According to popular view people accept money because of a government decree. A government decree it is argued makes a particular thing accepted as a general medium of exchange. But, does it make sense?
Demand for a good arises from its perceived benefit. For instance, people demand food because of the nourishment it offers them. It is different with money people demand it not for direct use in consumption but in order to exchange it for other goods and services.
Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services. Money is demanded because the benefit it offers is its purchasing power (i.e., its price). Consequently, for something to be accepted as money, it must have a pre-existing purchasing power, a price. So how does a thing that the government proclaims will become the medium of the exchange, acquire such a purchasing power, a price?
In his writings Carl Menger raised doubts about the soundness of the view that the origin of money is government proclamation. According to Menger,
An event of such high and universal significance and of notoriety so inevitable, as the establishment by law or convention of a universal medium of exchange, would certainly have been retained in the memory of man, the more certainly inasmuch as it would have had to be performed in a great number of places. Yet no historical monument gives us trustworthy tidings of any transactions either conferring distinct recognition on media of exchange already in use, or referring to their adoption by peoples of comparatively recent culture, much less testifying to an initiation of the earliest ages of economic civilization in the use of money.
Historically, many different goods have been used as medium of exchange. On this Mises observed that over time there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
Similarly Rothbard wrote that,
Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others; some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc.
Eventually, one or two commodities are used as general media — in almost all exchanges — and these are called money. Critical to this process of selection is the fact that demand for money depends on its pre-existing price. On this Rothbard maintained that,
Money cannot originate in any other way: neither by everyone suddenly deciding to create money out of useless material, nor by government calling bits of paper, “money”. For embedded in the demand for money is knowledge of the money-prices of the immediate past.
We know that the law of supply and demand can explain the price of a good. Likewise it would appear that the same law should explain the price of money. But, there is a problem with this way of thinking, since the demand for money arises because money has purchasing power (i.e. money has a price). Yet if the demand for money depends on its pre-existent price i.e., purchasing power, how can this price be explained by demand? We are seemingly caught here in a circular trap, for the purchasing power of money is explained by the demand for money while the demand for money is explained by its purchasing power. The circularity seems to cast doubt on the historical selection process of money, as described by Mises and Rothbard, and it seems to provide credence to the view that the acceptance of money is the result of a government decree.
In his writings Mises successfully refuted the popular view as to how money become accepted. Mises began his analysis by noting that today’s demand for money is determined by yesterday’s purchasing power of money.
Consequently for a given supply of money, today’s purchasing power is established in turn. Yesterday’s demand for money in turn was fixed by the prior day’s purchasing power of money. So, for a given supply of money, yesterday’s price of money was set.
The same procedure applies to past periods. By regressing through time we will eventually arrive at a point in time when money was just an ordinary commodity where demand and supply set its price. The commodity had an exchange value in terms of other commodities i.e. it’s exchange value was established in a barter.
To put it simply on the day a commodity becomes money it already has an established purchasing power or price in terms of other goods. This purchasing power enables us to set up the demand for this commodity as money. This in turn, for a given supply, sets its purchasing power on the day this commodity starts to function as money.
Once the price of money is fixed, it serves as input for the establishment of tomorrow’s price of money. It follows then, that without yesterday’s information about the price of money, today’s purchasing power of money cannot be established. (With regard to other goods and services past history is not required to ascertain present prices. As demand for these goods arises on account of the perceived benefits from consuming them. The benefit that money provides is that it can be exchanged for goods and services. Consequently, one needs to know the past purchasing power of money in order to establish today’s demand for it).
Using the Mises framework of thought, also known as the regression theorem, we can infer that it is not possible that money could have emerged as a result of a government decree. For the decree cannot bestow purchasing power upon a thing that the government proclaims will become the medium of the exchange. The theorem shows that money must emerge as a commodity. On this Rothbard wrote,
In contrast to directly used consumers’ or producers’ goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold). Thus government is powerless to create money for the economy; the process of the free market can only develop it.
