What Economists Mean When they Talk About Money (2 of 2)

A while back, I wrote about a pending academic research project I was embarking upon with Jeremiah Newhall, a good friend of the site. Below you will find a draft version of a section of our paper which discusses an economist's view of money, and which follows the section I posted Monday. Part of the reason I am posting this is to solicit feedback, so please feel free to submit your thoughts in the comments section below, and please bear with us on the citations.

Not every government could be so effective as the Khan’s, so in the 1700s European merchants and bankers created a new de facto paper currency in notes promising to pay real currency (i.e. coins).[1] This was the birth of commercial paper. The notes drawn on accounts of banks circulated as paper money, endorsed by each owner assigning his rights to the next, in chains so long that people ran out of room to sign their names, and attached still more paper.[2] The innovation permitted traders to buy goods in India using coins sitting in a bank vault in Europe. The money changed hands each time the note was signed, and the coins stayed where they were. Until the note was redeemed, the coins could just as well have sat at the bottom of the sea.

Europeans had finally hit upon an innovation that the people of Uap (also called Yap) had probably known for centuries: that money need not change hands to change possession.[3] Yap’s currency included enormous coins called fei, made of hand-carved limestone from an island hundreds of miles away and shipped to the islands on rafts.[4] Fei could have a diameter of up to twelve feet, and their value was measured by their size.[5] But moving the fei was often too much trouble, so instead they are traded by word alone, without so much as a mark of ownership of a slip of paper.[6] And because possession was immaterial to ownership, a fei could be owned and spent even when it had been lost at sea. The islanders would simply agree that the recipient was the new owner of the great fei at the bottom of the ocean; its location did not diminish its value.[7] The money could be spent as easily “as our silver dollars stacked in the treasury at Washington, which we never see nor touch, but trade with on the strength of a printed certificate that they are there.”[8] Although Yap’s primary currency is now the dollar, fei remain in circulation to this day.[9]

But it was the European’s combination of the ledger system with commercial paper that permitted depositors that really got money moving. The combination of abstract ownership and credit depositors to spend the same dollar (by crediting it to the account of another) that the bank had already lent to a borrower, either as physical money or, better still, crediting yet another account. Suddenly, a dollar could be everywhere at once.

The practice continues today—make a large withdrawal, and your bank will issue a cashier’s check, rather than give you cash. The Internet has merely streamlined the process, and the vast majority of transactions are credited electronically to computerized ledgers of deposit accounts. Buying an airline ticket, for example: Your employer pays you via direct deposit, meaning it orders the bank to debit its account and credit yours; you buy airline tickets by ordering your credit card-issuer to debit your card account and credit the airline’s bank account; you then pay your credit card bill with your salary by ordering your depositary bank to debit your checking account and credit the card-issuer’s account. At no point does physical money change hands, yet everyone has been paid. The money in your account might as well have been at the bottom of the ocean.[10]

So when economists talk about the money supply, they cannot limit the discussion to physical dollars and cents, as lawyers do. That would miss most of the money actually used in the economy—the money “at the bottom of the ocean” that paid for your salary, your credit card bill, and your airline tickets. So useful measures of the money supply, called M1 and M2,[11] include deposit accounts and demand notes, as well as reasonably liquid items (such as short term certificates of deposit).[12] A reasonably liquid security is the twenty-first century “knife money,” the abstraction of a universally demanded good.[13] These totals raise the “money supply” well above the number of dollars and cents physically circulating or sitting in vaults.[14]

[1] Gilmore, supra note 2, at 448.
[2] Id.
[3] W.H. Furness, The Island of Stone Money: Uap of the Carolines 93 (1910). The same point is made rather amusingly in Game of Thrones by the character Tyrion Lannister, who tries in vain to bribe a brute with a promise of gold. The brute points out that Lannister has no gold, to which Lannister replies: ”Sometimes possession is an abstract concept.” Game of Thrones: A Golden Crown (HBO television broadcast May 11, 2011).
[4] Id. at 93–95. An American shipwrecked on Yap, David Dean O’Keefe, exploited this economy and became Yap’s richest man by using a schooner to ship large quantities of the stones. He dubbed himself “King of Yap” and flew his own flag over the island until German occupation ended his “reign.” See Samuel Pyeatt Menefee, Republics of the Reefs: Nation-Building on the Continental Shelf and in the World's Oceans, 25 Cal. W. Int'l L.J. 81, 83 n.11 (1994).
[5] Id. at 96.
[6] Id.
[7] Id. at 97.
[8] Id. at 98. See also Bryan, supra note 1, at 2.
[9] See Bryan, supra note 1, at 3.
[10] We are not the first to make this comparison; no less than Milton Friedman compared Yap’s fei to the marking of bars of gold in the Federal Reserve. The bank of France had purchased the bars, but couldn’t be troubled to ship them. The gold continued to sit in the Fed’s vault, but everyone believed that they now belonged to the Bank of France—believed it so fully that it contributed to the bank rush of 1933. See Milton Friedman, Hoover Institution, The Island of Stone Money (1991) (unpublished working paper), available at http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCIQFjAA&url=http%3A%2F%2Fhoohila.stanford.edu%2Fworkingpapers%2FgetWorkingPaper.php%3Ffilename%3DE-91-3.pdf&ei=rmdVUKXqEsWkyQHLxYCgBQ&usg=AFQjCNEv3N54LU0E_phXtYyCRh3Myl6BAA.
[14] See Lewis D. Solomon, Local Currency: A Legal And Policy Analysis, 5 Kan. J.L. & Pub. Pol’y 59, 65 (1996) (noting that, as of 1992, circulating currency constituted only 31% of the American money supply).

Jeremiah Newhall is a graduate of The George Washington University Law School and currently serves as a law clerk in Chicago. He can be reached via the miracle of email. Joshua Sturtevant is also a GW Law grad, and currently serves as an in-house legal fellow at a renewable energy financing and development firm.

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