3 - The characteristics of Money

3 - The characteristics of Money

By CryptoGameTheory | Crypto4Friends | 4 May 2020


Why some money were more successful than others? What are the characteristics needed to work as money? This article try to explain these answers looking at the essence of money and its history.

Attributes of money

In the course of history, money developed in a non-linear fashion, which has lead to a different interpretation of its functions. However, we can recognize some attributes to distinguish different types of exchanging value that were used in ancient societies and in the following epochs.

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In this framework, we could observe that every step in the monetary evolution is essential to start the innovative process of the following phase, but also that different tools alternated at irregular intervals in the base of the possibilities of the environment.

Having in mind the path of the history of money, in this analysis, we would try to evaluate competitive forces that made some media of exchange more successful than others in satisfying individual's needs, even though these needs are continuously changed through time. This indirectly means that different kinds of money can differ from one another in more than one dimension. Indeed, "what we find is rather a continuum in which objects of various degrees of desirability, or with a value which can fluctuate independently of each other, shade into each other in the degree to which they function as money [1].

In the above table it is possible to notice that at a certain point in time, there is a split in the way money was conceived, with an increase of the levels of trust needed, which finally led to the development of different current of thoughts. Initially, money was dependent on real resources from which it derived value, and then, after the expansion of credit, money became merely an abstract concept.

In this regard, two distinctions are of primary importance.

The first one concerns the difference between commodity money, which is an object that acts as an intermediary of value, and accountability, which creates credit and debt, which are two faces of the same coin. Both are generally thought of as money, but the former is necessary to extinguish the latter; the so-called high powered money (High powered money, hard cash, sound money are different words for the same thing).

As an example, think about three persons, - Alice, Bob and Carol, which want to conclude an exchange in a credit system and in a cash system.

"In a credit-based system Alice and Bob would be able to trade with each other. Bob would give Alice a tool and Bob gets a favor that’s owed to him. In other words, Alice has a debt that she needs to settle with Bob some time in the future. Alice’s material needs are now satisfied, but she has a debt that she’d like to cancel, so that’s her new  'want'. If Alice encounters Carol in the future, Alice can trade her tool for Carol’s good, then go back to Bob with her good and cancel the debt. On the other hand, in a cash-based system, Alice would buy the tool from Bob. Later, she might sell her food to Carol, and Carol can sell her medicine to Bob, completing the cycle. These trades can happen in any order, provided that the buyer in each transaction has cash on hand. In the end, of course, it’s as if no money ever changed hands." [2, pag.4]

Therefore in cash-based system needs to be “bootstrapped” with some initial allocation of cash, without which no trades can occur. A credit-based system doesn’t need bootstrapping, but the drawback is that anyone who’s owed a debt is taking on some risk because there’s a chance that the other person never comes back to settle the debt.

The second distinction instead, concerns the difference between money and wealth, which represents a spectrum where the extremes have opposite characteristics. The ease and speed with which an asset can be converted into a medium of exchange without losing value are called liquidity, and its one of the main features of money, which is the most liquid asset. For instance, a real estate, even though it represents value, it doesn't work very well as an intermediary of value, because it is limited by size and transportability, its value is often difficult to compare and because of geographical constraints, which makes it less saleable. The more limited the trade it can facilitate, the more limited is the currency.

 

Constraints of Money

In particular, we can describe money as the sum of positive and negative attributes incorporated in the tool used, which, from time to time, has allowed to overcome some limitations such in the case of the multiple coincidence of wants, or in the case of spatial and temporal limitations. 

The way in which money has been interchangeably used to develop the economic activity, basically was possible only if the tool met, with different degrees, four conditions. An object, to serve as money, needs to be widely accepted, needs to lower transactional costs associated with trades, needs to guarantees relative stability of the expected value, and finally needs to be independent of sources of control. These conditions determine how much the tool can be useful as money and, thanks to its attributes, which functions the tool is able to perform as money.

The condition of acceptance could be analogous to what Menger calls 'saleableness', or Rothbard calls 'marketability', that refers to the degree to which a commodity command a sale, at a given market, at any time, at price corresponding to the economic situation [3].

