cowries introduced into the economy by European merchants who could harvest them with technology. However, in "Money in Colonial Transition: Cowries and Francs in West Africa", Mahir Şaul tells a slightly different story. Cowries remained a viable medium of exchange in Africa and they resisted all means of forced eradication from colonial powers in favour of colonial national currencies, due to their ability to retain purchasing power as compared to national currencies. These currencies were being devalued due to the mass printing of money by government that needed to buy equipment for the two world wars. In the end, cowries disappeared owing to the increase in trades with Europe which made them inconvenient, and lost value as the hoarded cowries at some point flooded the exchange market. This is a telling story, which hints to the role of convenience of use and amount of circulating currency on the (intrinsic) value of money. Paper money, which is what is used nowadays, has become advantageous with respect to gold due to its ease of transportation and divisibility into small units which allows small payments. Modern digital money, which has extended the definition of money and lives on computers of banks and payment circuits, has permitted even more ease of transportation through the connectivity provided by cables that power the world wide web.
Paper money was initially issued in place of gold, thus produced in exchange of a deposit of equivalent value of gold, and was thus also redeemable for that same amount of gold. In those (not so far away) times, gold was money, and banknotes were just a replacement that could be exchanged back with gold if desired. In 1971, the United States who had being printing dollars in excess of their gold reserves, ceased the convertibility of dollars into gold (a de facto bankruptcy according to Rothbard). Other countries followed, and paper money has since become fiat money, no more redeemable with gold1. The term fiat comes from Latin and has the meaning of declaring something into existence. So 'fiat money' can be translated as 'be it money'. This expresses the fact that this kind of money is only used as money because the government says so. The use of this money does not come from an emergent choice of individuals, but is imposed by governments that do not allow trading with alternative means. That places the issue and control of the money supply in the hands of governments, removing it from the free choice of individuals. It is this control that allows the economic engineering favoured by mainstream economics and disliked by Austrian economists. Indeed, the fact that money must simply be accepted to function as money leads to the idea that its value is not intrinsic, but rather attributed by the governments. If that is the case, the same should apply to prices, which represent the amount of money that is needed to trade an item, and thus are an indication of the object value.
The matter is however more complex. The Austrian school claims that value is subjective. In other words, we assign value to objects subjectively. If that is true, then prices are not an expression of intrinsic value. Indeed, when we buy an item, we are attributing a value equal or higher to its price. This is particular evident if we think to expensive items: a passionate collector of modern art was willing to buy "Girl with balloon" from renown artist Banksy for 18.5M£. However, that does not mean that anyone would be willing to pay that price for that piece of modern art. The same amount of money could buy things that are more valuable to someone else, for instance a luxurious house, or a castle. The price of an item does not represent anything intrinsic, but the person who buys it attributes to the item a value that matches or is above its sell price. That means that if that same modern collector decides to sell that work of art for a gain, he/she will need to find someone who values that same piece more. This is not guaranteed to occur, as the buyer of Jack Dorsey's first tweet discovered.
The same however can be seen on more mundane and less pricey goods. A customer is choosing a pair of trousers in a department store, where trousers are priced $50 apiece. The first pair of trousers he picks up are not of his liking, thus he searches more. Suppose that in the end he cannot find a pair of trousers of his liking, this means that he was not willing to exchange his $50 for one of those trousers. When he finally buys a pair of trousers in the neighbouring store, that means that he has valued them worthy of his $50. That however does not prevent someone else to find the trousers of the first store appealing, and worth their $50. The fact that we need to make a choice is consequence of our limited resources: in this case money. Having $50 at hand, we wish to fetch the best opportunity to trade our money. Thus when we buy something we are willing to exchange our hardly earned money with goods, but the value we attribute to items depends on our preferences. And our preference may change over time. We might wish to spend $50 for a pair of trousers, but when dinner time comes, we might decide that after all we will buy a $35 pair of trousers, and use the remaining $15 to get something nice to eat.
Prices thus represent the amount of money that we are willing to pay to obtain a specific good, but this per se is not sufficient because, as prices are expressed in terms of money, we need a proper definition of money. However money is hard to define: in fact economic theory rarely delves into the issue of defining money and, when it does so, it does not define it operationally (that is describing how you "measure" it, which is the basic tenet of scientific domains). When economists talk about monetary mass, they mean the amount of units of a currency: despite looking as a perfectly good definition, this is not a complete operational definition. 
To clarify, let us imagine that we wish to measure the mass of an object (or for those who are not familiar with the concept of mass, let us measure the weight of an object, which for the discussion here is an equivalent procedure). Let us suppose that, to this aim, we have a set of small beads of wood, all equal, that we can use to measure the mass (weight) of an object. So essentially, we measure the mass of an object using a balance scale, placing the object on one dish, and a number of beads on the second dish. When the the two dishes are in equilibrium, we count the number of beads and that will be the mass. Using this methodology thus, the mass of an object can be expressed as the number of beads required to balance the mass of the object: a pure number. Now, imagine that we have an object and we measure its mass with our wooden beads, finding out that the mass of the object is 163 beads. Another person might take the object, put it on the scale dish, use his own set of beads and find out that the object mass is... 39 beads. How come he is getting a different result? Because he is using iron beads, and this set of beads gives a different result. And so, depending on the specific set of beads (wood, iron, stone, plastic) one can get different numbers representing the mass of the object. This set up is analogous to what happens when we deal with money: there are different set of beads (the different currencies) which we count to determine the price of a good. Depending on the currency (the type of beads), we get a different result.
The number of beads, however, is a measure of a more fundamental physical quantity (the true mass of the object). The mass may be measured deciding a different unit of measure, with the beads representing the different units of measure of this physical quantity. The true mass is the number of beads times the mass of a single bead. Thus a bead has an intrinsic quality, which we can measure on its own. We can place one bead on a balance and compare it with beads of a different kind. The instrument that permits this comparison is the balance, an instrument that measures this intrinsic property. Thus 163 wooden beads times the mass of one wooden bead is the same as 39 iron beads times the mass of one iron bead: they represent the same physical quantity, which is the mass of the object. When it comes to money however, things are more complex as the price is expressed as a number of currency units, but we have no instrument to measure the "intrinsic quality" of a single currency unit. There is no balance where we can place one dollar bill on one dish and a euro bill on the other dish and see which has a higher "intrinsic quality". When the world followed the gold standard, this intrinsic quality might have been the weight of the gold coin, but modern fiat money is disentangled by its gold equivalent. So what is the intrinsic quality of a dollar bill? And how does it compare with the intrinsic quality of a euro bill, or a yen bill? To make things more complicated, money is used in trades so that it actually represents a measure of exchange. Given goods come in a variety of types, it is hard to find a common denominator to goods that may be put in direct relationship with prices.
...and no, exchange rates are not measures of this intrinsic quality: they are driven by offer and demand (and nowadays from expectations of the Futures market), whereas what we need is an independent objective instrument to perform the measurement. In the absence of such instrument, we can write down mathematical equations in economics, but they do not represent any intrinsic objective mathematical law between quantifiable quantities as discussed here.
- In reality, even before 1971, many central banks had suspended convertibility of their currencies with gold for extended periods, only to reinstate it to an inflated convertibility ratio. This occurred, for instance, during the two world wars, where the central banks of the UK, Italy, France, and many other countries created money to pay for war expenses.
