1980s >> 1980 >> no-906-february-1980

The Evolution of Money: From Barter to Inflation (Pt. 1)

Since inflation is a monetary question and nothing but a monetary question, it cannot be understood without first knowing what money is. To most people money is the notes and coins they use to buy things, a convenient technical device for ensuring the smooth exchange and distribution of goods. While it is indeed such a medium of exchange, the currency we use today is not, strictly speaking, money at all, but only tokens for it. But to explain money it is convenient to start with this role of medium of exchange.

Exchange, as the exchange of goods, only exists in societies where there is private property: the goods involved pass from one property owner to another. In societies where there is no private property, where wealth is regarded as the common property of all the members of society, there is no exchange. People don't get what they need through exchange but directly, either by being given it or by taking it in accordance with established rules for sharing wealth. The original human societies were organised on this basis, without property and without exchange –and without money.

Exchange probably originated not within such primitive communistic societies but between them, and would have been on the basis of barter, the direct exchange of so much of one good for so much of another. Barter is the most primitive form of exchange and has obvious problems which don't need explaining at length. A person with two pots who wants a blanket must find another person with a blanket who wants two pots before any exchange can take place. At a certain stage in the evolution of exchange, the need becomes apparent for a good which can be exchanged for all goods. Then the person with the two pots can exchange them for this good and then later exchange this good for a blanket. The good that can be exchanged for all other goods is precisely money, and this gives us the basic definition: money is the good or commodity that can be exchanged for all others.

Various goods have functioned as money in the history of humanity, from cowrie shells to cattle (the word 'pecuniary' comes from pecunia, the Latin word for cattle), but in the end the most convenient have proved to be the precious metals, silver and gold. With barter, goods exchange in proportions determined by the amount of time it took to make them. Primitive people would have had a pretty shrewd idea of how long it took to make particular goods and would have regarded an exchange as fair where the goods involved had taken more or less the same period of time to make (or to gather from nature). Thus, if two pots habitually exchanged for one blanket, a blanket took twice as long to make as a pot.

In other words, commodity exchange is essentially an exchange of equivalents. When one good becomes money, this is not altered. The person with the two pots is not going to exchange them for the money-good unless both goods are considered equivalents. The money-good itself must therefore have value, must be the product of labour. This leads us to the second function of money, that of being a store of value. Someone who has exchanged their goods for the money-commodity is not obliged to exchange the latter straight away for some other good. They can keep and, if wanted, store and accumulate the money-good.

The money-commodity can best perform its role if it is not too bulky – if. in other words, it concentrates a relatively large amount of value in a relatively small bulk. This is precisely what the precious metals do. They are 'precious', or valuable, because it takes considerable labour to obtain a small amount of them. This feature would be a disadvantage had the precious metals not another characteristic — that of being easily divisible. A precious stone such as a diamond also concentrates much value in a small bulk, but because it cannot be easily divided it can't serve as the money-commodity, since the differing values of goods to be exchanged (the different times it took to make them) demand that the money-good be available in finely distinguished different amounts.

The precious metals, gold and silver, because they possessed these two features and had a fairly stable value, eventually emerged everywhere as the money-goods. Once one good has become money then exchange becomes buying and selling. Selling is the exchange of a good for the money-good, while buying is the exchange of the money-good for a good. This is still the case today but is no longer obvious because of the complications brought about by the subsequent evolution of money. The price of a good is its labour-time value expressed in amounts of the money-good.(*) This, being the standard of price, is money's third function. Prices were in fact originally expressed directly as weights of gold or silver.

The next stage in the evolution of money is the introduction of coins. About 2,500 years ago a ruler of Lydia (now Turkey) struck the first coin by stamping its weight on a piece of precious metal (electrum, an amalgam of gold and silver). This stamp served as a guarantee that it really did weigh the amount indicated. And this is all coined money is: a piece of the precious metal which is the money-commodity stamped with a guarantee of weight. At first anybody could issue coins, merchants as well as rulers, but this soon became a government monopoly.

The names of coins were originally weights of the metal of which the coins were made. Thus a pound (£) was originally, in early medieval times, a pound (lb) of silver. But over the years, if only because coins lose weight through wear and tear (but in practice for other reasons as well, as we shall see), the names given to coins came to differ from the names of the units of weight. This did not mean that the money-commodity had ceased to be measured in terms of weight; it merely meant that the money-commodity could always be translated into the more usual unit. Indeed, the new unit of monetary weight was legally defined in terms of the general unit of weight. Thus, in Britain for most of the nineteenth century, the gold coin known as a sovereign or pound was legally defined as being slightly more than a quarter of an ounce of gold (one ounce of gold was equal to £3 17s l0d). hi other words, 'pound' was an alternative name for about a quarter of an ounce of gold. Similarly, other names of currencies – dollar, mark, franc –were also alternative names for (other) weights of gold (or silver).

