Possible Insight

In Part I, we saw how Money is an emergent phenomenon.  In Part II, we analyzed how changes to the supply of  Money affect trade.  Now, we’re going to examine how expected changes to the supply of Money in the future affect trade today.

Earlier, we considered what would happen if Sally became ill and were unable to meet the ever-growing demand for new silver figurines created by population growth and innovation.  We concluded that families would increase their reserves of figurines and the frequency of trades would decrease.  A current event affected future activity.  Now consider whether a future event could affect current activity.

Suppose Sally announces that she will retire in one year.  Moreover, she declares that she has not seen any other metalsmith whose work matches her standards for beauty and quality (and most people trust Sally’s opinion).  She’ll continue to manufacture figurines for a year, so there’s no effect on the actual supply of Money today.  It will just stop growing a year from now.  But what do you think will happen?

If I lived in this country, my wife and I would put a plan into place to accumulate a greater reserve of figurines over the next year.  If there were a significant fraction of people like us, the frequency of trades would immediately begin decreasing , with the negative impact growing over time as those with less foresight began initiating reserve plans as well.  You can see the potential for a snowball effect here: a constricting supply of figurines in circulation due to accumulating household reserves causes everyone to update their plans and desire… even greater household reserves!

We should also expect a general price decrease.  Here’s why.  Bob and Brad would probably tell their wives, Sue and Sara, that they need to accumulate a larger reserve of figurines to ensure they’ll be able to trade for necessities in the future.  So Sue and Sara will thus want to increase their sales.  But when Bob goes to buy clothes from Sara, he’s going to be less willing to part with his figurines due to his accumulation plan.  How will Sara convince Bob to buy clothes so she can help Brad build their family’s reserves?  That’s right, by lowering prices.  Same for when Brad goes to buy milk and meat from Sue.  So as the frequency of trade decreases due to greater demand for reserves, prices would go down.

But the worst part would be the effect on innovation.  If I were an entrepreneur and I knew that the supply of Money would stop growing a year from now, how would I adjust my efforts at creating new products and services?  I would probably reduce them because any innovation might end up in no man’s land; people want it, but they need to use their Money for higher priority items.  Lower chance of a payoff means lower investment.  Heck, entrepreneurs with currently successful products might well stop making improvements or even stop maintaining their means of production due to the combination of an expected future decrease in demand and their own desires to accumulate reserves. Our country could actually go backwards technologically! Not surprising though if you think of Money itself as a technology. You’d expect a similar effect if metal or computers became relatively scarce.

Of course, the opposite sequence of events would occur if everyone expected a future increase in the supply of Money.  Suppose Sally announces that her daughter, Sunny, will finish her metalsmithing apprenticeship in a year and the capacity to product new silver figurines will increase (but not double, Sunny won’t be nearly as productive as Sally to start).  I would expect the frequency of trades, prices, and investments in innovation to all increase.

Now, if Sally had ten apprentices and everyone expected the rate of new figurines introduced into the economy to skyrocket, our little economy might have a problem with runaway inflation.  Similarly, if someone figured out a way to mass produce silver figurines equivalent in quality to Sally’s handcrafted ones, people’s trust in silver figurines as Money might erode.  So more is not always better.

What we really want is for Sally and Sunny to have a fairy godfather who tells them exactly how many figurines they should make to keep up with population growth, innovation, and any changes in demand for household reserves.  I like to think he’d be named Alan.  Everyone would love Alan.  Unfortunately, nobody lasts in the fairy godfather job forever. So people in our little country would eventually need to somehow harness their collective wisdom to determine how many figurines they need.

I am undertaking a Quixotic quest.  I am going to try to explain Money.  I believe that hardly anyone (including me) fully understands Money.  Even economists.  A few appear to mostly understand it.  The vast majority, even some charged with running government monetary authorities, seem to get confused by Money some of the time.  Unfortunately, we are currently living during one of those times.  In my opinion, much of the sphincter tightening economic news we have been reading about is due to fundamental misconceptions about Money by the very people charged with supervising our economy.

It will take several posts for me to complete this tilt at the windmill.  But before I get started by laying out the overall plan, I would like to thank Scott Sumner.  First, his informative blog posts on monetary policy inspired me to undertake this venture.  Second, he graciously reviewed parts of my approach.  All mistakes (and there will some, I’m sure) remain my own.

Step 1 will explain how Money is an emergent phenomenon.  Step 2 will illustrate the concept of “monetary shocks”, culminating with dispelling the fallacy of commodity money’s superiority over fiat money.  Step 3 will extend this illustration to show how expectations about Money help steer the economy.  If I haven’t painted myself into a corner by then, I may try to push my luck even further.

