The Role of Money in Trade and Economics

Is money a means or ends?  Confusion over the answer to this question dominates much of the popular conversation regarding economic policy and methods.  Those who see money as an end tend to focus on the production side of economics; wealth is generated by producing and selling things.  The more you sell, the higher your profit, the more wealthy you are (this is the main argument behind mercantilism).  When money is treated as a means, then the focus tends to shift more towards the consumption and trade side of economics: wealth is created when people trade things of lesser value for things of higher value (this is the main argument behind free trade).  Precisely exploring the role of money in trade and economics will go a long way to understanding the means of wealth in society.

Money does not predate economic activity.  Money arose out of economic necessity.  In a simple two-person word, it’s easy to see how a barter economy based on comparative advantage can develop.  One person can make fishing hooks while the other fishes, for example.  They specialize in their comparative areas of expertise and barter physical goods for physical goods.  Both are made better off without the need for money.

But, as the world expands, the barter economy becomes more complex and can start to break down.  That is because barter requires double coincidence of wants.  In other words, to successfully barter, you need something that the other person wants.  I am an academic.  In a barter economy, all I can offer are my economic writings.  If I go to the grocery store and the grocer just happens to want an economic tome for the same amount of groceries I just happen to want, then a trade can be arraigned.  But, if he doesn’t, then no trade can occur.  What can solve this problem?  Well, what if there were some medium of exchange, something that both he and I wanted that could be exchanged in lieu of the physical goods/services but could itself be exchanged for physical goods/services?  A numeraire, if you will?  That numeraire is what we call “money.”

Money solves the double coincidence of wants problem.  I can sell my economic ramblings to some university or bookstore patron in exchange for money and turn around and exchange that money for groceries.  The bookstore patron needn’t necessarily have anything physical I desire other than his money; he needn’t provide me any good or service (he’s already done that for someone else).  He need only give me some pieces of paper.  Likewise, I needn’t perform any services for the grocer (I’ve already done that by providing the book to the patron).  I need only supply her with the desired amount of money.

Money also acts well in reducing transaction costs by being divisible.  Going back to our barter example, neither fish nor fishhooks are particularly dividable.  Selling someone one-and-a-half fishhooks is to really sell them one fishhook and a broken fishhook.  A barter deal may not come about because the amount needed to be exchanged in intact units would be too high.  But money solves this problem.  If, for example, my book sells for $10 and the number of groceries I want to purchase cost $5, then I can essentially sell half-a-book to pay for my grocery bill because money can be divisible.  So, the introduction of money as a numeraire into trade increases the number of transactions, thus the depth of the market and the potential wealth gains, into an economic system.

But, as this discussion shows, money is merely a means of increasing the number of transactions.  The goal is not to acquire money, but rather to acquire money in order to be exchanged for something else (don’t believe me?  How many people are clamoring for forms of money, like the Murphy-Bill, to pay bills?  I got a whole bunch of them for anyone who wants them).  In any given transaction, one may exchange their good/service for money, but that is because the money they acquire is desired to be used in other, more valuable, means (if the value they got from the money was less than the value they got from the labor, they’d not exchange).  Money, in and of itself, provides no other uses (indeed, one of the reasons something is chosen as money is because it has no other use.  For example, would anyone want pictures of dead people and numbers on paper if they couldn’t be exchanged for something else?).  You cannot eat money.  It can only satisfy wants and demands by being exchanged.

