What If I Was Nothing

An Essay On Money

Another week where I am out of the office and cannot write about current market developments. This time I wrote a little essay about something everyone knows but hardly knows anything about.

Of course, I am referring to money. Although everyone is talking about money, hardly anyone knows what money actually is. Even in economics, it is relatively hard to explain what money actually is. Most economists define money in the same way as most textbooks do.

According to the definition, a good must fulfill at least three functions to be considered money.

• Market participants use it as a medium of exchange

• It is a store of value

• It is used as a measure of value, which means that one can compare the prices of one good with others using it.

Most discussions about money are about whether commodity money, covered by a commodity, is better than paper money or fiat money. Today’s fiat money is paper money, which the state declares as legal tender.

While one side argues that commodity money is limiting the influence of the state, proponents of fiat money (although I prefer the German description by Ludwig von Mises, ‘Zeichengeld’) point out that a growing quantity of money is boosting economic growth because it’s slow devaluation is encouraging investment. That is why central bankers define an inflation rate of two percent as stable prices.

While modern economists represent the theory that money needs to fulfill all of the three functions from above, I want to question that in this essay. At least theoretically, it is possible that if politics does not intervene in the market, different forms of money or goods serve other purposes.

It is considered that money was a prerequisite for humankind to increase prosperity over time because an intermediary exchange good that two parties use in a goods exchange makes the trade easier if the parties do not know each other.

Initially, trade probably played only a minor role in ancient times because hunters and gatherers were roaming in small groups. Within these groups, everyone contributed to it by sharing the fruits of his own labor with everyone.

On the one hand, the community-made sure that no one needed to starve when one had a bad day and contributed nothing, and on the other hand, the community offered protection from attacks from outside.

From the moment humanity abandoned nomadism and started settling down, trade within the community gained importance. For exchanges within a community, likely, money did not play a significant role, and barter dominated. However, it is essential to notice that it is possible that goods were not exchanged immediately within the community.

More likely, the group had invented a simple form of bookkeeping, and goods were exchanged at different points in time. Assume that two people exchange meat for wheat, where meat is delivered in spring while the grain is harvested and delivered in the fall.

Such transactions heavily rely on the trust between trading partners, which establishes very fast in a small community because providing each other with various goods is necessary to secure one’s existence.

Indeed, it seems that book-keeping systems already existed in barter economies. The fact that trading partners knew each other and trusted that every side would fulfill its part of the barter narrowed trade possibilities.

If one wants to trade with an unknown counterparty, old-fashioned bookkeeping is reaching its limits. A merchant traveling into another area can hardly exchange his goods with a native if she does not accept the offered good. Further, there is also the possibility that she would not be able to buy a good if the good she provided was not of interest to the native.

The solution is obvious: An intermediary exchange good that both trade parties accept.

At first sight, it is irrelevant which good it is. Different types of commodity money were used worldwide: shellfish, diamonds, gold, silver, and so on. As long as bot trading parties assign value to the good, it can be used.

Now, if we ask ourselves if the value of the exchange good was stable, I tend to the answer that the price fluctuated for a long time until it leveled off. One can assume that the price fluctuated from area to area and was volatile, depending on how many other market participants were willing to accept the intermediary good.

Let us assume that, at first, gold bracelets were used as a medium of exchange. The valuation of such bracelets probably differentiated heavily, but more and more market participants may have accepted it in exchange for their goods over time. The more people value the medium of exchange; the faster prices reach equilibrium.

As a result, the increased use of gold in trade might have led to the effect that gold became money. As larger unities (principalities, duchies, kingdoms) developed, it was only a small step that the ruler declared gold legal tender. However, it is possible that money was primarily used by the rich, while the poor citizens from the countryside mostly used some bookkeeping system.

Before the industrial revolution, savings probably played no or hardly a role. As the division of labor moved forward, the use of the money might have also reached poorer classes. Nevertheless, this does not mean there were no savings before the industrial revolution. Still, the significant rise in the number of goods produced after the revolution that now also the poor could afford made it possible for poor people to build savings. A rising amount of savings leads to higher investments and more possibilities to produce more goods.

