Money: Medium of Exchange vs. Store of Value

Imagine that when the automobile was invented it was decided that instead of having a gas pedal and a brake pedal there would be just one pedal for both functions. Then imagine that we stood there scratching our heads as we watched mangled bodies and wreckage pile up all along our roadways. That would be pretty stupid, wouldn’t it?

But that’s exactly the situation with our monetary system, and it has been that way for thousands of years. The human wreckage that has resulted from a basic design flaw is incalculable, yet we still seem to have no inkling of why.

When you ask an economist what money is, you will get a fairly standard response. You will be told that money has two primary functions. First, money is a medium of exchange — that is, it is an instrument that facilitates the exchange of goods and services. And second, money is a store of value. It is a vehicle for storing wealth, so that those who sell goods and services can hold onto the proceeds for future use. (Some would say that money has a third function — namely as a unit of account — however I would argue that this function is inherent in the two primary functions already mentioned.)

OK, so far, so good. In a complex, modern economy we need both a medium of exchange as well as a store of value. However it is NOT necessary that both functions be served by the same instrument. This basic point seems to have eluded economists, bankers and policy makers throughout most of human history.

This incredibly important insight into the nature of money was first pointed out by Silvio Gesell in his book, The Natural Economic Order (1916). Gesell realized that the two functions of money are mutually contradictory. It is not possible for one instrument to serve effectively as both a medium of exchange and a store of value. The performance of one function necessarily precludes the performance of the other. If money is designed for use as a store of value it will systematically fail to perform its function as a medium of exchange. Why this is true requires a bit of explanation.

First, we need to take note of the fact that in an economy of real goods and services there is a strong compulsion on producers to sell their wares rather than hoard them. This is because of the fact that we live in an entropic universe. In other words, things degrade and lose value over time. Food rots, metal rusts, wood gets consumed by insects, equipment breaks, technology becomes obsolete, merchandise is destroyed by theft, fire and floods, etc. Therefore, those who earn their livelihoods by producing goods or services are under pressure to sell their products sooner rather than later. Generally speaking, if a producer chooses not to sell his product, he suffers a loss, and the longer he waits, the greater the loss. He MUST sell his product, even if he loses money in the process, because the longer he waits, the more he loses.

The same is true of labor. A worker who doesn’t like the wages being offered for his services can hold out for a day or two at most before hunger forces him to accept the price being offered.

This basic rule of nature is one of the primary forces that drives economic activity. Virtually all goods and services compel their own sale due to the fact that they lose value over time (with a few notable exceptions, like gold, fine art, wine, etc.). It is inherent in the nature of goods and services that they must be offered for sale, and the entropic nature of the universe punishes those who fail to transact.

In a non-monetary (i.e. barter) economy, the pressure to sell operates on both sides of every transaction. Therefore, economic exchange takes place on a level playing field. The producer of cheese is motivated by the fact that his product will go bad in a short amount of time, and the provider of labor is motivated by hunger and fatigue that grow more urgent with every passing hour. Therefore there is a strong compulsion to transact on both sides of the exchange.

However, the introduction of money as a vehicle to facilitate the exchange of goods and services fundamentally changes this basic dynamic. Unlike the 99% of real goods and services that lose value over time, money is generally exempt from this pressure to transact. It can be hoarded indefinitely without the owner suffering any loss. (* Gesell wrote his book at a time when most of the world was on the gold standard, so his analysis was based on the fact that gold is immune to all of the forces of nature which compel the exchange of other goods and services. One might argue that with fiat money his analysis no longer applies, since it is subject to inflation. I would argue that his reasoning is still valid under a fiat currency system. Why this is true will require a little further discussion, which I will provide at the end of this essay.)

Whereas in a pure barter economy both sides of every exchange are motivated by an urgent necessity to transact, when money is introduced into the equation that fundamental balance is disturbed. Instead of both sides of every transaction being subject to the same pressure, now only one side of the transaction is subject to that pressure.

