The Nature and Theories of Money

The modern world would be unimaginable without money. More than just a tool for economic transactions, money serves as a vital 'social technology' that links our present to future possibilities, shaping societal structures and individual positions. Despite its pervasive influence, the true nature and theories of money remain subjects of intense, often unresolved, debate, stretching back to ancient philosophers like Aristotle and Plato. This article explores these fundamental puzzles, contrasting dominant economic views with alternative perspectives and delving into the core theories that define our understanding of money today.

Unraveling Money's Puzzles: What is Money?

Money's role is paradoxical. While governments meticulously monitor monetary stability, mainstream economic theory often treats money as a 'neutral' or passive element. This classical economics view, rooted in Aristotle and formalized by figures like David Hume and Adam Smith, sees money merely as 'the oil which renders the motion of the wheels more smooth and easy,' facilitating the exchange of 'real' factors of production like labor and technology. Joseph Schumpeter famously described this as money being a 'garb' or 'veil' over what truly matters, to be discarded when analyzing fundamental economic processes.

The Classical Dichotomy: Real vs. Monetary Analysis

At the heart of these debates lies the Classical Dichotomy. This refers to the distinction between:

• Real Analysis: Focuses on goods, services, and decisions about them. Money is neutral and doesn't affect long-run economic value, which comes from productive forces. The economy would behave similarly in a barter system.
• Monetary Analysis: Views money, or money-capital, as a dynamic, independent economic force. It's not just oil; it's the 'social technology' that sets physical capital in motion. Proponents like John Maynard Keynes argued that depressions and unemployment can stem from a lack of money for investment and consumption, not just a failure of 'real' productive forces.

Mainstream economics largely adheres to money's long-run neutrality, dismissing 'monetary analysis' as a 'money illusion' – the belief that money has powers beyond measuring existing value. However, the persistence of these disputes suggests money is more than a technical device; it's a source of social power, capable of influencing both the ability to 'get things done' and 'control people.'

Functions of Money: Walker's Framework

In 1878, American economist Francis Amasa Walker attempted to simplify the complexities by defining money by its functions, stating: 'money is what money does.' He identified four key functions:

1. Money of Account/Measure of Value: A numerical standard for economic calculation, pricing goods, and recording debts, income, and wealth.
2. Means of Payment: Used to settle debts denominated in the same money of account.
3. Medium of Exchange: Something universally accepted in exchange for all other commodities.
4. Store of Value: A repository of purchasing power, allowing for the deferment of consumption or investment.

While these functions seem straightforward, their longevity masks deeper disagreements. Schumpeter highlighted that the core reason for unresolved disputes is the fundamental 'incompatibility' between two major theories of money: commodity theory and credit theory.

Incompatible Theories of Money: Commodity vs. Credit

These two theories represent a broader intellectual divide between materialism/naturalism and nominalism/social constructionism.

Commodity Theory of Money: Metallism Explained

Commodity theory, often linked to 'metallism,' posits that money originated in barter as an intrinsically valuable material commodity, such as gold or silver. Adam Smith, in The Wealth of Nations, suggested money emerged spontaneously from rational individuals seeking to maximize self-interest, overcoming the 'inconvenience' of barter's 'double coincidence of wants.'

Key characteristics of commodity theory:

• Intrinsic Value: Money derives its value from the material it's made of (e.g., gold), or its usefulness.
• Spontaneous Emergence: Arises naturally from trade to facilitate exchange.
• Metallism: Favors precious metals due to their portability, divisibility, and durability.
• Quantity Theory of Money: Price levels are determined by the exchange ratio of quantities of commodity money and goods (e.g., Fisher's MV = PT). Inflation is seen as 'too much money chasing too few goods.'

Historical examples like Alfred Russel Wallace's expedition to the Malay Peninsula or the use of cigarettes in POW camps (R.A. Radford's account) are often cited, though critics point out these don't fully support spontaneous emergence without an existing authority or social context.

Credit and State Theories of Money: Nominalism and Chartalism

In contrast, credit theory (also known as 'claim theory') and state theory of money (or 'chartalism') argue that money is fundamentally an abstract, socially constructed value, often a 'promise to pay' or a 'claim upon society.' It gains value from the existence of debts it can cancel, rather than intrinsic material worth.

Key aspects:

• Money of Account is Primary: Keynes argued that money of account – the unit in which debts and prices are expressed – is the primary concept. Money 'proper' settles debt because both are denominated in the same unit.
• Abstract Value: Money is an 'intangible, immaterial, abstract' value (Mitchell Innes), not a physical thing. This 'moneyness' is conferred nominally, by designation.
• Debt-Based: The value of money is derived from the existence of debts it can settle. As Georg Simmel noted, money is a 'claim upon society.'
• Banking as Producer: Unlike commodity theory's view of banks as intermediaries, credit theory sees banks as 'producers' of purchasing power, creating endogenous money through loans (credit expansion) rather than simply lending existing deposits.
• State Authority (Chartalism): Georg Knapp's State Theory of Money (chartalism) argues that money is a legal construct, devised and enforced by the state. The state declares what counts as money (its money of account) and accepts it for tax payments, compelling its acceptance. This creates 'impersonal trust', shifting the burden from individuals to the issuer.

