The Price of Agony
Money's greatest intrinsic value – and this can't be overstated – is its ability to give you control over your time ― Morgan Housel
[I am currently out of the office and unable to discuss current financial market developments, but I would like to take this opportunity to explore a more philosophical topic this week.]
Debate is a fundamental concept in science, as scientific progress often relies on the rigorous exchange and evaluation of ideas, evidence, and interpretations. The field of economics is no exception.
While recent debates among economists have widely touched upon topics like the necessity of government intervention, rational versus adaptive expectations theory, or the influence of psychological factors, one discourse focuses more on the methodology of thinking about the economy.
This conflict occurred among economists in the German-speaking area during the second half of the 19th century. After the Austro-Hungarian economist Carl Menger published his "Principles of Economics," he faced significant backlash from other German economists, especially from a young economist named Gustav Schmoller.
In contrast to Menger, who aimed to transform economic theory into an analytical science, Schmoller, and other German economists dismissed his theory of "laws that held true at all times and places." Schmoller and his colleagues pursued a complete overthrow of theoretical research, replacing it instead with historical studies.
Schmoller argued that everything needs to be interpreted in a historical context and maintained that the government needs to "promote the welfare of the working classes." Apart from the fact that the historians around Schmoller used a more qualitative approach, one could say that their way of looking at economic problems is similar to how modern, positivistic economists view the economy. Jonathan Newman writes:
Historicism and positivism preclude any universal, time-invariant claims about human action. It only produces tentative hypotheses based on data that is collected under specific circumstances—circumstances that include innumerable and unmeasurable factors that confound the collected data, especially when humans and their choices are the subject matter being observed…no economist calls himself a member of the German Historical School today, but their failed ideas persist.
Just as the German Historical School did, a broad tendency in modern economic studies seems to exist to justify government action and intervention solely. The difference lies more in the fact that the new empirical research includes mathematical modeling and statistical inference. In some sense, they have "enhanced" the theory of the historian school with methods and models borrowed from the natural sciences.
What aligns the two is the belief that government intervention in markets is justified mainly because it is thought to improve outcomes. Schmoller's stance on the role of government and the living conditions of the working class continues to dominate German social policies to this day, supported by all political parties from left to right.
Summed up, when the core belief is that government is necessary to "turn things for the better," economic science just underscores Ludwig von Mises' warning that there is no "middle way" and that such societies will slowly drift towards socialism. Economic science mostly supports such policies due to its flawed tools of economic analysis. Hence, perhaps we really need another "Methodenstreit."
While most economists would strongly disagree with this notion, there are definitely topics where, despite all the empiricism, "the science" is still not settled. "Money" is one of them. In fact, despite money being one of the essential cores of economics and economic development, there isn't really a consensus about what money really "is" or what "good money" is.
I'd go even further in saying that what we use as money today (dollars, euros, yen, etc.) doesn't serve the purposes that money had for most of its existence.
What is money, after all? How did it come into existence? Was it the free choice of people who chose to use a particular commodity as a medium of exchange, or was money always an invention of the state? Should one be in favor of a capped supply of money, or is the argument that the "quantity of money" doesn't matter correct?
While economists generally agree on the attributes of money, such as divisibility, portability, store of value, and unit of account, there is significant disagreement on its development and whether a country must have a monopoly on money production.
The dispute among certain schools of economic thought starts even earlier, with the question of whether money developed spontaneously through market actions or because of government intervention. While most economists support the first view, as formulated by Carl Menger in his "Principles of Economics," the theory that Menger initially argued against has recently gained traction due to the rise of Modern Monetary Theory (MMT).
The basic theory of money's development suggests it was created by people to overcome the "barter problem," finding it more efficient to trade goods and services indirectly through a "widely accepted medium of exchange"—something we now call money.
At this point, the "neo-chartalists," as the proponents of MMT describe themselves, usually interject and argue that many anthropologists have asserted there was never such a thing as a barter economy. A piece in the Atlantic from 2016 pointed at this fact, basically arguing that within ancient societies, there was more like an organized distribution system:
Communities of Iroquois Native Americans, for instance, stockpiled their goods in longhouses. Female councils then allocated the goods, explains Graeber. Other indigenous communities relied on “gift economies,” which went something like this: If you were a baker who needed meat, you didn’t offer your bagels for the butcher’s steaks. Instead, you got your wife to hint to the butcher’s wife that you two were low on iron, and she’d say something like “Oh really? Have a hamburger, we’ve got plenty!” Down the line, the butcher might want a birthday cake, or help moving to a new apartment, and you’d help him out.
