– September 26, 2020
exchange

Whatever its origins, money must be reckoned one of the greatest labor-saving technologies in human history. As we have seen, money eliminates the double coincidence of wants problem that exists under barter. It is no longer necessary to find someone who wants what you have, and also has what you want, when you make exchanges. If all exchanges take place using money, money itself becomes one-half of all exchanges. In practice, some transactions might continue to take place without money. But money is used in most transactions. Indeed, if money were not generally accepted, it would not be money, as money is defined as a commonly accepted medium of exchange. 

Money thus links all markets. Serving as the common element of exchanges, it brings into a single network a vast array of economic activity that otherwise would only take place in a disparate, fragmented form. Money thus promotes the integration of otherwise unrelated acts of exchange into a coherent system. Viewed this way, money is not just a way of economizing on transaction costs. It is also the ultimate market-maker!

It is not possible to comprehend the totality of these exchanges. The economic system is simply too complicated. But it is possible, and desirable, to understand the functional relationships governing economic activity that money makes possible. When we understand these relationships, we come to appreciate just how marvelous money and markets are as institutions for creating wealth. Nothing exists in human history comparable to the awesome power of money and markets to lift nations out of grinding poverty and into comfortable abundance.

The Marvel of the Market

Economics, as a science, is comparatively young. While writers have treated ideas like household management, labor, and wealth for millennia, investigations into these topics were usually narrow and scattered. Only starting in the 17th century did economic matters, hitherto relegated to ad hoc sections in works on politics, law, ethics, and religion, come to occupy a prominent place in dedicated works. What began in the 1600s reached fruition in the late 1700s: Adam Smith, the great Scottish philosopher, published his Inquiry into the Nature and Causes of the Wealth of Nations in 1776, and modern economics was born.

Perhaps the most celebrated idea from Smith’s Wealth of Nations is the division of labor. Although by today’s standards England and Scotland in the late 18th century were very poor, already they were starting to show signs of the nascent explosion of wealth that would occur during the Industrial Revolution. Smith noted that the root of increased wealth—which really means the increased supply of real goods and services, for only this can increase living standards—was due to specialization and trade. As workers focused on various tasks, they became more productive by specializing in one small part of that task: they were able to produce more outputs with given inputs. And as everybody specializes and then trades the resulting product, everyone becomes much wealthier. Provided there is sufficient market for the finished products—remember Smith’s famous maxim that “the division of labor is limited by the extent of the market”—specialization and trade are incredibly powerful ways of increasing national wealth.

But wait! The existence of an increasingly complex division of labor raises another question. With everybody specializing, what is it that gives the overall economic system its coherence? If each person participating in markets is focused on one small task, and nobody pays attention to the whole, should markets not be disorderly and chaotic? And, yet, casual observations suggest markets are almost always orderly and harmonious. This is surely a puzzle. 

Think of all the steps involved in getting milk from dairy farms to your table, for example. The cows, which need to be cared for, must be milked; the milk must be transported to the grocery store without spoiling; it must stay fresh long enough for people to buy it; and the grocery store needs to find a way to figure out how much milk people want, so they do not end up with too many or too few gallons of milk. We do not call up the grocery store to let them know we are coming by. We take it for granted that milk will be there whenever we want it, and not just one kind: we expect there to be regular milk, reduced fat milk, and skim milk, as well as related products such as heavy cream, half-and-half, and butter. How is this regularity brought about, since it is evident nobody is in charge?

Money and Economic Coordination

In brief: coordination is possible without command. Markets are orderly despite the fact that nobody is in charge. In fact, given just how complicated markets are, it is more correct to say that markets are orderly because nobody is in charge! The knowledge needed to “plan” a market is simply too great for any one mind, or even a group of minds, to possess. Something other than human intellect and willpower must be coordinating markets.

Smith had a pretty good understanding of what this “something else” was, but more than a century of development in economic thought was necessary before economists had a complete answer. Thanks in no small part to the great Austrian economist, Ludwig von Mises, by the early 20th century economists could confidently point to money and markets as the driver. The economic system—the incomprehensibly large number of exchanges that comprise what we call the economy—is ordered by market prices, denominated in money, adjusting to supply and demand conditions. This is how the milk gets on your table. This is how great metropolises get fed, even if nobody within the municipal boundaries is a farmer or a rancher. 

