Money and Monetary Policy

The Emergence of the Modern Monetary Economy and Its Neoliberal Aberrations

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium of Social Ecological Economics
Click here for the German-language version: Geld und Geldpolitik

Table of Contents

  1. Overview
  2. The Emergence and the Development of Money
  3. The Origin: The Natural Economy
    > Step 1: Division of Labour and Barter Transactions
    > Step 2: Lending Transactions and Natural Interest
  4. Transition from Natural to Monetary Economy
    > Step 3: Natural Economy with Debt Acknowledgement
    > Step 4: Natural Economy with Transferable Debt Acknowledgements
  5. The Pre-Modern Monetary Economy
    > Step 5: Standardized Money and Central Control
    > Step 6: Lending Transactions with Interest on Money
    > Step 7: State Control of the Monetary Economy
    > Step 8: National and International Gold Standard

In continuation of this article, the modern monetary economy and monetary policy is dealt with in the article Money Creation and Destruction.

1. Overview

Geld-regenBecause of its immateriality and fleetingness, money is entwined with myths like no other economic instrument. It can only be soberly categorized and disenchanted if one becomes aware of the logic of its genesis. However, the unique, even ingenious economic function of money has once again fallen into disrepute by the aberrations of the neoliberal globalization and particularly by the ongoing financial market and economic crisis. An honour rescue of the money is called for.

2. The Emergence and the Development of Money

Money is undoubtedly one of the few elementary inventions that have had a lasting impact on the economic development of mankind. To its defence it should be noted that it’s on a par with the utilization of fire and the invention of the wheel.

No other invention has boosted the exchange of goods and services and the division of labour more than money. But there is also no economic instrument around which so many myths entwine and which seems as mysterious as money. People say, in their infinite wisdom, that money reassures, but does not make happy, that it even corrupts the character. Money’s reputation was and still is dazzling: on the one hand it tempts to dream of wealth, power and absolute freedom, on the other it creates fear through its immateriality and fleetingness.

The ambivalent attitude towards money has intensified since the beginning of the hot phase of the economic globalization in the 1990s and reaches a new peak in the course of the financial market and economic crisis. What could be more obvious than to take a sober look at the function of money? Despite all the complexity, the principles of the modern monetary economy are easy to see through if one visualizes the emergence and development of money step by step throughout the historical process. The period considered extends from the Palaeolithic to the present:

3. The Origin: The Natural Economy

Step 1: Division of Labour and Barter Transactions

The trade in goods between people begins long before the settled lifestyle and the invention of agriculture and progresses with the increasing division of labour. The focus is on the direct exchange of goods between trading partners, which is bound to time and place. A disadvantage is that the barter transactions are difficult to initiate because each deal requires a double match of demand. That is, only trading partners can come together who have a particular need for each other’s goods. In addition, potential partners must agree in advance on the exchange ratio, i.e. in what quantitative ratio one good is to be exchanged for the other good. As the number of exchangeable goods rises, the exchange ratios naturally become more complex and more difficult for potential partners to assess, because practically every good can be exchanged for every other one. The complexity requires high search and thus ultimately high transaction costs, creates uncertainty and makes the initiation and speedy processing of transactions more difficult.

Economic evaluation: The barter economy generates little economic momentum with little technological progress. On the one hand, because of the above-mentioned double match required and the complexity of the exchange ratios, on the other, because there are no stimuli from fruitful tensions between debtors and creditors as created by the lending transactions of the later natural economy and even more so by the lending transactions of the present monetary economy.

Step 2: Lending Transactions and Natural Interest

In addition to barter transactions, lending transactions are also carried out in the natural economy – however, due to the necessary trust among traders, only in the immediate vicinity. For example, the skilful manufacturer of bows and arrows (as a lender) can lend his weapons to the skilful hunter (as a borrower) for a certain period of time, so that the hunter can hunt down more animals and compensate the weapon maker for the lending with part of his hunting bag (as a natural interest). The beginning of agriculture opens up further possibilities: For example, farmers can »lend« different kinds of seeds of particularly high-yielding cereals to each another, and, after the harvest, the borrower can repay the lender the amount of cereals borrowed (as redemption) and compensate him with an additional amount of cereals (as natural interest).

