The Theory of Money, Part 6

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Last week, I wrote about how the gold coin:Labor Unit (LU) ratio adjusts as the market demands depending on how many gold coins are available and how many LUs are needing to be stored.

I’ve been thinking about that topic since I wrote that, and, as is often the case, there’s something that bears clarifying.

This issue of stored LUs is a tricky one. How can you possibly store labor?

I did talk about this way back in part 1, but let me put it in different words this time.

Someone performing labor will typically be paid in accordance to the value they provided. It doesn’t matter so much what the laborer receives in compensation as long as they receive something in return that has a value approximately commensurate with the value they provided. In this way, labor gets turned into an asset. That asset could be gold coins or chickens or partial ownership of a business or anything else.

Historically, most societies have ended up using coins made of precious metals as compensation for labor. This is for many reasons, but the mains ones are that they are intrinsically valuable, they don’t rot or die easily, they’re easy to divide into different valuations, and their value to weight ratio is reasonable.

But what happens if the value of the asset you received in return for your hard-earned LUs suddenly goes down? Say, you got paid in corn, but you stored it in your damp cellar and it got moldy? Tough luck. It’s like you didn’t work as much to store as many LUs. Those LUs you earned are gone. This is why perishable things are not as handy for storing LUs. But non-perishable things are also susceptible to their value changing, so this isn’t a problem exclusive to perishable things. Even precious metals can have big swings in value depending on, of course, supply and demand, such as how fruitful the mines are, or how many other things people want to use them for.

The thing with gold (and other precious metals) is that it has built-in mechanisms to keep its value relatively constant. For example, if a society starts getting really wealthy and is trying to store more and more LUs in the form of gold coins (meaning people are starting to build up piles of gold coins in their houses), the demand for gold coins (and, therefore, its value) has increased. But in response to this, people will start acting differently. Fewer people will buy gold necklaces because they’re too expensive now. And gold miners will find ways to mine more gold, such as by adding a night shift to their mining operation or going after some gold deposits that were previously undesirable due to difficult terrain. The eventual result will be that more gold will be supplied and less gold will be demanded for other purposes, and the price will probably drop back down to close to where it was before.

My point is that market mechanisms will keep gold’s price relatively stable over time, which is very important when it’s being used to store Labor Units. Sure, innovations may end up decreasing the number of LUs it takes to mine new gold, which might make it cheaper over time, but it’s just as probable that over time more uses will be found for this unique metal, so its price may stay constant. Additionally, bigger changes in value are going to be the result of long-term changes in innovation and uses for gold (probably on the order of decades), so gold will be more reliable at storing LUs than other things that have more rapid swings in value.

I was trying to find the price of gold over the ages, but there’s no simple answer available. Even comparing the amount of gold someone would be paid for a day’s worth of unskilled labor in ancient Rome to a day’s worth of unskilled labor today, the number of hours would differ, the working conditions would differ, the quality of the gold may be different, and the quoted ancient prices of gold may have been influenced by government price setting (such as by anchoring a gold piece’s value to a set ratio with the value of a silver piece). So I don’t have any reliable information to show how stable the price of gold has been over the ages.

But I hope my point is clear: No matter what you use as money, it’s always going to be susceptible to shifts in value (meaning the LU:money exchange rate will always change), so the best we can hope for is something that meets the other criteria for an optimal money (i.e., nonperishable, easily carried, easily divided into different amounts, etc.) and that will also shift in value minimally or slowly or predictably.

Now, let’s consider an application of all this to our modern day. For the sake of simplicity, I’ll describe a scenario using our fictitious gold money-based society, and then I’ll talk about its application after.

Let’s say our blacksmith invents a way to counterfeit gold coins. He takes some worthless metal refuse, stamps it into the form of a coin, and paints it gold. The deception will be found out sooner or later (like when someone tries to melt down the coin to make a necklace, or when the paint chips), but until then, think about what would happen.

