The Nature of Money

Ben Kaufman
Aug 17 · 16 min read

Money is probably the most discussed phenomenon in economic literature. The issue of its origin and nature was extensively discussed in the past by a vast number of economists and political scientists. Throughout history, the dominant view on this issue of money can trace its acceptance to the writings of such old thinkers like Plato and Aristotle, whose positions are well expressed by the following quote:

“Plato calls money a “token for purposes of exchange” (Republic, II. 371; see B. Jowett, trans. & ed., The Dialogues of Plato, London, Oxford University Press, 1892, III, 52), and Aristotle, in a much quoted passage, says that money originated by convention, not by nature but by law (Ethica Nicomachea, v. 5, 1133a, 29–32). He expresses this view even more distinctly in his Politics, where he says that “men agreed to employ in their dealings with each other something…for example iron, silver, and the like,” and offers this as his explanation of the origin of money (i. 9. 1257a, 36–40).” ¹

Even today, the same notions of money being the result of some social contract, or of legislation, are the most prevailing. This notion goes as far as to the now popularized claim that money is merely a “shared illusion,” perceived by all members of society for the common good. The logical conclusions from the above assumption led to the incorrect view that everything people collectively agree upon can be money and that we as a society, not only can but should actively control the prevailing money and its production.

The first rebuttal against this view was initially presented by the Scottish economist John Law, which attributed the origins of money not to a social contract, but to the characteristics of the particular goods which served as money, especially concerning metallic money². One of the most prominent thinkers from this contrary theory was Carl Menger, the founder of the Austrian school of Economics. In his work Principles of Economics, he laid out the theory of the origins of money in probably the most precise manner to this day³.

This article deals with the question of the nature of money from an economic perspective, explaining its origins and debunking the “shared illusion” fallacy. We will discuss the economic reasons for the spontaneous emergence of money, as the result of individual rational behavior, and the characteristics most notably influencing the likelihood of a good to become money on the market. We will start with the fundamental economic concepts necessary for a complete understanding of money, and will gradually build upon them to reach a full explanation of the nature of money.

Economics and Economizing Actions

The problem of understanding the nature of money is of an economic character. As such, it requires us first to understand what the science of economics is, and from that, we should derive the appropriate way to approach this issue.

Economics is the study of the laws governing economizing individuals. It deals with the phenomena arising from the provident activity of economizing individuals and attempts to provide us with a framework for understanding these phenomena. The economic science assumes that every economizing individual’s endeavors, through the act of economizing, are purposeful attempts at providing for the most complete satisfaction of one’s needs, as one subjectively perceives them.

We shall define here an economic action, or action of economizing, as a purposeful action performed by an economizing individual with the intent to improve his well being by allowing him, directly or indirectly, to satisfy his individual needs more thoroughly.

We should, therefore, when approaching an economic phenomenon like money, attempt to explore which economic actions led to its appearance in about every human civilization throughout history.

The phenomenon of money is inseparably linked to and stems from the general economic activity of exchange. The usefulness of money can be mostly if not solely attributed to its employment in exchange. Undoubtedly, money will never be present in an economy without exchange (for example an individual economy), and so it would be most appropriate to start our investigation by exploring the economic phenomena of exchange.

Exchange as an Economic Action

Early days economists initially mistreated the subject of exchange, as they did not examine it necessarily as an economic activity. When Adam Smith wrote that the origins of exchange might be from “the propensity of men to truck, barter, and exchange”⁴, he refrained from addressing the issue from an economic perspective and did not look at exchange as a strictly economic action.

Later economists discovered that the rationale for performing exchange was the result of economizing individuals becoming aware of an opportunity to improve their well being. Exchange allows them, under specific conditions, to attain command of goods which have a higher value to them at the expense of goods with lesser value, by exchanging with another individual which experience the opposite relation regarding the value of the two goods to him. This realization was crucial for the further development of the economic science, as any economic theory dealing with exchange must base itself on this understanding.

We can observe that exchange is the most rational economic action individuals could perform when they become aware of certain relationships between the goods they own and their needs. Without both partners to an exchange finding it at their best economic interest to perform the transaction, there is no doubt the exchange will not take place (voluntarily). Therefore, we can see that exchange is a purely economic behavior, done not from a propensity but only at the condition it improves the well being of those who engage in it.

Commodities and Commerce

The fundamental understanding of money cannot be complete without a discussion about its origins. For that, we need to start with an examination of the commodity concept in economics.

