State or Market: Mystery of Money

{} There is a huge controversy about what money is – especially since the role and function of money has evolved and changed substantially over time. Curzio Giannini’s book “The Age of Central Banks” provides clarity and insight into this topic not easily available elsewhere. We will cover this book in a sequence of posts and videos. This is the first post in this sequence and covers Chapter 1, sections 1 to 3 of the book.

This material summarizes the first three sections of Chapter 1 of Curzio Giannini’s masterpiece, The Age Of Central Banks. Chapter 1 is entitled Money between state and market: the concept of payment technology. There are two view of money – as a private creation of markets to faciliate exchange, and as a creation of the government by fiat. This chapter resolves this controversy, showing how both market and state are necessary aspects of money. {ppt slides for video: }

Section 1.1: Introduction

What is Money? A bundle of contradictions. Debates about money spanning centuries. Unresolved controversies. Many different theories and schools of thought about role and function of money within an economy. Ranging from QTM: Money does not matter, to money is central to modern economy. To understand why this matter is so controversial, see “The Battle for the Control of Money

Does History Matter? We first consider whether we need to dive into the history of origins of money, in order to understand money: “Does History of Money Matter?” If it does matter, then HOW does it matter? It is interesting to note that Sir John Hicks reversed his stance on this question. In his early writings, he said that “Goal of Monetary Theory should be to explain the pattern of evolution of money.” BUT: Later reversed this stand, and joined neoclassicals, who make money irrelevant. According to the neoclassical school: One does not need the history of automobiles to understand how the car engine works.

Why Do Neoclassicals Say that Money Does Not Matter? Neoclassical approaches to money are wrong because Neoclassical Assumptions Make Money Irrelevant, If we assume that exchanges are settled and managed centrally by an omniscient auctioneer and that there is perfect trust among agents in the economy, the monetary issue becomes meaningless because there is no need for any medium of exchange, or quid pro quo, to conclude transactions. We can just write IOU notes to each other – everything is guaranteed to balance in the end. Money plays no role.

Uncertainty is KEY to understanding money: If I accept a payment in Money, what are the chances of my being able to USE this money to buy things? Will those who have commodities I want ACCEPT this money? What are my perceptions of the TRUST in the money, and the UTILITY of this money, in general public. EXPECTATIONS about public acceptability of money are KEY to use of money.

What determines Social Expectations about money? Here, HISTORY plays crucial role. Past experience with money is central to public trust. Money has evolved over time as mechanisms to improve trust and utility have been devised (or have collapsed).     Understanding history is key to understanding money. Conversely, having a theory of money will illuminate the history of evolution of money.

Two Functions of History: First: How past performance of money lead to increase or decrease in levels of confidence about general acceptability of money. (Understanding Variations in Levels of Trust). Second: Crises of confidence lead to efforts to build mechanism to create or restore confidence. This leads to building of monetary institutions, which shape history. Monetary Theory should explain how money has evolved over time, shaped by crises in confidence, and attempts to create confidence.

Origins of Money: Two Conflicting Stories Both go back to Aristotle!

  1. Cattalactic (Exchange-Theory): Money facilitates barter of goods. Double coincidence of wants is not required.
  2. State Theory of Money: Money is created by State authority, which provides legal framework and enforcement for use of money.

This sterile debate, carried out over centuries, continues to this day. Both aspects of money are essential to its operation, as an institutional analysis shows.

Institutional Analysis: Neoclassicala narrow focus on prices and exchange throws out essential elements of economic activity. Institutions which permit exchange are crucial to the story. When people give money, or take money, in exchange for goods, what they will be able to do with this money is subject to large amounts of uncertainty. Institutions are used to manage and reduce this uncertainty. These Institutions EVOLVE over time, in light of experience.

Resolving the State/Exchange Conflict

The State (or Other Institutional Frameworks) provide guarantees about usage of money. This creates trust. Exchange theory justifies the use of money for many kinds of transactions, provided that trust-creating mechanisms are available, and historically reliable for the public. Both aspects are necessary to understand money.

Central Elements of Institutional Analysis,


  1. Craft Order: Rules of the Game when failures of market transactions occur –
  2. Mitigate Conflict: Who is responsible for defective goods, unfulfilled credit promises, etc. Rules permit resolution.
  3. Realize Mutual Gains; Opportunities for mutual beneficial transactions exist but cannot be exploited due to risks of various kinds. Institution minimized this risk, and enable markets.

Oliver Williamson: Micro Aspects of Institutional Analysis.   

  • Look at transactions, not at individuals.
  • Investments needed to finalize transactions
  • Essential incompleteness of contracts, and mechanisms to cope with this.

Methodology of Institutional Approach: Market exchange is governed, not just by producers and consumers, but a host of institutions which enable and facilitate the market. Economists view of “rationality” is too strong. There are limits on knowledge, memory, and computational capabilities. Economies evolve through time, subject to different kinds of pressures to change. Studying static equilibria under optimal behavior by all agents does not provide necessary insights.


Three Conditions for A Monetary Economy

  1. Common measure of value of goods.
  2. Procedures for carrying out transactions to completion. Checks are first step of payment procedure (for example)
  3. Means for converting means-of-payment into unit of account.

These three elements – priced goods, payment procedures, conversion conventions – are called a Payment Technology.

3: is confusing because prices and means of payment are same today. But this has not been the case in most of history. Consider for example goods priced in USD, while means of payment is in PKR.