The natural interest already provides the economic justification for interest in general, which is still valid today: The interest is the price for the advantage of being able to immediately use third-party physical or monetary capital without delay, instead of generating it from one’s own resources and only being able to use it at a later point in time. While the lender of capital (the investor) waives the use of the capital for the agreed period, i.e. deliberately postpones its use into the future, the borrower earns an extraordinary return during the period of transfer. With the interest, the lender participates in the yield of the borrower and is thus compensated for his waiver. If an appropriate interest level is agreed upon, both sides win in lending transactions in principle: In modern business jargon one would speak of a win-win situation.

Economic evaluation: Lending transactions in the natural economy create a fruitful tension between lenders and borrowers that unfolds a previously unknown economic dynamism: The lenders are anxious to enforce the return of loan goods and the »payment« of interest, while the borrowers are anxious to make optimum use of the loan goods in order to achieve the highest possible net yield after deduction of interest. In addition, the lending of goods generally increases their consistently efficient use and triggers further profitable transactions and strengthens economic cycles. The same applies to the interest received by lenders, which also entails new economic transactions.

In addition still another interesting note: The historical development in principle suggests that the invention of interest should be dated earlier than that of money. However, there are no prehistoric finds to prove this.

4. Transition from Natural to Monetary Economy

Step 3: Natural Economy with Debt Acknowledgement

In the course of regional expansion, barter and lending transactions are secured against the sellers or lenders by personal acknowledgements of debt (today: promissory notes) on the part of the buyers or borrowers. The prerequisite for this is that the business partners agree on binding and forgery-proof objects or methods of »bookkeeping« for the recognition of the debt.

In barter transactions, for the first time individual commercial goods can now change owners without simultaneous exchange of goods, only against a personal acknowledgement of debt. Each player can now carry out an isolated purchase or sales transaction without having to carry out a counter transaction at the same time. The documented debt entitles the creditor to demand other commercial goods of the same value from the debtor at a later date against return or cancellation of the acknowledgement of debt.

Economic evaluation: Barter transactions gain in flexibility and can be handled in a time-decoupled manner: The introductory handover of goods takes place in one direction against an acknowledgment of debt, the counter handover in the other direction can take place at a later time and at another place. In lending transactions, personal acknowledgements of debt create greater flexibility and security and allow transactions even between persons who are not close to each other.

For the further development it is crucial that transactions based on personal acknowledgements of debt are the first intermediate step towards the invention of (un-personal) money.

Step 4: Natural Economy with Transferable Debt Acknowledgements

The second intermediate step towards the invention of money is the exchange of personal acknowledgements of debt for goods of a third party. In this case, the acknowledgement of debt is passed on from the original creditor to a new one. The condition for the passing on is that the new creditor places the same trust in the debtor as the original creditor. Wherever this trust can be established, the personal debt acknowledgements receive the status of un-personal valuable documents and can be traded at will.

Economic evaluation: The tradable debt acknowledgements stimulate trade by breaking open the previously strictly bilateral transactions of the documents and allowing multilateral transactions of any kind. This means that anyone can trade goods with anyone else against their own or other people’s debt acknowledgements. However, the great danger posed by transferable documents is that overall control is lost, as market participants are tempted to issue unlimited numbers of documents with unlimited total value, thus causing inflation of intermediate exchange mediums and thereby accumulating personal debts that they will never be able to redeem. In this case, the trust in all transferable debt acknowledgements is lost, the trading system collapses, and the return to a natural economy with barter transactions is inevitable. Today, such a development would be called hyperinflation with subsequent depression. In prehistoric times this danger was averted with the threat of draconian punishments.

5. The Pre-Modern Monetary Economy

Step 5: Standardized Money and Central Control

The final step towards a pre-modern monetary economy includes two measures:

  1. The transferable debt acknowledgements are replaced by uniform, distinctive, countable, durable, easily transportable and forgery-proof objects.
  2. The production and distribution of the objects is organized and controlled collaboratively and centrally.

Thereby, a non-personal, generally accepted intermediate exchange medium is invented, namely the money, – and by the way, in many cultures simultaneously and independently of each other. The traditional forms of money are numerous: valuable jewellery, collector’s items such as rare shells and valuable metal bars, above all made of gold and silver, but also processed stones, which besides their function as money have no material or collector’s value. Some isolated cultures also use valuable natural produce, so-called payments in kind or natural money, such as furs, live animals and grain.

