Money: A Taxonomy

What is money? Most people have only a vague idea. It has something to do with the green pieces of paper in one’s wallet; but then again such paper is rarely used in our digital age. The intention of the present article is to give an overview of the different financial instruments that people often refer to as money.

While seemingly a remarkably dry subject, I am convinced that no aspect of economic theory is as important in our time as a correct formulation of money and banking. The reason why understanding the different types of “money” is so vital is because modern phenomenons such as the business cycle, credit collapses, inflation, and the misallocation of resources all revolve around money. And it is only in understand what money is that we can identify where we went wrong.

What follows is, obviously, a view of money according to the Austrian tradition. And more specifically, it is a very Misesian approach and we rely heavily on Ludwig von Mises’ own definitions in order to make our point. But even here we immediately run into an obstacle. The book in which Mises most completely set out his typology of money was his Theory of Money and Credit. It was first published in 1912 with the German title Theorie des Geldes und der Umlaufsmittel. It was the first English edition in 1934 that translated the title as Theory of Money and Credit. But, as Jorg Guido Hulsmann points out in the first chapter of a celebratory collection of essays published in honor of Mises’ great work, the use of the word “credit” here is misleadingly broad, and we will discover why as we proceed. The point, however, is that we must choose an interpretation of Mises’ framework when we adopt our Misesian taxonomy.

The first English edition of Theory of Money and Credit includes the following diagram, added by the translator, but not by Mises.

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Anyone who just reads the English edition might consider it just fine and associate Mises’s thoughts on the matter with this diagram. Indeed, even in Robert Murphy’s new summary book of Mises’ Human Action (which is very highly recommended for those interested in learning the Misesian vision), Murphy adopts the diagram from the 1934 English translation. But this is a grave mistake. For as Hulsmann notes:

The diagram reflects precisely that sort of thinking about money that Mises wished to overcome. It clings to the physical surface of things. […] The very point of Mises’s theory was that these physical manifestations could be very different economic goods, depending on the legal and contractual context.

As such, and all this will become clear as we work through the taxonomy, we will use the following diagram created by Hulsmann for our purposes:

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Let us begin.

Money is a medium of exchange that developed naturally and organically on the free market as a result of the voluntary actions of many people over time. It is not, as many people assume, a creation of government. Money preceded government and our modern monetary systems which rely on state power only reflect the fact that governments have a natural tendency to desire control of money and banking.

Before there was money there was barter. The economic nature of barter can be termed “direct exchange.” Direct exchange takes place when two people exchange goods because the good being received is anticipated to directly satisfy the desires of the receiver. Example: Jones exchanges two apples that he grew for two oranges that Smith grew. Jones anticipates the oranges will satisfy him and Smith anticipates that the apples will satisfy him. And so they trade. This is a direct exchange; no money necessary.

But things become more complicated when we add in more people and more goods being produced. Jones has apples, Smith has oranges, and Higgs has lumber. Jones really desires lumber, but unfortunately, Higgs does not want the apples that Jones is offering in exchange. Higgs only wants oranges. Does this mean Jones can never acquire lumber?

The solution is that Jones trades apples with Smith to acquire oranges. These oranges are acquired not for their direct satisfaction, but so that they can be used to accumulate the lumber needed. In this scenario, the apples-to-oranges trade was an “indirect exchange.” The good being received (oranges) was intended merely to give Jones the ability to get what he really wanted the whole time.

As the economy grows and as more and more people and their products are added to the society, there arises certain goods that have a general and widespread demand for indirect exchanges. These certain goods are sought, not to directly satisfy the desires of the individuals, but to have the ability to offer them in exchange for the goods that they actually do think will directly satisfy them.

These certain goods become a medium of exchange and it is this that we call “money.” Throughout history, there have been many commodities that attained the role of money. Murray Rothbard, in his book What Has Government Done to Our Money?, explains the history:

Historically, many different goods have been used as media: tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities. Both are uniquely marketable, are in great demand as ornaments, and excel in the other necessary qualities. In recent times, silver, being relatively more abundant than gold, has been found more useful for smaller exchanges, while gold is more useful for larger transactions. At any rate, the important thing is that whatever the reason, the free market has found gold and silver to be the most efficient moneys.

So then: money is a medium of exchange and money originally developed as an economic good as a result of the market process.

Now, let’s refer back to the diagram above. You’ll notice the top line there in the hierarchy is “money in the broader sense.” What this refers to is anything that acts, on a consistent basis, as a medium of exchange in a society. This can be various forms of credit, green paper with Presidents on it that the government prints, coins, etc. Any instrument that is a medium of exchange is money in the broader sense.

But as you can see, there are two divisions from this point: “money in the narrower sense” and “money substitutes.”  What do these mean? We can explain this most clearly by referring to our original commodity money. Money in the narrower sense is the money itself. It is the gold or tobacco or salt or whatever the commodity is that has the greatest demand for use as medium of exchange in an economy. But carrying around these commodities can get cumbersome. Not only is it difficult to lug around pounds of gold, but it is also dangerous and insecure.

As such, institutions offered their warehousing services by keeping the actual commodity money safe and secure for the client. They would keep the money behind lock and key and give their clients a receipt for this money. The clients could at any time come back to the institution and trade in their receipts for their money. Soon the receipts of the major institutions were traded around in the place of the money itself. Jones could use the receipts for the gold that he held in the warehouse to exchange with Smith for a loaf of bread. After all, the receipts could be redeemed at anytime by whoever was holding the receipt. These receipts, to use the language of the diagram, are called “money certificates” because they are fully backed up by the actual money in the warehouse. As for the warehouses, these are what we now refer to as banks.