Money — as it currently exists — can be hoarded without loss. If you are a producer of milk and I am in possession of money and we are negotiating an exchange, we are NOT operating on a level playing field. If you don’t like the price I’m offering, you still need to transact, because failing to do so will cause you to suffer an economic loss. But the same pressure doesn’t apply to me, the holder of money. If I don’t like the deal you’re offering, I can just take my money and go home. I will be no worse off tomorrow, next week or next month as a result of the fact that we didn’t make an exchange. My money will still have the same value in a week or a month or a year. But you, with your rapidly depreciating merchandise, will be worse off with every day that passes. In the case of milk, 100% of its value will disappear within a couple weeks, whereas my money will retain all of its value.

So, by introducing money as a means for facilitating the exchange of real goods and services we have transformed a level playing field into a lopsided one that benefits the holders of money at the expense of producers of real goods and services. On one side of every exchange there are depreciating goods and services which compel producers to sell, and on the other side are holders of money who are under no pressure to transact.

The reason this is so is because money was deliberately designed NOT to lose value over time. This is because of the fact that money is supposed to act as a store of value. If money was designed solely with an eye toward facilitating exchange, we never would have created the kind of money we have.

Since real goods and services compel their own circulation, in order to properly facilitate their exchange, money, too, must compel its own circulation. But our current form of money doesn’t do that. By creating a currency that can be used as a store of value and hoarded without cost, we bestowed an advantage on money that doesn’t exist for the vast majority of real goods and services.

Furthermore — and this is a crucial detail — a hoardable form of money fails to circulate exactly when we most need it to do so — i.e. during times of economic distress and uncertainty. If prices are falling, the incentive to hoard money is maximized. Why buy something today if it can be bought for less tomorrow? So, falling prices reduce the incentive to spend money, which causes prices to fall even more, thereby creating a vicious cycle. In terms of the analogy of the gas/brake pedal, precisely at the times when we need the car to accelerate, the hoardable nature of money causes it to do the exact opposite. The consequences of this design flaw cannot be overstated. (In future installments I will discuss the specific ways in which hoardable money is responsible for the economic crises and growing inequality that seem to be an unavoidable feature of our economic system.)

Gesell’s proposed solution to this problem was simple yet revolutionary. Here it is in his own words:

“If money is not to hold sway over goods, it must deteriorate, as they do. Let it be attacked by moth and rust, let it sicken, let it run away; and when it comes to die let its possessor pay to have the carcass flayed and buried. Then, and not till then, shall we be able to say that money and goods are on an equal footing and perfect equivalents… the answer to our question is clear, we must subject money to the loss to which goods are liable through the necessity of storage. Money is then no longer superior to goods; it makes no difference to anyone whether he possesses, or saves, money or goods. Money and goods are then perfect equivalents.”

Money needs to depreciate in the same way that real goods and services do. And that is the exact opposite of what is required if money is meant to be used as a store of value. So the solution is that the two functions of money need to be separated. We need one instrument that is solely designed to function as a medium of exchange, and that instrument must NOT be used as a vehicle for saving.

In other words, we need a gas pedal and a brake pedal, not one pedal for both functions.

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* The most common objection to this argument goes as follows: While it may be true that Gesell’s analysis was correct under a gold-based monetary system, it no longer applies in a fiat currency system because inflation erodes the value of paper money and therefore compels its circulation. And, while it is true that inflation somewhat complicates the situation, it does not change the basic validity of Gesell’s analysis. Here’s why. Inflation is not constant. Sometimes it is high, sometimes it is low, sometimes it doesn’t exist at all, and sometimes it is even negative (i.e. deflation). Ideally, in order to avoid the boom and bust dynamic that is built into the DNA of our economic system we would want a currency that circulates faster during times of crisis and slower during periods of excess. But our current form of money does exactly the opposite. When the economy is weak and prices are falling, inflation disappears (or even turns negative). Holders of money, expecting falling prices, are motivated to postpone their purchases as much as possible. So, at precisely the times when we most need money to circulate, the compulsion for money to circulate disappears. And, conversely, when prices are rising and the economy is in danger of overheating, money holders are under the greatest pressure to spend their money. At such times inflation does indeed compel the circulation of money, since rising prices will erode the purchasing power of hoarded currency. In other words, with fiat money we get the worst of both worlds — money that fails to circulate when we most need it to and that circulates too much when we need it to slow down.