The total number of Labor Units that people are storing in the form of gold coins hasn’t changed, but suddenly gold coins are much more plentiful. This will make the value of gold coins drop rapidly. In other words, each gold coin will now represent fewer Labor Units. If someone has stored 1,000 LUs in the form of 100 gold coins (because the previous exchange rate was 1 gold coin:10 LUs), maybe now the exchange rate is only 1 gold coin:5 LUs, so their 100 gold coins are only worth 500 LUs now. Their purchasing power has been cut in half.

Things will self-correct once the counterfeits are found out, but what if those counterfeits are never found out? What if the blacksmith keeps counterfeiting more and more gold coins and they all stay in circulation?

The gold coin:LU exchange rate would continue to slowly adjust. What started as 1 gold coin:10 LUs would drop to 1:5 and then 1:1 and keep dropping as long as new counterfeit coins are entering circulation.

Prices would adjust along with the gold coin:LU exchange rate. If the blacksmith’s cook pot used to cost 1 gold coin (because it’s worth 10 LUs), with the new gold coin:LU exchange rate of 1:1, the price would have increased all the way up to 10 gold coins. People would say, “Remember 10 years ago when everything was so cheap? We could get a good quality cook pot for a single gold coin.”

But remember that the true price of things has not actually increased. In fact, I bet innovation in the intervening years would decrease the number of LUs that it takes to make things like cook pots. What’s happened is that the asset people are using to store their LUs in has lost value/purchasing power.

In most countries today, we use paper money, which has negligible intrinsic worth. The government (or, in the U.S., the Federal Reserve) can print as much of it as it likes. Each time they print* more money (like for a COVID-19 stimulus), the US Dollar:Labor Unit ratio has changed. Maybe in 2020 the ratio was something like 1:0.05, but now it’s dropped to 1:0.049. It’s a small change when I write it like that, but let’s think about this for a minute.

First question: Were any new labor units created when the government printed that money? No. So there are the same number of total labor units stored in the form of cash assets. But there are more total dollars now, which means each dollar represents less labor that it did before. The Labor Units stored as cash have all been diluted over a larger total number of dollars.

This is an important point. No new labor units were created! Printing money is not a way to make a society rich. It just dilutes the Labor Units already stored as cash.

So if someone worked hard and earned 1,000 LUs and chose to store them in the form of $20,000 (when the exchange rate was 1:0.05), now how many LUs do they have after the government printed a bunch of new money and changed the exchange rate to 1:0.049? They still have $20,000, but it’s now worth only 980 LUs. This is only a decrease of 2% of their cash-stored wealth, but if government is doing that every year, it will be slowly taking away this person’s savings of LUs without them even realizing how it’s happening!

In this way, the government is acting just like the blacksmith counterfeiting gold coins. They are not generating new Labor Units, they’re just taking them from others through dilution of the money supply.

One last interesting point. The government, when it creates this money, is the first one to spend it. The act of spending this new money is what introduces it into circulation. And prices will only adjust after the new money has entered circulation. So, not only does the government have all this new money that it can spend, but also it gets to spend it at pre-inflation prices!

Ok, this was a longer post than the others in this series, but I wanted to get to this stopping place. I have more to say about the theory of money–we haven’t even invented banks yet!–so this series will be continuing for several more weeks at least, after which I’ll get back to my usual health policy topics.

*I’m speaking metaphorically. Generally these new dollars are not printed, they’re created in a computer at the Federal Reserve by simply changing the listed value of an account. But the effect is the same.

The Theory of Money, Part 5

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Ok, part 5 already!

I’m going to explain what I promised at the end of part 4. But, first, I’d like to clarify a couple things so that my explanation makes sense.

First, I tried to describe this before, but let it sink in: The simplest way to quantify the true value of something is in Labor Units (LUs).

Therefore, when I am quantifying the true value of accumulated wealth a society has, I will tell it in terms of LUs. I could instead quantify it in terms of gold coins, but remember what I said in part 2 that this adds a conversion factor (the LU: gold coin exchange rate), which can muddy the waters when that exchange rate changes.

Second, wealth can be stored in many ways, but I’ll divide them into two broad exhaustive and mutually exclusive categories (my favourite): cash assets and non-cash assets. So someone’s total wealth is their cash assets plus their non-cash assets (minus any debts they have).

