EFTA02726077.pdf

Money as a Social Contract Lecture 2—Transcript Lot me begin this lecture by telling you this story of how I came to own the interesting item that I am holding. Several years ago during the Christm as holiday, my family was visiting my wife's family in Great Barrington. Massachusetts. A baking frenzy was underway, and I have no skills, so I was sent to a specialty store to gel some needed spices. While there, being a curious person and it being Christmas. I looked around and saw this item, and I asked the proprietor what it was. The proprietor came and looked at it and then answered, ••It is a block of pressed tea. Tea." So I picked it up and looked at it carefully, and I turned it over and saw the repeate d pattern that had been molded onto the back. And then it hit me. I recognized that I was holding a lot more than a block of pressed tea. I was holding money. In today's lecture, I will trace the origins of money from its earliest uses until our modem day. I will argue that money has evolved substa ntially, and I will identify $ stages in this evolutionary process. First, barter, where money is not used: then the earliest use of money using a commodity something intrinsically useful, but using it in a different way as money . And then, a form of money with which we are familiar, coins. Finally, we will come very close to the present day with phase 4 and take a look at paper money, but paper money somehow backed by coins. And finally, the fifth stage of the evaluation, fiat money: money that is valuable because the government says it is valuable. But first we need a working definition of money. What does he mean, you might ask, when he says money? I will give you the standa rd definition used by economists. Money is something that can be used as a medium of exchange. So. what does that mean? When we make a trade, when we make an exchange, money is something that can be used in that trade and that exchange. But the most important idea of today's lecture is not the definition of money. That is easy. It is that a person values money nor because it is intrinsically useful, but because it can be 'Sethi in exchan ge. It can be used to buy other useful things. 999ELZZO La—Vida 25 EFTA02726077  The connection between money and exchange will help us to understand Primitive societies face tremendous incentives to lower the cost of barter the most important point of today's lecture: that money is a social contract and often settled on successful schemes even including credit arrangements. that lowers the cost of trading and has evolved gradually through time. That Think about that. Primitive societies where there was no money, nevertheless, gradual evolution is not an evolution that was too slow. It was necessarily were able to come up with arrangements where someone would give their slow because as the contract evolved, trust was built. meat today, but receive payment a little bit in the future in order to facilitate the trades that made that society better off Let's talk about the first phase in the evolution of money. barter, which is no money at all. Jevons, in a famous book called Money and the Mechanism Well Adam Smith, again in the Wealth ofNations, suggested the next state of Exchange. said, and I quote, "The first difficulty in barter is to find 2 in the development of money when he said. and I quote. "Every prudent man persons whose disposable possessions mutually suit each other's wants." in every period of society ... must naturally have endeavored ... to have at So, mutually suit each other's wants: "There must be a double coincidence, all times by him ... a certain quantity of some one commodity or other, such which will rarely happen." Double coincidence? What does that mean? as he imagined few people would be likely to refuse in exchange." As Smith suggested, the next stage was the development of commodity monies. Well, you imagine 2 members of an early society. Let's call them Mark and George. Mart is a very skillful hunter who regularly comes back to his A society uses a commodity money when individuals typically buy and sell the village with more meat than his family can eat. What about George? He is goods they want by offering in exchange a particular commodity that is agreed the best axe maker in the village. He is really good at finding and crafting the upon in the society to be acceptable in exchange. Commodity money has taken right kind of axe head and then lashing it to a good piece of wood, so that many different forms. Salt was used in many societies and many different it works very well. The question is: Can Mark and George trade? Mark has geographic locations. Cowrie shells were used—I have some—in Indochina meat to offer, but he may not want an axe. lie may already have one. George and in Pacific regions. We do not know exactly why, but cowrie shells are probably wants meat, but he only has one thing to offer and that is an axe. beautiful, and they are available, but it takes effort to collect them. Economists That is what Jevons meant. Not only do I have to something to offer, but I would say that cowrie shells are scarce because of the effort it