Money, Continued

March 12, 2010

[Follow-up to: The Economics of Money]

First, one clarification/definition: economics continues to be the study of choice in general. Political economy is the study of the choices politicians and voters make. So, indeed, the assumption that government maximizes profit is a pretty clear violation of all common sense in the field of political economy.

Still, I’m going to see whether I can get anything useful out of that assumption, anyway. I’m going to do it, in my usual way, by making an analogy to biology, a subject about which I am blissfully ignorant.

If you can come up with conditions that have to be true in order for a system to be stable, then you will know that any stable system you observe must fulfill those conditions, regardless of what seems to be going on inside the system. Suppose I say that the human body is designed to breathe just the right amount of air to ensure an adequate supply of oxygen and keep all its various parts functioning. Of course, even a human body is not monolithic, but made up of various small systems that are in turn made up of various individual cells. Everything “the body” does is really just what the cells are doing.

All of which is fine, but it’s really hard to figure out what the heck cells are doing. But I do know that the people who are walking around every day tend to be alive. And people who are underwater or have plastic bags over their heads tend to be dead. Whatever else is going on, people who stay alive do so in part because they have adequate oxygen. I might say that I know what is going on, even if I don’t know how it’s going on.

In economics, there is this alleged difference between fiat and commodity currencies. I wrote that commodity currencies get their value from the fact that the production cost of the next produced unit is common knowledge, and that this production cost provides the ceiling on the value of the currency. As with most statements about economics, saying that everyone “knows” the production cost and that this cost determines the value is a gross misrepresentation of the actual market process, but a misrepresentation that is adequate enough for my purposes. You might say that the value is set as if everyone knew the production cost, even though they really don’t. And then you would be right for most purposes, but it would be a bad idea to try to prove that statement by going around asking people how much it costs to produce a bushel of gold (or even wheat).

So as far as I can tell (I haven’t actually read about this subject), economists are theorizing that every item of value in the world, from frisbees to gold coins, is subject to laws about costs and supply and demand, but there is this one thing, fiat currency, that has value just because the government says it should, and that value is whatever the government says it’s worth.

I’m proposing that that dichotomy is unreasonable. I admit that I don’t know much about the inner workings of government, but I’m just thinking about what has to be true in order for money to have value. If a $100 bill can buy some basket of goods, then there must be something that makes people believe that trading the basket for a $100 bill is a trade that is neutral at worst.

I’ve written before about how widespread by hard-to-define norms can have real effects. The interest rates on mortgage offerings prior to 2006 were lower in part because of the expectation that home buyers have some kind of special obligation to pay their debts, beyond even the explicit terms of the contract. Maybe the banks who made these loans couldn’t have told you that explicitly, or by how much rates were lower, but successful banks had to set their rates in accordance with the conditions of the market.

Robert asks how a theory about the production of fiat money is useful at all, or whether I’m just planning to claim that whatever decisions Ben Bernanke makes are necessarily in accordance with my theory. A good point, so here’s how I’d propose that it’s useful: if we accept that a successful monetary system must be managing expectations for money production, somehow or other. If we imagine that fiat currency’s value is held up by ropes made of expectations and rules and expected rules, then we can examine how these factors work in fiat currency systems. We are, ultimately, trying to figure out how these things work. But, as with the human body, the whole thing is complicated enough that we need guideposts to make sure we’re not going entirely off track.


6 Responses to “Money, Continued”

  1. Rrrobert! Says:

    I think I see what you’re saying, but correct me if I’m wrong/

    You seem to want to say, as a base condition, that any successful monetary system must have a currency which derives its value from the production cost of the next unit of currency. You propose that money is a commodity like any other, and that if there’s a distinction between a bushel of dollars and a bushel of gold it’s in the nature of its production cost rather than any fundamental exception to the laws of supply and demand.

    This is, I will grant, an appealing prospect from an aesthetic standpoint, and I can see how it might be a fruitful and useful course of inquiry. Starting from such an assumption, you might come up with a way of benchmarking preferences and coming up with testable predictions. Which would be neat.

    I’m somewhat skeptical about this kind of a priori economics, though. The mathematical realities of efficient choice given a set of preferences are pretty badass, and have proven all kinds of useful in all kinds of ways. But human preferences and behavior are also all kinds of complex and inconsistent (both logically and temporally) and those who would bring economics into practice in the real world ignore those complexities at their peril.

