Thursday, January 19, 2012

The money mill

The money mystery
Money is one of the most perplexing, contradictory things around. It’s the subject of contradictory sayings: “Money is the root of all evil.” “Money makes the world go ‘round.” (Wait, maybe those aren’t contradictory …) We use money on a daily basis and take its existence for granted, yet when we stop to think about what it is and how it works, we often find ourselves confused.

I’m going to show you that money is simple, but also that it’s magical. It can be called into being out of thin air. And yet it can bring about changes in the real, physical world.

The first requirement is to get past the story of barter. If you pick up an economics textbook at random, you’ll probably find something like a story about a village where people trade using barter. The people realize that barter is a real nuisance, because you have to lug your goods around with you, and you have to be so lucky as to encounter the famous “double coincidence of wants”: I have eggs and want shoes; you have shoes and want eggs. Hey! we can trade!

But what if I have eggs and want shoes; you have shoes and want milk; another neighbor has milk and wants strawberries …? Most inconvenient. What if there were something … something that stood for stuff in general? Then we could each go around with this … something in our pockets, buy what we need, and then later, sell what we want to sell when somebody else shows up with more of this … something. Voila—money!

Except that, as David Graeber says in his recent book (and in this blog post), there’s no evidence that that’s how money actually started.

The intuitive attraction of the barter story is that it begins with trade. Two people have different things, and each wants some of what the other has. The obvious solution is some form of exchange.  Eventually they realize that barter is awkward, so they invent money.

Following Graeber’s lead, I don’t start with an exchange of things, I start with debt. And surprisingly, my story doesn't even need two goods. Just grant me one good, and the ability to make a promise, and I’ll take you to money.

This isn’t meant to be an account of how money actually started; it’s a parable to help understand what money is and how it works.

The physical economy
Imagine an agricultural economy.  We're going to simplify all the way down to where there's only one thing produced, and we'll call it "food."  And we'll define 1 unit of food as the amount that a household needs in a year.  Because this is the economy's only good, your standard of living is defined by access to food.  You can eat more than 1 unit, maybe 1.5 units, but at some point, the extra enjoyment of the increased food is not worth the extra work required to produce the extra food.

It's a purely physical economy, with no money, no banks.  And for that matter, no saving: the food is perishable, so what you don't eat this year is gone.

The investment project
Now we introduce an investment project.  I want to build a watermill to grind grain.

File:Braine-le-Château JPG02.jpg

File:Roda de Vitruvi.jpg
Both images from

  This can actually increase the community's production of food.  We're currently grinding grain using mills powered by work animals.  We need to feed those work animals, so some of the crops we grow is devoted to feeding our "machines" instead of feeding us.  Once the watermill is built, we can either reduce our number of animals or redirect their labor to cultivating more land.  Either way, the new mill will allow the community to produce more food.

In other words, the mill is a piece of capital that will lead to economy-wide economic growth.

In addition to benefiting the community, the mill will benefit me personally.  It will be far bigger than I would need just to grind my own grain.  Since it will allow other farmers to get rid of their donkeys and produce more food, they'll be happy to pay me to grind their grain rather than doing it themselves.  And they don't need money to pay me, because they can pay me in food: if I grind 10 sacks of grain for someone, she'll let me keep one of them.  Let's say it's a big enough operation that my revenue will be comfortably more than 1 unit of food a year--at least 2.5 units, but maybe more.

Getting it built
Building the mill will take the labor of 10 people for a year (including me).  While we're busy building, we won't be able to produce food, which means that I'll have to find some way to provide food for all of us for the year.  But remember that food is not really storable, which means that I can't put aside half a unit of food for 20 years until I've got 10 units stored up to pay my builders.  I've got to convince people who are producing food now to hand over some so that I can feed (pay) my builders.

