Published in Wave Network online, June 2005

The public’s appreciation of economists and their contributions to society has probably never been excessively high. Part of this phenomenon may be due to the fact that economists have often enough been the ‘dirty realists of the social sciences’ (Diane Coyle) – telling people unpleasant truths that they did not want to hear. Another explanation may be that economists regularly fail to agree on questions of policy. As Winston Churchill famously put it: “If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions.” There is one area, however, which most people would believe to be so central to economics that there could hardly be any disagreement within the economics profession, and that is money. As economists deal with monetary figures almost on a daily basis, they are supposed to know what money is. Unfortunately and sadly though, this could not be further from the truth. On the contrary, I am tempted to claim that the vast majority of the profession does not have the slightest idea.

Try the following test yourself and ask an economist what money is. He will explain to you that money can be used to purchase goods and services and that it acts as a measure and a store of value. All of these characteristics are, of course, true. But has the economist really answered your question? In fact, he has not. All he did was enumerating some of the functions of money. But that does not tell us anything about the nature of money. By the same way, for example, you could explain what cars do (transport people and goods from A to B) without really explaining what a car is and how it works. Nevertheless, 95 per cent of the economics profession seems entirely content with this kind of ‘functional definition’ and proceed from there.

Only a minority of economists have put some more thought into this question, among them such outstanding academics as Ferdinando Galiani (1728-1791), Carl Menger (1841-1921) and Ludwig von Mises (1871-1973). Their answer to the question of the nature of money sounds quite different. According to their theories, money could only develop in a societies characterized by division of labour where people felt the need to exchange the goods they had produced for one another. The simplest form of exchange is known as barter of the kind “I give you a bit of my corn if you give me some of your apples”. However, this way of exchange was cumbersome. Your trading partner would sometimes lack the goods you desired in return, some goods were perishable or not easily divisible and besides it was simply unpractical. On a further stage of their development, all societies sooner or later discovered an easier way to cope with exchange. The most marketable (i.e. that most valuable, most sought after, most exchangeable) goods became the dominant means of exchange – not because some king or emperor said so, but because the market came up with this solution. These goods were mainly gold and silver. Only later did rulers start to put their portraits and symbols on the coins. The origin of money, however, was the free market.

For centuries, a system of gold based currencies worked very well with low or non-existing inflation, limited government spending, healthy public finances and none of the boom-bust cycles we are experiencing today. The big change occurred when governments all over the world saw the potential to take money as something they could manipulate. Instead of relying on gold, they simply printed paper notes and declared them to be money. In effect, they nationalized money. It made it much easier for them to finance wars and welfare programmes because now they did not need to collect taxes to spend money. The effects of such policies would only be felt later, especially in the form of inflation, currency crises and economic cycles.

Strangely enough, although most other kinds of socialism have frequently been attacked by advocates of the free market, the ‘meta-intervention’ of government-created paper money is hardly being called into question. In the long run, however, the destructive effects of false money could be even more disastrous than Soviet-style communism.

As Nobel Laureate Friedrich August von Hayek wrote, the “past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.” And in the same book he warned: “I still believe that, so long as the management of money is in the hands of government, the gold standard, with all its imperfections, is the only tolerably safe system, but it is better to take money completely out of the control of government. The only way to save civilization will be to deprive governments of the power over the supply of money.” If I may add, the first step on that way would be to tell economists what money really is.