The central problem of economic coordination is how the plans of producers—and hence the division of labor—are brought into balance with the desires of consumers. Market prices are the answer. When the price of a good is too high, sellers want to sell more goods than buyers want to buy. As a result, sellers compete for relatively scarce buyers by cutting prices. When the price of a good is too low, buyers want to buy more goods than sellers want to sell. As a result, sellers compete for relatively scarce buyers by bidding higher prices. Coordination is reached when, at a given price, the amount sellers want to sell equals the amount buyers want to buy. Thus, market prices are a means of communication between buyers and sellers. Prices are pieces of information that detail relative resource scarcities. Buyers and sellers “talk” through the price system, and are able to convey more information to each other through this medium than they are able to comprehend consciously.

On the seller’s side, we must also make note of profit-and-loss accounting as a crucial practice driving economic order. Businesses exist to make a profit. They produce and sell goods in such a way as to (try to) make the largest profit possible. This is how they know whether they are satisfying consumer demand. Profits are a signal to firms by consumers: “We like what you are doing! Please do more of it.” Profits mean businesses have added value to society’s scarce resources through the act of production. 

Losses imply the opposite. Losses are a signal to firms by consumers: “We dislike what you are doing! Please do less of it.” Losses mean businesses have reduced the value of society’s scarce resources through the act of production. 

It is easy to see that profits and losses give businesses the incentive they need to satisfy consumer wants. Everyone wants to make money; nobody wants to lose money. But just as important, if not more important, is the informational role of profits. Profit-and-loss accounting is how firms discover, through the market, which production methods and what quantity of goods consumers like best.

Both profits and losses, however, require market prices for their computation. And this is where money comes in explicitly. Without money, profit-and-loss accounting would not be possible. Businesses can keep track of revenues and costs, and compare them in a single accounting equation, because money serves as the common denominator in which prices are expressed. Revenues and costs are expressed in dollars. Thus the calculation of profits or losses presupposes money. Imagine trying to compute profits or losses in a barter system! You buy and care for a cow using ten bushels of grain. You then sell the milk for five pounds of vegetables and a yard of rope. Have you made a profit and, if so, how much? The very question is absurd. Profit only makes sense if there is some common medium in which revenues and costs can be expressed. That medium is money.

Likewise, the balance between the quantity supplied by producers and the quantity demanded by consumers requires money. If there were no common medium of exchange that served as the measuring rod for various market prices, how could these disparate lines of production be compared? If the exchange ratios we call prices were expressed in different goods for each market, how could there be anything like a tendency for producers’ supply to track consumer demand? Markets would be incredibly difficult to navigate without money.

This is why economists, as a group, cannot stop talking about the price system. Non-economists are often surprised that something so unremarkable as prices can excite economists so much. The reason is the incredible acts of coordination prices make possible. 

Prices are not just exchange ratios, the amount of one good you have to give up to get one unit of another. These seemingly uninteresting numbers are at the heart of how markets are governed, although there is no governor. As economists Tyler Cowen and Alex Tabarrok explain, “A price is a signal wrapped in an incentive.” The price system generates the information necessary for buyers and sellers to adjust their separate plans in a manner compatible with the plans of others, and also creates the incentives necessary for them to do so. None of this would be possible without money and markets.

Money and markets are thus complementary institutions. Humans have traded with each other for millennia. But trade by itself is insufficient to sustain an advanced division of labor, and hence modern economic prosperity. If we want the wealth of nations, we need money, and the incredible degree of economic coordination it permits. To paraphrase the argument as put by Mises: you can’t have rational economic calculation without both markets and money. 

Provided there is widespread social respect and protection for the institution of private property, we can have both markets and money, and the material bounties they create. But if we fiddle with markets and money, for example by conducting misguided political experiments, we jeopardize the very roots of our economic well-being.

Alexander William Salter

Alexander W. Salter

Alexander William Salter is an Associate Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute, both at Texas Tech University. He has published articles in leading scholarly journals, such as the Journal of Money, Credit and Banking, the Journal of Economic Dynamics and Control, the Journal of Macroeconomics, and the American Political Science Review. His opinion pieces have appeared in The HillThe American ConservativeUS News and World ReportQuillette, and numerous other outlets. Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.

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