Let's say there are (at least) 10 farmers in this village that are good farmers--and you're one of them.  Right now, you're each producing 1.5 units of food, and also eating 1.5 units.  But you've got enough land, equipment, skill, and labor power that you could produce 2 units each--you just don't bother, because you'd have no use for the extra food.  But since you can produce 2 units, and you only need to eat 1, each of you is capable of providing me with 1 unit of food to feed my builders.  But since there's no money, how do I pay for this?

I can make a promise to each of you:
  • Give me 1 unit of food this year.
  • Then next year, and the year after that, and every year for 10 years, I'll give you 0.15 units of food.
You may recognize this as essentially no different from a mortgage, where you make an agreement with a bank:
  • Give me $150,000 right now.
  • Every month for the next 15 years, I'll give you $1,445.
(Both of those examples happen to represent an interest rate of 8.14%.)

So you farmers agree to this deal.  To hold up your end of the bargain and actually hand over 1 unit, you have to do two things.
  1. Work harder and increase your output to 2 units; and
  2. Cut back your consumption to only 1 unit.
The unit of food I get from each of you is the result of your activity of saving.  The part that comes from consuming less sounds more like our intuitive notion of saving; saving means "not spending."  But the other part is equally saving: working more but not consuming the increased output.

Each farmer has to open up a space between output and consumption.  Creating that space is the farmer's act of saving.  The savings themselves, thought of as something that you can use in the future, are not the food grown and not consumed--remember, if you put that aside, it would just rot.  Rather, the savings are nothing other than my promise.

Let's pause for a moment to look at the effects of this investment project.
  1. Real output has gone up in the present.  The ten of us engaged in construction aren't growing food, so that represents a decrease in the village's food production, but we're working just as hard building the mill instead.  Presumably the nine other builders I'm paying aren't the super-productive ones who were growing 1.5 units before, but other farmers who only grew 1 unit.  I hired them, because I'd only have to provide 1 unit of food to entice them to work for me, and apparently I think that's what they're worth, since that's what I'm paying them.  So there's no change in the value of what they produce, it's just that now their output is a mill isntead of a quantity of food.  The other farmers, on the other hand, were producing 15 units in total, and now they're producing 20, so the economy as a whole has seen an increase of output worth 5 units of food.
  2. Real output will increase in the future.  The mill will allow everyone to produce more food.
  3. The debt is sustainable.  I've promised to hand over 0.15 units every year, to each of 10 farmers, or 1.5 units a year.  But my income will be at least 2.5 units a year, and I only need 1 to live on, so I'm "solvent": my debt obligations are no more than my expected future revenues.
All this as the result of my entrepreneurialism, the farmers' ability to produce more and willingness to consume less, and a promise.  Let's take the next step.

Beyond promises
The promise works (as long as you accept it), but it's somewhat clunky.  It's an individualized thing, attached to a particular farmer.  When you, a farmer by the name of Dear Reader, show up at my mill a year from now, I'll give you 0.15 units of food.  But if some Joe Schmoe shows up, I owe him nothing.  You could in theory sell your copy of my promise to Joe Schmoe, but what would you sell it for?  There's no money, so it would have to be another version of what you and I did (Joe Schmoe gives you food now, you give Joe a promise of food later--only it's not a promise you made, it's a promise I made, to you).  And selling just part of it rather than the whole thing might be laborious.

But what if I replace the promise with a set of tokens?

Each token is worth 0.01 units of food, and it also has a "maturity" date.  It's now 2012; 15 tokens become valid in 2013, another 15 in 2014, etc., with the last 15 becoming valid in 2022.  It's the same deal we agreed to above, but it's more convenient.  If you show up at my mill in 2016 and give me one of these tokens with a 2016 "maturity" date, I'll give you 0.01 units of food.  You could also show up at my mill with a token that matured in 2015 but that you had decided to hold onto rather than using right away.

And it doesn't even have to be you.  Anyone who shows up at my mill can get 0.01 units of food, so long as they hand over a "mature" token that I originally handed over to one of the farmers.  But this has big implications.