takes; and it have to have what the counterparty, in exchange, wants. may be that cowrie shells were used as commodity monies in areas where the political leader, the chief, liked wearing cowrie shell necklaces. The search for such a narrowly defined trading partner—meat, axe, meat, axe—is costly because it takes time to find someone who wants an axe and There arc other famous examples of commodity money. Pretty much has meat to trade. Indeed, an axe maker might trade his axes for, say, grain everyone in school has seen these pictures of large stones on the Island of only because he thinks it will be easier to find someone who will trade meat Yap. That is an example of commodity money. Back to my tea brick, tea for grain than someone who will trade meat for an axe. Wow, that is wasteful bricks were used as money in inner Asia. And that pattern that I pointed out to right? Not wanting grain, but buying some just because you can then trade you on the back? Why was that there? It was there to make it easier to make it away? change. It allowed that tea brick to be broken into smaller uniform pieces. It was a device that made that block of tea more efficient in facilitating trade. 699£LZZO La—Vida The costs of locating trading partners and negotiating trades are disincentives to specialization. They lead George to be less willing to ply his trade as an axe Before we leave commodity money, I want to point out that government maker, where he is really excellent. In fact, if the costs arc high enough, the often played a role in deciding what commodity would function as money. best axe maker in the world may decide to split his time between making axes Animals such as oxen or birds were more likely to be money in societies and raising cattle. That is a waste, and you know what, economists hate waste. Where live animal sacrifice was required. If the ruler favored a certain kind 26 27 EFTA02726078 of shell or feather, it might become money. Keep in mind that the commodity We have already argued that governments play an important role by coining chosen as money would have to be scarce. If anyone could pick up unlimited money. It is solving the problems of weight and measures, and governments quantities of money from the seashore or the backyard, then no one in his typically derived important revenues from its coining operations. The right mind would give up something that he worked to produce in exchange governments owned the mints that converted raw metals into coins, and they for those shells or feathers. collected fees from those who sold metal to the mint. Ah, ha! But the owner of the mint, the government, could also raise revenue by lowering the metal Well, as we think about the evolution to the next phase of money content of its coins. development, we have to realize that primitive peoples traveled beyond their borders of their homelands. When they did, they frequently found that what The word "seigniorage" denotes the revenue that a government obtains by they considered to be money at home was not accepted by potential trading deflating the value of its money and that word, "seignioragc," derives from partners in the new lands that they visited. But what they did observe was the French word for "lord." Now, when I say "lord" here, I mean lord of the that metal, especially gold. silver, bronze, copper, and iron, were valued in manor, the seignior. How does seigniorage work? It could be as simple as other lands. Indeed. Captain Cook on his voyage was able to give iron nails shaving metal from the edges of the coin, or it could be as complicated as from the Endeavour to the peoples he visited. They liked to have those nails. changing the price that the mint offered for metal to be coined. It was a big So, the next stage of the evolution of money was the use of metals and the deal, this seigniorage revenue, a big deal for government. coining of those metals. In 1542, Henry VIII earned—this is a staggering statistic-6 times the normal Several forces favored the use of metals rather than other commodities as annual crown revenue by lowering the silver content of English coins. Six money. Metal was more likely to be useful in trade in other lands because times. Every day, we handle quarters and dimes minted in the United States it could be used to make a variety of useful goods such as knives that were and every day, if we think about it, we realize that those quarters and dimes used throughout the world. Metal was durable, and typically, metal was are fluted. They have fluted edges. Why? Was it the coin maker's art? Not more valuable, per unit weight, which made the cost of transporting it on at all. It was a very practical reason. The ridges in our quarters and dimes a trade mission sufficiently more efficient. But, there wcrc 2 important derive from the early attempts to assure the coin owner that the coins had not disadvantages to the use of lumps of metal as money. It was costly to verify been shaved. Well, there is no silver in our quarters and dimes anymore, so it the true metallic content of a lump and that purity of that lump. Remember is no longer necessary, but that is why those ridges are