Let’s apply this reasoning to international trade.  Money is a means to an ends (consumption).  Thus, people trade with other people on the other side of political borders in order to consume.  Just as I traded my money with the grocer to consume food, I traded a few bills with a French producer to consume gin.  I “exported” my labor to the grocery store so I could “import” food.  I “exported” my labor to the French distiller so I could “import” gin.  Thus, we can see that “exports” are what are given up in a trade (the cost) and “imports” are what are gained (the benefit).  Unfortunately, much popular conversation surrounding trade has this exactly backward.  A “successful” trade is one where a person (or group of people called a “nation”) export more than they import.  In other words, they give up more than they get.  This would be akin to saying the person who is a “successful” grocery shopper is the one who spends the most at the grocery store and gets the least in return.  The “smart” shopper spurns all bargains, sales, discounts, and specials.  Indeed, the “winning” shopper would be the one who demands he pay higher prices.  The “best” shopper “laughs” at all the other shoppers who are buying food in bulk, buying what’s on sale, buying specials.  He laughs at the foolish shopper who, by taking advantage of low prices, buys a month’s worth of food for a week’s salary while he buys a week’s worth of food for a month’s salary.

If we treat money as something that merely represents a divisible number of physical goods and services, we can see that all trade is still ultimately bartering.  Just as the goal of barter exchange is to get as much as possible while giving up as little as possible (that is, to “import” as much as possible while “exporting” as little as possible), the goal of trade is to get as much as possible (import) while giving up as little as possible (export).  the inclusion of money into the equation does not change the underlying logic.

Increased Opportunities Do Not Indicate a Shortfall

Trade deficits are often pointed to as a sign that there is a “savings shortfall” or “savings imbalance” within a nation (see, for example, this article).  This description, as Scott Sumner reminds us, is an implication of the GDP accounting model.  In this lens, there is no objection to classifying as trade deficit as a savings imbalance.  But does it make economic sense to view it in such way?

Let’s go back to a main question of economics: why do people trade?  Specialization of labor allows people to focus on the things they are comparatively better at and trade with others to get the rest of their needs.  In other words, people trade because their time is best spent doing what they are best at.

As David Ricardo showed us, when people specialize, they increase production; that is to say, new consumption opportunities emerge when people specialize and trade.  At no point is this development considered a “production imbalance.”  So, why then is the identical situation considered a savings imbalance when viewed at a macroeconomic level?  Other than the mathematical wrangling of the GDP accounting formula, I have no good explanation.  As people specalize and trade, new opportunities, both for consumption and investment emerge, which indicates a new balance developing.  The economy has gotten larger; there is no imbalance.

Trade-Offs and Public Policy

This semester, I have been studying Law & Economics with Robin Hanson at GMU.  In class, we have been discussing the legal system, how it is structured, and other ways to structure it.  Questions we’ve pondered include: why can one appeal on matters of law and not matters of evidence?  Why are rules of evidence what they are?  Should all contracts be enforced or what limits should be placed on them?  Why are property taxes structured they way they are?  Why common law in the US as opposed to civil law?  Etc.

Simultaneously, I am evaluating a book for my course this summer: Trade-Offs by Harold Winter.  Trade-Offs is a public policy-focused look at economic reasoning.  In the book, he points out one of the dangers of public policy analysis (Page 5, original emphasis):

Even if there is agreement on the broad objective of maximizing social welfare, policy objectives may differ due to differences in the definition of social welfare.  A good example of this can be found in the economic analysis of crime.  To deter crime, we must use resources for the apprehension, conviction, and punishment od criminals.  But should the benefits that accrue to individuals who commit crime (also members of society) be added to social welfare?  If yes, this may suggest that fewer resources can be used to deter crime, because crime itself has offsetting benefits.  If not, crime is more costly to society, and more resources may be needed for deterrence.  Notice, however, that it is a fact that a criminal reaps a benefit from commiting a crime (or why commit the crime?), yet it is an opinion as to whether that benefit should be counted as social welfare.  Policy objectives and definitions of social welfare are subjectively determined.

What is also subjectively determined, as explained by Carl Dahlman in his 1979 Journal of Law & Economics article The Problem of Externality, is the effectiveness of the policy change proposed.  When a policy proposal is made, the proposer implicitly assumes that whatever institution he is invoking (government, market, etc) can necessarily solve the problem he’s subjectively identified better than the status quo (otherwise, why would he make such a proposal?).