So let’s tackle the concept of Money as an emergent phenomenon. I claim that Money will emerge out of a desire to trade.  As a didactic device, I propose analyzing an imaginary country.  All the adults are married, the women do all the selling, and the men do all the buying.  Conveniently, all the women’s names start with S and all the men’s names start with B.  The reason for this device to create an explicit need for households to coordinate production and consumption behaviors. So let’s start by examining this country back in a time before Money existed and barter was the only means of trade.

Sue is married to Bob and is shepherd.  Sara is married to Brad and is a seamstress.  Sally is married to Billy and is a metalsmith.  Now, suppose that Billy needs clothes for his children.  He must to go to Sara and trade metal objects made by his wife for those clothes.  Unfortunately, Billy can’t just go and trade with Sara.  Billy doesn’t have enough information about the relative production value of the various metal items his wife could make to trade.  Moreover, Sara doesn’t have enough information about the relative consumption value of those metal items because that’s Brad’s responsibility.  So Sally & Billy and Sara & Brad must all get together to arrange the trade.  In many cases, the expected value from the trade won’t be worth the hassle of getting them all together, so they won’t bother.

Now, let’s consider trades between the Sue-Bob and Sally-Billy households.  Sue always has a supply of wool and sometimes has a supply mutton.  Of course, wool is useless by itself to Billy.  So if Bob needs metal items from Sally and his wife hasn’t slaughtered any sheep lately, Bob has to first go to the Sara-Brad household.  As a seamstress, Sara can always use wool.  After he trades for clothes, he can go back to Sally-Billy who always have some demand for them.  Of course, he doesn’t have enough information about the Sally-Billy clothing preferences to tell Sara what he wants.  Moreover, we have the same household coordination problem as before.  So Sue & Bob, Sally & Billy, and Sara & Brad all have to get together to hash out a trade or one person has to go back and forth among the others until they converge on an acceptable series of trades.  This inter-household coordination cost is even higher than the intra-household coordination cost discussed above, so even fewer of these trades are worth the hassle.

Notice that a lot of potential trades won”t happen because the transaction costs are greater than the expected gains.  Then one day, something important happens.  Sally makes a little silver figurine for her and Billy’s daughter, Sunny.  Bob sees it one day when he’s over completing a trade and wants one for his son, Bert.  Pretty soon, all three families and everyone in their town is in the grip of a silver figurine collecting craze.  Almost everyone wants to trade for figurines.  Everyone knows almost everyone wants to trade for figurines.  So even those people who don’t care much for the figurines know they can easily trade them to people who do want them.

Billy finds he no longer needs to bring Sally along when he trades with Sara.  Sally can simply give him five figurines to trade for clothes because they know roughly how much clothing Sara will trade for figurines.  Things also get easier for Bob when he needs metal items from Sally.  He can just trade her some of his figurines for other metal items.  Even though she can make figurines herself, especially because she makes them herself, she realizes their value in terms of trades that Billy can make down the line.

So Money has emerged.  It didn’t have to be figurines.  It could have been turquoise, salt, or leather.  The key ingredients were that it was relatively portable and a group of people began expecting everyone in the group to accept it in trades.  Within the group, the item’s trading value became common knowledge (in the game theory sense of the term).  In this case, a collecting craze precipitated this mutual agreement.  In other cases, it could arise out of established tradition, explicit negotiation, or random discovery.

Notice that Money adds value.  It’s not merely an accounting fiction.  All sorts or trades that weren’t possible before become possible, creating new sources of value.  Moreover, a lot of trades that did occur previously now produce more value because they cost less to make.  So there’s a lot of “pull” for Money to emerge.  Once it happens, there’s an equilibrium that will tend to hold unless perturbed.

Moreover, once Money emerges, it’s like any other technological innovation such as electricity or steel.  It becomes embedded in the pattern of trade across the economy.  People will be out and about more often because there will be more trades to make.  Hey, that means more restaurants and hotels.  Smaller trades become possible.  Hey, that means whole new markets for accessories to larger items.  Trades across larger distances become practical.  Hey, that means more regional specialization of industries.  And so on.

But what happens to this network of effects if something undermines common knowledge foundation of Money?  We’ll explore the possibilities in the next post.

a small country where all the adults are
married, the women do all the selling, and the men do all buying.
Conveniently, all the women's names start with S and all the men's names
start with B.  The reason for assuming such a fantasy world is to create
an explicit need for coordinating production and consumption behaviors
in households.