While this indeed supports the claims of MMT proponents, I'd argue that it doesn't directly oppose the barter theory envisioned by Adam Smith and, consequently, Menger. These societies often serve as role models for an "anti-capitalist" society. However, while such systems might work in small groups with limited specialization and familiar members, problems emerge when scaling up.
Indeed, the article notes that trade existed among people who weren't familiar with each other. It even acknowledges that the two parties involved in trade had to agree on a medium of exchange, which closely aligns with Menger's formulation. Hence, although the notion that barter trade didn't exist within a closed, small group is valid, it did occur in engagements among strangers.
The conclusion here would be that money developed from a universally accepted commodity, such as sugar, shells, or, ultimately, gold or silver, there is still disagreement about the origins of money at the state level. Neo-chartalists argue that while this might have been the case in "foreign trade," it doesn't explain the use of money within state jurisdictions.
Recently, MMT icon Stephanie Kelton, Randall Wray, and other MMT proponents published a documentary called "Finding The Money," in which they make exactly this point. By doing so, they downplay the role commodities played in the evolution of money. They go so far as to disagree with the argument that people assume, for example, the dollar has value because it had value in the past (due to its convertibility promise) and, therefore, has value today and tomorrow.
To them, all these theories have no practical application in the real world. They argue that money has value not because it was redeemable in gold in the past but for a totally different reason. They argue that money has value because "the state" says so, and citizens are obliged to pay taxes on the pieces of paper that governments print and distribute.
In the documentary and various papers, they provide historical examples where people were obliged to pay their taxes in some form of "paper money," like tally sticks. I won't go into much detail here, but Per Bylund has made a compelling case that challenges this argument, as I summed up in my article "Archetype" from a year ago as follows:
Yet, the historical facts are chosen selectively on the one hand, and on the other, they are no proof that state-issued currency is indeed money. The first question that must be raised (which Bylund does) is that even if tokens are obligated to pay taxes, there is no reason to use the state-issued token for barter between individuals.
That brings me to the central part of this text. Although I agree with Bylund that the neo-chartalist assumption is historically and empirically flawed, it still highlights governments' impact on money. Let's recall the commonly assumed attributes of money: divisibility, portability, store of value, and unit of account.
Undoubtedly, the form of money used today is divisible, portable, and a unit of account. Prices of goods and services are still quoted in national currencies, underscoring its role as a unit of account. People pay for goods and services with the money they carry, highlighting its portability, and businesses use it for accounting purposes.
However, the situation becomes more complicated regarding the store of value attributes. In past generations, people stored their wealth in the currency they used, especially when it was redeemable in "real money," such as gold or silver. This convertibility made people believe that their paper bills were equivalent to gold stored in a bank's vault.
Throughout history, there have been numerous examples of governments misusing their power and distorting the value of money, either by diluting the gold content in coins or by excessively printing such "claims." From Ancient Rome to the Weimar Republic and more recent currency crises in Argentina or Zimbabwe, the mechanism has remained the same.
While these are extreme examples, it's undeniable that even the gradual devaluation of money by governments and central banks, like in the United States or European countries, has eroded the purpose of money as a store of value. The era of fiat money, since the US abandoned the gold standard in 1971, has made this gradual erosion easier to achieve.
Critics of the state's monopoly on money creation have always existed, with Friedrich August von Hayek being one of the most prominent. Hayek wrote a book titled "The Denationalization of Money," advocating for a market-based monetary system where businesses can issue their own money, leading to various currencies people can choose from.
In a narrow sense, the world is still far from what Hayek envisioned. However, in a broader sense, these changes have been in motion since the start of financialization in the 1980s. The onset of globalization and free trade and the gradual loosening of monetary policy created a clash of contradictory forces.
Globalization and productivity growth led to lower consumer prices, while monetary policy countered these deflationary forces. On the surface, these policies seemed favorable for the economy, as inflation slowed without the threat of deflation. Whenever the economy experienced a deflationary shock, monetary authorities responded with an influx of money.
One could argue that the gradual erosion of money's purchasing power has been seen as positive for consumption because a dollar can buy more today than it will in a year or two. On the other hand, I would argue that such policies lead to a loss of trust in using money as a store of value.
Although the days when it paid off to store money at home or even in overnight deposits were long gone before the 1980s, people could still earn interest above the inflation rate if they invested their savings in longer-term products such as government bonds.
Apparently, inflation hasn't been a problem since the 1980s when the financial economy really started to emerge and expand. In terms of consumer prices, this notion is indeed correct. However, if one considers the term "inflation" more broadly, in its original sense, this is incorrect.
