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What role does money play?

Money was and is a substitute that enables traders to simplify the exchange of goods. The prosperity of our society is based on the division of labor and the exchange of goods that have been produced, harvested or extracted from the earth.

In “PRINCIPLES OF ECONOMICS” (1871) Carl Menger* (mathematician and Austrian economist) wrote the following:  

“As each economizing individual becomes increasingly more aware of his economic interest, he is led by this interest, without any agreement, without legislative compulsion, and even without regard to the public interest, to give his commodities in exchange for other, more saleable, commodities, even if he does not need them for any immediate consumption purpose. With economic progress, therefore, we can everywhere observe the phenomenon of a certain number of goods, especially those that are most easily saleable at a given time and place, becoming, under the powerful influence of custom, acceptable to everyone in trade, and thus capable of being given in exchange for any other commodity. These goods were called Geld” (i.e. money) by our ancestors, [...].” (p. 260)

Here, Carl Menger describes how through the exchange of goods, money was brought into being by individuals without any mutual agreement. Over time, people began to exchange their own goods for other goods that they did not need or want to use themselves. They were only willing to do this because they were convinced that they could exchange these new goods quickly and universally to satisfy their own needs or desires. These means of exchange therefore had to be in demand by a vast majority of the people. As time went on, people employed fewer and fewer goods as a means of exchange, because they preferred to use only the means of exchange that had the greatest marketability. About 1000 years ago, “money surrogates” (convertible claims on goods) were developed for the first time and used as a means of exchange. At first, however, they were only coveted because they could be converted into commodity money at any time. But today, almost exclusively only fiat money is exchanged (which means former money surrogates that will never again be convertible into commodity money) because governments only accept such money as payment and legally require all citizens to accept it.

Money is only money when it is a store of value and is thus in scarce supply and cannot be readily duplicated. Until World War I, the Western countries therefore had a gold standard. This guaranteed that the vast majority of the money issued in the respective countries was backed by gold. And this meant that paper money represented nothing else than a sales receipt for gold that guaranteed the holder of the receipt the right to exchange it at any time for gold from the issuer.

In this way, it was impossible for governments and banks to entice and buy people with unfinanceable (election) promises through the creation of debt money (without backing).

The gold backing was gradually abandoned over the past decades. Since 1971, we have a system that allows governments to create money at will through the central banks.

Since money is no longer a scarce good if it can be created at will, it inevitably loses value. Looking for example at the history of the USD since establishment of the Federal Reserve System (US central bank) in 1913, one sees that the currency has lost more than 95% of its value in this period. This makes it clear that the necessary stability has been lacking for quite some time. Cheap money inevitably leads to bubbles in existing assets.

The unrealistically high valuations that result from this reflect only the inflation building up, concentrated within a few of these “asset classes” such as stocks, real estate and bonds. These assets are purely of a virtual nature. Be that as it may, bubbles always come to the same end, they burst.  

*More on this topic by Carl Menger is available at:

http://docs.mises.de/Menger/Menger_Grundsaetze.pdf (German)

http://mises.org/books/origins_of_money.pdf (English)