The key element of a payment technology is without doubt the possibility to complete an exchange when there is no ‘double coincidence of wants’ in such a way that no further legally binding obligations exist after the exchange is completed. In other words, the key element is the existence of a means of payment or, in a word, of money.

The 3 x 3 Theorem: Money is not useful if there are only TWO goods – they can be traded for each other at some suitable exchange rate. Money is not useful if there are only TWO people – they can carry out barter with each other at mutually agreed terms. We need THREE goods and THREE people for a monetary economy.

From this, it follows that Money is a social convention! : Money exchange between A and B is implicitly built on the assumption that C will be willing to accept money! Social Agreement that exchange of Money for Good extinguishes all social obligations –

Money is like a Durable Good, which provides a flow of services: Increases in supply of money raise general price level, and reduce the value of service being provided. Loss of public confidence in value of money also reduces the value of service being provided by money. Thus, the value of Money Depends on Two Factors

  • Rate of Interest on Deposit Accounts Minus Rate of Inflation (Cost of holding money).
  • b – The Confidence in Stability of Value of Money across time.

The first factor is just the cost of holding money. What are the factors the affect beta: the confidence level?

Guarantees by Producers of Money Producers of money can destroy value of money by reckless money creation. To hold money, public need some assurance that money creation will be done with responsibility. For every payment technology there must therefore be a body of rules, conventions and institutional mechanisms designed to sustain the confidence of the people using it.

Theory of Money: The purpose of a theory of money as an institution is precisely to study the confidence- creating mechanisms that evolved in order to support the acceptability of money as quid pro quo in a world of imperfect information or, put another way, of potentially fraudulent agents. Law – legal enforcements of violations of social conventions – MUST always be part of the confidence creating mechanisms. (Except for commodity money).

Three Types of Confidence Creating Mechanisms

  1. Commodity Money: something of general value to public (or socially recognized as such)
  2. Producers Guarantee: pledge, legal constraint, binding producers of money to responsibility in money creation
  3. Vertical Integration: Producers and Consumers are bound together within a single governance structure assigning rights and responsibilities to all parties.

Examples of the 3 types

  • Type 1: Gold and Silver, but also other commodities generally recognized by public as being of value.
  • Type 2: Guarantee of Value (Responsible Behavior)  Guaranteed conversion to gold at fixed rate ensures that too much money cannot be printed.
  • Type 3: Vertical Integration. Producers of Money are Banks. But they are put under control of Central Banks, answerable to Public.


Commodity Money Paradox (and its resolution). The paradox is this:

  • Commodity money is highly inefficient (to be demonstrated)
  • Yet, it has persisted for a long time, and across diverse cultures.

WHY? Why does an inefficient payment technology show such strength?

Textbooks discuss characteristics of commodity money: portability, indestructibility, homogeneity, divisibility and recognizability. But these are of secondary importance, and miss the main point. First we explain why commodity money is highly inefficient.

Disadvantages of Commodity Money

  • Costs of Production
  • Unavailability of Commodity for other uses.

Giannini estimates above two items, and shows costs are quite large. It is very expensive to mint gold, and this also makes it unavailable for other purposes. However, an even more serious problem caused by commodity money is:

Inflexibility: inability to adapt the quantity of money according to the requirements of the economy. This is also called maladaptation

This leads to Deflationary Bias: If amount of money – like gold stock – is fixed, and economy is expanding, then prices must fall to accommodate all transactions. BUT, generally speaking, prices are sticky downwards. This is because one needs to make economy-wide coordinated reductions in prices. This involves huge transaction and information costs (ignored by neoclassicals). With sticky prices, the economy will fall into recession or depression – Volume of transactions will be reduced below what is possible, because of insufficient money.

Vulnerability to Exogenous Money Shocks: History of Middle Ages provides MANY examples of shortage-of-gold induced recessions. Standard method of handling was to use “coinage” where the actual gold content would be less than the official value. But such subterfuge would result in crises, with regularity. The economy required price adjustments which were hard. On the other side, influx of gold could lead to inflations, causing other kinds of damage to the economy. Commodity Money incurs HUGE Maladaptation costs – mismatch between quantity of money and needs of the economy.

Paradox Resolved: Fiat Money has been known since antiquity. However, the relatively inefficient commodity money persisted for a very long time, across a very broad geographic region. WHY? Fiat money requires confidence-creating mechanisms. It was not possible to create sufficient levels of trust by the public to allow for use of fiat money. Neoclassical ignores confidence, trust, uncertainty, and therefore leads to this pseudo-paradox.

Characteristics of Commodity Money: In light of this discussion, the characteristics of commodity money are not those discussed in textbooks. Rather, Commodity money:

  • Should lend itself to alternative, non-monetary, uses without much adaptation.
  • Should have a rigid, or fixed and predictable, supply schedule, preventing exogenous supply shocks which destroy the stability of value of money.

“Partial” commodity money: minted gold coins: face value of coin may be greater than gold content. Reducing gold weight solves adaptation to market problem, but creates confidence problems. 

Central monetary problem of Middle Ages: discrepancies between face value and actual value. 

Tension Between Efficiency & Confidence governs the evolution of money. The fundamental tension is between adaptability versus confidence: To make money adaptable to the needs of the economy, producers of money must be given the power to flexibly create and destroy money. However, this power can be ABUSED. To create confidence, money supply must be subjected to strict rules of creation. Milton Friedman’s rule of fixed rate of increase of money comes from this vision, based on neoclassical assumptions of quick and costless adjustment of prices to equilibrium. Advocates of Government Control of Money favor flexibility but discount the confidence required for use of money. End of Section 3, and of this Part

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