Yesterday I talked a bit about money, a common medium of exchange, where it came from, and why it makes economic transactions more efficient (meaning more goods and services produced for the same total expenditure of resources–which include time and effort–than if one is limited to a pure barter economy).
One of the things I mentioned was that early money consisted of small bits (whether made into coins or otherwise) of precious metals. One of the advantages of this form of money is that it limited the supply of money keeping the value of the money high. I have discussed why limiting the growth of the money supply is a good thing elsewhere.
One of the things that money allows that is harder to do in a barter economy is savings and investment. It’s not entirely impossible to do those in a barter economy and I used an example in a discussion of interest previously. In that previous post I show that “interest” is justified by the fact that when one loans something, even if it is returned exactly in the condition in which it was loaned, one is still out the benefits that one could have had of it during the period of the loan. This loss, the benefits one could accrue from the use of the lent object, is deserving of compensation and thus forms the basis of interest.
While one can save many material goods–grain storage, a shed full of pottery, duplicates of tools one might use in the future–others are more difficult. Fresh milk and meat only keep so long, especially in the days before modern refrigeration. Money, in addition to being convenient for also commerce, is also generally non-perishable.
Money also makes investment far more convenient. John and his plane (from the earlier post on interest) only works because John, being a carpenter has the plane and is able to loan it to another carpenter. If John were a baker with an extra oven and George still needed a plane, well, neither would be able to help the other. If, however, instead of putting his extra effort into making an oven (analogous to making the plane the first time) John could instead put aside some money that could be used to purchase an oven and instead loan the money to George which George could then use to buy or rent a plane. Even though the transaction is now one of money rather than material goods the same principle applies. John could use the money to buy an oven to increase the capacity of his bakery. Instead, he loans the money to George and thus is deprived of the benefit of that increased productivity. This deserves compensation and so, George is expected to pay back not just the amount loaned, but a somewhat greater amount…interest.
The idea that money, put into others hands for use, in return for a greater amount to be returned later is a very old one–common enough in Biblical times for Jesus to use it as an example in the Parable of the Talents (a “talent” being a weight measure of gold or silver–a rather large one in fact, about 130 lbs).
This works, however, when the value of the money itself is relatively consistent. As I describe in the blog post on inflation dramatic increases in the money supply relative to economic output cause the value of money to go down–more money is required to buy the same goods or services. This is bad for John. What he gets back at the end of the loan/investment is less, in terms of what he can do with the return than it would be absent the increase in money supply. On the other hand, it’s great for George. His goods are selling for a lot more of the money he needs to pay John back.
The flip side can also happen. A decrease in the money supply relative to the economic output leads to an increase in the value of money–a given amount of money will buy more goods and services–deflation. This, as it happens, is great for John (to a point–which we’ll get to momentarily). The money he’s getting back from George (again, to a point) buys more than it would otherwise. This is, however, bad for George. His goods are selling for less, but he still owes John the same amount of money. And this is where we reach the “to a point.” The deflation doesn’t have to go very far at all before George finds himself unable to pay the loan at all. He defaults. And John gets nothing. Both of them are harmed by the deflation.
While people have a natural reaction to think that low prices are a good thing, it should be clear from the above that a general deflation is actually harmful and may actually be worse than a similar level of inflation.
These twin monsters, the Scylla and Charybdis of money, are why one ideally wants money supply to keep close pace with economic output. As populations grow, as industrialization and technical innovation increases productivity, the money supply needs to grow as well. And, so the very benefit of precious metals becomes a weakness. The scarcity of precious metals that prevents runaway inflation also means that one might not be able to increase the supply (finding and developing new ores or shifting from other uses such as jewelry to use as currency) sufficiently to match economic growth.
The “solution” that governments have used to escape this weakness of precious metals standards has been to go to “fiat” currencies, not tied to anything except the “faith and credit” of the issuing government. In principle, the money supply could then be adjusted to match economic output, avoiding either inflation or deflation.
In practice, however, government generally find themselves unable to resist the temptation to “solve” short term economic woes by inflating currency as “stimulus”.