The economic definition of a “commodity” I shall use here is the one traditionally used by the old German economists of the 19th century⁵. This definition is different from the frequent use of the word in everyday speech, but it is the appropriate definition when dealing with economic literature. A commodity we define as an economic good held by its owner with the intention not to consume it, but to exchange it in commerce. For example, the shoes made by a shoemaker are mostly not prepared for his own use, but for exchanging them for something more useful to him, therefore, the shoes made by the shoemaker are commodities to him. When an individual possesses what he considers to be a commodity, it means he assigns a higher value to the goods he may exchange for it than to the satisfaction of consuming or using it. That is, he perceives the good to have a higher “exchange-value” than “use-value” to him. Therefore, we consider the shoes to be commodities when held by the shoemaker who intends to sell them, but not so after he exchanges the shoes with a consumer planning to use them.

The more progressive the division of labor, and the more advanced the economy is, we will observe an increasing number of cases where producers manufacture goods solely for their exchange value as commodities, with little to no regard for their use-value to them. We can even see the development of trade in commodities, not between their producers and consumers alone, but also with another type of trader. This different type consists of those traders who wish to purchase the goods, not for consumption, but for the value they expect to obtain later by exchanging them. This is, in fact, the work of many entities in the modern economy, such as retailers, which purchase goods with the sole intention of exchanging them with consumers (for example grocery stores), and speculators, which attempt to predict the future prices of goods and trade in them accordingly.

The general phenomenon of economizing individuals producing and exchanging for goods which have no use-value to them, but which they intend to exchange for, is evidently the result of individuals performing economic actions to better provide for themselves. When performing these actions, the individuals expect a certain demand for the goods at a certain time in the future and base their economizing activity upon their subjective assumptions. This expectation results in the general phenomenon of exchange and commerce we observe through daily life.

Saleability of Commodities

The concept of saleability deals with the extent of the economic sacrifices needed for selling a commodity. It is evident that different commodities, from their many characteristics and sources of demand, tend to require varying degrees of economic sacrifices to make an exchange of them. The economic sacrifice required for selling a commodity may come in the form of a discount on its price, but more commonly, it will be the cost of delaying the sale, that is, the time a seller must wait until an exchange can take place.

We may think for example, of the difficulty a glasses producer will encounter in finding an exchange opportunity if he were to come to the market with glasses optimized for a specific degree of myopia. Even though there is likely to be a potential buyer for the glasses, willing to purchase them at an economic price, finding that buyer is likely to take time. Moreover, even if a buyer is found, it is likely that he will not have any commodity in his possession which has a use value to the glasses seller. If we would now assume that for some reason the glasses seller is in an urgent need to exchange them, it is not likely he will find someone willing to accept them at price corresponding to that an interested buyer would be willing to pay, that is, for “economic price”. If we will now consider instead of glasses seller, a baker which brings with him bread to the market, it is clear he will be in a much better position to find an exchange opportunity for the goods he wants at an economic price.

The reason for the difference could be attributed in this case to the glasses having a much smaller market, as the need for it arises for only but a few individuals. Other causes for the differences in saleability in other cases we may attribute to differences in their supply, the production cost of new units, the divisibility of a certain quantity of the good into smaller portions, the transportation costs of the good, and others.

The Origins of Money

When economizing individuals are aware of the increased exchange opportunities available to them when offering a highly saleable commodity, they will be compelled to exchange their commodities not only for goods with use value to them, but also for commodities which will lower the economic costs for exchanging them, that is, which are more saleable. The more aware people are of the differences in the saleability of commodities, the more exchange opportunities they will be willing to accept. Exchanging for more saleable commodities will eventually allow them to achieve their ultimate goal of obtaining goods useful to them, but with lower economic costs and hardships than without an intermediary exchange.

We shall return to the above example, and now assuming the seller of glasses becomes aware of the greater saleability, the relatively smaller economic costs to find an exchange opportunity, of bread compared to the glasses he offers. Being conscious of that, he will surely be willing to exchange his glasses for bread if he encounters an opportunity to do so for what he considers a reasonable price, even if the bread has no use-value to him. The reason is that he knows his chance to find an exchange opportunity (for economic prices) for goods which do possess use-value to him will be much better if he were to go to the market with the bread rather than glasses. By accepting bread in exchange for his glasses, the glasses seller can reduce the economic costs of the complete exchange process, allowing him to attain the goods he desire for at a lower economic sacrifice of time or value.

It thus becomes clear that the willingness of an individual to accept a commodity which has greater saleability compared to the commodities currently under his possession is of the most rational nature, in the absence of a direct exchange opportunity in economic prices for goods he actually wants. This behavior will increase the demand for the more saleable goods in an economy, not for their use-value but for their value in exchange alone, as more saleable commodities.

The process of increasing demand for more saleable goods will further enhance their saleability, as more individuals will be willing to exchange for them. We can see how this process reinforces itself, causing the more saleable commodities to become even more saleable and the less to become even less so.

