6. The Perfection of Exchange: Money

If not to make the world better, what is money for?
– ELIZABETH TAYLOR

The logic contained in the sentence “Humans act” explains why people seek peaceful coexistence, why they cooperate voluntarily: it is the diversity of their abilities, desires, and goals that makes them enter into a division of labor. Division of labor means specialization: everyone concentrates on the activity that they are comparatively best able to perform. As a result, people no longer produce goods exclusively for their own needs, but also, above all, goods that their fellow humans wish to ask for.

Division of labor and specialization require interpersonal exchange. The most primitive form is barter: everyone exchanges the goods he has produced for the goods that others have produced and which he would like to possess. However, such barter (“goods for goods”) is cumbersome. After all, you always have to find someone who requires exactly what you have to offer. If this is not the case, if there is no “double coincidence” of wants, no exchange takes place.

If, however, the exchange possibilities are limited, the possibility of extending the division of labor and specialization reaches its limits: Productivity and thus prosperity are lower compared to a situation in which exchange possibilities are virtually unlimited. The possibilities for exchange can, however, be expanded if people switch to indirect exchange. Everyone begins to exchange his goods for those goods (indirect means of exchange) which themselves do not serve the final purpose, but which are subsequently exchanged for the ultimately desired goods.

Initially, there is a whole range of indirect means of exchange. Gradually, however, people reduce this multitude to a few means of exchange. The most widespread indirect medium of exchange becomes the generally accepted medium of exchange: money. Seen in this light, money is the commodity that has achieved the greatest marketability. However, money not only performs the extremely important function of a medium of exchange, it also plays another important role: money enables economic calculation.

In a primitive subsistence economy, in which everyone works for himself, there is no need for money. For example, a farmer working alone can judge whether he is better able to use his daily labor to clear a forest or to hunt. He can see which of these activities is most advantageous for him. In modern economies, which are organized on the basis of the division of labor and in which complex production routes have to be followed, money is indispensable, because an economic calculation cannot be carried out without money.

An economy is always faced with the question: How should the available resources (which are necessarily scarce) be used to best serve the needs? Let’s take, as an example, energy supply: Should a hydro-electric power station or a coal-fired power station be built? Both projects are complex. A lot of preparatory work is needed to make hydro power usable. For example, excavators, transport capacity, and manpower must be provided before the diversion of the watercourse and the construction of a dam can begin. Considerable preparatory work is also required for the construction of a coal-fired power plant. For example, drills, pit fans, and winding towers must be provided before coal mining can begin.

Such complex decisions can be managed by using money. The monetary prices formed in the market for the individual means of production reflect the value which the market players assign to them. If, for example, the price of a good rises, this shows that it has become scarce and must be used carefully. If, for example, it turns out that the costs incurred for rectifying the watercourse cannot be covered by the expected energy prices, this means that this form of energy supply does not make economic sense, because obviously there are other, more worthwhile uses for the scarce resources. Only economic calculation, which calculates with money prices, allows the most urgent needs to be met with scarce resources and the less urgent needs to be postponed. Advanced production based on the division of labor would not be possible without money.

This insight is not limited to a single isolated economy, it can also be applied to the world economic system. Up to now, people have been accustomed to using national money: purchases and sales are made in US dollars in the US, in euros in the eurozone, in Chinese renminbi in China, and in Japanese yen in Japan. But economic reason tells us that these regional monies are suboptimal if the goal is to advance the possibility of developing the division of labor worldwide.

A world economy in which different types of money are used is still a form of barter economy. Economic calculation which has to cope with many currencies does not fully exploit the potential that can be achieved by using a single currency. For economic calculation, the productive power of money is optimized only when everyone uses the same money, when a uniform type of money is used throughout the world. By the way, this was already the case in the last quarter of the nineteenth century: a uniform currency was used internationally—gold money. It had risen to a position of being world money, so to speak.

Using the logic of human action, we can justify why having one type of money is optimal for the economy or rather for the global economy.35 Let us assume that there is money A and money B. If both are equally good money from the point of view of the money users, one of them is expendable. If, on the other hand, money A is better than money B, money A is used, and money B is not required and is pushed out of the market. Could it be that money A and B are used side by side, if we assume we act from a position of uncertainty, meaning that the market players, because they are not quite sure whether money A or B is better, ask for both money A and money B? The answer is no.

