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  • The Evolution of Money Part I: The Past

    Posted by Shannon Love on December 7th, 2007 (All posts by )

    The Chinese say that fish are not aware of water. We talk about and use money so often that we seldom think to stop and ask: What is money? Why do we need it? What function does it serve?

    I think money is a type of information technology that calculates, stores and transmits information about the quantity of one good one must exchange for a certain quantity of another good.

    Money did not always exist. For millennia humans exchanged good for good between themselves in a system we call “barter.” Barter worked (and works) well if the number of goods and traders remains small enough that most traders in the network can calculate the relative quantities of any two goods needed to exchange one for one another. When the number of trade goods is small, individuals can track the optimum amount of good ‘A’ that should be traded for any other good ‘B-Z.’ However, when the number of goods soars the barter network collapses from information overload. With thousands or even millions of trade goods, no human can calculate the optimal trade amounts between any two goods. In modern terms, barter networks did not scale. They could only work efficiently with a small number of goods and traders.

    Money evolved to solve this informational scaling problem in barter networks.

    Money solves this problem by providing a universal trade good (UTG), a single good that anyone, anywhere will trade for any other good. With a UTG, traders need only know one trade quantity, the quantity of the UTG needed to exchange for any quantity of any other specific good. In effect, the UTG stores information about the quantity of the good that it itself was exchanged for. We label this quantity ‘the price’ of the good.

    By storing and managing much more information, an exchange network that used a UTG could scale much larger than one based on barter. Networks with reliable and standardized UTGs, such as gold coins, grew much larger and faster than those without.

    Using a UTG worked well up until the industrial age, when productivity began to increase rapidly. With no change in productivity, the amount of the UTG needed in exchange for any particular good remains fixed for long periods. Quantity ‘X’ of the UTG will consistently buy quantity ‘Y’ of trade good ‘A’. When productivity increases, Quantity ‘X’ of the UTG might buy quantity ‘2Y’ tomorrow. Knowing the amount of UTG one exchanged in the past ceases to predict the amount one will pay in the future. The UTG ‘forgets’ the ‘price.’ We call this effect ‘deflation’ and it dogged the economies of the 18th and 19th centuries.

    Conversely, sudden increases in the supply of the UTG likewise destroyed the relationship between exchange quantities and erased the information they stored. We call this effect “inflation”. Gold rushes caused inflation in the 1800s.

    By the early 1900s the the Gold Standard UTG had reached the limits of its scalability. To function as a UTG, the quantity of gold available had to grow and shrink in sync with the increase and decrease of productivity and that proved impossible.

    Fiat money evolved to solve this problem. It solved the physical-availability problem by employing an Abstract Universal Trade Good (AUTG) to store information. Since the creator of the AUTG could adjust its physical availability at will, the quantities of AUTG could grow and shrink in sync with increases and decreases in productivity. The AUTG could calculate, store and transmit information about exchange quantities on a much larger scale and in a much faster-changing environment than could a physical UTG.

    Making an AUTG function requires iron discipline to keep its quantities in sync with growth. Such discipline has not always existed, but on the whole using AUTG technology allowed us to grow a much larger and much more diverse economy than either barter or a physical UTG like the gold standard could support.

    Some people like to think we could return to a physical UTG system using gold or other goods. We can’t. A physical UTG system just isn’t capable of doing the job of a fiat currency, anymore than barter can do the job of a gold standard.

    The past is not the future.

     

    10 Responses to “The Evolution of Money Part I: The Past”

    1. Peter Jackson Says:

      A physical UTG system just isn’t capable of doing the job of a fiat currency, anymore than barter can do the job of a gold standard.

      Any UTG is going to have it’s limitations; the limitation of fiat money is the natural limitations on the knowledge knowable by monetary authorities to when to inflate or deflate the money supply in the amounts necessary to produce price stability. But most of these limitations are only issues because we give the state a monopoly on legal tender. If the dollar had to compete against private currencies based on gold, silver, platinum, we’d all be better off having not having to rely on single-source money of any kind.

      yours/
      peter.

    2. sol vason Says:

      In 1957 you could buy a brand new Chevy with 60 1oz gold pieces, given a dealer willing to take gold. Today you can still buy a brand new Chevy with the same 60 gold pieces.

      This is not just true of gold. A Chevy was worth 8000 packs of cigarettes, 40,000 1 oz bags of M&Ms, or 8000 gallons of gas. Still is today. Your statement “Such discipline has not always existed” is a massive understatement. The govt cannot manage the money supply properly. We need a money supply that grows with the economy, no faster, no slower.

      Perhaps, instead of gold, we should peg our currency to the M&M.

    3. Shannon Love Says:

      Peter Jackson,

      Any UTG is going to have it’s limitations;

      That’s the problem. A UTG, especially one pegged to one commodity, cannot scale to transmit information in a rapidly growing economy.

      To illustrate he problem, consider this thought experiment: Suppose the supply of the UTG, say gold, was absolutely frozen. No more could be mined and it was never lost. How long could it function as money in the modern world? Not long because it would deflate. The amount of any other quantity one could get for a fixed amount of gold would always increase. Since no more gold enters the system, no one would exchange anything for gold because gold would always trade for more tomorrow than it does today.

      If the dollar had to compete against private currencies based on gold, silver, platinum, we’d all be better off having not having to rely on single-source money of any kind.

      Not necessarily. There is a significant information cost associated with tracking the value of non-standardized currencies. If you have 5 units of “Bob” notes issued by Bob and backed by platinum or oil, how many units of grain should you accept in exchange at any given time? Multiple currencies backed by multiple commodities would force everyone to become commodity brokers just to buy a gallon of milk.