"If one good is more marketable than another - if everyone is confident that it will be more readily sold - then it will come into greater demand because it will be used as a medium of exchange. It will be the medium through which one specialist can exchange his product for the goods of other specialists. Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media in almost all exchanges and these are called money." [4,pag.8]

Indeed, as long as the tool succeded in lowering transactional costs or costs related to money management, it further became accepted not only by many, but all the economic agents, in the exchange of their less saleable goods. From what follows, the expectation of relative stability will evidently affect the liquidity and acceptability of a particular kind of money, even though it may be that in the short run the liquidity may be more important than stability [1]. This is because in markets objects find expression of their value through the ratio of the quantity demanded and the quantity offered, which is the only way to give it a price and a market capitalization. As a consequence, this means that a market that is liquid could be also stable, while if a market is illiquid, for sure it will not be steady, when there are changes in supply and demand. Moreover:

"The expected value of a currency, will, of course, not be the only consideration that will lead the public to borrow or buy it. But the expected value will be the decisive factor determining how much of it the public will wish to hold, and the issuing entity will soon discover that the desire of the public to hold its currency will be the essential circumstance on which its value depends"[1].

Indeed, it's likely that rational individuals prefer a kind of money that allows strictly calculation of the expected value needed for the economic activity to take place, a kind of money that preserve its value through time and that is resistant to manipulation. The last characteristic, in the case of money and in the way it has evolved, has shown to be of increasing importance for acceptance and stability, and is often useful to distinguish independent monetary instruments. For instance, the devaluation of money created by inflationary policies many times in history induced a gradual loss in trust of the issuing central authorities, where gold and other metals extended as a guarantee against the loss in purchasing power.

This is because the market prefers a durable commodity as money, a commodity for which the annual production to its total stock that tends to be quite small, preventing devaluations. Therefore, the total supply of a commodity is the focal point to look for and could be represented by a measure called Stock to flow, which is the relation between the total quantity of the stock of the asset, and how much of this material you will get in a year. Put differently, the Stock to Flow measures the rate of "inflation" of a specific object or material in a periodic interval of time, measuring its scarcity in absolute terms [5].

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"Further, the ratio of the available quantity of the precious metals to the total requirement is so small, that the number of those whose need of them is unsupplied, or at least insufficiently supplied, together with the extent of this unsupplied need, is always relatively larger more or less than in the case of other more important, though more abundantly available, commodities" [3].

The scarcity of the element is important to maintain the high demand and high levels of liquidity, thus preventing a sharp decline in prices, and relative stability. The reason is that when money is scarce, the number of those who need it will be always relatively larger than in the case of other more abundant commodities.

More generally, the circumstances to which the extent of the saleability of an object depends, are:

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All these circumstances, on which the different degrees of the saleableness of commodities depend, explain why certain commodities can be disposed of with ease and certainty in definite markets, at any time and practically in any quantities of the economic price, while the saleableness of other commodities is confined within narrow spatial and temporal limits [3].

 

The functions of money

Understanding the basic functioning of the market, and the conditions that made possible the diffusion of certain kinds of money in history, finally bring us to a complete definition of money through its three basic functions, which chiefly affect the choice among available kinds of currencies.

  • Medium of Exchange: The first dimension concerns the usage of a tool as an intermediary. To the great mass of wage and salary earners the main interest will probably be that they can make their daily purchases in the currency in which they are paid, and that they find prices everywhere indicated in the currency they use. \lq\lq Shopkeepers, on the other hand, so long as they know they can instantaneously exchange any currency at a known rate against any other, would be only too willing to accept any currency at an appropriate price [1]". Thus, to satisfy this property, money should be widely accepted, easy to carry, easy to verify, authentical, standardized, fungible, censorship-resistant and liquid.
  • Unit of Account: Considering the second dimension, people use objects as an unit of account because helps them recognizing how much a good is worth in terms of the monetary unit. It allows the calculation of relative prices and the comparison between goods and as a consequence, the market activity. To fulfill this function money should be divisible, limited in units, fungible, standardized and stable through time.
  • Reserve of Value: Third, money can be considered a good store of value if it does not drastically lose its value between the time to get it and the time to buy something else, indeed goods that were long-lasting and easy to store did better as currencies. Beyond the desire to use his regular receipts for his ordinary expenditure, the wage and salary earner would probably be interested in stability. Hence, to work as a store of value, the tool should be durable, easier to store, easier to transfer, stable, secure, widely accepted, scarce, difficult to counterfeit and not censurable.

Each of these dimensions is important and if one is missing, probably people would not consider it as good money. But it should be clear that, although they are interdependent, all of these functions are simply the consequence of the basic function of money as a medium of exchange.

 

The 'kernel' of money

Actually, when an individual waives some goods in exchange for money, the only reason is to exchange that money in the future for other goods or services, thus, shifting the purchasing power ahead. More consumer goods mean a higher standard of living for the public in the present; more holdings of capital goods mean sustained and increased living standards in the future.