For example, the broad money supply (M2) grew at an 8% annual rate in the US during the 1980s. From 1980 to the end of 1982, consumer prices rose at an equal rate but then slowed down, meaning that the impact of money supply growth on consumer prices diminished. Until today, that divergence has become larger and larger, leading New Keynesian macroeconomists to believe that the money supply has a minimal role in consumer price inflation.
That conclusion, however, is a total misinterpretation, in my opinion. It partially stems from the belief that monetary expansion is somewhat neutral and affects all sectors of the economy uniformly, at least in the long term. If one recalls the "Cantillon Effect," which is still not well-known among modern economists, monetary expansion has first and second-round effects on wealth and income distribution that change the overall economic structure.
When the money supply expands, it depends on where the newly created currency units appear, raising demand and, consequently, prices. In the case of the financialization of the economy and globalization, the effect of monetary expansion on consumer prices remained relatively subdued because economic activity shifted to the Far East, increasing production there. At the same time, the US and the West benefited from lower prices.
Furthermore, long-term average monetary expansion in the US slowed considerably during the 1990s and from 2000 to 2020. Therefore, it shouldn't be surprising that inflation was lower, given that the impact of monetary expansion on economic growth also diminished. However, this doesn't mean that monetary expansion was without consequences; it just didn't show up in consumer prices for the reasons I briefly touched on.
The consequences remained mostly contained within financial markets and asset prices. Monetary expansion and decreasing interest rates led to a shift in the demand for financial assets, which accelerated with every crisis. Money and its most liquid equivalent, government bonds, became less effective as stores of value.
So, what do market participants do when they discover that money no longer serves as a good store of value? They switch from money to assets such as stocks, real estate, or gold. If one looks at the percentage increases since 1990, most of the money growth found its way into stocks, but gold and real estate also served as stores of value, shielding people's savings from rising consumer prices.
I conclude that during the last 40 years, money has already lost its function as a store of value, prompting economic actors to shift to assets to preserve their purchasing power. Whether it’s stocks or real estate, it often depends on one's wealth and income brackets. For low-wealth groups, the most important asset is usually their home, while the share of stocks and bonds increases with accumulated wealth.
Investing savings in stocks has no immediate impact on the real economy, although it does affect the economic structure by making credit access easier for companies with rising stock prices. It has secondary effects as well. People who benefit from stock-market appreciation find it easier to access credit for real economic purchases, such as real estate.
That increases the demand for housing. Young families and first-time home buyers suddenly compete with those looking for real estate to preserve their purchasing power, driving up prices. Purchasing a first home becomes more expensive, especially relative to income.
In German-speaking countries, for example, financial markets have a terrible reputation. For years, the media has claimed that investing in the stock market is highly risky and that investing in housing ("Betongold") is better due to its intrinsic value.
Hence, I conclude that although the "denationalization of money" did not occur, people increasingly switched to other, riskier assets as stores of value, and "money" itself lost that attribute long ago. This brings us back to the initial question: "What is good money?"
Let's consider Per Bylund's argument against the MMT theory of money. He concluded that the obligation to pay taxes in government-issued currency does not explain why people would use it for other transactions, especially around the time the government monopolized money production.
This has implications for the current state of money. As Bylund correctly argued, the government's monopolization of money resulted from adopting money (a commodity) already used in the private sector, like gold. The erosion of purchasing power didn’t lead to a switch to different money for transactions beyond tax payments because there hasn’t been a cheap, widely accepted alternative, at least in advanced economies.
However, in emerging markets, where domestic currencies lose value faster than the dollar, people have indeed adopted and switched to "non-government money," increasingly accepting and using dollars for payments.
Finally, I want to make a provocative claim: maybe it's time to abandon the belief that money needs to fulfill all the attributes that modern-day economists claim. In the future, people might use different forms of money that only satisfy one of these attributes. One might pay taxes in domestic currency but switch to daily payments in another fiat currency, a cryptocurrency, or something else.
For savings, one might switch to another store of value. Although Bitcoin is still highly speculative, its ability to store value long-term has exceeded every other asset or currency. It's the first currency one can transport globally without carrying physical units. Further, cryptocurrencies can be transferred worldwide without intermediaries.
Perhaps the monetary system is already experiencing significant change, which started when governments abandoned the gold standard and switched to fiat money. While this change has been slow and gradual, if it follows an exponential curve, we might experience rapid changes in the global monetary order in the coming years. Bitcoin and cryptocurrencies might not have started this evolution, but they are a result of the natural evolution of money.
Every day we're growing colder
Our divide is growing further and further
The hands of time are moving faster
When will we stop paying
The price of agony?Fit For A King - The Price of Agony
Have a great weekend!
Fabian Wintersberger
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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.