PART 2: The Origin of Money
This is the second part of my series where I examine Bitcoin through the lens of Austrian economics. In his part, I explore the origin and the essence of money. Read other parts here:
Just like any other good that arises in the free market, money emerges because the market has a problem and needs something to solve that problem (satisfy a need). Before money existed, individuals trying to trade goods were limited to direct exchange, i.e., barter, which resulted in the problem of the “double-coincidence of wants.” The number of exchanges an individual can undertake is limited because it would require the coincidence of skills, supply, transaction costs, and time. These problems can be alleviated with an indirect exchange, which is the function of money. Money emerged to alleviate this problem and increase the number of possible exchanges.
The most basic problem of coincidence of wants: ‘A’ wants something that ‘B’ has, but ‘’B’ only wants something ‘C’ has, and ‘C’ wants something ‘A’ has.
Before examining what money is more closely, it is beneficial to understand why and how it emerges in a free market, its functions in an economy, and the common characteristics that monies tend to possess. In this part, only the emergence of money will be discussed.
Origin of money and theory of salability
While many Austrian economists disagree on various topics regarding the origin of money, the most notable and agreed-upon theory on the origin of money is Menger’s theory of salability. For clarity, it has been categorized into three stages, which shall be examined below.
From a good to a medium of exchange
The emergence of money arises after a problem in a market where a direct exchange of goods is employed; facilitating an exchange between two individuals requires a “double coincidence of wants.” This means that for a shoemaker to get meat in exchange for his shoes, he needs to find a butcher who also happens to want shoes in exchange for his meat. The problem is that a double coincidence of wants is rare and would require luck for a meat-wanting shoemaker to find a butcher in need of new shoes by a chance.
The shoemaker may see that the butcher also needs wheat and that the wheat farmer needs shoes. This scenario would enable the shoemaker to trade his shoes for the farmer’s wheat to further trade the wheat for butcher’s meat, which was the ultimate consumption goal of the shoemaker in the first place. However, these ad hoc scenarios are even more limited than trade between two parties. It would require considerable luck for the shoemaker to find a third party that offers something the butcher wants and that also wants the shoemaker’s shoes.
This series of exchanges can last for a long time until the shoemaker finally gets what he wants, and the same process goes for all goods he wants. One can quickly realize that this indirect exchange is not scalable and logistically problematic. As individuals specialize more, it becomes less likely that they can acquire goods that they want in exchange for their more specialized products. These problems are emphasized even more when a market matures and the division of labor increases making individuals’ wants more precise and sophisticated. These problems create a market fit for a good that can be employed as a medium of indirect exchange, and, thus, is valued for its ability to facilitate indirect exchange.
From a medium of exchange to a more commonly used medium of exchange
The previously mentioned process is logically followed by a medium of exchange gaining momentum and being used more widely. The extent of how commonly a medium of exchange is used depends on its salability. Salability (liquidity) is how much economic sacrifice is required for disposing of or acquiring a good, i.e., how easy it is to sell a good at a market at any time and at any economic price. The sacrifice usually comes in the form of a discount on the price, or in the cost of delaying the exchange resulting in the seller having to wait until the exchange can take place. The more salable a good is, the easier it is for the owner to exchange it for other goods for a reasonable economic price, i.e., prices corresponding to the general economic situation. Another way of thinking about salability is the narrowness of the gap in which an individual can immediately buy and sell a good.
A helpful example for comparing the salability of different goods is cotton and Sanskrit writings, both worth an equal amount. This example demonstrates that an individual selling cotton is in a much better position than someone selling Sanskrit writings because he would not have to search for a long time to find a buyer for his cotton, as opposed to the seller trying to get rid of his writings. The owner of the writings might find a fair price offer for his good, but it might take some time for him to do so. This is because of the difference in the two goods’ salability, which puts the owner of the writings at a disadvantage when trying to acquire his desired goods compared to the cotton seller, who will sell his cotton much more efficiently without a discount on the price or waiting long period to find a buyer.
The market recognizes this disadvantageous dynamic: vendors of less salable goods will generally trade for more salable goods before they trade for the goods they ultimately want. In this article’s example, the shoemaker becomes aware that using a more salable good, compared to his shoes, offers him more exchange opportunities for smaller exchange costs. Assuming he is a rational actor, he will be willing to exchange his shoes for this good, even if he does not use them for consumption. This is because he knows that going to a marketplace with these goods results in better and less costly exchange opportunities instead of going there with his shoes. This allows him to attain the goods he ultimately wants to consume with minor economic sacrifice, whether in terms of the discount on price or the time to execute a sale.
Since salability can be viewed as a proxy for how much demand there is for a good, the salability of a good increases as demand increases, creating an upward spiral; a good’s high salability draws more demand, which increases its salability further. This again draws more demand, and so on. This process continues until a few goods are regarded as “commonly used media of exchange”. Salability is not static nor a binary characteristic. This means that in different types of economies and different historical periods, different goods possessed different levels of salability based on the type of society and the technological capabilities present in this society.
