In his recent Public Discourse essay, “The Counterfeit Money of Our Casino Economy,” S. Adam Seagrave argues that many of our contemporary economic problems won’t be resolved until money is refocused on its fundamental economic function: to serve as a means of exchange. According to Seagrave, “Whenever money shows up on the end of the equation rather than only in the middle—meaning that money is both the medium of exchange and one of the goods exchanged—its value and purpose are distorted.”
Certainly, the purpose of money and finance more generally is to serve the real economy. Money makes no sense outside the world of supply and demand. It’s also true that many of the problems characterizing modern capitalist economies owe much to dysfunctions in the financial industry. That’s why we call the economic upheavals of 2008 a “financial” crisis.
That said, I would suggest that a return to what I will call “good money” necessitates serious rethinking of the role of government institutions vis-à-vis money. Herein lie the roots of significant problems in many economies today, the reasons for which become more apparent once we appreciate money’s multiple purposes and functions.
What Money Does
The first lesson in any textbook about money is that its most basic function is to be a medium of exchange. Money serves as a proxy for the value of real goods and services, which are objects of economic exchange. This, however, allows money to perform three other functions: a store of value through time, a unit of account, and a standard of deferred payment.
These functions permit money to serve two other important purposes. First, it can be an efficient conveyor of information through the price system. Prices bring a type of order to the seemingly anarchic character of market economies. Prices increase and decline in response to consumer demand and the emergence and refinement of products and services. This information allows resources to be constantly reallocated in accordance with ceaseless changes in supply and demand. Money-as-prices thus permits a coordination of millions of pieces of economic information dispersed among billions of individuals.
A second important purpose of money is to be financial capital. If money could not function as a store of value, we would be condemned to living in the type of subsistence economies that largely prevailed up until the beginning of the Middle Ages. As the Franciscan Peter Olivi (1248-1298) wrote in his De contractibus usurariis:
For since money or property which is directly managed by its owner is put to work for a certain probable gain, it not only has the simple quality of money or goods, but, even beyond that, a certain seminal quality of generating profit, which we commonly call capital.
A contemporary way of describing this would be that financial capital is created when people produce more than what’s immediately needed, make a profit, and save some of this surplus purchasing power. This financial capital may be invested to facilitate the further production of goods and services by oneself or others to whom you loan the capital.
The gradual realization that (1) money-as-means-of-exchange and (2) money-as-price-conveyor could also simultaneously function as (3) money-as-financial-capital was crucial for the identification of just titles to charging interest throughout the Middle Ages by scholastic thinkers. The process by which this occurred without contradicting orthodox Christian teaching on the wrongness of usury was carefully explained by Thomas Divine, S.J., in his 1959 book, Interest: An Historical and Analytical Study in Economics and Modern Ethics.
It’s important to note that such titles were in some way premised on the realization that financial capital in the conditions of a genuine market for investment (stocks, shares, bonds, etc.) is a productive force. When combined with recognition of the time value of money—the insight that money available now is worth more than the identical amount promised in the future due to its possible earning capacity—we start to see how those who specialize in the accumulation and investment of financial capital play a crucial role in fueling the economic growth that’s needed to take and keep millions of individuals and families out of poverty.
Stable Money Matters
If these are accepted as money’s essential functions and roles, it’s important that monetary stability prevails. This involves stability in (1) the purchasing power of money; (2) the relative value of a currency compared to other currencies (the exchange rate); and (3) the opportunity cost with respect to amounts of money available in the future (i.e., interest rates).
Monetary stability in all three areas spurs productivity and investment because it gives individuals and businesses the confidence that the prices of goods, services, labor, and capital will remain relatively constant and predictable over time. Monetary instability, by contrast, undermines this assurance and makes people wary of investing. For consumers, monetary instability undercuts their ability to distinguish what they find marginally preferable in the marketplace from what they find marginally inferior. This makes it harder for consumers to align their available resources with meeting their needs and pursuing their wants over extended periods of time.
If this is true, then we need monetary policies that prevent monetary stability from being undermined, especially by disturbances emanating from the money supply itself. The primary and long-term goal of monetary policy should thus be to keep the supply of money as “neutral” as possible. Certainly, as observed by the Nobel Prize-winning economist Friedrich von Hayek, perfect monetary stability could only be maintained if the flow of money remained constant, all prices were perfectly flexible, and the future movement of prices was very predictable. The second and third of these conditions, he stated, are unlikely to be fulfilled. Hence, when we speak of “neutral” money, we’re really talking about minimizing unnecessary friction and volatility in order to maintain some predictable constancy in exchange rates, interest rates, and a currency’s average purchasing power over time.
In more recent decades, governments and central banks have tried to use monetary policy to achieve goals besides monetary stability. In such schemas, money becomes one of several statistically traceable macro-aggregates that government institutions use to try to direct the economy in order to realize goals such as full employment.
Eventually, such policies contributed to the growth of inflationary pressures in many countries, until central banks such as the Federal Reserve used interest rates to break inflation in the late 1970s and early 1980s. Although it was necessary, this step contributed to higher unemployment for several years. Even so, few governments have given up viewing monetary policy as a means of addressing economic problems in ways that help them avoid making economically necessary—but electorally costly—decisions.
Governments on the left and right have seen monetary policy as a macroeconomic tool for boosting short-to-medium term employment, at the expense of devaluing people’s savings and their money’s purchasing power, among other things. This is despite knowing that reducing unemployment over the long term depends much more on microeconomic factors such as ensuring labor market flexibility and exorcising cronyism as far as possible from the economy.
The most recent instance of using monetary policy to avoid making politically hard decisions is called “quantitative easing.” In simple terms, this involves keeping distressed economies ticking by increasing the money supply via the central bank’s buying of bonds and other financial assets from private banks and other financial institutions. The goal is to encourage private lending, which in turn increases the money supply, thereby stimulating the economy—but also avoiding or putting off the painful process of allowing fiscally unsustainable businesses to be liquidated.
Like all addictive stimulants, quantitative easing provides short-term stimulation at the price of some undesirable long-term effects. In market economies, for example, people need to be able to distinguish between viable and nonviable companies so that they can invest in the former and avoid the losses associated with the latter’s probable failure. Quantitative easing, however, helps to keep unsustainable businesses afloat. This distorts the information that people need to make prudent investment choices. That helps to undermine opportunity cost in the economy and facilitates serious misallocations of financial capital. And this means less economic growth over the long term.
Much more could be said about the ways in which our contemporary economic challenges are being facilitated by questionable monetary policy. How all this will end is an open question. But if we are going to fix these problems, we need to recall what are money’s core functions and purposes, and what are not. That is the path to good money—and a sounder economy.
Samuel Gregg is Research Director at the Acton Institute.