there. all that glitters is not gold. It was also costly to weigh the lump. The transition from coins to paper money is rooted in the practice of allowing But by creating coins from metal, eovernment again played an important citizens in many civilizations to deposit their goods in temples and palaces. role. They lowered the cost of using metal as money. Coins are very old. The This is a very old practice. Temples and palaces were not only places of earliest known coins are from Lydia, which is in modern Turkey, from the worship. They were not only places to which you came to offer sacrifice, but 7th century B.C. Copper. bronze, silver, and gold coins arc widely found in they were places that were secure and well guarded, and they evolve to take ancient Greece and in ancient Rome. Words in use today trace their origins to on the role of protecting the wealth of their citizens. In Babylon. by 1000 early coins. We have heard of the phrase "the pound sterling." But a sterling B.C., private deposits were accepted at the Babylonia temple. Even the Code was originally a silver penny used in England by the Normans at around of Hammurabi set out the rules for those deposits. Officials issued receipts to 1300. Today, sterling has a technical meaning, an alloy that is 92.5% silver. depositors and allowed them to transfer their deposits to third parties. How about the word "dollar"? The word "dollar" derives from the German word "Thaler," which was a minted in Bohemia in the early le century. 28 29 EFTA_R1_02213660 EFTA02726079 So the next step in the evolution ofmoney is the use of money that is backed steps. In August 1971, United States President Nixon temporarily suspended by metal such as gold or silver, but itself takes on paper form. The origins the convertibility of the U.S. dollar into gold and made that suspension of this paper money are the warehouse receipts that we just talked about. permanent in 1973. Those receipts are receipts given by depositors for the precious metals that their customers left or their temple worshipers left in their possession. The So we come then, to the final step in the evolution of money from barter warehouse receipts began to function as money, not when the metal was where there is no money, through commodity money, through gold coins, deposited. but when third parties traded them for commodities rather than to fiat money; money that is valuable by fiat. It is valuable because the withdrawing their deposits. Let's think of an example here. government declares that it is valuable. So. let's do a kind of experiment here. Pause for a minute, reach into your pocket, and take out a dollar bill. So, I have deposited, kt us say some gold, at my temple. I have received a This is a little bit like a scavenger hunt. Search on that bill for evidence paper receipt. I now, say weeks later, wish to make a purchase for my home. that that bill is not just money, you knew that, but fiat money. You're doing I go to the individual who is going to sell me what I desire, and instead of it? Well, you will not have to search for long before you find the words, first going back to the temple to get the gold, I simply present my warehouse •"This note is legal tender for all debts, public and private." Folks, that is the receipt. I, in a sense, sign it over to the person from whom I am buying. When clear declaration that our money, the U.S. dollar, is valuable because the U.S. that third party, the person who is selling me goods, takes my warehouse Government says it is. receipt and thinks of it as her own, or his own, that is when those receipts begin circulating as money. In 1844, the Bank of England established a rigid link between the amount of paper money in circulation and the gold reserves of the Bank of England. Marco Polo found money printed on mulberry bark in China in the 13th This meant that the supply of money in England would fluctuate with the century. In the west, London goldsmiths gave receipts for gold deposited gold reserves of the bank and with the availability• of gold in general. For with them, and those receipts functioned as money in the I7th century. The example, discoveries of gold in the new world led to rising prices of goods in use of paper money lowered exchange costs since it was a heck of a lot easier terms of gold. As gold became more plentiful, its value decreased. to exchange warehouse receipts than the actual deposits. For one thing, the receipts were for a particular quality and quantity of gold, and the receipt It was typical for the next 130 years for western economies to back their actually said that. If you handed over the gold, you would have to weigh and paper money with gold. In most cases, paper money was convertible. it and assay it again. Holders of the paper money could demand gold in exchange at a rate set by the government. So they could bring their paper money to the government Ah. and here is a very subtle, but very, very important step in the evolution. and get the predefined amount of gold whenever they wished. Ah, ha. But in Think about the people who are managing the depository: the London times of national emergencies, obviously World