From a commonly used medium of exchange to money
The selection process does not stop there. As individuals are incentivized to trade their goods for the most salable of the media of exchange, markets converge on a few monetary media. This process benefits only those media, while other less salable media of exchange continue their downside spiral until they drop out of the competition entirely. In Mengerian theory, one can think of the money market as a process of elimination where less salable goods are not demanded for their monetary value anymore, and the only goods left after this process of elimination start being regarded as money. This process of elimination creates a positive feedback loop which results in people emulating this behavior, furthering the monetization process of this good. According to the Austrian definition, this results in one dominant medium becoming generally used, which is money.
There is a tendency for less salable goods to be used as media of exchange to be one by one rejected until the last good remains. As the good goes through the monetization process, less salable goods become simultaneously even less salable, resulting in a loss of monetary value. Individuals holding less salable goods will be punished economically as the opportunity cost of holding less salable goods manifests in fewer exchange opportunities and higher costs related to exchange. Thus, using inferior media of exchange, as opposed to commonly used superior media of exchange, has opportunity costs not only to the individual giving it away but also to the individual receiving it.
Individuals who go to the marketplace with a commonly used medium of exchange, i.e., money, have a higher probability of being able to exchange it for the goods that they want for consumption. Contrast this with individuals who go there with non-money goods, precisely because of the difference in their salability. Money can be described as the most salable good of all. However, two goods can be regarded as commonly used media of exchange. One historical example would be that of gold and silver, which were used as money simultaneously. Although possible, the outcome of this involves disadvantages and complicates the process of exchange.
It is hard to define “money” because the moment a medium of exchange becomes commonly used is ambiguous, and thus, cannot be strictly defined. The broader definition of a medium of exchange is hard to differentiate from the narrower definition of money making the transition from former to latter not sharp, but rather gradual, which is why agreement on the definitions cannot be reached. Whether or not a medium of exchange is money is left to the judgment of the historian and other observers.
Before the idea of a medium of exchange existed, goods had to have demand for their own sake, i.e., not as media of exchange, but as consumption. This creates a feedback loop that pushes the concept of a medium of exchange into the market’s consciousness, making individuals aware that they can use these salable goods as media of exchange and direct consumption. This is further exploited by individuals using this tool to satisfy their wants.
The essence of Money
The emergence of money is a spontaneous market process where individuals are trying to fulfill their economic interests. Individuals are led by increasing awareness of their economic interests without any agreement or legislative compulsion to trade their goods in exchange for other, more salable goods. These exchanges are performed to hoard these salable goods, not just for their immediate consumption, but for an opportunity to exchange them later for goods they ultimately desire.
Free market money emerges when individuals begin perceiving the economic advantage they can obtain by exchanging their goods for more salable ones as their exchange opportunities grow because of lower economic costs, satisfying their ultimate wants more effectively. During the monetization process, an economic actor finds it beneficial to pursue a more effective way to achieve his end goals when resorting to indirect exchange, when he uses a commonly used medium of exchange, and finally, when he uses money. Ultimately, money is a phenomenon of individuals trying to satisfy their wants by acting economically and performing an exchange.
Money is a good that serves as a medium of exchange on a large enough scale. However, “large enough” cannot be quantitatively assessed as it is subjective, and also, there are no measurable thresholds for evaluating how widely a medium of exchange is used. Thus it is hard to establish exactly a commonly used medium of exchange becomes money. Monies are never random goods chosen for arbitrary reasons. As we have shown above, the emergence of money is a competitive “last man standing” type elimination process where presently available different goods are competing based on their characteristics (salability) for the status of being the most salable goods. The market of individuals chooses winner (s) based on their subjective views by individuals attaching extrinsic value to these goods. The present technological progress also influences individuals in society: it is easy to imagine gold not being very portable or divisible money when humans did not yet know about smelting technology.
No enforcement from authority is required during the monetization process of a good. Money does not emerge from any private initiative nor any entity’s goodwill or sacrifice for public gain. Although historically, monies have emerged as a free-market process, as described above, it is not impossible for money to be instituted through legislation of some sort. This, however, is not the primary mode in which money has originated.
Money emerges as an outcome of an individual’s self-interested actions. Although the generally accepted Austrian theory on the origin of money is described as a spontaneous event, an individual performs a calculated action to improve their situation at every step of this market process. No person, or ruler, conceived of a universal medium of exchange, and no mandate was required to set into motion the transformation from a barter economy to a money economy.
To conclude, money arises in the market because of a problem; a lack of double coincidence of wants. With barter, individuals rarely get what they want in one or even two transactions. Having this problem, individuals started noticing increased efficiency when they trade their goods for something widely accepted and demanded and then use this widely accepted good to buy the goods they desire. The good that is left for its salability at the end of this market process, which is also called monetization, can be called money.
In PART 3, I will examine the function and properties of money.