Lesson 1 of 9
The problem money solves
Money exists to break a requirement that direct exchange imposes: that two people each want what the other has, at the same time, in the same place.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Direct exchange requires a double coincidence: each party wanting what the other holds, at one time and place. Most useful trades fail that test.
- Money is whatever removes the requirement by being generally accepted, which splits one impossible trade into two ordinary ones.
- The second thing money makes possible is arithmetic across unlike goods, and without that there is no way to compare one production plan with another.
Mises opens The Theory of Money and Credit by saying what money is for before saying what it is worth. The order matters, because the function is what the rest of the theory has to explain.
One impossible trade becomes two ordinary ones
- 1Direct exchangeA wants B's grain and B must want A's net. Both conditions, at once
- 2The requirement failsUsually. The coincidence is rare and both parties go without
- 3A generally accepted good appearsTaken by nearly everyone, whether or not they want it
- 4Two tradesNet for money, later money for grain. Neither needs a coincidence
The double coincidence, stated properly
Menger's argument in the second course of this track is the starting point. Direct exchange needs two people who each hold something the other wants more than what they hold, at the same moment and in the same place. Mises's chapter on the nature of money puts the same point as the function money performs: it is there to make the business of the market work by serving as a common medium of exchange.
Everything else money does is secondary to that, and Mises treats it that way in his third chapter: deferred payment, storing value, carrying value from one place to another, all derive from the first function rather than standing beside it.
What generally accepted means
The property that matters is not physical. It is that other people will take it. A good is money when a seller accepts it without wanting it, because they know the next seller will do the same.
That makes acceptance self-reinforcing, and it is why money tends toward one good rather than several. Mises's second chapter describes exactly that narrowing: traders move toward the most marketable commodities, and the process ends with one thing generally employed.
The second function, which is the one this track needs
Money makes unlike things comparable. Once prices are expressed in one unit, a firm can add the cost of steel to the cost of a month of labour and compare the total with the price it expects to get.
That sounds mundane and it is the foundation of every later argument in this track. A plan of production is a comparison between quantities of unlike things now and unlike things later. Without a common unit the comparison cannot be made at all, and a price system cannot do the job the previous course described.
It also creates the exposure. If the unit itself is unstable, every comparison made in it inherits the instability, and nobody reading a price can see which part of a change was in the goods and which was in the unit.
Check yourself
What requirement does direct exchange impose?
- That both goods are equally valuable
- That each party wants what the other holds, at the same time and place
- That a price has been agreed in advance
Show the answer
Answer: B.
This is the double coincidence of wants. Most useful trades fail it, which is the problem a medium of exchange removes.What makes a good money, on this account?
- Its physical durability
- That other people will accept it, so a seller takes it without wanting it
- That a government has declared it legal tender
Show the answer
Answer: B.
Acceptance is the property, and it is self-reinforcing, which is why Mises describes exchange narrowing toward a single generally employed good.Why does the common unit matter for the rest of this track?
- It allows taxes to be collected
- It makes unlike quantities comparable, so a production plan can be evaluated at all
- It removes uncertainty about the future
Show the answer
Answer: B.
Every production plan compares unlike things now with unlike things later. Without a common unit the comparison cannot be made, and instability in the unit contaminates every comparison made in it.Sources
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part one, chapter 1 on the function of money as a common medium of exchange, chapter 2 on the origin of money and the narrowing of exchange toward the most marketable goods, and chapter 3 on the secondary functions deriving from the first.
- Menger, Principles of Economics, 1871, English translation 1950, chapter VIII, section 1, for the rarity of the double coincidence.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The three-person example is invented to show the structure of the problem. It is not a historical claim about how exchange worked anywhere.
- That money removes the coincidence problem is not disputed. What is disputed is how money came to exist, and that argument is set out in the earlier lesson this one links to.