"The more uncertain and fearful people are, the more cash balances they will want to hold; the more secure, the less cash they will wish to keep on hand. Another reason for keeping cash is also a function of the real world of uncertainty. If people expect the price of money to fall in the near future, they will spend their money now while money is more valuable, thus "dishoarding" and reducing their demand for money. Conversely, if they expect the price of money to rise, they will wait to spend money later when it is more valuable, and their demand for cash will increase. People's demands for cash balances, then, rise and fall for good and sound reasons." [4, pag.17]

Because stability and acceptance depend on people's demands for money, network effects and the convergence to a standardized protocol play a major role in the function of a medium of exchange, which in turn conveys another benefit. Since all exchanges are made in money, all the exchange-rates are expressed in money, and so people can now compare the market worth of each good to that of every other good. Thanks to money divisibility, money can be employed to function as a unit of account for production.

For instance, if a PC set exchanges for three ounces of gold, and an automobile exchanges for sixty ounces of gold, then everyone can see that one automobile is "worth" twenty PC sets on the market [4].

These exchange-rates are prices, and the money-commodity serves as a common denominator for all prices; at any time, all goods in the economy will exchange at certain money-ratios. The purchasing power tells what quantity of the selected money you need to purchase other goods, just as the money-price of an object tells how much money that object can bring in exchange.

"But what of money itself? Does it have a 'price'? Since a price is simply an exchange-ratio, it clearly does. But, in this case, the 'price of money' is an array of the infinite number of exchange-ratios for all the various goods on the market. [...] The price of money, then, is the purchasing power of the monetary unit" [4, pag.14]

This is because money differs from other commodities in one essential fact, and grasping this difference furnishes a key to understanding monetary matters. When the supply of any other good increases, this increase confers a social benefit, but unlike other commodities, an increase in the stock of money does not confer social benefits.

As we will see, new money only raises prices and dilutes the purchasing power in the present and moreover in the future, but the public at large is not made richer. On the other hand, a fall in the supply raises the power of each money-unit to do its work.

The reason for this puzzle is that money is only useful for its exchange value. Other goods have various "real" utilities, so than an increase in their supply satisfies more consumer wants. Money has only utility for prospective exchange and it is not consumed directly; its utility lies in its exchange value, or "purchasing power" for future consumption [4].

Therefore, to fulfill the function of the measure of value needed to conclude exchanges, money has to be fixed in number and divisible; we may wonder what would be to measure distances with a unit that is constantly changing through time. In the same way, if money represents the relationship among all prices, it seems that it does not have economic sense to choose a monetary unit that changes over the years, with the addition that the value cannot be measured in the same way of the matter, because the value is subjective. The only thing that changes during the market activity is the perception of the utility of goods and services in relation to each other, which then is reflected upon the monetary-unit.

"We come to the startling truth that it doesn't matter what the supply of money is. Any supply will do as well as any other supply as long as it is fixed; the free market will simply adjust by changing the purchasing power, or effectiveness of the money-unit [4]".

Then, it is up to the people to decide the best commodity to use as money. Over the millennia money chosen by people and markets was gold, where the total supply of money was the total weight of gold existing in society. If platinum were the money, it would likely be traded in terms of fractions of an ounce; if iron were used, it would be reckoned in pounds or tons. It is obvious that the size of the common unit chosen in trading makes no difference to the economist, neither does the shape of the monetary metal. Therefore:

"Money, is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a "claim on society"; it is not a guarantee of a fixed price level. It is simply a commodity. It differs from other commodities in being demanded mainly as a medium of exchange. But aside from this, it is a commodity and, like all commodities, it has an existing stock, it faces demands by people to buy and hold it, etc. Like all commodities, its "price"- in terms of other goods- is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it." [4, pag.9]

Finally, it is misleading to say that money "circulates". Like all metaphors taken from the physical sciences, this expression connotes some sort of mechanical process, independent of human will, which moves at a certain speed of flow, or "velocity". Actually, money does not "circulate"; it is, from time to time, transferred from one person's cash balance to another's [4].

Money is independent from the currency that is used, in the sense that money represent the base layer needed to evaluate the exchanges, while the currency could be defined as the method of payment used within that protocol. The existence of money, once again, depends on its expected value and upon people's willingness to hold cash balances.

 


Index:

 


 

References:

 

[1] - F.V.Hayek. Denationalization of money.

[2] - A. Narayanan et all. Bitcoin and cryptocurrency technologies: A comprehensive introduction.

[3] - C. Menger. The Origins of Money.

[4] - M. Rothbard. What has government done to our money? 

[5] - S. Ammous. The Bitcoin Standard.

 


CryptoGameTheory     



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