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Karl Smith on Money

by on February 11, 2011

Karl Smith, an economist who blogs frequently at Modeled Behavior, has written a short post criticizing Will Wilkinson’s idea that money should serve as a store of value. That isn’t, of course, Wilkinson’s original idea or anybody else’s; it’s a fact of life due to uncertainty. The world is an uncertain place, as everyone knows. We can’t predict the future. We don’t know what’s going to happen ten years down the road or even five minutes down the road. I might very well have an airplane crash through my roof the moment I get up off my computer. The Euro could collapse tomorrow and lead to a global depression the likes of which we have never seen before.

That is why people desire to hold money. It alleviates uncertainty. There’s no point, however, in holding onto money if it won’t be worth something the next time you attempt to put it to use. That’s why,  if given the chance, most people will flock to a hard commodity like gold rather than to paper money. Paper money is easily manipulated whereas gold is not.

Smith’s primary argument against money acting as a store of value rests on his claim that an increase in the demand to hold money is a major source of economic instability in the modern world. If enough people suddenly desire to hold money, that money plays no useful role in the economy. People need money to demand goods and services. If people aren’t spending then demand drops, businesses layoff workers, factories goes kaput and so forth. It all sounds very dire.

I’m skeptical that our price system is so rigid that prices couldn’t adjust to some extent in the face of an increasing demand to hold money, but that’s not what I want to get into right now. I want to focus on something Smith wrote which I think reveals a rather shallow understanding of money in general. He writes,

That people sometimes see it as advantageous to stop investing in capital and start holding money is the source of enormous economic instability.

What he is saying here is that investing in capital is important because capital is productive. Capital is used to expand our output of goods and services. Capital raises people’s wages because it makes them more productive (increases their marginal productivity in technical terms). But where does capital come from? It comes from savings. People save money which then gets loaned out to businesses and entrepreneurs by banks and invested in new capital. Why, though, do people save? Given what Smith has said above, one could be forgiven for believing that people save purely for the purpose of  investing in capital.

That, though, is largely incorrect. Some people who save may do it specifically to increase the capital structure, but I can promise you that isn’t why most people save. Most people save in order to store money! Because the future is uncertain, people desire a method through which they can meet unanticipated obligations (a car breaking down, for example) or finance future spending (a new TV). Holding money is one way to do that and putting it in a savings deposit at a bank is another. Most people opt for the savings deposit option.

That leads to an interesting question: if money didn’t act as a store of value, why would anyone put their money in a bank? If I know the money I am holding will lose half its value within six months I certainly will not be giving it to a bank. I’ll rid myself of it as quickly as I can before my purchasing power gets halved. So if money isn’t supposed to act as a store of value how would capital accumulation happen? How would investment happen? Savings is a prerequisite for investment. If savings doesn’t happen, the investment Smith correctly states is so important won’t take place either.

That’s why it’s important for money to serve as a store of value. It very well may be the case that an increased desire on the part of many people to hold money can have adverse effects on the economy. The “quasi-monetarist” approach of increasing the money supply to maintain nominal GDP is one possible solution. Regardless, somehow trying to make money less useful as a store of value won’t solve anything. It will probably just make things a lot worse.

 

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