From the Lectern: Week 2

This week we introduced the primary tool economists use for developing intuitions about markets: supply and demand. Although there is a lot more to understanding markets than just supply and demand, economic intuitions will pretty much always start by what we can get from competitive markets. In fact, the first two-thirds of the course revolve around thoroughly understanding all their implications, with the last third focused on what happens when markets fall short of perfect competition.

To facilitate our study, it's usually easier to have a specific market in mind as a source of  examples. I thought I'd pick a memorable one, so this week we talked about the market for Pet Care Rapture Insurance. Although Wikipedia can explain the rapture more fully than I intend to do here, many evangelical Christians believe that the rapture is a coming event in which Christians will suddenly disappear from the earth because they have been taken up in anticipation of the return of Jesus to the earth. Now, for some Christians who believe this but are also animal lovers, this leaves in question how their pets will be cared for when they are no longer present. The insurance, which is offered by non-Christians, says that in the event of the rapture, the insurance agency will pay to have an agent go to your home and care for your animals. A couple of firms in the market are Eternal Earthbound Pets and Jesus Pets.

With that information as background, lets consider the market for this insurance itself. There are two groups of people interacting in this (and any other) market, the buyers and the sellers. In order to describe the behavior in the market, we need to describe these two groups. Let's look at buyers first.

What might influence the amount of pet care rapture insurance people want to buy? Well, first and foremost is going to be the price of the insurance. If it means giving up twice the cost of your house, it seems unlikely even the most pet-loving person in the world is going to buy it. If it's only a few dollars up front, it might be attractive to anyone who owns pets and believes there's even the slightest chance of the rapture happening. For $20 total up front, why not hedge your bets? We can see this relationship graphically in the demand curve.



In order to make sure what we are looking at is just the relationship between price and quantity, we have to impose the condition 'everything else held constant,' or ceteris paribus if you want to impress your friends with some Latin. If anything that might affect this relationship changes, we have to draw a new demand curve by shifting the curve either to the left or to the right.

Other things that could shift a demand curve fall into four broad categories: (1) other prices, such as the price of a substitute good like extra pampering for your pets now or the price of a complement good (perhaps buyers of rapture insurance also buy services that will email friends to help them understand what just happened); (2) income; (3) expectations about what will happen to prices or incomes in the future; and (4) individual preferences and tastes (if people who believe in the rapture start to like pets more, they'll probably buy more insurance). The number of buyers also affects the market demand curve, since market demand is just adding up all the quantities individuals are willing and able to buy at each price.

Notice that a couple things you might expect to change the relationship between price and quantity demanded are not on the list.  Availability (or supply) isn't on there; you can pretty much always get a product you want (assuming it exists) if you're willing to pay enough for it, so availability changes the price itself, rather than the relationship between price and quantity. Need also isn't on there. Do people need pet care rapture insurance? We might be inclined to say no, but do we really get to start telling people what is and isn't needful for them? Do you want a bunch of economics students telling you what you do or don't need? Does the market even care what you need? Yeah. That's what I thought.

On the other side of the market we have sellers. So what affects seller behavior? You guessed it, the price, which gives us (ceteris paribus) the supply curve. Generally, the more money per item sellers can make, the more they'll want to put the time and effort into producing and selling their wares.

So what are we holding constant with the supply curve? Again there are a couple of categories: (1) related prices, such as the prices of other goods sold by the same firm (If the same employees can take care of post-rapture pets and post-rapture houses, a higher price for the latter will make the firm want to provide more of the former; if they have to pick one, the opposite will occur) and firms' expectations about future prices; and (2) things that affect the costs of production, which may either be prices of inputs (how much do we have to pay employees to take care of pets in a post-rapture world) or technology (how many people do we need to cover a certain area? Fewer people means lower costs, regardless of what we pay per person). Again, the number of sellers also matters to the market, although not to the individual firms.

What doesn't make it to the list? Demand. You can sell whatever you want if it's cheap enough, so demand affects the price, but not the relationship between price and quantity.

