Tuesday, October 8, 2013

Some monetary history

With money and debt on everyone's mind, it might be a good time to review some economic history.
When an American explorer named William Henry Furness III arrived on the remote Pacific island of Yap at the start of the last century, he found a scarcely touched place that made his previous destination of Borneo look almost developed. Yet despite having only a few thousand inhabitants and a market encompassing just three products – fish, coconuts and sea cucumber – he was amazed to discover an advanced system of money.

This revolved around an unwieldy coinage called fei, created from hefty stone wheels up to 12 feet in diameter. These were rarely handed over, perhaps unsurprisingly given their size; indeed, following a shipwreck the considerable wealth of one family relied on a huge stone on the sea bed under several hundred feet of water. Instead, there was a sophisticated system of credit management. "The noteworthy feature of this stone currency is that it is not necessary for its owner to reduce it to possession," wrote the adventurer.

After Furness's travelogue was published in 1910, a copy found its way to John Maynard Keynes – and the man who was to become the century's most influential economist proclaimed that modern experts had much to learn from the Pacific islanders' philosophical approach to currency. One other leading economist extolled the wisdom of Yap some eight decades later: Milton Friedman, far from Keynes's ideological soulmate. And now Felix Martin, an economist and City fund manager, has seized upon their story for the foundation stone of his enjoyable exploration of money.

He uses the discovery on Yap to debunk standard textbook theories that money evolved from societies frustrated by the obvious limitations of barter. Here was an economy so simple it would have been easier to simply swap some fish or coconuts when wanting a nice sea cucumber. Indeed, Martin claims a consensus is emerging among anthropologists that there is little evidence any society ever relied on barter, for all the long-standing claims to the contrary.

The author believes Yap does not simply challenge conventional theories of money's origins, however. Far more profoundly, he says it should challenge our conception of what money actually is – for it is not something tangible, based on precious metals such as gold and silver. This, he argues, gives too much weight to the surviving historical evidence of metal-based coins and the views of muddle-headed economists and philosophers. Chief villain in his eyes appears to be John Locke, who may have provided intellectual ballast for modern liberal democracy but misunderstood money with devastating consequences.

Martin sees it as based upon a system of credit and clearing from the start. Giving it a suitably modern twist, he says we should view money as a social technology, a set of ideas and practices for organising society. It was created after the collision of Mesopotamian inventions of literacy, numeracy and accounting with Greek notions of equality, and evolved amid struggles for supremacy between sovereigns and their subjects. Ultimately, it was a liberating force for individuals against the state – but also something prone to near-ceaseless speculation and financial crises.
Given that 25 countries have experienced major banking meltdowns in the most recent crisis, and that we seem to have socialised risk while privatising vast profit in the financial sector, this is clearly a good time to grapple with our understanding of money. As Martin shows, economic theory persistently lags behind practice...
Money: The Unauthorised Biography by Felix Martin – review (The Guardian)
Over most of my 18 years of teaching at Augustana College in Sioux Falls, South Dakota, I too have perpetuated this error by repeating the traditional story of money.  It goes something like this.  In a barter economy, as in the (chronologically vague) days of old, goods were traded (in a geographically ambiguous location) for other goods without the use of money.  Without money trade is only possible if there is a double coincidence of wants.  If one person raises and sells potatoes and the other makes shoes, they will only engage in exchange if the one selling shoes wants potatoes and the one selling potatoes wants a new pair of shoes.  Even if they each have a surplus of the good they wish to sell, no trade will occur since the potential buyer lacks anything needed by the seller.  They are at an impasse.

Adam Smith (1776, 25-36) explains how money arose to resolve this economic conundrum with these words.

    "In order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner, as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry."

So for Smith over time (and in every place and time) eventually a specific commodity—perhaps gold or silver—arises to serve as a money-thing that can be used to purchase other goods and services.  Economists refer to this monetary function as a medium of exchange.

Over time, economists have come to define money as anything that fulfills the four functions of money.  In addition to serving as a medium of exchange, money can also serve as a way to postpone purchases by serving as a store of value.  As long as a currency is not experiencing rapid inflation, holding wealth in money form allows us to delay purchases for a sunny or rainy day.  Money can also be used to pay debts as a means of payment to fulfill our contractual obligations to other individuals, firms, lenders, or governmental entities.  And perhaps most importantly, money serves as a way of keeping score as a unit of account.  It is in this last function that money is not a “thing,” like a coin, but instead serves instead as a point system or standard of measurement by which sales, debts, and payments can be accounted.  Just as an inch or a centimeter can be used to measure length, a dollar or euro as a unit of account can be used to measure value without actually being a money-thing.