Great. Now let’s answer the question of how much gold our fictitious society needs to be able to store all its wealth.

Let’s say our society had one goldmine and that it collapsed, so there is no access to new gold. In other words, the total amount of the gold in the society has become fixed (apparently no one loses any gold either).

Everyone is working very diligently for a year and they all get bitten with the save-up-for-an-emergency bug, so they start trying to save some extra cash (in the form of gold coins, of course, since that’s the only form of money our society has so far).

As the total number of LUs attempted to be saved as cash increases, the demand for gold coins increases, so each gold coin comes to be worth more LUs.

This was a really short lead-up, but hopefully it’s enough to illustrate the principle that any amount of gold is enough to store the entire cash assets of a society because the gold coin:LU exchange rate will adjust to meet the market’s needs.

I guess this provides a new way to calculate the value of a gold coin. It can be determined by the aggregate-number-of-gold-coins:aggregate-number-of-LUs-attempting-to-be-saved-as-cash ratio.

This will be useful information when we talk next week about what might happen if someone figures out how to counterfeit gold coins, which will finally offer some (possibly troubling) insight into at least one modern money issue.

The Theory of Money, Part 4

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Let’s continue on with the theory that will help modern-day money issues make sense. In part 3, we talked about the options of what someone can do with their excess wealth that they have stored in the form of money: spend it, save it, or invest it. And that there are two types of investments: lending or ownership.

If society is continually getting new wealth introduced by wealth-gleaners, does that mean society is getting wealthier and wealthier?

No. Wealth is always being introduced into society, but it’s also being lost. When someone spends their wealth on something that depreciates/gets consumed, that wealth is slowly being lost.

For example, when the farmer eats some of the food he has grown (maybe his family consumes 1 Labor Unit’s (LU) worth of food every meal), that wealth has been consumed. It’s all gone.

Or, when the blacksmith paints his house black, that paint is slowly getting worn off and the house will need to be repainted in several years. If he paid a total of 20 Labor Units (LUs) to paint his house—5 LUs for the paint, and 15 LUs for the painter—how much was lost? The painter has 15 LUs in payment, so that was a simple transfer of wealth, not a consumption of it. And the paint got consumed, but maybe 1 LU’s worth of the paint’s price was profit for the paint maker, so that too was a simple transfer of wealth. Assuming the paint maker didn’t have to buy supplies from someone else, then we could consider the rest of the cost of the paint as being consumed. 4 LUs total.

This goes to show that when someone chooses to spend their wealth, not all of it is lost from society. But some of it is. Compare that to when someone chooses to save their wealth by stashing their gold coins under their floorboard. When they save their wealth, it’s preserved (assuming the price of gold stays constant). And when someone chooses to invest their wealth, the impact on the total wealth of society depends on what the investment is in.

If the investment is in a company that provides luxury items, then it’s one more thing that people can now consume their wealth on, so it will probably lead to a net decrease in society’s stored wealth. Maybe the paint maker invests wealth into the development of a new kind of paint—glittery black paint—which costs 10 LUs instead of 5 LUs. Even if 3 of those 10 LUs are profit for the paint maker, it’s still 7 LUs getting consumed on paint for the blacksmith’s house instead of only 4 LUs.

If an investment is in a company providing non-luxury items, it could lead to a net increase in society’s stored wealth. For example, maybe the paint maker invests his wealth into developing a new kind of paint that takes the same effort to produce but it lasts twice as long. He has just lowered the cost of living (assuming painting a house is necessary for the sake of preserving the wood so the house lasts). The blacksmith only needs to repaint his house every 10 years instead of every 5 years, so less wealth is being consumed to maintain his standard of living.

Or maybe the blacksmith invents a new kind of plough that decreases the time it takes the farmer to glean wealth from the land.

Whether the company is lowering the number of LUs it takes to maintain the same standard of living, or whether it is enabling more wealth to be gleaned from the land, it will be increasing society’s total amount of stored wealth.