So what happens when these two sides of the market come together? Suppose sellers quote a high price and are willing to provide a lot of policies at that price. However, buyers don't want to buy that many policies at a high price. So the sellers will find that some of them can't sell as much as they are willing to at this price. For goods, this usually takes the form of a growing inventory of the good, or a surplus of the good. Sellers have an incentive, then, to lower their prices and steal customers away from those who would be selling at a high price. Sellers essentially bid the price down. If sellers quote a low price, though, they won't want to sell many policies, and some buyers will instead be willing to buy more than they can at this price; we usually call this a shortage. Buyers then have an incentive to offer more so that sellers will insure them, and they bid the price up. This bidding up and down only stops when nobody involved has any incentive to do things differently: at this point we say the market is in equilibrium (or, alternatively, that the markets 'clear,' so there are no lasting surpluses or shortages). If either supply or demand (or sometimes both!) shift, then we will have a new equilibrium to go with the new curves.

With the supply and demand graph, we can see what will happen to prices and quantities exchanged whenever some incentive changes the behavior of those in the market. In the graph above, dog treats (substitute) got really expensive, leading more people to buy the insurance instead. Amazingly enough, the price went up.

Why do we care so much what happens to prices and quantities? First of all, gains from trade. Notice that demand curves tell us not only how much people will buy at any price, but for any particular unit sold, it tells us how much the buyer would pay to get it. Willingness-to-pay essentially tells us how much a buyer values the good in terms of other things they could do with the money. Most buyers don't have to pay as much as they would be willing to, meaning there's surplus value that they get to keep. Similarly, the supply curve represents the opportunity cost of producing and selling each extra unit, but most units produced bring in more extra revenue (the price) than it took to make them. Firms then get surplus value that they get to keep, too. This consumer surplus and producer surplus represent the total gains from trade, or total surplus. We can even see the consumer and producer surplus, and thus the gains from trade, on the graph. It's the area below the demand curve (the benefit of the product) and above the supply curve (the opportunity cost of the product) for all units that get exchanged in the market.

In the context of the market, bidding the price up or down until it reaches equilibrium guarantees some very good things when it comes to gains from trade. First and foremost, market price guarantees that buyers and sellers will exchange every unit (in our example, every policy) that creates gains from trade, because every unit where the demand curve is above the supply curve gets produced and sold. Even better, the market price guarantees that no wasted trades take place, since none of the units where the opportunity cost (supply curve) is above the benefits (demand curve) gets produced.

Prices also contain valuable information for people thinking about getting into this market. Market prices can tell firms whether they should provide pet care rapture insurance policies (if your costs are lower than the price, sell it), and they can tell buyers whether they should use some of their limited wealth on this product or save it for something else (if you're willing to pay more than the price, buy it). In this way, the firms that produce the good are those with the lowest costs, and the buyers that get the goods are those who value the good the most (relative to other things you can buy, anyway).

In economics, when all these things happen we say that a market is efficient. Efficiency is good, because it gets us all the gains from trade we can get, and frees up as many resources as possible to do other, more useful things like create gains from trade elsewhere. One of the best -- and most important -- features of competitive markets is that, as long as the government keeps its fingers out of things, the market will and must be efficient. Hurray!

"I'm so glad there are markets!"

Why a Central Bank? Part 2: Banking Experiments

This post was prompted by this review of Ron Paul's End the Fed and a subsequent online discussion. By virtue of my economics background, a friend asked me to chime in on why Ron Paul's solution to various economic problems should be discarded as easily as his opponents suggest. Part 1, in which I discuss the origins and nature of modern money, is here.

Now that we have an understanding of what central banks are about controlling, we need to see some history of  the problems banking systems have faced and how they've tried to solve them. To facilitate this discussion, I'm again drawing from Walton and Rockoff's History of the American Economy tenth edition.

Once colonial governments started issuing paper as a substitute for gold and silver (recall that Britain had extracted most of the gold from colonial circulation, making money transactions harder to manage), they found it hard to stop. This led to the market value, or the rate of exchange between colonial paper money and the metal money of Europe, differing substantially from the face value printed on the paper. This was no problem for either colonists or English merchants as long as transactions were based on the market value, ignoring face value. But colonial governments required all merchants in the colonies to accept the paper at face value; essentially, colonial legal tender laws cheated foreign merchants, because when they got back to England the paper would only exchange for the market value. Eventually the British government made it illegal for colonies to force private payments in paper at face value. The colonists were none too happy with these new rules, so (SPOILERS) they had a revolution.