Now for Smith, the most important function of money is to serve as a medium of exchange.  Because once this is established his apocryphal story expands.  As a medium of exchange money facilitates trade, encourages greater specialization and productivity, reduces transactions costs, and allows for the further flowering of capitalism.  It also serves as the beginning of the banking system.  As metals become the preferred medium of exchange, banks are created to store and manage these wealth holdings.  The coining of metal by state governments facilitates this process by standardizing weights and degrees of alloyed purity.  The bankers than issue receipts describing the amount of gold stored or deposited on its premises.  Over time, bankers realize that these gold receipts are circulating as money.  They also realize that only a fraction of their holdings are called for on any given day.  Thus they can make loans at interest and issue gold receipts far in excess of their actual holdings.  This emergence of credit further greases the wheels of capitalist exchange, savings, and investment.  However, in the overall economy, money only affects prices and not the process of actual physical production.

This standard story has been repeated in uncountable numbers of articles and textbooks.  And it is this story that Innes challenged 100 years ago.  Innes asserts that the barter story that emerged from Smith contradicts both the logic and the historical record.  In terms of logic, Smith’s story is simply not convincing.  For example, if you grew up in a small town in the western US in the 1970s, you might remember that you could go to the grocery store, pick up groceries, and simply sign a slip a paper acknowledging your receipt of the groceries.  The same could be done in Smith’s hypothetical example.  If the shoe seller or potato seller were trustworthy, the shoe seller could simply create a record of the shoes purchased on credit by the potato seller/shoe buyer and their value in some agreed upon unit of account.  This is not barter and it is not a purchase using a medium of exchange.  Instead it is (p. 391) “the exchange of a commodity for a credit.”  And it is far easier that the use of a medium of exchange.

Is there no anthropological evidence of a society based on barter trade? In his recent book David Graeber (2010) asserts that there is not.  Graeber claims that Stanley Jevons’s book in 1871 “took his examples straight from Smith, with Indians swapping venison for elk and beaver hides, and made no use of actual descriptions of Indian life…” (p. 29) Similarly “around that same time, missionaries, adventures, and colonial administrators were fanning out across the world, many bringing copies of Smith’s book with them, expecting to find the land of barter.  No one ever did.”  To make his point as clear as possible, Graeber (p. 29) quotes from Caroline Humphrey’s Cambridge University dissertation as the definitive anthropological work on barter.  Her statement is as clear as it is emphatic. “No example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money; all available ethnography suggests there has never been such a thing.”  Innes knew this 100 years ago, yet the myth persists.

So if there has never been a land of barter, where did we get money and credit?  Innes (p. 397) argues that systems of credit pre-date coins by over a thousand years.  “The earliest known coins of the western world are those of ancient Greece, the oldest of which, belonging to the settlements on the coast of Asia Minor, date from the sixth or seventh centuries B.C.”  In contrast, the law of debt goes back to at least the Code of Hammurabi in Babylonia 2000 years B.C.  Innes saw that the foundation of society and thereby of credit was that promises or obligations were and are viewed as sacred.  In all societies (p. 391) the breaking of the pledged word, or the refusal to carry out an obligation is held equally disgraceful.”  He goes on to explain how wooden tally sticks and clay shubati tablets were used to track credits/purchases and debits/sales long before the existence of coins.  And that one could repay a debt by returning a credit of the same amount to the lender.  In fact, village fairs were convened so that those holding the debts of others could match credits and debits together and thereby clear their accounts.  Over time others showed up to buy and sell other goods and services or to cater to those in this most basic business of banking.

There are a variety of reasons why this matters for monetary theory and macroeconomic policy.  But let me leave you with just one.  From the Smithian story, it was gold and silver that backed the issuance of a paper currency.  However, if Innes is right, the banking system never worked in that way.  In Innes’s world, money is and always has been a token representing a socially constructed debit-credit relationship. A stamped coin, $20 bill, or tax refund check is an asset—a credit— to those who hold it and a liability—a debit—for the government who issues it.  When the federal government spends, perhaps by directly depositing a Social Security recipient’s check into her account, a special kind of credit is created.  This credit—a new “debt” of the federal government—satisfies all four functions that are used to define money.  It serves as a medium of exchange, store of value, means of payment, and a unit of account.  But what gives this money value?  The money is valuable because it is the only token acceptable for the payment of taxes.  And when those taxes are paid, the money that had been spent into existence is extinguished. Thus, it is through federal government spending that money enters the economy and through taxation that it is destroyed.  This is where Innes’s 100- year-old insights lead.  If these ideas are hold up under academic scrutiny, are further disseminated, and become the basis of how we understand money and credit, an entirely new paradigm will need to emerge in the study of monetary economics.
Was money created to overcome barter? (Naked Capitalism) Here is more on Adam Smith's "Truck, barter and exchange" quote.
To “barter” meant to exchange goods for some other different goods.  It is still prevalent though on a small scale, with occasional utopian attempts to bring it back to replace monetary transactions.