One thing I haven’t already mentioned is the impact of war and natural disasters on the total amount of wealth a society has. These things cause a society to lose a lot of wealth. For example, if there is a flood that destroys the farmer’s crops, a ton of LUs worth of wealth has been lost from the society in the space of a few hours or days. Or, if the society starts having to spend a bunch of LUs on guns and ammo instead of on living essentials, it’s similar to black glitter paint; the investment into developing those things will not help decrease the cost of living or increase the efficiency with which new wealth can be gleaned from the land (assuming the innovations don’t cross over and help in other ways), and spending LUs on guns and ammo means those LUs will get consumed and therefore lost from society.

So now we’ve considered the main factors that lead to an increase or decrease in the total amount of stored wealth a society has.

Next week I’ll get to how much gold is needed for a society to store all its wealth in gold.

The Theory of Money, Part 3

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Links to part 1 and part 2.

Ok, so we’ve talked already about the purpose of money and then delved more into wealth and where it originates and is distributed, and I also introduced Labor Units (LUs) as a standard unit of labor and showed how it can also be used to quantify wealth and the true price of things.

This week, we’ll continue on with our early society to discuss what we can do with stored wealth/stored Labor Units.

Remember that blacksmith? Let’s say he’s been selling a lot of items and has accumulated a lot of gold coins that he doesn’t need to use in the near future. He has a three options of what he can do with that excess wealth/stored labor.

Option 1: Spend it. He can finally splurge on painting his house black like he’s always wanted. He is consuming his stored wealth, but it doesn’t just disappear out of society because it gets transferred to the paint supplier and the painter in compensation for them providing those goods and services.

Option 2: Save it. In other words, keep those coins hidden under his loose floorboard. Or maybe there’s a vault somewhere that he can rent space in to more securely store it.

Option 3: Invest it. My definition of the term “invest” is that you give up something now with the expectation of getting back more later. So he will give up that money now expecting to get it back plus some more later.

There are actually two different kinds of investments he can make: (a) He could simply loan his money to someone, or (b) he could purchase something that will earn money for him.

The loan option is straightforward. The farmer wants to buy a new plough, so the blacksmith loans the farmer 10 gold coins to buy a plough, and then the farmer pays him back 11 gold coins after the harvest. Hopefully the plough enabled the farmer to be so much more efficient that he earned enough to pay the blacksmith back the principal plus interest. The modern equivalent to this is investing in bonds.

The “purchase something that will earn money for him” option is more flexible, and it comes down to him putting his money into some kind of business venture. Maybe he has a passion for town news and wants to start a town newspaper with the new town printer who owns a printing press. Maybe he wants to own 30% of a new mail carrying venture that his neighbor is starting. These investments could be relatively active (with him contributing his own labor, like doing all that work with his printer friend to found a newspaper) or relatively passive (like buying 30% of his neighbor’s mail carrying venture, where the only thing he’s contributing is money and he is promised a share of the profit commensurate with the percent of the business that he owns). The modern equivalent to the active investment type is starting your own business, and the modern equivalent to the passive investment type is buying stocks.

So, as a society becomes wealthier, more people have more excess wealth stored up in cash, and then they can choose among those three options what to do with it. Note that choosing to save the money (as opposed to spending or investing it) is the only option that doesn’t put that stored wealth back into circulation to be used and reused in society.

Let’s stop there for this week. Next week, I’ll talk more about how wealth gets destroyed, how much money a society needs to be able to store all its accumulated wealth, and maybe we’ll even get into the origin of banks.

The Theory of Money, Part 2

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Last week, I talked about the origin and purpose of money and also how new wealth is introduced into a society. This week, I want to talk more about how wealth transfers from one person to another.

As I explained before, new wealth is always being generated using the land + labor combo (i.e., the natural resources from the earth, combined with human labor, produce new wealth). We could call the people doing this work the wealth-from-the-earth-gleaners (or maybe wealth-gleaners for short). Wealth-gleaners are the original owners of all wealth in society, and then they distribute that wealth to others in exchange for the goods and services they want. In this way, the wealth of a society is both generated and distributed.

