The Basics of Money Jude Wanniski October 5, 2001

To: SSU Students
From: Jude Wanniski
Re: The Basics of Money

In the course of your life, the concept of "money" will go through your head more than any other. More than "food" or "sleep" or "sex." If humanity began with the "word," the first utterances by Adam and Eve to each other, civilization probably began with "money," another means of communication. Indeed, the U.S. Supreme Court still recognizes "money" as being protected by the First Amendment's guarantee of free speech as it applies to campaign contributions. In the course of a day, a man or a woman thinks many dozens of times of money -- as they approach a toll booth or a news stand or a parking meter, as they shop for groceries, as they hear stock market reports, as they think of bills to pay, goods and services they need, gifts to buy, the taxes they pay. "Dollars" and "cents" click through our heads all day long.

Just as the "word" was invented by the first person who spoke one, in order to communicate more quickly and more efficiently than we could through sign language or body language, "money" came about as an extension of the word. As long as people could trade their surplus wares with each other "on the spot" through barter -- two fish for one rabbit -- the concept of money was unnecessary. Necessity is the mother of invention, and when it became necessary to trade goods over longer time and distance, humanity was forced to develop a common abstract understanding of what things were worth. The first human to do this may have made a mark on a cave wall, signifying "one rabbit" owed for two fish received. The fisherman then could point to the mark as a reminder he had a rabbit coming. If it were a German cave, would we call it a "Deutschemark"? A bad joke, you think? Actually the word "dollar" comes from the German "thaler," or "counter."

We will never know, but my hunch is that "money" began in this fashion, as a "bond" -- a promise to pay in the future with an equivalent value of something received today. Because a mark on a wall is not convenient when distance is involved, portable substitutes evolved as distance became a factor. Cave people would come to agreement on a common measure of value. It had to be something that would not perish with time, the way a fish or rabbit does. It had to be small and compact if it were to be portable. And it had to clearly have intrinsic labor value, which could translate into the time taken to catch fish and rabbits. The aboriginal Indians used "wampum" as money, woven animal skins that would take as much time to weave as it would to catch two fish or a rabbit. Aristotle, who was among the first of the philosophers to write about money, had this to say: "The various necessities of life are not easily carried about, and hence man agreed to employ in their dealings with each other something which was intrinsically useful and easily applicable to the purposes of life, for example, iron, silver, and the like. Of this the value was at first measured by size and weight, but in process of time they put a stamp upon it, to save the trouble of weighing and to mark the value."

It's useful to transport yourself back in time to think of these origins, because they remain the foundations of our modern money. We are taught that the human species evolved from earlier primates, and "money" evolved in similar ways, by trial and error. The human species sought more efficient forms of trading goods over distance and time, and over millennia fixed upon precious metals for "big money" and base metals for "little money."

In the modern world, "big" metallic money became less convenient as a means of exchanging fish for rabbits, mostly because of the development of banking. A bank is nothing more than an intermediary between many fishermen and many hunters. In simplest terms, a bank buys up all the fish at the seaport and all the rabbits in the woods, and makes the exchange of thousands of fish for thousands of rabbits. This reduces the effort that would otherwise have to go into making that exchange by many fishermen and hunters. A bank "finances" the transaction with "money" that really is created especially for the transaction. It credits the agent for the fishermen with the money to buy the rabbits and it credits the agent for the hunters the money to buy the fish. As the exchange takes place, the money is no longer needed for that purpose and the agents of the fishermen and hunters liquidate their debts at the bank. If you hear the term "self-liquidating bill of exchange," it will help to recall this sequence. The bank does keep a small portion of the fish and rabbits for the service it renders. The bank does not immediately see the fish or rabbits, which the agents sell to their customers, turning the cash received over to the bank as payment. The banks' owners and employees actually may spend this money on the fish and rabbits when they shop for dinner or dine out.

I take the trouble to introduce the concept of "banking" or "financial intermediation" into our discussion of money so you will see why the money of old became inconvenient in the modern world. We still use base metals as "small" money, pocket change. But with several billion people on Earth and giant banks now buying up billions of fish and billions of rabbits, the precious metals can no longer serve as "money" in the old sense. Gold still is held by governments around the world as a monetary asset. The U.S. government still holds, in Fort Knox, Kentucky, 5% of all the gold ever produced There is too little of the metal to serve as a circulating media, with which we could pay for big-ticket items. In the whole world, there is only about 125,000 metric tons of gold, in public and private hands (and teeth). It is so dense that if it all were put in one place it only would be able to build the bottom third of the Washington Monument or the first three feet of the Empire State Building.

There also are more functions of "money" than simply the exchange of goods and services, which is why gold remains a "commodity money" of some importance. In addition to its utility as a medium of exchange, "money" also serves as a "store of value" -- which is self-explanatory -- and as a "unit of account." This latter function is in many ways the most important, because it permits the exchange or trade of trillions of goods and services over the course of a year without the need of a physical "money." A unit of account gets us back to the term "count," which enables the financial intermediary to accurately judge the value of fish and rabbits in arranging a self-liquidating bill of exchange. The "dollar" is the accounting unit and has been since the beginning of the Republic. The only difference in U.S. history has been in the "definition" of the dollar. What does it mean? Is it equal to a loaf of bread or to a suit of clothes or a new automobile? To have any value to people who are trading or thinking of trading goods small and large, the concept of "dollar" has to have a definition upon which everyone agrees.

