3. The Various Kinds of Money

CHAPTER 3 THE VARIOUS KINDS OF MONEY

Summary

A money substitute is a perfectly secure and immediate claim on money. Because the claims themselves can facilitate indirect exchange, they become a “substitute” for the original commodity money.

The definition of money should serve the purposes of economic theory, the most important being the explanation of the purchasing power of money. For economics, what matters is the actual practices and expectations of individuals in the market, rather than legal formalities.

Commodity money is a common medium of exchange that is also an economic good in its own right. For example, gold, silver, and even tobacco have historically been used as money, and yet people also valued and traded these commodities for other reasons.

Credit money occurs when a claim on a physical or legal person, falling due in the future, is itself used as a medium of exchange.

Some theorists explain the value of money as due to State commands. But the government cannot force people to adopt a particular item as the commonly accepted medium of exchange, let alone to accept it with a particular purchasing power. The government can use its tremendous power to make it more likely that people will adopt a particular item (such as green pieces of paper with certain ink patterns) as money, but economically something is money because of its usage by people in the market. A government edict per se cannot transform it into money.

Chapter Outline

1. Money and Money Substitutes

A money substitute is a perfectly secure and immediate claim on money. For example, suppose the commonly accepted medium of exchange is gold, and a reputable bank issues a paper ticket entitling the bearer to one ounce of gold. So long as people in the community are certain that they will be paid in physical gold whenever they present the ticket to a branch of the bank, then such tickets are money substitutes and may change hands during purchases the same way physical gold would.

In the market economy, people can issue perfectly secure and immediate claims (i.e., redemption tickets) to all sorts of goods, not just money. But the crucial feature of such claims on money is that the claims themselves can facilitate indirect exchange, and so become a “substitute” for the original commodity money. In other words, pieces of paper entitling the owner to an ounce of gold can circulate in the market the same way actual 1 oz. gold coins would (so long as everyone is assured of immediate redemption). In principle merchants might never actually turn the tickets in, to receive the physical gold. In contrast, people might trade paper claims guaranteeing the owner to a loaf of bread, but they would eventually redeem them. Such tickets could never become “bread-substitutes” because the paper couldn’t serve the same function as actual bread.

For economists—as opposed to legal theorists or the businessperson—the definition of money should serve the purposes of economic theory. The central task of the economic analysis of money is to explain the exchange ratios between money and all other goods, i.e., to explain the purchasing power of money.

In Mises’s judgment, the most fruitful classification scheme distinguishes between the underlying “money in the narrower sense” versus perfectly secure and immediate claims to such money, i.e., money substitutes. He concedes that it would be logically consistent to include money substitutes in the definition of money itself, but believes his preferred distinction (i.e., between money and money substitutes) will make it easier to explain other phenomena (such as the purchasing power of money, as well as the boom-bust cycle) more clearly in later chapters. (See the Appendix B on page 231 for a diagram outlining Mises’s classification scheme for various items that are often included in the concept of money.)

2. The Peculiarities of Money Substitutes

In the economic analysis of money, what matters is the actual practices and expectations of individuals in the market. For example, whether or not legislation declares that token coins are legally binding claims on money, if in practice the holder of a token can easily exchange it for the “equivalent” amount of actual money, then economically speaking the token is a money substitute.

The same principle applies to banknotes. For example, conventional accounts say that Austria-Hungary from 1900 to 1914 possessed a paper standard, because legally the Austro-Hungarian Bank had no obligation to redeem its paper notes for commodity money, and in fact the notes were declared legal tender. Yet in practice during this period, the Austro-Hungarian Bank would voluntarily cash its paper notes for gold upon request, and so economically speaking Austria-Hungary was on a gold standard.

3. Commodity Money, Credit Money, and Fiat Money

Fiat money is accepted as a common medium of exchange not because of its technological properties, but because of a special legal designation provided by the appropriate authority. For example, in the current United States “green rectangular pieces of paper” are not money per se. They only become money when they are cut to exact size and printed with the correct designs by the U.S. Treasury. Thus the green pieces of paper appear to become money by “fiat” (i.e., command) of the U.S. government. However, in economics the definition of money is a commonly accepted medium of exchange. The government can only use its powers to encourage people to use a particular class of items—for example, green pieces of paper with the appropriate ink patterns—as a common medium of exchange; the mere legal declaration isn’t what makes them money, economically speaking.

Credit money occurs when a claim on a physical or legal person (e.g., a corporation or government agency), falling due in the future, is itself used as a medium of exchange. To distinguish credit money from mere credit, it is necessary that people are generally willing to accept the claim in trade not because they want to wait and receive the underlying payment (to which the claim entitles them), but because they expect to be able to easily trade away the claim itself for other goods. For example, suppose a government originally promised to redeem its paper notes immediately upon demand for commodity money (such as gold). But during a war, the government suspends convertibility, so that the paper notes are now not legally binding claims on anything. However, if the public expects that at some point in the future, redeemability will be restored, then the notes would circulate as credit money (not fiat money) because they would be claims to gold falling due in the future (at an uncertain date). So long as the paper notes are considered so liquid that virtually everyone is willing to accept them in trade, they are a common medium of exchange and hence money.

