Monday, January 28, 2013

When a Currency Is Working, It Isn't Questioned.

Definitions matter

Economists are fond of defining money by enumerating its uses.  The ECONOMIST Magazine had an article on the topic.  It first reviewed the standard definition:
“Money fulfills three main functions. First, it must be a medium of exchange, easily traded for goods and services. Second, it must be a store of value, so that it can be saved and used for consumption in the future. Third, it must be a unit of account, a useful measuring-stick. Lots of things can do these jobs. Tea, salt and cattle have all been used as money.”

Economists do a substantial disservice to the public's understanding of the role of money by enumerating its potential uses as if they were all equally important.  As is discussed below, there are important caveats to the notion that money is a store of wealth.  If money is not channeled into something that produces in the future, there is no wealth in the future. 
ECONOMIST magazine goes on to describe the function of money as reducing the cost of barter (“On the Origin of Specie,” Aug 18th 2012).  The emphasis on reduced cost of barter has the advantage of automatically explaining the benefit of having a well-functioning currency.  There is tremendous benefit to society from making barter (trade) less costly.  It introduces tremendous efficiencies into the economy.  Reduced costs of exchange allow the same resources to produce more benefits to society.

Considerable controversy about monetary policy and the government's role can arise from placing different emphasis on “store of wealth” verses “media of exchange.” That can be seen immediately from the fact that inflation is inherently an issue "across time."  So, it relates only to the role of money as a store of wealth.  If one places a high value on the role of money as a medium of exchange and a low value on the role as a store of wealth, one’s policy conclusions will be different from those of somebody who inverts those priorities.
The focus on making barter efficient can lend perspective to this often contentious debate.  The role of money as a store of wealth can be viewed as making barter more efficient.  However, in the case of "store of wealth" the barter is across time.  Essentially, the store of wealth function of money relates to only a subset of the broader category of medium of exchange. 

Monetary theorists do not seem to realize that the issue of whether the different roles of money can be separated is more important than the emphasis on specific aspects of the role of money.  Clearly, they can be separated for prolonged periods of time.  Further, there is a distinct possibility that too much emphasis upon the role for money as a store of wealth is counterproductive.  Wealth can never be produced by money.  It is always produced by the effective deployment of resources to produce in the future. 
If a substantial portion of the population does not know how to use current resources to produce in the future, money may have a default role as a store of wealth.  When money fills that default role as a store of wealth, it becomes a mechanism by which society can transfer current productive effort into the future, but for that to happen the money must be entrusted to someone who can effectively use it to produce in the future.  In that respect, the size of the financial service industry, or at least its importance, is inversely related to the portion of the population who know how to productively employ resources.  If few people know what to do with money other than spend it, they need a large financial service sector to channel resources into future production.

Differences in the emphasis placed on the various functions of money are often assumed to relate primarily to one's balance sheet.  Specifically, the role as a store of wealth is far more important to those with wealth.  Those with debt, on the other hand, do not want money to function well as a store of wealth.  They benefit from a depreciating currency. But they will care whether it is an effective means of exchange. 
A strong argument can be made for the position that the wealth is not the cause for the attitude about the importance of money as a store of wealth.  Both the wealth and the belief that money should serve as a store of wealth reflect an individual's preference for income in the future rather than immediate consumption.  The inverse is also true.  Those who think the exchange value of money (i.e., the ability to spend it) is most important probably are those most anxious to spend it now.

It never seems to occur to people that what applies to the individual may also apply to the entire society.  A society that is wealthy and producing wealth may lean toward a stable currency, while a society in decline where wealth and income are falling favors a currency that is declining in value along with their income and wealth.  What is not clear is the direction of causality.  Does a society with growing income and wealth want a stable currency?  Or, does a stable currency produce rising income and wealth within a society?

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