(Yes, I know the Revolutionary War was precipitated by much, much more than not being allowed to cheat British merchants anymore. But that was a non-trivial part of it, despite its exclusion from the Bob Jones curriculum.)

In hindsight, not the best curriculum I've ever used.

Of course, paper money that is not backed by a commodity has its own problems, which the colonies discovered while using this system during the Revolutionary War (and subsequently during the War of 1912 and the Civil War). Even when paper money is issued but is not backed by a more trusted form of money, it still has a market value in terms of all other goods: we economists call them prices. When governments just print money to pay off debts, the market value of money falls, meaning prices of all goods have to go up; in other words, we have inflation. Inflation can be a problem since it affects money's ability to function as a store of value, since the market value is falling. Because money functions as the unit of account, lenders that don't account for inflation lose out, since they are paid back with money based on its face value rather than its market value.

If inflation is low and relatively constant, contracts and loans can easily be written to compensate for these issues. However, If inflation is very high and variable, then people won't want to use money as a store of value or unit of account, making it less desirable in exchange. In other words, money ceases to be money since people don't believe it's money anymore.

It's kinda like fairies in that way.















Similar problems occur when prices fall, too, which is called deflation. Actually, deflation can be even more costly than inflation because deflation tends to steal value from borrowers rather than lenders. Since borrowers tend to be poorer already, surprise deflation very quickly leads to failed businesses, foreclosed farms and homes, and general economic decline. Although not always the case, deflation is associated with slowed economic growth or recession since in order to function effectively as a medium of exchange, the money in circulation needs to grow at roughly the same rate as the real economic activity it is designed to facilitate. And because high deflation causes losses on the side of the poor, it can leads to economic panic and bank runs easier even than high inflation.

But I digress. After the Revolutionary War, the inflationary problems with paper convinced the US government to use a metal standard. Actually, they used a sort of double standard: gold was used for high-denomination money, while silver was used for low-denomination money. The US Mint decided to assign a face value exchange rate between gold and silver at 15 to 1, the prevailing market value at the time. But market values change, and it didn't take long for silver to be "overvalued" relative to its market price in gold (or alternatively, gold was "undervalued"). The face value / market value problem led to gold be exported to Europe, sold for silver, and the silver re-imported. In practical terms, then, the US system became a silver-only standard as the overvalued metal drove out the undervalued (a principle economists call Gresham's Law after a guy named Gresham).

At this stage, the individual states tried to help smooth out wrinkles in the monetary system by chartering corporations known as commercial banks with the power to issues their own notes (redeemable, of course, for gold or silver). It turned out that banks had a tendency to over-issue the notes, just as the colonial governments had, and it was somewhat risky to accept notes printed by banks on the other side of the state (the banks couldn't operate across state lines). Because of this, these commercial bank notes would usually have to be converted to local currency at a risk-compensating discount, which varied depending on distance, how well established the bank was, and so on.

Alexander Hamilton's solution to the problem of having a reliable medium of exchange was the first Bank of the United States. This one bank would regulate the face value of paper money, it would produce money that was easily and credibly exchangeable across state lines, and its strong-handed influence and ability to lend to banks that are temporarily short on deposits (the lender of last resort power) would help avoid major inflations, deflations, and bank panics. That, and by buying Treasury bonds when the government needed temporary funds (like in wartime) Hamilton hoped the Bank could prevent the government from just printing money.

The main objections to the bank were that (1) it wasn't in the constitution, (2) it threatened personal liberty, and (probably most importantly) (3) it benefited the North but not the agricultural South (and later the West). These objections didn't prevent George Washington, corporate stooge, from signing the first Bank's 20 year charter in 1791. The bank worked pretty much as Hamilton had envisioned, and the US economy functioned pretty well until the opposition finally won out by refusing to renew the charter in 1811. Then along came the War of 1812, and the government had no Bank to borrow money from. So what did it do?

Yeah, pretty much.















Deciding (after the fact, of course) that Politicians + Printing Presses = