The Origin of Money
Carl Menger's account of the origin of money is my favourite scientific explanation. It is deeply satisfying because it shows how money can develop from barter without anyone consciously inventing it. As such, it is a great example of Adam Smith's invisible hand, or what scientists now call "emergence."
Menger (1840-1921) founded the Austrian school of economics, a heterodox school of thought which is derided by many mainstream economists. Yet their accounts of the origin of money beg the very question which Menger answered. The typical mainstream economics textbook lists the problems of barter exchange, and then explains how money overcomes these problems. However, that does not really explain how money actually got started, any more than listing the advantages of air travel explains how aeroplanes were invented. As Lawrence White puts it in his book on The Theory of Monetary Institutions (1999), "one is left with the impression that barterers, one morning, suddenly became alert to the benefits of monetary exchange, and, by that afternoon, were busy using some good as money."
That, of course, is ridiculous. In Menger's account, money emerges through a series of small steps, each of which is based on self-interested choices by individual traders with limited knowledge. First, individual barterers realize that, when direct exchange is difficult, they can get what they want by indirect exchange. Rather than finding someone who both has what I want and wants what I have, I need only find someone who wants what I have. I can then trade what I have for his good, even though I don't want to consume it myself, and then trade that for something I do want to consume. In that case, I will have used the intermediate good as a medium of exchange.
Menger notes that not all goods are equally marketable. In other words, some goods are easier to trade than others. It therefore pays a trader to accumulate an inventory of highly marketable items for use as media of exchange. Other alert traders in the market catch on, and eventually the market converges on a single common medium of exchange. This is money.
Menger's theory does not merely show how money can evolve without any conscious plan; it also shows that money does not depend on legal decrees or central banks. Yet this too is often overlooked by mainstream economists. Take Michael Woodford for example. Woodford is one of the most influential academic monetary economists alive today, yet in his 2003 book Interest and Prices: Foundations of a Theory of Monetary Policy, a central bank somehow becomes part of the economy within less than a page after the initial assumptions are introduced. In other words, Woodford does not even pause for a page to consider what a banking system would look like without a central bank. Yet free banking has a long history; the first such system began in China in about 995 AD, more than 600 years before the first central bank.
Can we account for the emergence of central banking by the same invisible-hand type of explanation that Menger proposed for money? The answer depends, according to Lawrence White, on just what we mean by the term "central banking." If government sponsorship is among the defining features of a central bank, then the answer is no. In other words, the emergence of central banks cannot be accounted for entirely by market forces. At some point, deliberate state action must enter the story. The government's motives for getting involved are not hard to imagine. For one thing, exclusive supply of banknotes gives the government a source of monopoly profits in the form of a zero-interest loan from the public's holding of these non-interest bearing notes.
In these troubled times, when central banks are expanding the stock of high-powered money through massive quantitative easing, Menger's theory is more relevant than ever. It alerts us to the possibility that the response to the current crisis in the eurozone need not be ever more centralization, but could instead consist of a move in the opposite direction, towards a regime in which any bank is free to issue its own banknotes, and market forces—not central banks—control the money supply.