Even in an uncertain situation, using one type of money is optimal from the point of view of economic calculation. There may be uncertainty as to whether the money used will retain its purchasing power over time; or whether it will be recovered if it is held by banks (i.e., a default or counterparty risk). However, in free markets such uncertainties are resolved contractually if necessary. For example, money users can take out inflation and payment default insurance if they wish. Therefore, even after taking uncertainty into account, the optimal number of money types remains one. A free market for money thus amounts to predatory competition that works toward establishing one type of money, the best money.

At this point a very fundamental question arises: How did money come about? Menger argues in his treatise Grundsätze der Volkswirthschaftslehre (1871; Principles of Economics, 1994) that money developed solely on the basis of the self-interest of the people involved, and spontaneously in the free market, without the intervention of the state:

The origin of money (as distinct from coin, which is only one variety of money) is, as we have seen, entirely natural. … Money is not an invention of the state. It is not the product of a legislative act. Even the sanction of political authority is not necessary for its existence. Certain commodities came to be money quite naturally, as the result of economic relationships that were independent of the power of the state.36

According to Menger, money arose from material assets, a commodity that, before it was used as money, was valued and traded solely for its non-monetary use. At some point it was used as money, because it was particularly suitable as a medium of exchange.

Menger’s theory that money originated spontaneously from the free market, from a tangible asset, is subsequently confirmed by Ludwig von Mises in terms of the logic of action. With his regression theorem, Mises shows that Menger’s theory of the formation of money is logically necessary.37 Mises argues that money is in demand because it has purchasing power. The purchasing power of money is determined by the supply of and demand for money. But wait, isn’t that circular reasoning? If you say that money is in demand because it has purchasing power, but at the same time you say that the purchasing power of money comes from the supply and demand for money—isn’t the dog chasing its tail? The answer is no.

Mises shows that the demand for money has a time dimension. Money is in demand today, because it had purchasing power yesterday. And yesterday, money was in demand, because it had purchasing power the day before yesterday. And so on. If we go back further and further in time with this explanation, we finally arrive logically at the point at which a good was first used as money. At that time, the good must have already had a market price, which, however, was explained only by its nonmonetary services. This nonmonetary exchange value was the starting point for the first purely monetary exchange value of the good.

According to the regression theorem, it is therefore not possible to introduce money “from above.” No ruler, no central authority can create money “just like that.” This realization raises questions, above all, the question of how it can be that today’s money is unbacked paper money. In his book The Ethics of Money Production (2008), the economist Jörg Guido Hülsmann writes pointedly: “Paper money has never been introduced through voluntary cooperation. In all known cases it has been introduced through coercion and compulsion, sometimes with the threat of the death penalty.”38 But if today’s unbacked paper money cannot have originated “naturally” in the free market, how, then, did it enter the world? In order to find an answer to this question, it is necessary to first deal with the state. This is done in the following chapter.

• 35This thought is usually not pursued by mainstream economists. Rather, there are ad hoc arguments. For example, Kenneth Rogoff argues for at least three or four currencies that should be globally sustainable. (Rogoff, “Why Not a Global Currency?,” American Economic Review 91, no. 2 (2001): 234–47.) Barry Eichengreen says a multiple currency system will emerge based on US dollars, euros, and renminbi. (Eichengreen, “Managing a Multiple Reserve Currency World” [paper prepared for the Asian Development Bank Institute/Earth Institute project Reform of the Global Monetary System, April 2010].)
• 36Carl Menger, Principles of Economics trans. James Dingwall and Bert F. Hoselitz (1974; repr., Grove City, PA: Libertarian Press, 1994), pp. 261–62.
• 37It should only be pointed out here that the regression theorem applies a priori; it can be derived from the logic of human action.
• 38Jörg Guido Hülsmann, The Ethics of Money Production (Auburn, AL: Ludwig von Mises Institute, 2008), p. 172.