But there is another type of money substitute: fiduciary media. Fiduciary media is a result of a banking practice that has come to be known as “fractional reserve banking.” Whereas by definition all money certificates are backed up 100% by the money in the warehouse bank, fiduciary media comes about by these banks issuing receipts for the money where there is actually no money backing it. We won’t get into the legal ramifications of this practice in the present essay.

So let’s give an example. Say that Jones has 100 grams of gold-money and he uses the Hulsmann Bank to store this gold. Hulsmann bank has only one client: Jones. Hulsmann Bank issues money certificates to Jones that he may carry around with him as he pleases. He has 100 receipts, each of which can claim 1 gram of gold (obviously, banks can issue receipts with higher denominations as they see fit). Since each receipt is backed up by the money in the bank, all outstanding receipts are money certificates.

However, let’s say that Smith wants to borrow some money from Hulsmann bank. There are two ways of accomplishing this. The first is called loan banking. We will not get into this here, but it should be known that loan banking per se is a healthy and encouraged aspect of a banking system. However, the second method is as follows: Hulsmann bank, having the 100 grams of gold deposited by Jones, may issue 20 receipts to Smith as a loan that needs to be paid back. These receipts can claim 20 grams of gold from Hulsmann bank. But since Jones already has a claim on 100% of the money in the bank, the additional receipts issued to Smith are fiduciary media. 

Thus, any money substitute that is traded in the economy in place of the money itself is either a money certificate (if it is backed up by the money) or it is fiduciary money (if it is not backed up). How can one tell whether the receipt in his hand is one or the other? The answer is that he can’t.

So then, under a system in which gold is money, there are coins, notes (paper), and bank deposits (checks and debit cards). These are either backed up by the money itself (gold) or they aren’t. If they are, they are money certificates; if they are not, they are fiduciary media. It is this latter phrase (fiduciary media) that was an important aspect of Mises’ 1912 treatise on money and it is what he meant by the word that the English translator simply put as “Credit.”  This is why Guido Huslmann, in editing the collection of essays in honor of this book, restored the true meaning of the book title by called it “The Theory of Money and Fiduciary Media.”

Now, most people know that we are not on a gold (or any commodity) standard. Gold-as-money is suppressed by all kinds of legal tender laws, competition laws, monopoly banking provisions, and other restrictions. In gold’s place, beginning in 1971 with Nixon’s closing of the gold backed dollar, came the dollar standard. Historically, the dollar was actually a name for a certain weight of silver. Silver was money, and the dollar was a specific unit of it. But now, in our present system, the dollar itself is the money.  Unfortunately, there is not definition for what a dollar actually is. It is declared to be money based on the arbitrary declaration of the Federal Government. But these dollars represent for our system a fiat money; that is, a money in the narrower sense that was not created on the market by the voluntary exchanges of human market participants. Rather, the dollar is fiat money, that is, money declared to be money by government decree.

These fiat dollars come in the form of paper ($1 bills, $5 bills, etc), coin (pennies, nickels, and other fractions of a dollar), or in bank deposits accessible via debit cards and checks (and now smart phones!). The depository reserves held by banks at the Federal Reserve (which is in part a bank for the banks) also counts as the supply of money in the narrower sense. The dollar is no longer a unit of money, it is now the money itself. As such, there are still money certificates and fiduciary media that have a relationship with this money in the narrower sense.

Let’s give a quick example. Jones has typical one hundred, $1 bills that he goes and deposits in Wells Fargo. He now has the ability to demand those dollar bills with his debit card or a check book. But, as in our previous example, Smith wants a loan. Let’s say Smith wants a $50 dollar loan and he goes to Wells Fargo with his request to get this in currency form (as opposed to having it in an account). In granting him the request, Wells Fargo extends him 50 of the $100 that Jones had deposited. Now, Jones still has $100 is money substitutes (accessible via a debit card), but this is only backed up by $50 of the money itself because the other $50 went to Smith. As you can see, together Jones and Smith can together demand $150 worth of goods in the economy even though there is only $100 of actual money. Therefore, there is $50 of fiduciary media; money substitute backed by nothing at all. The consequences of this expansion of the money supply are for a future essay.

The only category that was not touched above is under the Money in the narrower sense side of the diagram: “Credit Money.” Mises referred to credit money as a temporary phenomenon sort of “in between” commodity money and fiat money. Here’s what that looks like. Historically, say in a time of war, it was common for a commodity money to be considered by governments as too restrictive for the needs of the spending levels required. Under a commodity standard, money substitutes could be redeemed for the money that backed it at any time. But during a time of war, there was more and more fiduciary media being produced to fund the war. It was obvious that this fiduciary media could not be redeemed and everyone knew it. So instead of letting the banks go bankrupt, the government would temporarily suspend the ability of the money substitutes to be redeemed. During the temporary timeframe, the money substitutes would still act as money and people trusted that soon the temporary war measures were over and things would go back to normal. Mises referred to the money substitutes during this timeframe as being “credit money,” since they could not be redeemed by the money itself.

The above represents a taxonomy of money. It does not look at the consequences and implications of the development of these different categories. It does not consider the ramifications of banking under a fractional reserve model. It does not touch on the legal and economic results of the extension of fiduciary media. To anticipate future essays, it is in the above that we have several of the tools needed to locate the cause of banking crises, boom-bust-cycles, and economic depressions.

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