All this subjectivity means that discussing “optimal” policy gets really tricky.  Optimal tariffs, Pigouvian taxes, optimal forms of law, legislation, etc are going to depend greatly on how we measure social welfare.  When discussing tariffs, should the welfare of foreign producers and consumers be counted?  If so, why?  If not, why not?  When discussing Pigouvian taxes, should the welfare of clean-up companies be taken into account (eg, the laundromat who loses business because fewer people are washing soot-caked clothes) and is government necessarily the best solution?  What makes sense given a certain accounting of social welfare doesn’t with a different accounting.

Answers to these questions can go a long way in helping us consider supposed market failures: whether something optimal or suboptimal will depend a lot on how these trade-offs and welfare are measured (to Winter’s point above, if the welfare of criminals is taken into account, there may be too much police activity.  If the welfare of criminals is not, there may be too little).  In this sense, optimality is in the eye of the beholder.

I’d argue that the subjective nature of social welfare policy suggests a strong presumption of liberty for people to choose their own way.  Indeed, there is no initial reason to believe any given action taken by an individual is somehow sub-optimal given the subjective nature of social welfare.  Even something like pollution is subject to these conditions.  This realization also should force economists (and their consumers) to ask the question “what are we assuming?” and “how are my biases affecting this analysis?”

Economists rarely argue about data.  It’s somewhat rare that someone made a math mistake or jumbled data (ideally, that gets caught long before publication).  Outcomes are not in question, but the subjectivity of trade-offs are.

A Robust Theory of Trade

Economists are often accused of ignoring moral consequences of trade, or in particular, being focused too much on material well-being (for example, see here).  There is a lot of truth to this claim; much of our models to focus narrowly on measurable items like material wealth.  I agree with this criticism very much and lots of my research focuses on ways of re-inserting moral man into economic models.

But it is incorrect to argue that free trade is either immoral or amoral.  The earliest free trade philosophers (Adam Smith, David Hume, Frederic Bastiat) all approached trade from a moral point of view.  Hume gives us a justice argument for free trade, Smith demonstrates the strong presumption of liberty in a modern society, and Bastiat shows how protectionism can quickly become a perversion of law and justice.  Economists have long spent time considering the moral aspects of trade.

But one thing that really rubs people the wrong way regarding trade is the concept of competition.  Firms and individuals compete with one another for scarce resources and that competition can sometimes lead to outcomes that make some observers uncomfortable (workers getting laid off in favor of machinery, for example.  Or low-cost labor overseas).  Because of the unpleasant nature of this competition, free trade often gets labeled immoral.  But let’s look at the nature of competition and how it is used in economics.

Economics appears to begin with the assumption of a somewhat Hobbseian jungle world: all actors are self-interested and looking to maximize their own gains.  From this, we derive the concepts of competition and the “invisible hand” which leads to improvement for everyone while appealing to their self-interest.  To quote Adam Smith: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

But surely altruism exists!  Surely people are not so wrapped up in self-love they dismiss all of humanity!  How can this dismal view of humanity, that we are merely self-interested, dominate economics?  The answer is two-fold: 1) Everyone is, to some extent, self-interested (what Russ Roberts likes to call “the Iron Law of Me”).  We tend to focus on events close to us and our loved ones far more than events separate from us.  2) This method of conceptualizing humanity makes our models robust.  Lots have been written on #1, so I’d like to focus on #2.

The idea of self-interested humans makes economic models robust.  In a sense, by assuming humans at their “worst,” it allows for humans to act at their “best.”  For example, simple economics indicates that, after a disaster, prices should rise in order to incentivize people to bring more supplies into the area.  The pursuit of profit will bring in people looking to make a buck.  This is the self-interested story.  But what happens if the community and nation band together and donations fly to the area?  The effect is the same: an increased supply to where it is needed most.  By weakening the assumption, the result remains: the model is robust.

So, why the assumption of self-love in the first place?  Well, let’s reverse the scenario.  A disaster strikes.  People are altruistic and chip in and send supplies to the disaster area.  People will band together when things get tough.  This is our model.  But let’s weaken the assumption of altruism.  Disaster strikes.  People are only self-interested.  What happens?  Nobody sends supplies.  Since the results of the model change, it is not robust.