I don’t want you to assume that just because someone is the original generator/owner of wealth that it means they will automatically be wealthier than all others. Think about a farmer working a particularly infertile plot of land. He may be only generating just enough wealth (in the form of crops) to have a roof over his head and clothes on his back and food on his table, and nothing extra. This is what Adam Smith called a “subsistence wage,” when you’re earning just enough wealth to continue subsisting and that’s it. This farmer’s wealth, as limited as it is, will still be distributed to others in society when he buys things he needs from them, such as clothes or a re-thatched roof.

An interesting effect of wealth-gleaners being the original generators of new wealth in societies is that the society’s growth of total wealth is limited by how much these wealth-gleaners are generating and introducing into a society. So, if you want the total wealth of a society to grow quickly, you want the farmers and other wealth-gleaners to be rich (i.e., generating way more than just bare subsistence wealth for themselves)!

The foundational nature of labor in the generation and distribution of wealth should be clear by now. So I’m going to take advantage of this by quantifying wealth in terms of standard labor units.

*Trumpets sound*

I hereby define a new standard unit of labor, which will be known as a Labor Unit (LU), as one hour’s worth of unskilled, low-risk, average-physical-intensity work.

Let me explain that a little bit. One LU could mean an hour’s worth of a farmhand picking fruit from the orchards, or it could be the blacksmith’s assistant carrying wood for the forge and pumping the bellows, or any other labor of that ilk. If the work is especially onerous and/or dangerous and/or if it requires training and expertise, then one hour of work could generate more than 1 LU. And if it’s super easy work, it could generate less than 1 LU/hour. This should all be obvious–when I work as a physician, I make more money per hour than when I worked at Costco as a teen.

One important use of this idea of a Labor Unit is that it can quantify the cost of production of anything. If a blacksmith’s time is worth 4 LUs per hour (he is very skilled), and it takes him 1 hour to make a cook pot, the cost of labor that went into that cook pot is 4 LUs. And if the cost of the metal plus the depreciation of his shop plus cost of wood for the forge plus cost of his assistant’s time etc. all totaled to be 2 LUs, then he will break even if he exchanges the cook pot for something else worth 6 LUs. If he sells it for 7 LUs because this pot turns out especially beautiful and round, then he has made a profit of 1 LU.

The beautiful thing about LUs is that their value remains constant over time because they are defined by a constant (1 hour of non-dangerous/average-onerousness/non-skilled labor). This means that if the price of cook pots goes down over time, it’s attributable to a change in the total amount of labor required to produce one (assuming profit is the same). For example, maybe the price of metal (in LUs) has gone down because a new innovation now allows it to be procured for less labor. This would be reflected in the price of cook pots going down (assuming profit is constant).

When we quantify the price of something in money instead of Labor Units, we add an additional confounding element. For example, let’s say an ancient society is using gold coins as money, and suddenly it’s all the rage to worship golden calf statues. The demand for gold has gone up, which means the price of gold has gone up as well. So maybe a single gold coin used to be worth 1 LU, but now a single gold coin is worth 1.2 LUs. Therefore, the price of that blacksmith’s cook pot has changed! He had a price tag on it that said “7 gold coins”, but he crossed out the 7 and wrote 8.4 instead. The customers might all complain, saying he’s gouging them! But really what’s going on is that the exchange rate from LUs to gold coins has changed. The cook pot is still worth 7 LUs (cost plus profit), but since prices are never displayed in my fictitious Labor Units, we have to quantify them in money, and therefore this additional LUs:money exchange rate is integrated into every price.

The upshot of this is that any time the price of something changes, it could be due to two different things. Either the LU:money exchange rate has changed (i.e., the “listed price”), or the amount of labor required to produce the thing (i.e., the “true price”) has changed, or both.

I feel compelled to add, for anyone who’s wondering what the point of all this is, that the real-world application of these principles of money may not yet be apparent, but these are the pieces of information that will allow later discussions on inflation and government debt and the role of cryptocurrencies to make sense. We’ll get there! Part 3 here.

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