Therefore, it is not surprising that the result of this process will be that only a few, or even just a single commodity will maintain demand for the sake of its saleability. The commodity left in vast demand at the end of this process, we call “money.” The process we may call the “monetization” of a commodity.

The origins of money can, therefore, be traced to the specific characteristics which resulted in a commodity’s initial greater saleability, which then attracted more demand and caused it to emerge as a common medium of exchange, which we term as money.

The theory described is compatible with all known instances of money throughout history. Cattle, seashells, glass beads, furs, copper, silver, and gold are some of the most notable examples of commodity money throughout history. We can see how their characteristics, such as their use-value, divisibility, fungibility, portability, and durability may have caused them to be initially more saleable than other commodities. Thus, they gained further demand and emerged as money, according to the economic situation of certain economies at specific periods in history.

Another influencer on their emergence as money can be attributed to the general economic situation and the type of society which used them. For example, cattle was the common money in the nomadic stages of societies, as they were durable, easily transportable, and people had plenty of space to “store” them. However, with the development of civilization to more permanent settlements, and then cities, the suitability of cattle as a medium of exchange vastly declined. At the same time, the saleability of precious metals started to increase rapidly, until they eventually emerged as the new money standard.

The Saleability of Fiat Money

There is a particular type of money, which seems at first glance to be incompatible with the theory presented above, which is fiat money. However, here I’d like to argue that we can apply the same theory for the understanding of its emergence if we take into account government legislation as a given influencer on the economic situation.

Fiat money is, as its name implies, money which is decreed as money by the government. Historically, governments usually exploited the circulation of another money and converted it to fiat money, for example by suspending redemption of gold certificates. We can observe two interventions which governments employ to make and preserve the fiat money as a circulating medium of exchange: 1) regulations which impose limitations and barriers to the saleability of other commodities⁶; and 2) legal tender laws which require the subjects of a government to accept their fiat as money at a value determined by them, and which demand fiat as the only accepted money for tax payments.

The reason for the two types of interventions can be easily understood if we apply the theory of money. With the former, the government, by using its monopoly on violence, artificially reduces the saleability of commodities which otherwise could be more saleable than their fiat money, and therefore were more likely to circulate as a medium of exchange. With the latter type, it generates artificial demand for its fiat money, both by requiring its use in tax payments and by requiring people to accept it at “face value”, usually much higher than its value would otherwise be on the market. This increased “artificial” demand for government fiat money, accompanied by an artificial decrease in the saleability of other commodities, results in the fiat money becoming the most saleable commodity thus becoming medium of exchange, i.e., money.

The peculiarity of fiat money compared to other types of money is that fiat money does not gain its saleability from the free actions of economizing individuals but from coercion and the threat of violence through legislation. We should, however, state that this manipulation still aligns with the theory of money emergence, of the most saleable commodity becoming money, with no necessity of a collective agreement on the substance of money. There is a long historical record of fiat money losing its saleability even when regulations are still effective (for example in hyperinflation scenarios). These cases should reinforce the argument presented here, as it shows that even if the “political agreement” (legislation) is still present, the legal money may lose its saleability due to a change in its characteristics (in hyperinflation case, its production rate). When this happens, we can see another commodity, which is not the legal tender, getting into circulation and replacing the fiat money as a medium of exchange, which gets pushed out of circulation. We can therefore see that money is not decreed upon people but emerges from their individual economic actions.

There is a solid case, both historically and theoretically, against the imposition of fiat money. However, here we deal with its origins, and the cause of its use in the economy, and need to treat government intervention as a given economic situation while trying to understand its implications on money emergence. We thus conclude that fiat money is indeed compatible with the Mengerian theory of the origins of money.

The Nature of Money

We shall now turn to the question with which we started, that is, what is the nature of money. From the above discussion, we should conclude that the phenomenon of money is the logical, spontaneous result of the economizing efforts of individuals. It does not originate from a collective decision, but from the provident activity of economizing individuals acting at their best self-interest. Throughout history, we witnessed various occurrences of money not only emerging without legislation, but sometimes even despite and against the existing legislation, and without any explicit coordination between the market participants. Hence, money is not a social or political, but an economic phenomenon of individuals acting economically.

The fallacy of money being a “shared illusion” is a shallow observation at best, and does not provide us with any economic explanation for the phenomenon of money. The reason many find this fallacy compelling is most likely the confusion of use-value and exchange-value, and a flawed understanding of commodity theory in general.

The explanation usually given to justify this claim is that people assign value to money, not from its use in consumption, but because they expect others will provide them with other, useful, goods in the future in exchange for it. It is evident, in many cases, that the use-value of money is generally nonexistent for many people, yet they are willing to exchange for it. From this observation, they conclude that accepting money in exchange must be against the individual best self-interest, and thus that it could only originate from a collective agreement.

