In what kind of economy do we live and operate our daily lives?  This is not a trivial question.  As ideas about how human beings can best organize their resources developed into enlightenment philosophy, a prominent method for expressing what a society free of the feudal constraints would look like involved imaginary stories.  Philosophers, such as John Locke, Thomas Hobbes, and Jean-Jacques Rousseau asked their audience to imagine a place called the state of nature to consider possible social outcomes when this place is populated with free individuals.  In the state of nature, will chaos, barbarism, or a harmonious stable society result?

In Locke’s version, individuals needed to follow two constraints or simple rules in order for a harmonious and stable society to emerge.  The first of these constraints is the spoilage constraint.  In the state of nature, no individual should collect more food, nuts, and berries than they can consume before they spoil.  Second, the prejudice constraint cannot be violated.  This constraint is “predicated on the right to subsistence: the privatization of land [can]not disadvantage non-property holders, violating their right to subsistence goods.”[1]  As long as all those in the state of nature follow these two simple moral constraints, then a harmonious and stable society is argued to emerge.  Through the evolution of similar stories, political economist would add their own plot twists and establish the setting for neoclassical economics.

What these imaginary stories have in common is the collective illusion that capitalism or free-market economics grows out of a state of nature.  The basic plot and stage for this story remain the same in neoclassical economics.  How many of you got dressed and ready for your classes today in the Cartesian plane?  Like their enlightenment predecessors’ use of the state of nature, the neoclassical story also takes place in a space that is not inhabited by human beings.  The mathematical universe of maximization and optimal decisions, like Locke’s imagined individuals, aggregates to a harmonious and stable solution.  This solution is known as equilibrium in the formalized mathematical models of neoclassical economics.  While the technical names and the math provide the neoclassical story with a scientific veneer, the underlying plot remains generally the same as those told over the previous four hundred plus years.   A strong characteristic of these stories is their staying power, but a significant cost of such longevity is a lack of analysis regarding the actual economy in which we live and conduct our daily lives.

The economy described by Jean-Baptiste Say[2] and other classical political economists of his era, as well as by modern neoclassical economists, is a barter economy.  In a barter economy, goods trade for other goods.  If we were to open a barter market in class, students could trade their hats, backpacks, books, shoes, and whatever else they had in their possession with other students.  In this scenario, would much trade occur?  Generally, the answer would be no.  This is because it would be rare that the double coincidence of wants would be solved very often.  This means that for trade to occur I must have what you want and you must have what I want.  If and only if this is the case will trade occur because trade must make us both better off than we were before the trade took place.  To solve this problem and reduce the amount of time individuals would need to spend seeking out solutions to the double coincidence of wants, society spontaneously agrees to accept a commodity as the facilitator of exchange—or at least this is how the story is told from the state of nature and Cartesian plane origins.

The magical device that solves the double coincidence of wants and sets the economy free is money.  Commodity money in the form of gold or silver has an intrinsic value that can be measured and all parties understand its value.  Intrinsic value is a key concept and can be defined as the value the object has in and of itself. This is why precious metals are central to this story, as it is believed gold has value in and of itself.  Thus, through this agreement, the transaction costs for all the producers and consumers in this economy are reduced and are therefore better off.  This is the story often told by a group of economists known as the Metallists, because of the use of precious metals to denote the value of money.  We can model money as the facilitator of a barter transaction using the following notation of C for commodity and M for money.

This is likely the story you have heard before, and it is definitely the one told to your parents in their introductory economics courses. As mentioned above, it is an old story.  Roots to its origins go as far back as Plato and Aristotle, but the more modern versions are linked to the 16th and 17th-century enlightenment philosophers discussed above. The staying power and continued adherence to this story are heavily reliant upon metal’s intrinsic value.  If money’s value is connected to the weight and quality of metal, then it, just like the gold, silver, or the other goods it trades for, is a commodity.  As a commodity, money preserves the barter system.  In a barter framework, economists are able to practice real analysis.

Real analysis is described by the 20th-century economist Joseph Schumpeter as:

[all] the essential phenomena of economic life are capable of being described in terms of goods and services, of decisions about them, and of relations between them.  Money enters the picture only in the modest role of a technical device that has been adopted in order to facilitate transactions.  This device can no doubt get out of order, and if it does it will indeed produce phenomena that are specifically attributable to its modus operandi.  But so long as it functions normally, it does not affect the economic process, which behaves in the same way as it would in a barter economy.[3]

In other words, economists can study real changes to output, employment, distribution, and growth without addressing money as anything other than a facilitator of exchange, because in the long-run money is neutral.  Money does not generate real changes only nominal changes that create short-run disturbances to the stability of economic equilibrium. In other words, it disrupts the modus operandi in Schumpeter’s quote. By examining money,  within the context of modern economic events, it will become clear that the commitment made by neoclassical economics to the Metallist’s story is not intended to provide an accurate understanding of history, but is rather an effort to preserve their method of economic analysis and the continued application of optimization techniques and mathematical modeling.

While the barter story is intuitively appealing, especially when described as an economy at a time and place far, far away, difficult questions about value and the role of the state complicate the drama.  For instance, when gold or silver was spontaneously accepted as the commodity money, did people just trade nuggets of the metal?  Where did coins come from?  Who made the coins, and how was their value determined?  Then finally, as economies incorporate paper money, how is the value of the currency maintained, especially if it cannot be directly converted into gold or silver? These questions are examples of critical analysis.  Rather than accepting the story as given, critical thinking and investigation will help economists and policymakers to develop an understanding of money and its evolution in economic systems.

To address these critical inquiries, let us return to Schumpeter’s description.  Money’s value is as a technical device used in the facilitation of exchanges.  Its value is intrinsically derived through a precious metal.  In this scenario, it is a commodity like all other commodities.  Difficulty only emerges, if it gets out of order.  If money’s modus operandi extends beyond the facilitator role, then the economy is no longer functioning as a barter system.  It is in this capacity, as something more than a technical device that the Chartalist school of thought is introduced here, in the second act.

The complications, regarding money’s value, have become increasingly difficult for Medallists to assume away and maintain money’s status as a commodity.  The most significant of these changes to the global economy has been the development of fiat currency systems that have completely broken monetary systems from the gold standard. An example of fiat money is the U.S. dollar.  They are issued by fiat because the issuer will not give us anything other than other dollars in return.  It is an inconvertible paper money. The gold standard allowed for the commodity money story to survive the complications associated with the expansions of both credit money lending and paper money, because money remained convertible into gold. However, the elimination of the gold standard has ended the convertibility scene and requires a new dialogue.  If money cannot be converted into gold, and value is not intrinsically determined, then where does its value come from?

Endnotes

Glossary

barter economy

a system in which goods trade for other goods, that is, without money as an intermediary

double coincidence of wants

the fundamental problem of barter in which, for trade to occur, I must have what you want and you must have what I want

intrinsic value (of commodity money)

the value the object has in and of itself

metallism

the belief that the value of money derives from the intrinsic value of the commodity (for instance, gold) the physical money is made from

real-analysis

the study of real changes to output, employment, distribution, and growth without addressing money as anything other than a facilitator of exchange