“Exchange” is on quite another scale.  It goes deeper in long history. Smith was conscious of its antiquity and its generality into all aspects of social behaviour.  For example in his essay on the Origins of Language (1761), a necessary consequence of acquiring the “faculties of reason and speech” distinguishes the human lineage, though I read a paper recently that deduced from Neanderthal remains and their DNA that proto-speech may have been possible in our nearest relatives.   It certainly flowered in the human species.  Linguists study speech and languages in humans.

James Otteson: Marketplace of Life, 2002, identified exchange, as a common behavioural facility in various forms across all of Smith’s Works.  I discussed examples of this in the first edition (2008) of my: ‘Adam Smith: a moral philosopher and his political economy’. Palgrave-Macmillan.

Exchange is strongly supported as a general human behaviour by anthropologists, for example Mailinowski, B. ‘Argonauts of the West Pacific’. London: Routledge, 1932).

I conclude that exchange is a general human trait and Smith was right to credit exchange as the dominant characteristic that is “the necessary consequence of the faculties of reason and speech” and the great precursor of bargaining behaviour.   I would go further and assert that the anthropological study of the roles of “gift” and “reciprocation” behaviours are also common to humans and are examples of exchange behaviours that are deeply embedded in human behaviour.


  1. "The money is valuable because it is the only token acceptable for the payment of taxes. And when those taxes are paid, the money that had been spent into existence is extinguished. Thus, it is through federal government spending that money enters the economy and through taxation that it is destroyed."

    That's an idea that will really piss off the gold bugs, both because it confirms their suspicions about the interaction between government and money and because it destroys their ideas about the nature of money. I'll be sure to use it on the hard-money doomers out there such as Kunstler and Elaine Meinel Supkis.

    1. Contrary to the belief that gold standards stabilize prices, the most dramatic historical episodes of deflation and inflation occurred when the United States had one in place. According to William Gavin, an economist at the Federal Reserve Bank of St. Louis who has conducted research on the effects of a gold standard on price levels, pegging the dollar to gold would make prices fluctuate wildly. "With the gold standard you have far too much price volatility," he told Life's Little Mysteries.

      This is because, even if the price of gold is fixed, demand for it continues to wax and wane. People tend to hoard gold during periods of economic uncertainty, and this causes prices to fall (deflation). "When you take money out of the system by hoarding gold, that makes the available money able to support transactions and economic activity go down," Gavin explained. Less money in circulation means prices fall and unemployment rises, and the government must adjust interest rates in response to try to stimulate economic activity.

      Historically, when a gold standard was in place, the average unemployment was almost 2 percentage points higher, and a measure of price volatility called the "coefficient of variation" was 13 times higher.

      Furthermore, with the gold standard, the financial system frequently experienced shocks and rapid inflation due to new gold discoveries, such as the California Gold Rush of the 1840s and '50s. These unpredictable increases in the money supply tended to be less beneficial to the economy than the kind of controlled increases enacted by the Federal Reserve today.

      In Gavin's opinion, people who support the gold standard are "looking at history through rose-colored glasses."

      If the United States returned to the gold standard and then faced an economic crisis, the government would not be permitted to use monetary policy (such as injecting stimulus money into the economy) to avert financial disaster. Similarly, the government would no longer have the option of creating money in order to fund a war.

      This inflexibility means any small economic downturn would be expected to rapidly intensify, because there would be few mechanisms available for stopping a plunge. Barry Eichengreen, an economist at the University of California, Berkeley, argues that this economic rigidity greatly exacerbated and prolonged the Great Depression during the 1930s. If, after the 1929 stock market crash, the government had immediately abandoned the gold standard and taken measures to curb deflation and job losses, the crisis could have been minimized.

      Even during the period that many gold supporters view as a golden era of economic prosperity — the years from 1880 to 1914, when the majority of countries went on a gold standard together — financial crises occurred repeatedly and were severe and disruptive and led to sharp recessions. "The idea that this was a smoothly functioning monetary system is not correct," Eichengreen told Life's Little Mysteries.

      Supporters of the gold standard may wrongly attribute the economic growth and boom in international trade during that post-Civil War period to the monetary system that was in place, when in fact the gold standard caused frequent problems in a time that was otherwise experiencing the glory of the Industrial Revolution.

      In a recent article about the recession of 2008-09, Eichengreen and economist Peter Temin of the Massachusetts Institute of Technology argue that it was the government's aggressive fiscal stimuli that helped the United States avoid a Depression-level catastrophe three years ago. If we had still been on the gold standard, the government would not have been permitted to take palliative measures, and the downfall would have been disastrous.

      In short, gold standards "intensify problems when times are bad," the economists wrote.



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