      If you study the history of private currency, you see this problem quite clearly.

    4. Shannon Love Says:

      Sol Vasson,

      A Chevy was worth 8000 packs of cigarettes, 40,000 1 oz bags of M&Ms, or 8000 gallons of gas. Still is today.

      No, it isn’t. That’s the problem. The relative value of everything in the economy shifts continuously. Things today produced largely by machine are much cheaper while things produced by hand are much more expensive.

      A couple of examples to illustrate the problem: How much computing power could you trade a Chevy for in 1957 and how much could you trade it for today? Keep in mind that the common desktop computer today has more computing power than all the computers in America combined did in 1960! Alternatively, how much gold would the Chevy trade for if someone had discovered a vast vein of gold in say 1990 that tripled the worlds supply of gold?

      We’re talking about exchange amounts and those evolve continuously. No physical commodity can grow and shrink in availability in sync with the production of other commodities. Only an abstract commodity can do that.

    5. Shannon Love Says:

      Peter Jackson,

      It’s good to here from you.

      Shannon

    6. Lex Says:

      Shannon, what do you think about the idea of a commodity reserve currency? Hayek at one time advocated it as, apparently did Benjamin Graham.

      I tend to think that the long term solution is to privatize banking and let market forces sort out what kinds of currency meet the test of acceptance and use.

      The fact that I can put my cash card in a machine in London and get Pounds, or my use Visa in Paris and have it pay Euros, suggests to me that we could fairly easily set up accounts so that you could use charge cards and debit cards to make cross-currency transaction easily based on the current exchange rate between traded currencies.

      Privately issued and government issued currencies could exist at the same time, and each may have its uses.

      But we could have more productive innovation in the area of UTGs if we created a space for private initiative.

    7. Shannon Love Says:

      Lex,

      …what do you think about the idea of a commodity reserve currency?

      Not much. Basically, we’d just be trading on universal trade good for several. No other trade good will work as well as gold because it has no other significant use beyond decoration (especially historically). Remember, the entire purpose of money is to store information. Gold could store information because people only wanted largely because it stored information. Other commodities, however, have practical uses. Changes in those uses will destroy the information stored in the money backed by those commodities.

      For example, take a currency backed by oil. A sudden interruption in oil supplies or a technological breakthrough in energy technology could significantly alter the value of oil and thus alter the value of the backed currency.

      Even using a cluster of commodities provides only short term stability on the order of a few years. We really need something that can store information over several decades at least.

      The fact that I can put my cash card in a machine in London and get Pounds…

      As I well explain in my next post (Part II), that’s actually part of the problem. The ability of currencies to move instantly over borders means that no national authority can easily gauge any specific currencies money supply.

      But we could have more productive innovation in the area of UTGs if we created a space for private initiative.

      I think this is already happening but it is taking a form we don’t recognize as “money” just as people who for generations used metallic coins did not recognize letters of deposit as an incipient fiat currency. I’ll cover that in part III.

    8. w sol vaso Says:

      In 1957 a chevy cost $1800-$3000 depending on extras and bargaining skill, M&Ms were 5 cents, cigarettes were 35 cents/pack, and gasoline 30 cents/gallon. Today prices of just about everything, including politicians, are 10 times higher with the exception of computer time. This means the government has really screwed up the currency and that long term capital gains should be adjusted for inflation before they are taxed. Neither problem is going to be fixed.

      I suppose the way to identify an ideal currency is to figure out why people prefer currency to barter. During the German hyperinflation in the 20s most Germans stopped using their own currency and used foreign currency or barter. Same was true in Argentina. After the war in Berlin cigarettes and chocolate were used as currency. Indeed, cigarettes are used as currency in many parts of the world. I’ve often wondered- when cigarettes are used as money, do people still smoke them?

      I have been in many countries where local citizens preferred US dollars or West German marks or British pounds over their native currency. OTOH, they didsn’t want Italian lire, French francs, or Mexican Pesos. I don’t think backing is important; I think faith is.

      If you can explain why people prefer currency over barter you can understand how to create faith in it. I don’t think Joe citizen cares about backing. Its up to you to learn what he cares about and why.

    9. Michael Says:

      “No other trade good will work as well as gold because it has no other significant use beyond decoration”

      Yet gold has an increasing number of industrial uses including in circuit boards, wires and contacts, as well as in dental fillings.

      Here’s a reference: http://www.gold.org/value/markets/supply_demand/industrial.html

      They say “Industrial and dental uses account for around 11% of gold demand”. Certainly not insignificant.

    10. phwest Says:

      But a 1957 Chevy is not directly comparable to a 2007 Chevy. The modern car has significant (and costly) safety enhancements, is less expensive to operate, and will last significantly longer. The fact that its sticker price is comparable means that it is actually vastly cheaper.

      As an example – I bought my first new car in 1984 (Dodge Daytona) for just under $10,000. I recently bought my wife a 2007 VW Beetle for $19,000 or roughly double. Both are two-door hatchbacks, with similar interior room. Adjusted for inflation that makes the Beetle actually somewhat cheaper. (I don’t have the number in front of me but from what I remember 1984 gold was in the $200 range, which would make the Beetle a good deal cheaper on a gold basis)

      The Dodge was a completely stripped down model (no A/C, no radio, manual windows, etc). The VW has ABS, traction control, air bags, radio/CD/satellite, a 50% more powerful engine, leather seats, power windows/mirrors/steering etc., tilt steering, and more. It is a vastly better car than the Dodge, and much cheaper on a value/UTG unit basis – whether that UTG be constant $ or gold.