A commonly-held view is that money has value because the government in power says so. For other commentators, the value of money is established because money is accepted. But why is it accepted? Well, because it is accepted!
The demand for a good arises because of its perceived benefit. For instance, people demand food because of the nourishment it offers them. The difference with money is that people demand money not for direct use in consumption but in order to exchange it for other goods and services. According to Murray Rothbard,
Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.
Money is not useful in itself, but rather because it has an exchange value—it is exchangeable in terms of other goods and services. Money is demanded because the benefit it offers is its purchasing power. Consequently, for something to be accepted as money, it must have a preexisting purchasing power.
So, how does money originally acquire purchasing power?
In his writings on this subject, Austrian economist Carl Menger raised doubts about the soundness of the view that the origin of money is government proclamation. According to Menger,
Money is not an invention of the state. It is not the product of a legislative act. Even the sanction of political authority is not necessary for its existence. Certain commodities came to be money quite naturally, as the result of economic relationships that were independent of the power of the state.
He further stated,
An event of such high and universal significance and of notoriety so inevitable, as the establishment by law or convention of a universal medium of exchange, would certainly have been retained in the memory of man, the more certainly inasmuch as it would have had to be performed in a great number of places. Yet no historical monument gives us trustworthy tidings of any transactions either conferring distinct recognition on media of exchange already in use, or referring to their adoption by peoples of comparatively recent culture, much less testifying to an initiation of the earliest ages of economic civilization in the use of money.
The Difference between Money and Other Goods
To recap, the demand for a good arises from its perceived benefit. For instance, people demand food because of the nourishment it offers them. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money’s usefulness is its exchange value—it is exchangeable in terms of other goods and services. The benefit it offers is its purchasing power (i.e., its price).
Given that the law of supply and demand explains the price of a good, it would seem logical that the same law should explain the price of money. However, there is a problem with this logic since the demand for money arises because money has purchasing power. Yet if the demand for money depends on its pre-existent purchasing power, then how can this price be explained by demand? We are seemingly caught here in a circular trap, for the purchasing power of money is explained by the demand for money while the demand for money is explained by its purchasing power.
Mises Explains How Value of Money is Established
In his writings, Ludwig von Mises shows how money became accepted. He began his analysis by noting that today’s demand for money is determined by yesterday’s purchasing power of money. Consequently, for a given supply of money, today’s purchasing power is established in turn. Yesterday’s demand for money, in turn, was fixed by the prior day’s purchasing power of money.
Therefore, for a given supply of money, yesterday’s price of money was set. The same procedure applies to past periods. By regressing through time, we will arrive at a point in time when money was just an ordinary commodity where demand and supply set its price. The commodity had an exchange value in terms of other commodities; its exchange value was established in barter. On the day a commodity becomes money, it already has an established purchasing power or price in terms of other goods. This establishes the demand for this commodity as money. Once the price of a commodity has been established as money, it serves as a basis for the establishment of tomorrow’s price of money.
With regard to other goods and services, history is not required in order to ascertain present prices. A demand for these goods arises because of the perceived benefits from consuming them. Consequently, one needs to know the past purchasing power of money in order to establish today’s demand for it. Using the Mises framework—the regression theorem—we can infer that it is not possible for money to emerge as a result of a government decree or government endorsement or social convention. The theorem shows that money must emerge as a commodity.
According to Rothbard,
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.
The introduction of electronic money has introduced some confusion regarding the actual definition of money. A growing view is that electronic money is likely to make current cash redundant. Various forms of electronic money do not have an independent “life of their own.” Electronic money is not money as such but a particular way of using money. Various financial innovations do not generate a new form of money, but rather new ways of employing existing money in transactions. Importantly, these financial innovations do not change the nature of money.
The fact that an object must have a preexisting price before it becomes money precludes the possibility that money in a free market could be issued by just anybody. Why would anyone accept notes printed by Mr. Jones or by a famous movie star as money? In similarity to demand deposits, electronic money can function only as long as individuals know that they can convert it into fiat money on demand.
One could argue that the government could by decree force electronic money to displace the current paper standard. This, however, would not work. Mises argued,
The concept of money as a creature of law and the state is clearly untenable. It is not justified by a single phenomenon of the market. To ascribe to the state the power of dictating the laws of exchange, is to ignore the fundamental principles of money-using society.
Conclusion
Using the Misesian framework of money, it is impossible that money can emerge as a result of government decree or government endorsement. The theorem shows that money must emerge as a commodity. This basic principle cannot be changed by legislative decree.