Because now other people have a motive to accept these tokens from you and give you something real: they're confident they can take the tokens to my mill and get something real for them (0.01 units of food for each token).  So a "mature" token should be accepted in the village at face value; a person who gets it can take it to my mill right away if they want.  But an "immature" token, one whose maturity date is a couple of years further into the future, should trade at a discount; people are confident they'll eventually be able to bring me the token and get food, but they can't do that just yet.

Look at what's happened now.  These tokens, having no worth in themselves, but only as a representation of my promise, are circulating around.  People are accepting tokens in exchange for something real, something with a physical use.  The tokens have become money.

Money, debt, saving, borrowing, investment
The tokens have value because somebody (that happens to be me) has made a credible promise to redeem them for real goods (either now or at some defined point in the future).  That credible promise is my debt, my obligation.

==> Money requires the existence of debt.

What happens when you (or someone else) does bring by a "mature" token?  When you and Joe Schmoe traded, you gave Joe a token, and he gave you food; that was the end of the trade.  When Joe brings me the token, he gives me the token, I give him food, I reduce the amount of food I owe by 0.01 units, and I destroy the token Joe paid me with.  If I didn't do that, I would be getting an unfair advantage. When you and Joe traded, you got food, he got a token.  When Joe and I trade, he gets food, I get a token, and I get my debt reduced.  If I didn't also destroy the token but held onto it to buy something with, I'd have gotten more for the token than you got for it when you used it to buy food from Joe.  Which leads to our next observation:

==> The money only exists so long as my debt exists.

What about saving?  It turns out that your saving was impossible without my borrowing.  The food rots, so you could engage in saving activity by consuming less than you produce, but you wouldn't end up with savings--you'd end up with a rotten mess.  I made a credible promise to provide food in the future, and that gave you the ability to claim some food in the future without producing any.  That's something you can't do on your own.

==> Your ability to save depends on my willingness to assume an obligation about the future.

Another way of looking at it is that money is the representation of somebody's debt, and saving (the accumulation of claims on stuff that will be produced in the future) is only possible through somebody assuming debt (an obligation to hand over some of what gets produced in the future).

And investment?  It turns out my investment would have been impossible without your saving.  I needed food for my builders and me, and for that food to be available, I needed you to work harder and consume less--I needed you to engage in saving.

But my investment would have been equally impossible without my borrowing, without my creating money out of thin air.  And isn't that what it was?  I did create money, and it was based on nothing more than my credible promise that I would obtain food in the future and hand it over.

The borrowing was necessary because of the relationship between the investment and the 10 years' worth of labor required to carry it out.  I could perhaps have built the mill myself, devoting two thirds of my time each year to producing food and a third of my time to construction; it would have taken me (at least!) 30 years to complete it.  My borrowing and your saving and lending allowed it to get done in a year.

==> Borrowing and lending and money creation allow us as a society to direct far more resources to investment than otherwise, and thus to grow faster.

Magic money
So let's see what all happened here.

I had no prior saved wealth.

I had no "money" on hand.

The whole economy had no money in it at all.

There was no prior trade of any sort.

Gold played no part in this story.

We had:
  • My knowledge of how to build the mill.
  • My willingness to arrange and supervise the bulding of the mill.
  • Your belief in my promise to hand you real goods in the future.  (This includes your belief that I'll be able to do it, and your belief that I will actually do it.)
Those requirements are actually pretty significant, but that is "all it takes."

Next: More than one way to skin a cat


  1. Larry Gonick sent me this post "on the invention of money", which you might find interesting.

    1. Thanks, Yoram. I actually read that post back when it went up, and it inspired me to (eventually) get my hands on Graeber's new book, "Debt: the first 5,000 years." In a sense what I'm trying to do is merge Graeber's historically informed view of money's origins into a more generalized view of what it essentially is. I highly recommend the book.

    2. (I've revised the post itself, mentioning the book and the post.)