The concept of self-love does nothing to reduce the usefulness of our models.  Whether true or false is irrelevant as the results of the model do not change.  So long as the presumption of liberty is upheld, in other words, no central planning is attempted, then the assumption of human behavior and its results are largely irrelevant and economic models are robust to the changes.

Today’s Quote of the Day…

…is from Chapter 3 of Frederic Bastiat’s final work Economic Harmonies (page 499 of the Mises Institute Edition):

Can we concieve a time when man can no longer form even reasonable desires? Let us not forget that a desire that might be unreasonable in a former state of civilization–at a time when all the human faculties were absorbed in providing for low material wants–ceases to be so when improvement opens to these faculties a more extended field. A desire to travel at the rate of thirty miles per hour would have been unreasonable two centuries ago–it is not so at the present day [or 70mph in Bastiat’s time! -JMM]. To pretend that the wants and desires of man are fixed and stationary quantities, is to mistake the nature of the human soul, to deny facts, and to render civilization inexplicable.

JMM: What we take for granted were once unobtainable wants because we had to focus on growing food. As that food was automated (thus destroying a lot of farmer jobs) and became cheaper and taken for granted, more desires, once unobtainable, became obtainable. Desires like kitchen appliances, faster transportation, recorded music, etc. Then, as more of those desires became taken for granted and cheap (displacing lots of manufacturing jobs), we moved to other desires, like better health, better medicine, more diversions (theatre, movies, sports, TVs, etc).

Shift happens, but it happens because desires are being met, which in turn allows new desires to come about. Human desires are indefinite.

Let the Market Process Work!

In response to this Carpe Diem blog post on steel tariffs, aiken_bob writes:

I think everyone needs to take a chill pill. I believe what Trump is doing on so many fronts is just testing the old rules to find out what really works today.
In the era of big government, both here and in the EU, there have been countless lobbyist working for the NGOs or corporate masters that have written the rules that benefit them. I have to believe that the vast majority are now outdated or just wrong.
It is pretty obvious that you can’t get congress to change every little law so enter Trump to shake things up. I really believe there is a method to his maddness.

You’ll get no argument from me that there are many, many, many rules and regulations written by lobbyists to benefit themselves.  However, if that is a problem (as both aiken_bob and I consider it to be), then Trump’s actions are just more of the same: more rule writing and more regulations written by lobbyists to benefit themselves at the expense of others.  Steel tariffs are just another line item in this ledger from Hell.

If the problem is the rules were written by lobbyists then the solution is simple: tear them up.  Unilateral free trade.  You will see very quickly what works and what doesn’t when subjected to the forces of competition.  Those that work will remain.  Those that do not will be chased out.  People will be allowed to choose what they will, act how they want, without lobbyists influencing/mandating their decisions.  As Mark Perry likes to say: competition breeds competence.  In short, let the market process work!

Today’s Quote of the Day…

…is from Page 6 of the Foundation for Economic Education’s 1996 edition of Bastiat’s classic 1850 magnum opus Economic Harmonies:

The moving parts [of economies] are men, that is, beings capable of learning, reflecting, reasoning, of making errors and of correcting them, and consequently of making the mechanism itself better or worse. They are capable of pain and pleasure, and in that respect they are not only the wheels, but the springs of the machine. They are also the motive forces, for the source of the power is in them. They are more than that, for they are the ultimate object and raison d’être of the mechanism, since in the last analysis the problems of its operation must be solved in terms of their individual pain or pleasure.

Economics has long forgotten this simple insight: economies are human.  They are made up of human actors who have their own motives.  The bundle of plans, what my GMU professor Richard Wagner likes to call “an ecology of plans”, that emerges from these trillions of interactions is what we call an “economy” or “society.”

Models are helpful for thinking about a situation, but we musn’t forget that our models are populated with people and not “representative agents.”