For most of U.S. history, the legal definition of the dollar was its exchange value in a specific weight of gold. For the first several decades of our history, the definition also included silver, which meant you could take silver to the mint and exchange it for Treasury's paper dollars or you could take gold to the mint and make the exchange. Because the price of gold and silver varied slightly, given the relative difficulty of their discovery, the ratio of their paper value varied from 15 ounces of silver to one of gold to a 16-to-1 ratio. The paper notes of the Treasury were deemed "legal tender," which essentially meant that the government would accept them in payment of taxes and thus would recognize their use in private transactions. With both metals "monetized" in this way, the ratios remained close to each other as gold mines or silver mines would open or close at the margin, depending on which was easier to convert the labor involved into dollars. In 1834, the government formally altered the ratio to 16:1.

In the Civil War, the dollar's definition in terms of precious metals was suspended as the costs of the war mounted and the government had difficulty raising funds through bond sales, having to pay higher and higher interest rates. It simply would print the money it needed, which meant it would confiscate fish and rabbits out of the exchange economy, leaving a green "IOU" that had no definition. Think of it another way: The greenback dollars spent had not been earned through production of goods. Thus there were more dollars in circulation than goods, and with interest rates to persuade some fishermen and hunters to forego immediate consumption of each other's wares, prices were bid up on each until the aggregate stock of money equaled the aggregate value of the goods for sale.

This was the "greenback era" of government finance, during which the dollar price of gold rose to roughly $40 an ounce from $20.67. In that period, as the value of the dollar as a unit of account declined, what we know as a devaluation of the currency, a general inflation, ensued. The price of fish and rabbits and most everything else went up, including the price of labor, to $2 a day from $1, and grains, to $1 a bushel from 50 cents. When the war ended, the decision was made by the government to gradually return to gold convertibility at the pre-war exchange rate of $20.67 in paper for one ounce of gold. This forced a painful monetary deflation on the national economy as the pre-war prices of everything else had to readjust. Workers who had borrowed thinking they could pay their loans at $2 a day labor now had to pay them with $1 a day, as employers were forced to cut wages or go out of business. Farmers who had borrowed thinking they would pay their debts with $1 wheat or corn were squeezed and bankrupted as farm prices halved along with gold.

At the same time, the decision was made to demonetize silver, which meant it would no longer automatically be converted into paper that could buy gold at the 16:1 ratio. Its utility as an official unit of account thus removed, silver became cheaper relative to gold. Workers and farmers complained they were victimized by not being able to meet their debt obligations with cheap silver and tried to restore the bimetallic standard. Three times the Democratic Party nominated William Jennings Bryan as its presidential candidate, as he spoke of the "Cross of Gold," on which his followers were crucified. On the other hand, the nation as a whole benefited enormously by having a constant, reliable unit of account established by the government. The economic expansion that followed the restoration of the dollar/gold ratio in 1879 was unparalleled in U.S. history, and Bryan three times was outvoted by the Republicans who pledged faithfulness to the single standard of gold. It must be emphasized that Bryan was not opposed to gold, only that he favored a bi-metallic standard that would permit his followers to liquidate their debts with the cheaper of the two metals.

We will develop this history later in this semester, bringing us into the present day where the greenback floats again. I wanted to get us at least through the Civil War period so you could understand the difficulties that are caused society when the accounting unit changes in value. In 1848, John Stuart Mill wrote in Principles of Political Economy: "There cannot...be, intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labor. It is a machinery for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it; and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order." Except for the "greenback" era and its aftermath, and for the last 30 years of floating currencies, Americans never paid much attention to monetary policy. Money is "insignificant" when it is a constant as a measure of value, in the sense that a "yardstick" becomes insignificant as a concern when we know its length is constant.

In ancient societies, before there was money, people would trade at close range and remember they gave two fish with the promise of a rabbit to be paid later. In this modern world of international banking, we should remember that essentially the same procedure is followed, except that instead of a mark on the wall, the mark is made in a computer. When you hear of trillions of dollars of transactions taking place every day in the currency markets around the world, remember that these are merely the sums of fish and rabbits in terms of dollars, being traded through banking intermediaries. There are no "real dollars" involved, the only "real dollars" being those which the U.S. government has created, and for which it thus is responsible. This is the "base money" of the money supply in dollars, now almost $630 billion, with about $520 billion of that amount in currency, only $80 billion or so held as "bank reserves," the amount of money banks must refrain from lending out -- holding it back to meet unforeseen problems arising out of its existing loans or from national economic conditions.

Next week we will go over this material again and focus on how dollars are created by the government, with special attention to the topic of "bank reserves." In our simplest example of how a bank intermediary buys up all the fish on one side of town and all the rabbits on the other side, we left out important steps of what the bank uses to initiate the process of exchange. By adding another layer of simple explanation on top of today's, you more easily will understand the complexity of money in an increasingly complex world economy -- and realize that at bottom, nothing much has really changed in the process of production and exchange. The single most important point of today's lesson on money is that its most important function is as an accounting unit -- from a mark on the wall of a cave thousands of years ago to today's digital money.