War 1 and then again, World goldsmith. We will talk about that London goldsmith in detail in another War II, nations, United Kingdom among them, abandoned the gold standard, lecture, but let's just get a highlight. Those goldsmiths soon realized that and it suspended the convertibility of their currencies into gold. Why would they could make loans to new parties by issuing new warehouse receipts. they do that? The scheme worked because on any given day, only a very small fraction of the people who had deposited gold with those goldsmiths actually tried Well, suspending convertibility allowed nations to finance some of the to get it back. So, here we are with money as gold or silver or copper coins. costs of the war by issuing more currency than their gold stocks would But we know that that is not our money today, so what happened? The final have previously permitted. They wished to buy more munitions, buy more demise of the gold standard, according to Angelo Redish, occurred in 2 soldiers, and buy more of all the other war goods that were required, and they 30 31 EFTA_R1_02213661 EFTA02726080 did not want to be limited by the amount of gold in their repositories. But. something of intrinsic value, a pound of nails, for something of no intrinsic at the end of World War I and again at the end of WWII, nations did return value, a British pound note. That trust had to be developed very slowly and to the gold standard. But they quickly experienced problems, problems that had to be developed in the context of the codes. the laws, and the belief of they had not had before. the society that began to accept different forms of money. The supply of gold was growing too slowly and also too erratically to allow Third, the contract has developed as it has because members of society the supply of money to keep pace with growth in the world's developed have constantly sought to meet 2 goals. I have always found that those economies. Money in the form of gold was not growing as rapidly as goals to be in competition with one another. They have constantly sought production in the post-World War II economics of the nations of the world. ways of changing the money contract to lower the cost of trade. We want So for a time, the International Monetary Fund, and we will talk about trade to be efficient and inexpensive, so that we could do more of it. But them in a future kcture, attempted to keep the gold standard working by at the same time, we have wanted to make sure that we adopt a money that supplementing the supply of gold with paper gold that were called special holds its value. Throughout history, government has played a crucial role drawing rights. But, the gold standard ended, as Redish reminds us, with in development of the money contract. From coordinating the choice of a President Nixon's decisions to suspend convertibility, to make a break particular commodity. to ensuring that the contracts made by goldsmiths between the number of U.S. dollars and the quantity of gold held by the were honored so those goldsmiths did not just renege, to setting up rules for United Stales. the coining of precious metals, to developing laws that define the powers and responsibilities of the Federal Reserve. Today, in western economies, we have pure fiat monies that are backed by no commodity at all. The money is valued partly because governments So, government is essential to organization of monetary arrangements, and declare the money to be "legal tender for all debts public and private." But that is not surprising. We are government. A fiat money system is highly ultimately, money is valued because people agree it is valuable. It is valued efficient. Valuable metals such as gold and silver are not tied up as backing because people agree to accept money in exchange. It is valuable because for money but are released to alternative uses in electronics, jewelry, and people believe they can accept money and then turn around and purchase many other purposes. The Federal Reserve can allow the supply of money useful things whenever they wish. to keep pace with the growth in our nation. But our fiat money holds its value only if our Federal Reserve keeps the supply of money from growing Four important themes have emerged from our examination of the evolution too rapidly. If the Fed fails, inflation results, and inflation is the modem of money. First, money is truly a social contract in which the members of a counterpart to seigniorage. society agree to accept money in exchange for goods and services. It is an act of faith for me to give something that is truly useful, an axe or a pound Thank you very much. of meat, in exchange for a piece of paper that really would not even do a very good job of lighting a cigarette or starting a fire. It is true that the words "In God We Trust" are printed on the back of our bills. But if we want to understand why the dollar has value, we would be far better off with the words, "In One Another We Trust." Second, the social contract that is money has developed gradually through history because it has taken time to develop the trust necessary to exchange 32 33 EFTA_R1_02213662 EFTA02726081