Early examples include ancient Babylon, which used nominal units of account for measuring value and denominating contracts, and Charlemagne's 'décrochement' in medieval Europe, which delinked the money of account from physical coinage, fostering the concept of 'imaginary money.' The English 'Case of Mixt Monies' (1604) also affirmed the state's power to declare the formal validity of money, independent of its metal content.

Money and Power: Beyond Neutrality

The theoretical disputes over money are not merely academic; they are deeply ideological and political. If money is neutral, its control can be left to technical experts. But if money is a 'social technology' and a 'weapon,' then the power to create and control it is central to political struggles.

Monetary sovereignty – the power to create money – is an essential element of state power, yet in modern capitalism, it is shared with the banking system. This dual nature of money, as a public resource ('infrastructural power') and a means of domination ('despotic power'), is evident in the inherent inequality between creditors and debtors created by debt-based money.

Monetary (Dis)Order: Inflation and Instability

Money's social nature means its value is highly sensitive to self-fulfilling expectations, leading to potential disorder. Monetary authorities constantly manage expectations to maintain 'the working fiction of an invariant standard.' When money fails to perform its functions, it signals disorder in the underlying social and political foundations.

There are three basic conditions where money struggles:

• Deflation: Sustained fall in general price levels.
• Inflation: A general increase in prices. While moderate inflation (around 2%) can indicate a healthy economy, hyperinflation (monthly rates of 50% or more, as seen in Zimbabwe or Weimar Germany) leads to economic chaos, social disintegration, and even state collapse, as money loses its function.
• Disintegration: When the money of account itself is abandoned.

Classical 'quantity theory' often attributed inflation to 'too much money chasing too few goods.' However, more nuanced Keynesian analyses consider 'cost-push' (rising production costs) and 'demand-pull' (excess demand) factors. The relationship between money supply and prices is complex and non-linear, often influenced by short-run phenomena like 'money illusion' or 'rational expectations,' yet the debate continues on whether 'real' factors ultimately determine value in the long run.

Coming to Terms with Modern Capitalist Money

The evolution of money, from infrequent full-weight precious metal coins to widespread paper banknotes and now digital credit, has continually challenged traditional theories. The fact that 'promissory notes' and 'bills of exchange' became the basis of capitalist enterprise, often without being redeemed in precious metal, underscored the growing relevance of credit theory.

Modern money is a complex system involving state-issued currency, private bank credit, and myriad 'near' moneys. It's crucial to understand that currency (notes and coins) is now an insignificant part of the overall money supply. Bank deposits, representing abstract credits, are transmitted digitally, blurring the lines between 'money' and 'credit.'

Ultimately, money's stability relies on impersonal trust rooted in social and political legitimacy. Successful states, with their monopoly on legitimate force and the power to declare what counts as payment for taxes, have historically provided the most stable monetary systems. As Henry Ford Sr. famously quipped, a true understanding of the monetary system could spark a revolution, highlighting how the 'mysteries of monetary theory' preserve the social order by masking the political nature of money creation and control.

FAQ: Understanding Money for Students

What are the main theories of money for students?

The two main theories of money are the Commodity Theory (also called Metallism) and the Credit Theory (also called Nominalism or State Theory/Chartalism). Commodity theory views money as an intrinsically valuable material commodity that emerged from barter. Credit theory sees money as an abstract social construct, essentially a promise to pay or a claim on society, deriving its value from debt and state authority.

Why is money considered a 'social technology'?

Money is called a 'social technology' because it's a human invention, like literacy or numeracy, that enables the creation and maintenance of large-scale, complex societies. It facilitates economic transactions, records financial linkages, and allows for planning between the present and future, acting as a crucial 'operating system' for the modern world.

What is the 'Classical Dichotomy' in economics?

The Classical Dichotomy is a concept in economics that separates the analysis of 'real' variables (like output, employment, and relative prices) from 'nominal' variables (like the price level and the money supply). It implies that changes in the money supply only affect nominal variables in the long run, and money is considered 'neutral' because it doesn't influence the real factors that create economic value.

How do banks create money according to credit theory?

According to credit theory, banks are not just intermediaries lending out existing money. Instead, they create money (known as endogenous money creation) when they issue loans. When a bank lends money, it creates a new deposit in the borrower's account with a stroke of a pen. This new deposit is new money, backed by the borrower's promise to repay, thus expanding the overall money supply.

Why are theories of money considered political?

Theories of money are deeply political because they determine who controls money creation, for what purposes, and in what quantities. Debates over monetary policy—such as whether to expand the money supply to boost employment or restrict it to prevent inflation—directly reflect conflicting interests in society (e.g., debtors vs. creditors, 'Wall Street' vs. 'Main Street'). These aren't just technical economic questions but fundamental struggles over the kind of society we want to achieve.