So, one can conclude that money was primarily used to exchange goods and compare the value of different goods, while the savings component gained importance much later. The fact that the creation of money in recent (and also ancient) history was always seized by the ruler mainly caused a devaluation of value until the value was restored after default or currency reform. However, during the devaluation period, a lot of wealth was redistributed.

During the period of incredible economic growth in the 19th century and before the first world war, global trade based on a gold standard. The fixed exchange rate for gold encouraged people to build up savings because they kept value because of the peg. If the value of money remains constant, and there is no, or minor, inflation (inflation in the classical sense: inflation = expansion of the money supply in the real economy), market participants can save almost risk-free via holding the gold-pegged money on savings accounts.

As we all know, money savings depreciated over time due to inflation. While the ancient kings and emperors devalued the currency by lowering the purity of the empires’ coins, it is easier nowadays because money is created on the computer.

However, as we all know, through all stages of history, money lost more and more of its store of value function over the years. Even in German-speaking countries, where most market participants park their savings in bank accounts, more and more people look for alternatives to store wealth.

If analysts talk about the fact that investors move farther out on the risk curve, from low-risk investments to riskier assets, this is the observed effect. If the price rise is higher than the interest rate on money offered by the market, money loses its attractiveness as a savings good. So, instead of parking cash in a savings account, market participants start to buy other goods to store wealth.

When bond yields were above inflation, one could easily save by buying longer-dated government bonds. Until today, those are a foundation for every pension funds investment portfolio. However, it gets tougher and tougher to realize the yield they promised investors 20 years ago because of the downtrending interest rate environment.

As I noted before, this causes investors to look for higher-yielding investments, even though they are riskier. The demand for other, limited, tangible assets, like equities and real estate, rose. Gold had a comeback, too, and enjoyed a rise in demand. Rising demand for not arbitrarily multipliable goods leads to higher prices of the goods. The growing quantity of money and decreasing interest rates further fueled demand for those assets but also caused unintended consequences.

People who already possess assets could use them as collateral to borrow money to buy more assets, while households with little income had to pay more and more for their first home. Although the total payment (loan + interest) remained stable, the (artificially) depreciating interest rate environment made it harder for many households to build up savings they could use their funds if they wanted to buy a house.

Thus, I challenge the argument that our current fiat money is still used as a store of value. The only currency where this might still be true is the US dollar, which bases mainly on the fact that it is the world’s reserve currency that enjoys a rise in demand in uncertain times.

The importance of money savings has lost its significance over time. Nowadays, most people buy real estate to secure their savings. As I already noted, this causes a spike in housing prices, as houses are used not only to satisfy the basic need for shelter but also as an investment.

To underline this worrying development, I want you to assume what would happen if food suddenly became a store of value. Rising demand for food would lead to skyrocketing food prices, making it harder for people with lower incomes to buy food. I know this is a fabricated example, but it underlines that one could become worried when a basic need, shelter, becomes an investment good.

Housing has become a money substitute, where the house itself backs the ownership certificate. Broadly speaking, this is similar to gold-backed money, when banknotes simply represent the claim for a certain amount of gold, although, unlike banknotes, it is not used for basic transactions.

Therefore, I do not think that currency must fulfill all characteristics to be considered money. I would assume that different currencies would be used for various purposes if there were a free market. Hence, I briefly want to touch on the subject of forms of money. Ludwig von Mises distinguishes four different types of money in his Theory of Money and Credit:

• commodity money (like gold coins)

• money substitutes (for example, the dollar in times of the gold peg)

• credit money (which comes into existence when banks loan money)

• fiat money (Zeichengeld) (money without inherent value)

As previously noted, fiat money has an advantage compared to commodity money: the lower cost of production, which makes it easier to adjust it to international trade requirements. Another one is that if trust is lost, a shrinking of the quantity of money in circulation can stabilize its value. However, the dominant disadvantage is that paper money is declared legal tender by the state, and the state has an incentive to expand the quantity of money to cover its expenses that cannot be funded via tax receipts. Voltaire was right when he noted that paper money eventually returns to its intrinsic value: zero.

