The Economics of Money

March 5, 2010

Seems like a redundant title, right? Of course it’s not though. Economics is the study of choices, and the choice to use money is only one of the many decisions economists study.

A lot of people have probably seen that cartoon video in elementary school about “the development of money.” In this video, a fisherman lives in a town where every uses barter for exchange, and since the fisherman has fish but wants shoes or whatever, he runs all over town trying to make trades with people so that in the end he can get some shoes. Seems like a waste of resources.

Like most myths, this one is true. It’s not hard for people, once they have the idea of money, to see that trading with some unit of currency as a common standard offers huge advantages over a barter system of trade. Running around town trying to negotiate trades is not most people’s idea of a good time.

An important question, and one that doesn’t have a theoretical answer, is what to use for currency, once everyone agrees that a currency is desirable. It’s the same problem that a group of friends has trying to pick a restaurant or a movie. The payoff to individual actors certainly depends in part on the inherent value of that restaurant or movie, but much more important is simply that they agree. Coordinating big groups of people is very difficult and costly, so

Throughout history, most money has taken the form of some commodity or other. Many commodities would serve as suitable currencies, but what they must have in common are these (non-exhaustive, necessary but not sufficient) features:

Identifiability – it must be immediately obvious upon visual and tactile inspection that an object proffered as currency really is valid currency. The more it costs to verify objects as currency, the less useful they are as money, since after all, the whole point is to reduce transaction costs.

Common Knowledge Production – Once something is established as currency, which as I note above, is very complicated, people must have some way of valuing that currency. I submit that the value people give to currency is the value that they believe the marginal unit of that currency would have, given what they know about its production. Everyone knows that you can’t just make more gold, which means that if I found a bar of gold unexpectedly stashed away in my couch cushion, I know exactly what that gold bar would be worth (per ounce). Gold can’t be produced, only discovered, but commodities that can be produced can be currencies, too. Wheat or chickens could be a currency, not because nobody can make more, but because if people did make more, everyone basically knows what making more would cost. You can’t just snap your fingers and get chickens, you’ve got to put some time, effort, and resources into it. The value of those factors sets the upper bound on the value of a commodity currency.

Why the hell am I talking about this subject? Well, since yesterday, I’ve been thinking about the other kind of currency, in use more recently, called fiat currency. Dollar bills are an example. In common understanding, fiat currency is valuable “because the government says it’s valuable.” But I don’t think that’s right. I actually think that fiat currency is just the same as commodity currency, in all relevant ways.

First, fiat currency is valuable because having some form of money is valuable (for reducing transaction costs), and dollars is as good a money as any. It’s easily identifiable, and I expect that other people will accept it for transactions (because they expect other people to accept it etc.).

So what about that second part? It seems like it’s much cheaper for the government to produce dollar notes, on the margin, than dollars are worth. As I wrote above, the value of a commodity currency can’t exceed the cost of producing that commodity. If it did, an entrepreneur could produce more chickens at some cost, spend those chickens in the market, and pocket the difference until chickens were devalued enough to take away that profit opportunity. Dollars are just some ink and paper, though, and not even fancy ink and paper is worth $100 per square foot. What, then, sets the upper bound for the value of a dollar?

I’m convinced that the simple fiat/commodity division is ignoring some substantial costs of producing fiat money. In the traditional view of fiat currency, the government stand to gain a lot by producing more $100 notes, which cost, say, $.06 each to produce, and pocketing the difference.

But this analysis exhibits a degree of naiveté that economists rightly deride in other areas. When someone claims, “If there were no FDA, companies could just put deadly poison in their products and get rich! They wouldn’t have to care about consumer safety at all!” economists know what to say: “Actually, no.” Consumers aren’t idiots and neither are corporations. That’s why we have brands, which allows companies to establish and advertise a reputation for quality, safety, reliability, and myriad other factors that consumers care about.

So what are economists saying when they say that fiat currencies can be produced at a lower cost than they are worth? That reputation doesn’t matter? That costs to reputation are not properly considered a part of the production cost of dollars?