Gold and silver coins can lose weight not only through wear and tear but also through people deliberately filing them down, a criminal offence generally punished in the past by death. But there was a third way which was perfectly legal and unpunishable, since the 'criminal' was the government itself! Governments discovered soon after the invention of coins that issuing underweight coins – stamping one weighing, say, only 0.24 ounces as a 'pound' or 0.25 ounces –was an easy source of finance, at least in the short term. Such debasement of the coinage, however, had an unfortunate side-effect: it led to a rise in prices, not just of some goods but of all goods, a rise in the general price level. Since exactly the same mechanism operates here as with modern inflation, let's examine it in more detail.

Exchange, remember, is the exchange of equivalents (of equal amounts of socially necessary labour), selling is the exchange of a particular good for a certain amount of the money-commodity; and price is the expression of the value of a good in terms of amounts of the money-commodity. Say that four blankets are worth the same as an ounce of gold. That means that it takes as much socially necessary labour to produce four blankets as it does to produce one ounce of gold. The price of one blanket would then be a quarter of an ounce of gold, or £l.

This is an underlying real economic relationship which remains in force whatever the government does. If the government debases its coins by stamping 'pound' (quarter-ounce) on coins weighing only one-eighth of an ounce,(** )then this economic reality does not change. One blanket will still tend to exchange for a quarter-ounce of gold. If the government, by debasing the coinage, in effect changes the weight designated by the name 'pound' from a quarter-ounce to one-eighth of an ounce, then the price of one blanket will no longer be £1, since this now signifies one-eighth not one quarter of an ounce. The price will now be £2, the new way of indicating a quarter-ounce of gold. All other prices will also rise in the same proportion of 100 per cent. Prices will in fact tend to rise in the same proportion that the coinage has been debased. This would not happen immediately and all at once but would be spread out over a period of time as the effect of the debased coinage worked its way through, but the end result will be the 100 per cent rise in prices.

What will have happened is that the government's action will have changed the standard of price. This is a purely monetary matter and is in the end just a question of definition, of the weight of the money-commodity named by the word 'pound'.

The general level of prices can also change for real economic reasons as well as through the action of a government, intended or otherwise. If the amount of socially necessary labour required to produce an ounce of gold changes –if its value changes –then the prices of all other commodities are necessarily affected. To come back to our example of four blankets equal to one ounce of gold, we saw that this meant that four blankets and one ounce of gold contained the same amount of socially necessary labour, let us say five hours. Suppose that as a result of a new mining machine the average time it takes to produce one ounce of gold falls by ten per cent, to 4½ hours, while the time taken to produce four blankets remains unchanged. Four blankets will now no longer tend to exchange for one ounce of gold but for the amount of gold that can now be produced in five hours, 1.11 ounces. Since no government monkeying with the currency is involved here, 'pound' remains the name of one ounce of gold, so the price of four blankets now rises to £1.11. This happens to the price of all other goods too. This has in fact occurred a number of times in history, the last being in the thirty years up to the First World War when the value of gold fell due to the opening up of the South African and Alaskan gold mines.

A rise in the value of gold, on the other hand, due for instance to geological difficulties in working mines as they get older, would have the opposite effect, leading to a fall in the general level of prices.

The amount of money in circulation — the total weight of the coins made of the money-commodity (say, gold) which circulate as the currency — is determined by the workings of the economy and depends on three factors and their changes in particular:

1) the number of buying and selling transactions to be carried out, or the level of economic activity;

2) the total of the prices of the goods and services involved in these transactions (reflecting their value as measured by the amount of socially necessary labour they contain);

3) the average number of transactions carried out by a single coin in a given period (since coins of course circulate and are not cancelled after use), or the 'velocity of circulation' of money.

Other factors can be introduced, such as the number of debts to be settled and taxes, to be paid, and their amounts, but the basic formula is:

Amount of money (total weight of gold) needed =

Number of transactions x total price Velocity of circulation

This has been expressed algebraically as M = TP/V, and is known in the history of monetary theory as the Quantity Theory of Money.

Various versions of it exist, not all of which are correct. But if it is understood not as an equation but as a formula for what determines the amount of money (weight of gold coins) needed by the economy, then it is a key concept for understanding inflation. For it is saying that the amount of money needed by the economy at any time is a real economic fact determined by other economic facts, and as such not something that can be changed at will by government action. In fact it continues to be valid even when gold itself does not circulate as the currency and has been replaced in this role by paper and metallic tokens.


(*) "A relation between a weight of metal and the value of an object" is how Belgium's leading economist, Fernand Baudhin, who died in 1977, defined price in his Dictionnaire de 1' économie contemporaine (1973 edition).

(* *) This of course is an unreal example, but the mathematics is easier to follow.

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