Monday, June 18, 2012

A Few Points on the Value of Money

The notion of the value of money is understandably a confusing one. A few words of clarification from yours truly.

First, it should be pointed out that all economic value is imputed subjectively by people. Which is a complicated way of saying that the value of anything arises in you, and not in the thing itself. Thus, there can be no 'intrinsic value' in money, or gold, silver, or anything else. There is only the value imputed to it by human beings.

The actual value that money has on a market is therefore a very complex and complicated result of an enormous number of dynamic forces -- mainly the imputations of various and diverse people with different opinions on everything, and whose opinions can be influenced by changes in external circumstances. One useful way to get a handle on this is to think about a 'demand for money,' an important component of which is a desire simply to hold money, a demand for a cash balance in reserve.

Suppose that the supply of money increases. Will this result in generally rising prices -- a change, or more specifically, a fall in the value of money? Not necessarily.

Because people have a demand to hold money in cash balances, the increase in supply can simply be absorbed into these balances, with little or no decrease at all in imputed value. This is especially true if the increase in supply comes during a time of economic uncertainty -- like a recession, when people are worried about their ability to continue paying their bills. They may simply 'hoard' the extra cash, so that their valuation of cash as against other goods remains constant or even increases, even in the face of enormous increases in supplies of money.

The value of money is intrinsically dependent on people's behavior. This is a big reason, in my opinion, that vast increases in the money supply over the last several years has not resulted in proportional price increases -- yet. Uncertainty has prompted many people to hoard cash, especially the banks. On the other hand, I and others have gone in the opposite direction. I have drastically reduced my cash balances, and make every effort to spend my cash almost as soon as I receive it. If everyone behaved as I have, the US would already be experiencing mass price inflation. At some point, some critical mass of the rest of the population may come to see things my way, and mass price inflation will begin.

This can happen with almost any asset. Consider the Chinese housing market. There are families holding multiple empty units, collecting no rent on them, even as new construction continually adds new supply. There are entire cities being built which are nearly vacant -- and still people buy properties there and hold them, with no intention of establishing any cash flow by renting them, but merely hoping they will appreciate in value. This may appear completely insane to an outsider, and yet the process continues, with empty properties piling up in the hands of eager buyers who have no intention of using them. Eventually, it would seem that sanity should prevail and an enormous bust ensue, but it hasn't happened just yet. Likewise, we are probably in the midst of a dollar-bubble, but until that critical mass re-evaluates its notions of what a dollar is worth, the dollars continue to get socked away into apparently bottomless accounts content to collect almost no interest.

The quest for a money of 'stable value' -- nay, 'constant value,' even! -- is thus something of an enigma, as its valuation is entirely dependent upon human free will, which will do as it pleases. It is the pursuit of an impossibility. Unfortunately, the desirability of a money of constant value is an opinion often attributed to the Austrian school of economic thought, and not without some justification. Austrians themselves are often confused on the topic.

In fact, the notion of the desirability of 'stable money' was part of what led to the present regime of perpetual inflation, and still dominates conventional thinking. It was an idea that the Austrian school historically fought against. In the 19th century, the dominant notion of money was 'gold and silver,' whatever their value happened to be. 'Stable money' and 'stable price' fever took hold in the early twentieth century. It was thought -- and still is -- that monetary authorities could use control over the supply of money to keep its value constant over time. It was deemed necessary that, generally, the money supply should always be rising in a growing economy, as an increase in production not reflected in increasing money supplies would result in falling prices -- an indication of instability in the value of money and an impediment to growth and 'progress.' As the supply of goods on the market for sale was rising, naturally, so should the supply of money to 'reflect this,' keeping prices stable.

This is to attribute the value of money to 'impersonal forces' akin to the laws of physics, and it is precisely ideas like these which the Austrian school rose up to fight against. The valuation of money, as of anything, is an intensely personal matter, and no conceivable force or policy could render its value stable. I think that it is probably incorrect to believe that money of stable value is actually desirable or would result in a smoother functioning and more efficient economy, but even so, it does not matter. It is inconceivable that such a thing could exist, as it flies in the face of the very most basic notions of economics.

This is why I tend to favor Hayek over Mises in the former's criticism of the latter's tendency to focus on the value of money in works like The Theory of Money and Credit. By emphasizing money's value as opposed to quantity, Mises may be addressing the issue of interest to most observers, but this is not really the fundamental parameter in operation as far as the function of money within the economy is concerned, or something which may be intelligently addressed by policy since it is almost entirely out of anyone's hands. In the sense that he calls attention to it rather than to the issue of quantity, to some degree he plays into the hands of his enemies. They, after all, were the ones looking for the magic formula that holds the value of money constant and prices stable. It would have been better to point out more emphatically that such thinkers were being distracted by a tangential issue and were chasing after unicorns as a result, and to then to discuss the destructive effects of fluctuating money supplies on the production structure in terms of money quantities rather than valuation.

You might think of it in terms of a sort of C.S. Lewis first-things-and-second-things of money. Austrian school thinkers -- if they are thinking clearly at the moment -- first want a 'proper money.' For them, the first priority is the integrity of money's constitution and function within the economy, such that artificial fluctuations of quantity due to credit transactions and the like are prevented to as great a degree as possible. By making this -- the issue of quantity -- their 'first thing,' and allowing value to be what it will be, as a secondary effect, the money proposed actually does turn out to be more or less stable in value over time -- especially over the long term.

For those who put stability of value first, inevitably they propose some method of making the money supply 'flexible' in order to theoretically keep its value constant, which results in neither stability in value nor in proper function. Which is to say, that they achieve neither their first things nor second things and wind up producing an all-around economic mess.


  1. Scott, thank you for another instructive essay.

    We've had great philosophers of the state and of economics. These have been studied by students and masters of each. We've even had some - like you - who have tried to explain it simply to the rest of us.

    But those with the power to tinker seem unable to stop themselves. . . and the rest of us are either too uneducated or too self-interested to howl at them to stop.

  2. Thanks furball, but I think I disagree with you. After re-reading it, I think it's kind of unclear. I should have substituted something like "fixed value" for about half of my "stable value"s. Also, I should have said something about trying to 'fix' the exchange rate of gold versus dollars is not an attempt to 'fix' the value of money -- which I think is where the confusion starts.

    Maybe I'll do an update...


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