The introduction of the monetary economy within a community or an economic area takes place by initially distributing the centrally produced money either equally to all residents, so that each person has the same limited advance of purchasing power without any return service, or by distributing the money to the residents according to their economic power. Those who want to buy beyond the amount of money originally distributed are required to offer their own goods or services for money first. The value of the initially distributed money supply must be at least equal to the value of the highest trade volume conceivable at the given time. If money shortages occur, the money supply can be increased by producing new money and distributing it to all players in the manner shown.

Economic evaluation: The advantages of money are obvious: Compared to barter transactions, the search for suitable barter products and partners willing to barter as well as the necessary simultaneity of the transfer of goods or services to be exchanged against each other is overcome with money. Compared to barter transactions based on transferable debt acknowledgements, the security is further improved, above all because type and quantity of money are determined centrally and so it’s no longer at the discretion of individual players to circulate any number of intermediate exchange mediums and thus incurring high debts and contributing to inflation. Goods and services can now be exchanged between suppliers and demanders in one direction for a secure and countable intermediate exchange medium. Trading becomes more efficient because it causes lower search and transaction costs, and it becomes more effective because goods and services can be traded without regard to immediate material return and without regard to a possibly crooked, half-heartedly accepted countervalue of the intermediate exchange medium. These advantages boost supra-regional trade relations.

With its invention, money immediately fulfils three unique economic functions:

  1. It is a generally accepted intermediate exchange medium that causes very low transaction costs when used.
  2. It serves as a calculation tool that replaces the countless exchange relations between the multitude of products with a single, comparable monetary price for each product (the price, however, remains negotiable).
  3. And it can be used as a store of value, because its purchasing power is preserved as long as there is no inflation; but irrespective of possible inflation, it can always be used with a time delay; however, the disadvantage being that stored money basically does not yield interest.

Step 6: Lending Transactions with Interest on Money

After the introduction of the money economy, lending business is also experiencing a revival. Interest on borrowed physical capital such as weapons (see above) can now also be paid in money instead of goods such as bagged animals or personal debt acknowledgements. The same applies to the lending of real estate, vehicles, machines and tools, which can be provided in return for a rent. Monetary capital can now also be lent instead of physical capital, i.e. as a loan. The reason and justification for the interest on money is, as shown above, the same as for the interest on physical capital (natural interest). However, lending transactions, especially under the anonymous conditions of a supra-regional monetary economy, require clear and binding agreements between the partners regarding duration, interest and repayment (redemption). Under fair conditions, the amount of interest (or the interest rate) is calculated from the sum of three estimated values: the amount of the presumed inflation, the amount of the presumed default risk of the borrower, and the amount of the lender’s profit waiver.

Economic evaluation: The immateriality of lending transactions with monetary capital and money interest allows for supra-regional relationships and increases the overall volume of business – but also with the risk of extortion with regard to the level of interest against borrowers who are in distress. Thus the lending business comes into disrepute at times by usurious interest rates and provokes central regulations for limiting as well as for completely prohibiting interest demands. That’s why some religions condemn interest as immoral or sinful, which continues to have an effect to the present day. However, since effective interest bans would bring the lending business to a standstill, because naturally nobody is prepared to transfer his laboriously earned liquidity advantage without consideration to strangers, bans are undermined in practice with hidden interest payments.

Step 7: State Control of the Monetary Economy

From the seventeenth century onwards, experience in antiquity and the Middle Ages lead to the conviction that the uncertainties and the cheating to which traders are exposed in the face of increasing trade volumes and geographical expansion of trade require central regulation and control of the monetary economy at the national level and beyond. Above all, it is necessary to get a grip on the devaluation of money as a result of uncontrolled increases in the money supply and on the extortionate usurious interest rates, which are spreading in lawless areas.

First, in the late Middle Ages, private trading houses become the first private banks to conduct lending business on a large scale, including internationally, trying to make business more efficient by means of paper money (bank notes) and book money (bank deposits) held in bank accounts. In order to counter the widespread fear of money supply increases (inflation) and the associated money depreciation, the new private banks guarantee the exchange of paper and book money at any time into precious metal coins of lasting value.

By the nineteenth century, paper and book money have been established in Europe, and the guarantees for exchanging money for precious metal coins of lasting value are now being conducted for the first time by state-owned banks – the forerunners of today’s central banks.

