General accounting
VIII. 31. Money (1): what is money?
Video
In this General Accounting course, we have done the most difficult: we constructed the first Income Statement and Balance Sheet of a firm. We shall learn of course many more things concerning these tools.
However, even though it is not an official topic of General Accounting, let's have a glance at money.
Money, in a community, is the medium with which we exchange.
Actually, this definition is too narrow. A better one is; "money, in a community, is a system of signs with which we exchange". But since most of the time, the system of signs is a "quantitative medium", or something that mimics it, and the signs are the quantities of the medium people have in their hand, the first definition is alright for practical purposes (if not for a deep understanding of money).
When it appeared in the Middle-East, in the civilisations of Antiquity, in the third and second milleniums bc, money incorporated its own value. By this we mean that gold nuggets had themselves the value they were traded for.
Mind you, this notion is more delicate than it looks because the concept of "value" of gold nuggets is not undisputable. Of course, it is the value of whatever we can buy with it, but this applies to paper money too... And if we were to go and live on a desert island, we would take neither paper money nor gold nuggets with us.
Modern money we use in our everyday purchases is made of paper notes and metallic coins with very little value by themselves. Nothing would prevent us, however, from using gold coins. And most shopkeepers all over the world would be quite happy to accept them. The problem is that a coin the weight of a US dime would have a purchasing power of $130 (as of August 2012) and would be quite unconvenient to use.
King Croesus, of Lydia, 560-546 bc, is the first monarch to have coined their value on the face of gold tokens, thereby inventing "coins", and also opening the door to money made only of signs on material support.
In Antiquity, in Roman times, and in the centuries which followed, up to this day, money was often debased by the authorities. The mechanism is this: start from a gold coin with a certain value, this value being stamped (= "coined") on it, and produce new coins with less gold, but still the same facial value stamped on them.
This was often done in order to bring money into the treasury of the authorities, at a time when collecting taxes was not an efficient means of financing the State.
By the fourth century ad, Roman coins were very thin, and can be viewed almost as "paper money", since the metal support of the coins was (almost) as thin as paper.
In the XIIth and XIIIth centuries, when Western Europe had recovered from the Dark Ages of the second half of the first millenium, society revived. We saw many wonderful developments: demographic growth (and therefore appearance of last names), construction of cathedrals, foundation of universities, of big trade fairs, adoption of the Arabic numerals and system of counting, double-entry accounting, banking... We also saw the appearance of bills of exchange which are true (private) paper money.
Precious metal money still existed and was still regularly debased. Two monarchs who debased their money stand out among others: Philippe the Fair of France, 1268-1314, and Henry the VIIIth of England, 1491-1547. But paper money kept developing, particularly in the XVIIth and XVIIIth centuries.
John Law, 1671-1729, is one of the first to have understood that the money used by a community does not have to have "intrinsic value" and that any system of signs, for example paper money (that is, signs on paper) could be the standard medium of exchange.
In the XVIIth and XVIIIth centuries, Western monarchies reached the climax of their power and could begin to control their (paper) money supply. (Of course I am going very fast through a complex history.) In the XIXth century monarchies declined but the centralisation of power remained. Central banks appeared, as well as the concept of legal tender money: paper money you cannot refuse as a means of payment.
Remember that the foundation of money (paper money) is exchanges in communities and their measurements: therefore it is accounting.
The biggest problem posed by money which does not incorporate its own value is how to preserve the stability of its purchasing power. In other words, how to preserve the stability of prices?
The most commonsense idea is that prices are simply related to the quantity of money in circulation:
- this is the so-called "quantitative theory" of money
- it is based on the observation that if you multiply by 2 the money supply, as well as by 2 all the prices, you haven't changed anything
But the "money supply" (i.e. the quantity of money in circulation) is a vague concept. If I give you a receipt aknowledging that I owe you 100€, and at the same time you give me a comparable receipt, we have increased the quantity of (private) money by 200€.
Milton Friedman's car
Despite fast talkers like Milton Friedman, who advocated the quantitative theory all their life, and wrote books making the apology of free markets, it is a simplistic idea. Inflation can appear without a change in the money supply.
The formula PQ = MV (that is, prices x quantities produced during one year = monetary mass x velocity of money), which is supposed to be a remarkable relationship between the four variables P, Q, M and V, actually is a tautology, since it is the only way to know V.
For instance, between 1500 and 1650 prices in Europe increased five fold. It is called "the Great Price Revolution". Some people claim that it is an obvious consequence of the inflow of precious metals from the New World. But others point out that the phenomenon began more than fifty years before the inflow of gold and silver. They say: "the increase in the money supply is a consequence of inflation, not a cause". (When prices go up you begin to look for gold and silver.)
Friedman is famous for having said "inflation is always and everywhere a monetary phenomenon". The sentence is certainly a beautiful English period. Inflation in our view, however, is first of all a social phenomenon corresponding to a redistribution of power among various social agents. When a subgroup of society can impose the price of something it controls (labor, real-estate, or whatever) a power struggle sets in.
And indeed at the end of the Great Price Revolution, the landed aristocracy had lost its social power to the new merchant class. It lead to 1) the Enlightenment and 2) to the French revolution, but this is another story...
If the State authorities are powerful enough, they can impose price control. But this leads to all sorts of dysfunctionings, the first of which is black market. An alternative is to let the market forces play freely. But this leads to a powerful subgroup imposing low prices for labor. The consequence is a society where a large working class is dominated and exploited by a smaller rich one.
Over the last generation, since the Thatcher/Reagan revolution of the late 1970's early 1980's, it seems that we are witnessing this phenomenon:
- free markets were facilitated all over the world (deregulation, disintermediation, ie direct access to financial markets for borrowers, dismantling of economic and trade barriers of all sorts),
- and at the same time telluric forces yet to be clearly understood created widening wealth disparities in western developped societies between a thin class of rich people getting ever richer, and a large middle class slowly sinking into comparative poverty (rise of unemployment, expensive housing, deteriorating quality of life...)
The last to understand economics are economists, who are busy building mathematical models unrelated to reality. Tradition began with Ricardo's theorem (which is as distant from the reality of exchanges between countries as is possible, and enabled the take off of Japan, South Korea, Taiwan and Singapore by carefully not applying it) and Walras's ludicrous states of equilibrium, to continue up to this day with the integral of prosperity over the course of their lives of couples of Gary Becker.
The best to try and understand economics and money, beside thinking by yourself, is to study the works of anthropologists, like for instance Jack Weatherford.
To figure out how to maintain the stability of prices in a society where life is acceptable will require new ideas from powerful free and innovative minds.
Remember that the foundation of the problem, once again, is in the recording of exchanges: i.e. in accounting.
To close this digression on money, let's make three observations:
- for the past three or four decades, Nation-States have been losing power. This contributes to the recurrent social crises we see.
- we witness the appearance of new private moneys (Local Exchange Trading Systems) all over the place.
- computers and Internet will make new private currencies easy to create and manage. The main problem yet to be solved is that of security. (The ludicrous mishaps of MtGox, in March 2014, who "lost" 750 000 bitcoins of its clients, supposedly "worth" more than half a billion dollars - although it should only be recordings, and how can you "lose recordings"? - are here to remind the gullible of the problem.)
Notice that all monetary innovations of the past (with the exception of central banking) were spontaneous: bills of exchange, accounting, banking, bank notes, etc. This will be true of new means of exchange as well. These new private currencies, managed by large multinational corporations, are likely to replace Nation-States currencies within our lifetime. (To go farther see: multiple currency systems).