This argument may sound compelling at first, but after our examination of the origins of money, we can easily dismiss it, as we proved that accepting money is indeed in at the best self-interest of economizing individuals. It is evident that the first individuals in an economy to recognize the economic gains they can obtain by exchanging their commodities for more saleable ones will have better and more numerous exchange opportunities for lower economic costs. Thus they will be able to provide for their needs better than the rest. Over time, as the saleability of some commodities increases, and with knowledge passing between people, more individuals will imitate this behavior, as its positive results will become more visible. Thus, the use of some commodities as a medium of exchange will prevail until money fully emerges in the market.

Along with this process, as some commodities become more saleable, others will consequently become less saleable, economically punishing those who do not exchange for money as they will have fewer exchange opportunities and become increasingly more economically isolated. We see here how the use of money in the economy is an economic activity at the best self-interest of each individual, which repudiates the need for a “social contract,” or “shared illusion” for the emergence of money.

We can also learn from the process that the choice of the substance of money is not at all arbitrary. Rather, this choice is the predictable result of the influence of the characteristics of the specific commodity, combined with the influence of the contemporary economic situation present at an economy during the monetization process of the substance.

We could stop here with our exposition on the flaws of the “social contract” theory of money. However, I think we can learn even more on money and economics by digging a bit deeper.

We may notice that this theory fails to identify that the same relationship it describes exists not only with money but by definition with all commodities. For example, a farmer may produce grain in quantities which greatly exceed his personal needs, making any single unit of it practically have no use value to him. However, no-one can argue that it is irrational for the farmer to produce in such quantities because of the expectation for future exchange. This relationship is the same one we observe with money and all other commodities.

The peculiarity in the case of money is that its demand comes mostly from its use as a medium of exchange, which tends to dwarf its demand for its use-value. However, this observation is irrelevant for the general relationship we discuss here, as the case of production and exchange of goods, only for their exchange-value is evident regardless of the source of their demand.

The second significant flaw I would like to emphasize in the view of money as a “shared illusion” is that such an explanation is not of an economic nature, and we may as well reject it as too shallow for that reason alone. The very essence of the economic science is to discover the laws governing economizing individuals, that is to understand the phenomena which we observe in economic life as resulting from the purposeful economic actions of individuals.

The science of economics accepts the fundamental praxeological aprioristic reasoning which assumes humans engage in purposeful behavior. Therefore any explanation treating economic actions as unexplainable propensities, illusions, animal spirits or whatever other excuses to avoid reasoning must be unaccepted on the grounds of contradicting the a priori of economics.

Conclusions

The nature of money results from the economic activity of individuals, acting as to satisfy their needs most thoroughly. Money is a commodity demanded for its relatively higher saleability compared to other commodities, and which thus circulates in the economy as a medium of exchange. The emergence of money is spontaneous and results from economizing individuals attempting to exchange their commodities for other commodities which will require lesser economic sacrifices for finding an exchange opportunity. Throughout the entire recorded history of money, there has never been even a single case where people assembled together to make a collective decision to set some arbitrary object as money. The concept of a “social contract” is utterly foreign to the origin of money, which begins from the economic actions of individuals and spreads through the market. The specific money substance is not arbitrary and arises from the internal characteristics of a good, and its consequent saleability in a given contemporary economic situation.


[1]: Carl Menger, Principles of Economics, p. 315, Appendix J, “History of Theories of the Origin of Money”

[2]: John Law, Money and Trade Considered.

[3]: Carl Menger, Principles of Economics, chapter VIII “The Theory of Money”. See also his later work “The Origins of Money”.

[4]: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, p. 24.

[5]: Carl Menger, Principles of Economics, page 239, “A large number of economists, especially German economists, therefore defined commodities as (economic) goods of any kind that are intended for sale.”

[6]: Probably the most relevant contemporary example is Executive Order 6102 issued on April 5, 1933, by President Franklin D. Roosevelt. The executive order prohibited gold ownership almost entirely in the USA until it was repealed in 1974, 3 years after the introduction of completely irredeemable paper fiat money.


Special thanks to Ben Prentice (mrcoolbp), Neil Woodfine (nwoodfine), The Bitcoin Observer (festina_lente_2) and Bezant Denier (bezantdenier) for all the feedback I received from their reviews, comments, and suggestions which helped me shape this article.

Dialogue & Discourse

News and ideas worth talking about. Fundamentally informative and intelligently analytical.

Ben Kaufman

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Coding and Austrian Economics

Dialogue & Discourse

News and ideas worth talking about. Fundamentally informative and intelligently analytical.

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