Economic evaluation: The urge to expand and the power of private trading houses and banks inaugurate a fruitful phase of »late medieval globalization« of trade. The experiences made during this period with a controlled monetary economy form the foundation for the state-controlled monetary economies of the nineteenth and twentieth centuries.

Step 8: National and International Gold Standard

goldstandardIn the nineteenth century so-called national gold standards are developed by state banks in many countries. Two options are used: Either the money itself is put into circulation as valuable gold or silver coins, or the state banks commit themselves to exchange banknotes (paper money) as well as coins, which have no or only small material value, at any time on demand into an amount of gold or silver corresponding to the monetary value.

Building upon this, an international monetary regime based on gold backing is developed: the international gold standard. Each country sets its own gold price, and the national banks commit themselves to buy and sell gold internationally at the fixed prices at any time. This automatically results in a fixed gold parity for the exchange rates. At the same time, the buying and selling of gold against foreign exchange, which takes place between economic players and national banks, can be used to adjust the balance of payments.

The so-called gold foreign exchange standard is the third variant: a large country provides the reserve currency and introduces the gold standard, while fixed exchange rates are agreed upon for the currencies of the partner countries. The partner countries then have the right to exchange their holdings in reserve currency for gold at any time upon request. In 1944, this variant was introduced by the Bretton Woods Agreement with the US dollar as reserve currency, and was in force until the early 1970s. For details see the article Bretton Woods System (English).

Economic evaluation: The national gold standard offers the advantage that the danger of money devaluation due to negligent money supply increase (inflation) is low because it presupposes a costly increase in gold reserves. At the same time, however, the advantage has an essential disadvantage: Economic growth can be slowed down by an appreciation of money caused by an unadjusted, relatively shrinking money supply (deflation). In concrete terms, this means that on the one hand there is too little new money available for investments, and on the other that economic players keep their money in the till to speculate on further currency appreciation instead of spending it and thus return it to the money and economic cycle.

The advantages and disadvantages described also apply to the international gold standard, which, however, offers two other advantages: Firstly, the above-mentioned chance to continuously adjust the balance of payments in international trade with skillful control through gold transfers (so-called gold automatism) and, in general, owing to the slight inflation of the money supply caused by the system, to keep surpluses and deficits in foreign trade within narrow limits.

In addition the opportunity arises to fix exchange rates from the outset in such a way that they neutralize productivity and price differences on average in all bilateral trade relations, so that competition can take place constructively based on relative price advantages. That is, prices that deviate from the average price of all trade products can determine the bilateral trade flows and generate trading profits on both sides. For further details please see the articles Future-Proof Foreign Trade and Comparative Advantage – Upgraded.

The above mentioned Gold Foreign Exchange Standard of the Bretton Woods Agreement fails at the beginning of the seventies of the last century, because the USA inflates the dollar supply to finance the Vietnam War. As a result they pile up an irresponsible trade deficit and finally can no longer exchange the dollar reserves accumulated abroad for gold.

With the failure of the Bretton Woods Agreement, the era of gold standards in economic history has come to an end once and for all. However, the financial market and economic crisis that took its course in 2008 has led to a return to gold as a stable investment, both for central banks worldwide and for private individuals. The Chinese and the Indian central bank, in particular, are currently buying gold again to reduce their risky dollar reserves, while Western central banks have restricted their successive gold sales in order to keep a residual stock of gold as a last resort. By proving the gold standard to be an obstacle to dynamic economic development, gold has now assumed its presumably natural role as an aid to bridging economic crises.

In continuation of this article, the modern monetary economy and monetary policy is dealt with in the article Money Creation and Destruction.

Note on the COVID-19 Pandemic

The pandemic has noticeably revealed the significant weaknesses of the neoliberal economic system for everyone, above all the shortage of medical, but also other products, caused by disruptions in the absurdly networked value and supply chains across the globe.

The analyses of the neoliberal system as well as the principles and practical procedures based on them for building a sustainable system, which are presented in this compendium, thereby obtain an unexpected topicality. Now is the time to seize the opportunity and build up economic policy pressure to enforce the development of an economic order that is sustainably oriented towards social and ecological welfare.

The following article refers to the targeted arguments contained in the Compendium: COVID-19 and Globalization
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Click here for the German-language version: Geld und Geldpolitik.

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