However, if, as the example with food as a form of investment above shows, tangible goods from the bottom of the pyramid of needs became money, it would be very problematic because now investors are competing with people who demand the goods to fulfill their basic needs.

As housing became arguably the most important form of investment for the middle class and living space has become significantly more expensive, it is now farmland that has received investors' growing interest.

Rising farmland prices put more pressure on food prices, as many farmers rent land and now have to pay higher fees.

The same phenomenon can be observed in the gold market. If gold was not a save heaven asset, would it have the same price? If it was only used for bracelets, necklaces, and electronics? In 2021, the share of central banks and investors in total gold demand was 36 %. Of course, it is debatable whether supply would also fall if demand is falling by 36 %, but a fall in demand by 36 % would, if nothing else changes, result in a much lower price.

So, once it was observable over time, while the supply of fiat money grew (or the market perceives it that way), people looked for alternatives to store wealth and purchasing power. They moved to gold, real estate or equities, tangible assets, so to say, which drove up the exchange rate of those goods to the currency.

All those things have one thing in common: they have a use-case apart from using it to secure purchasing power. Gold (and silver) for jewelry and electronics, real estate as living space, equities shares as participation in a company. Usually, when people talk about it, they argue that those things have intrinsic value, although this is not entirely true because the value is purely subjective.

If people lose interest in gold and silver and industries discover ways to replace them in electronics, prices might indeed fall to zero. Individual stocks can drop to zero. Housing is a little bit different because one can always use it as shelter, so probably, it will not fall to zero.

As we approach the end of this essay, I want to discuss if it is even desirable that people use a good as a store of value with another use case. While this is more of a philosophical question that can be answered in both ways, this question especially is of interest to housing. As I mentioned various times here already, housing has become the store of savings for the middle-class. Demand for accommodation for a store of savings purpose makes it harder for households at the beginning of their wealth-building to buy a home.

Over time, economists and journalists have promoted that form of investing and thus are at least partially accountable for the extreme demand for housing. What could be an alternative? The first thing that pops into mind is gold. Why does the middle class not buy gold instead of houses?

Because gold is often labeled as bad, I think. Keynes once said,

In truth, the gold standard is already a barbarous relic (A Tract on Monetary Reform (1923), p. 172)

It does not pay yield like bonds and has no actual use case (critics argue), while one can always live in a house.

Interestingly, gold bugs use similar arguments when the discussion is about Bitcoin, and I mean Bitcoin, not Crypto. Bitcoin is decentralized, while other crypto is centralized. No one can create more bitcoin or change the rules. It is minted digitally, which is why some people call digital gold. Because of that, it has the properties of commodity money.

On the other hand, Bitcoin is also some form of fiat money because, just as paper money, it has no other use case. That is why many people are skeptical about Bitcoin (and gold). That is probably why so many people prefer to buy real estate instead of gold or Bitcoin because of its intrinsic value. But when it is about finding a better form of (savings) money, why is it a disadvantage if money is only a unit of account or used to protect savings?

Philosophically speaking, one probably could argue that it is an advantage if money is just money and is not used for something else, like houses, stocks, or gold. Only people who want to save or speculate about a potential rise in value use it. From a moral standpoint, would it not be better for speculators to be active in the Bitcoin market than in the housing market?

In the end, the Blockchain is simply an accounting book. In a way, it is similar to the basic bookkeeping system that humanity used for trading in ancient times. A simple billing system, where the unit of account, the exchange good, has no value. However, in contrast to ancient times, it does not matter if the trading parties know or trust each other because the transaction is saved in a global cash book. Probably, Bitcoin is not the future but a way of bringing the past into the future.

Have a fabulous weekend!

Fabian Wintersberger

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