    I worry here about castles built on sand. It might be so that assuming money is just a normal commodity can lead to some interesting inferences about the role of government or its ideal behavior. But in pursuit of such revelations, be sure you’re confining yourself to theory rather than imposing artificial constraints on people’s intangible processes.

    Don’t underestimate the place of descriptive economics that seeks patterns in the way people do behave, rather than discovering how they should behave given a set of assumptions. We generally think of Copernicus as having a better model of the universe than Ptolemy, but Ptolemy’s model gave better predictions for generations afterward.

    Anyway, let me know if you figure out anything awesome.

  2. guy Says:

    There is no contradiction between money being a commodity whose price is set by supply and demand, which it is, and attributing the value of a particular money to the government.

    Money is simply whichever good happens to win the coordination game to become the universal medium of exchange. The government, being big and powerful, can influence the outcome of this coordination game in various ways, such as allowing its citizens to defray taxes with a particular commodity. Once a commodity is chosen to be the medium of exchange, it gains a considerable amount of new demand from people who have no direct use for the commodity but instead wish to hold money, i.e. monetary demand.

    If the commodity chosen is a paper currency which the government has a monopoly of production over, then the government can indeed set the general purchasing power of money (aka its price), at least in one direction, by arbitrarily increasing the supply.

    None of the above circumvents the law of supply and demand. Instead, the government affects price by working through supply and demand.

    Also, I am totally perplexed by your reasoning about productions costs. You seem to think that a good can become valuable simply by being costly to produce, so long as people know that it’s costly. What on earth? You need to learn some economics. Start here

    • guy,

      Don’t be perplexed. There’s a huge difference between saying that in the long-run, a commodity can’t trade for more than the cost of acquiring it, and saying that commodities are exactly as valuable as whatever cost it takes to acquire them. Look up Smith or Buchanan (Cost and Choice, chaps. 1-3) on the choice to hunt beaver or deer.

      I’ll agree that money is basically the product of a coordination game, but you still have to use marginalist principles to think about the value of money. Money is worth whatever people expect the next unit to be worth – that’s the implication of supply and demand curves. The thought experiment where everyone wakes up with “twice as much money” really isn’t very good, then, because it matters a lot why everyone has twice as much money.

  3. guy Says:

    But you didn’t say that commodities “can’t trade for more than the cost of acquiring it.” You said that commodities “get their value from the fact that the production cost of the next produced unit is common knowledge,” which you later qualified but didn’t repudiate. And in your previous post you said 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.”

    The production cost of a good has precisely zero effect on the value of the good – that is, it does not change the position of that good on anyone’s scale of values. Suppose, for instance, that you were willing to pay $500 (but not $501) for an Apple iPad. Tell me, would this preference suddenly change if you found out that it costs Apple $100000 to produce an iPad? Would you suddenly become willing to pay $100000? Now suppose you found out that an iPad costs $.10 to produce. Would you suddenly become unwilling to pay more than $.10 for an iPad? If the best price you could possibly find was $10, would you be unwilling to pay it?

    If your answers were all “no”, then you agree that the production cost of an iPad does not affect your valuation of the iPad against money. If you believe the same laws of economics that apply to iPads apply to money, as you claim to believe, then the production cost of money does not determine “the value people give to currency.”

  4. guy Says:

    Edit – “You said that commodities” should be “You said that commodity currencies”

  5. I’m not sure we actually disagree about anything, guy. If you just want me to admit that mainstream economics is right about where things get their value, then okay, that’s not a problem for me. I know I was being imprecise and even saying things that, interpreted in a certain light, seem false, but I promise I didn’t mean them in the Marxist way.

    But I think you got overzealous in trying to get me to accept mainstream economic principles, because after we agree that value is subjective, production cost does affect the value of a good, if I’m buying it primarily as a store of value or medium of exchange. If our currency were iPads, then no, I wouldn’t pay $100,000 for an iPad if I knew they could be produced for $100. Knowing that would make me expect that the price of iPads was going to drop.

    That’s the main point of these money posts, actually. Since people are willing to pay 70 Euro for $100, they must believe there is something keeping the value of the US Dollar at a relatively stable level. And I’m proposing that commonly-known rules for how dollars are produced form those expectations.

    That said, I’m happy to repudiate the statement that commodity currencies “get their value from the fact that the production cost” is common knowledge, if that is taken to mean that production cost alone is sufficient to determine the value of a commodity. Again, I apologize for being imprecise, but I really was not saying what you thought I was saying. Like I said, I don’t think we have a genuine disagreement here.

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