Free exchange, the economics column in the Economist, has a really interesting piece in this week’s issue on two theories of the origin of money. The first theory is the evolutionary market theory propounded by Carl Menger, one of the three independent and simultaneous co-discoverers of the marginal utility theory of value in the early 1870s, (the two co-discoverers being William Stanley Jevons and Leon Walras) in a classic 1892 paper “On the Origins of Money,” and the other being the Cartalist theory, famously advanced by G. F. Knapp in his State Theory of Money, but also by other more orthodox theorists like P. H. Wicksteed (see my earlier posts here and here), and more recently in a paper by Charles Goodhart, discover of Goodhart’s Law, an only slightly less general statement of what came to be known some years later as the Lucas Critique.
Menger’s theory is a brilliant conjectural history of how money might have evolved as the result of individual choices by individuals seeking to reduce their transactions costs in an economic environment that is changing from subsistence farming into a market economy characterized by specialization. Some individuals, realizing that certain commodities were easier to trade than others, would begin holding inventories of those goods beyond their immediate demands, thereby enhancing their ability to find trading partners. But by holding inventories of those commodities, these alert individuals would do two things, first they would make it even easier to trade in those commodities, and second they would induce other people to follow their example. As others followed their example, the costs of trading in those commodities originally identified as low cost commodities to trade would be reduced still more. This was an early description of what have recently come to be known as network effects or network externalities. A good characterized by a network effect is a good for which the demand increases as more people demand it. Menger beautifully described the process by which a commodity would emerge as money owing to the network effects inherent in being used as a medium of exchange.
While theoretically brilliant and supported by some historical evidence, Menger’s conjectural history hardly provides a complete or unerring account of the development of money. One important part of the story that Menger left out is the pervasive, though not necessarily exclusive, role of the state in the development of money. Here is Free exchange:
Take the widespread use of precious metals as money. A Mengerian would say that this happens because metals are durable, divisible and portable: that makes them an ideal medium of exchange. But it is incredibly hard to value raw metals, Mr Goodhart argued, so the cost of using them in trade is high. It is much easier to assess the value of a bag of salt or a cow than a lump of metal. Raw metals fail Menger’s own saleableness test.
This is complicated. Traders traveling long distances would want to use a medium of exchange that had a high value relative to the cost of transportation. So precious metals probably became more important as media of exchange not in the earliest stages of the historical development of money, when salt and cattle were widely used, but at a later stage, when professional traders began buying in one location and selling in other, distant locations, precious metals served their purposes better than bulkier commodities, much more costly to transport than precious metals. Free exchange continues:
This problem explains why metal money has circulated not in lumps but as coins, with a regulated amount of metal in each coin. But history shows that minting developed not as a private-sector attempt to minimise the costs of trading, but as a government operation. It was state intervention, not the private market, that made metal specie work as money.
Again, my reading of the historical evidence – and I don’t claim more than a superficial knowledge of the historical evidence – is that there is evidence of early private minting operations. However, the early private mints were quickly displaced by mints operated by the state (or whatever you care to call the organizations headed by early monarchs). In my book Free Banking and Monetary Reform, I argued that having a monopoly over the mint was beneficial to the survival chances of any “state” competing for survival against other nearby states. To be able to survive, a state needed to be able to hire soldiers and pay for weapons. How could a monarch do that if he didn’t have an efficient system of collecting taxes? One very good way was to own a mint, and have at least a local monopoly over the minting of coins, which gave the monarch the ability to raise funds in an emergency by debasing the coinage. A prudent state would not debase the coinage except under dire circumstances, but in order to be able to engage in currency debasement, the state needed a monopoly over the coinage, and the ability to force its subjects to accept those coins at face value to discharge previously contracted obligations. Monarchs that were also monopolists over mints had an important advantage in competition with monarchs without a mint. So mints became part of the essential equipment of any self-respecting monarch. Back to Free exchange:
Mr Goodhart used monetary history to test these competing theories. He examined the overthrow of Rome and a period in the tenth century when the Japanese government stopped minting coins. If the origin of money were purely private, these shocks should have had no monetary effects. But after Rome’s collapse, traders resorted to barter; in Japan they started to use rice instead of coins. There is a clear link between fiscal power and money.
My interpretation of Roman history (I am afraid that I must plead ignorance about Japanese history) is a bit different. The overthrow of Rome was largely the work of the Arab conquests of the seventh and eighth centuries. Henri Pirenne in his wonderful book Mohammed and Charlemagne argued that the Arab conquests of most of the Mediterranean sea ports essentially cut off the long-distance Mediterranean trade of the remnants of Western Roman empire. The closing off of export markets and the corresponding loss of imported goods caused a regression from specialization and trade back to autarchy. As foreign trade collapsed, local economies became increasingly self-sufficient and the demand for money dropped correspondingly. Reversion to barter was not occasioned by the absence of a state that provided coinage, but by the collapse of an exchange economy that created the demand for coinage.
So I don’t see the conflict between the Mengerian theory and Cartalist theory as being as sharp as Goodhart and Free exchange seem to suggest. On the other hand, the 1998 paper by Goodhart was remarkably prescient in describing the kinds of problems that have beset the euro, problems closely associated with “unprecedented divorce between the main monetary and fiscal authorities” in charge of conducting policy for the Eurozone.
The topic is far from exhausted, but I am. Perhaps I will have more to say on subject in a future post.