Saturday, June 27, 2015
The Standard Definition of Money is in Error
The standard definition of money is in error.
The standard definition of money is given in terms of its three functions:
1: Money is a medium of exchange.
2: Money is a measure of value.
3: Money is a store of value.
Number 1 is at best misleading. Numbers 2 and 3 are simply wrong, and these things are easy to show. It is also easy to show that this is important.
First, the actual definition of money:
1: Money is a token, or instrument, of demand, which is exchanged for goods or services. Or simply: Money is demand.
2: Money is a measure of demand.
3: Money is a store of demand.
In the standard definition, Number 3 cannot possibly be true. Were Number 3 true, money would have value of itself. The value of money would be independent of what ever else an economy produced. But consider, the best monies are those instruments which have no intrinsic value whatever. How can any amount of something which has no value, be a store of value? Even where commodities have been used for money, (and this may be the origin of the error,) they have tended to be those commodities, precious metals, for instance, which, because of their properties, were of only limited economic use. The reason for this is known and simple: These commodities had to be more valuable as money than they were valuable as commodities. If they were more valuable as commodities, they would be consumed, and so their use as money would disappear. But this implies that the value of these commodities, as money, over their value as a commodity, is not intrinsic, but as with plain fiat money, purely a matter of other factors. That is, the value of the commodity as money is not based on any intrinsic value of the commodity to the economy.
So fiat money has no intrinsic value, and therefore cannot be a store of value. If the economy produced only money, that money would have no value. It does not have value as, say, a refrigerator full of food has value, or a tank filled with gasoline. But, what the third function of money actually is is as a store of demand. If you have $100 in the bank, or in your pocket, you have a store of demand, which you can keep as long as you want, and when you choose to, you can spend it. You can demand something which is offered for sale, to the amount of $100.
Then you can take your $100 of tokens of demand and you can go to the grocery store and with it buy $100 worth of food. This shows that money is also a measure of demand: You have as much demand for food, or anything else, as $100 will purchase. If you have more money, you have more demand. If you have less money, you have less demand. If you have no money, you have no demand.
Money is not a store of value. Can it reliably be a measure of value? Economically worthless things may be in much demand, and therefore command a price beyond their value. Yachts, for instance. Economically valuable things may be in little demand, or supplied at prices below their value. Water, for instance. With money, you have demand for these things, at the prices they are offered. But their prices do not reflect their economic value, only the amount of demand, the amount of money, which must be exchanged for them.
This counters the claim that the only value a thing has is that set and measured by the market: The toys of the wealthy are much in demand, but of little value. The goods needed by the poor are to them of great value, but it may be that those poor are only able to demand a meager portion of them. Markets only measure demand. They need not measure value. This is the primary inadequacy of markets.
So because money is demand, or more exactly a token or instrument of demand, it serves as a 'medium' of exchange: Because money is not demand for any particular good or service, but is demand for any offered good or service, it may be exchanged for any offered good or service. Money is a medium not in the sense of being an environment for exchange, but in the sense of being a generalized instrument. It is an abstract good, which is offered in exchange for other goods and services. The individual who exchanges his good or service for money then himself has equal demand on others for different goods or services. Money thus flows opposite to the flow of goods and services, not to the degree of the value of these goods and services, but according to the demand for these goods and services that are offered.
Goods or services are thus exchanged for an equal demand on other goods or services. Money, then, is an instrument for comparing the demand for dissimilar objects. However, we have shown it is not reliable for comparing the value of dissimilar objects.
By mistaking demand for value, the standard definition of money thus implicitly fails to distinguish between the value of an object, and the demand for that object. In an informal sense, this results in the failure to distinguish between the needs of an economy, and its wants.To provide another example, the economy 'needs' streetlights in Highland Park, Mi. It 'wants' yachts in Newport, RI.
If we regard the economy as like a tree, money cannot distinguish between the fruits of a tree, and its roots.
There is a larger issue. The standard definition of money goes back, essentially unchanged, to 1875. See eg. Wikipedia. It is, implicitly, a key part of the foundations of the entire field of economics. That it is in error calls into question the soundness of the entire economics project.