I, on the other hand, take seriously the presumption that in normal economic activity, producers will continue to produce until the marginal cost of production equals the marginal benefit of producing the next unit. My rough estimate, then, is that if the ink and paper in a $100 bill cost $.06, then the expected cost to the Federal Reserve of printing the next note is approximately $99.94. If it were any less, they’d print more notes.

Oh, there are many problems with this analysis as I’ve presented it (political economy, anyone?), but the core is just basic economics. What I’ve said ought to be true, and if it isn’t, then that’s something that’s weird and noteworthy in itself. But it probably is true.

Addendum: At this point I sort of believe that if I ever write a paper, it will be on this topic, so that’s why I’ve produced this badly-organized jumble right now.

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2 Responses to “The Economics of Money”

  1. Rrrobert! Says:

    So rather than just mocking your chosen profession again, I’ll bite – and forgive me if it starts off too basic:

    Consider the perspective of the average dude. Contemplating a bushel of wheat, he might have some idea of how much effort it would take to grow a bushel of wheat, and value it appropriately.

    Contemplating a bushel of gold, though, it seems to me that he actually has a different perspective. Probably your average dude doesn’t know how much effort it would take to dig a bushel of gold out of the ground and process it into bushels. What he knows is how much effort he would have to spend farming enough wheat to trade for a bushel of gold.

    But the dude who makes bushels of gold, he knows how much effort it takes to make gold, and how much wheat it’s likely to earn him. So he stops digging it out of the ground at the point where it takes more effort than its worth. He determines the supply of gold, and the rest of the economy calibrates around that supply (as it does around everything else).

    But the dude who makes gold’s incentives are aligned in a way that encourages him to make as much gold as makes sense. For government, it doesn’t seem like that’s the case.

    For one thing, it doesn’t make sense to talk about government as a monolithic entity. We’re used to thinking about companies as rational actors, because in corporations an attempt is made to align everyone’s incentives as if they were monolithic. And even so, it seems like we find that companies sometimes don’t act as monolithic rational actors precisely because their incentives aren’t aligned properly (think embezzlement, or infighting, or whatever).

    Even more than corporations, government features a huge array of individual incentives which are by no means monolithic and often at cross-purposes. Sometimes this is an accident, and sometimes by design. So it doesn’t always make sense to say “the government has an interest in doing X”, because who has that interest and why?

    If the people who controlled the money supply were also in control of spending, it might make sense for them to print as much money as they felt was worth printing, but I don’t think that’s actually how the Fed’s incentives are aligned.

    What are the incentives of the people who make the actual decisions at the Fed? Well, the financially and personally, it seems like the goal of the Fed is to set monetary policy in a way that minimizes the chances of a disaster and maximizes the chances of steady growth in the private economy. Bernanke doesn’t really care that much if the government can buy planes, except insofar as its ability to buy planes affects the broader economy. He just wants his stocks to go up, and his reputation to be like Alan Greenspan’s pre-crash, rather than post-.

    Now, of course there’s some truth to the idea that Bernanke weighs the consequences of not printing money against the consequences of printing money, and prints money at the equilibrium point. But (a) he maximizes with respect to the broader economy, not the government’s profit [this is, I think, just articulating your point about political economy] and (b) I don’t think know that it makes sense to insist on the math this way. Even if, in the final analysis, you decide that Bernanke thinks the next $100 bill costs $99.94 in political economy (presumably for him, not the government as a whole), what the hell does that mean, given the diversity of interests at stake and its obvious irrelevance to the actual thought processes of the actors? What empirical advantage can we gain from the analysis? Say the price of a $100 bill went up one cent. Do you think we would print less, or would you just adjust your assumption about Bernanke’s calculations of cost? What predictive power would this have?

    Those aren’t rhetorical question, either. I realize you might have quite good answers to them, though they’re not apparent to me.


  2. […] March 12, 2010 [Follow-up to: The Economics of Money] […]


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