4. The Commodity Money of the Past and of the Present

Some theorists explain the value of money as due to State commands. For example, “The monetary unit of the United States is the dollar, because the U.S. government has passed a law.” But this is a very inadequate reading of history, because governments cannot simply force a particular good to command a particular purchasing power in the market. For example, a king can collect taxes in the form of silver coins, and then debase them by melting them down and minting a greater number of coins with less silver content per coin. But the market will react by raising prices (quoted in terms of the coins), and even if the king resorts to price controls with draconian penalties, he will cause shortages in accordance with economic law.

Technical Notes

• On pages 56–57, Mises argues that token coinage is not an independent economic concept, but rather a special type of money substitute. Token coinage was developed to facilitate small transactions. For example, in a country using gold as its commodity money, it would be awkward to purchase an item with a price of th of an ounce of gold, if customers had to use the physical gold itself. The government might therefore produce a limited number of small discs (perhaps made of copper or nickel) that were stamped with, “Legal Tender, th oz. of gold.” Even though the actual metal content of the tokens would be less, they would nonetheless trade at their face value so long as everyone believed that the government would faithfully exchange one ounce of physical gold for 100 tokens. The important point is not whether such redemption were a legal requirement, but merely whether in practice people expected the option to be available upon demand. (Also note that the “coins” Mises discusses on pages 50–51 are not token coins, but coins consisting of the commodity money. In other words, such coins are valued because they actually consist of a recognized weight in gold or silver, not because the holders expect to be able to redeem them for gold or silver.)

• In the Misesian scheme, credit money is not the same as a money substitute because the claims constituting credit money are not due immediately, whereas they must be for a true money substitute. Money substitutes are valued the same as the underlying money to which they are claims; a banknote entitling the bearer to one ounce of gold, upon request, will have the same purchasing power as one ounce of gold. However, a corporate bond promising the bearer one ounce of gold in 30 years, if it is to become a credit money and circulate as a common medium of exchange, will be subject to an independent valuation, depending not merely on the reliability of the claim and the wait involved, but also on the liquidity of the bond. (See p. 61.)

New Terminology

Banknotes: Paper notes issued by banks, typically entitling the bearer to a specified amount of the money good.

Cash (verb): To redeem a claim (such as a banknote) by paying the specified amount of the money good.

Commodity money: A common medium of exchange that is an economic good in its own right, valued for nonmonetary reasons.

Credit money: A common medium of exchange that is a claim on a person or legal person (such as a corporation or government agency), not falling due until a (possibly uncertain) future date.

Debase: To dilute the value of the money, for example when a ruler introduces “base” metals into the coinage, reducing their precious-metal content.

Fiat money: A common medium of exchange accepted not because of its technological properties, but because of a special legal designation provided by the appropriate authority. Fiat money is not “backed up” by anything else.

Gold standard: The arrangement by which a nation’s money (such as the U.S. dollar or the British pound) can be redeemed for a definite weight of gold.

Legal tender: An item that the government declares to be valid for the payment of debts denominated in money, at par value.

Liquid (adjective): The ability of being sold for the full market price with a very short search time. (For example, a share of corporate stock is much more liquid than a house.)

Money in the narrower sense: The actual money good (whether commodity, fiat, or credit money), not including money substitutes.

Money in the broader sense: The actual money good (whether commodity, fiat, or credit money), plus money substitutes.

Money substitute: A perfectly secure and instantly redeemable claim on money, which itself circulates as money (in the broader sense) because it fulfills the functions of money.

Paper standard: The arrangement by which the government does not redeem paper notes for a precious metal. (A paper standard stands in contrast to a gold standard.)

Price controls: Government decrees threatening fines or other punishment for people trading at prices that are either too high (in the case of a price ceiling) or too low (in the case of a price floor).

Purchasing power: The amount of goods and services that a unit of money can command because of the various prices in the market.

Token coins: Coins that serve as representatives of money (usually in very small denominations), even though they do not contain the full weight of metal in the case of a commodity money.

Study Questions

1. What is “peculiar” about the fact that people may use claims on money, rather than money itself? How is this peculiarity “explained by reference to the special characteristics of money”? (p. 50)

2. What does Mises think of the treatment economists had given to money, before his own contribution? (p. 51)

3. What is the task of economic theory, regarding money? (p.51)

4. Explain: “[W]hereas it is impossible to satisfy an increase in the demand, say, for bread by issuing more bread-tickets ... it is perfectly possible to satisfy an increased demand for money by just such a process as this.” (p. 53)

5. Would Mises be surprised at the world’s current monetary system? (p. 61)

Study Guide to the Theory of Money and Credit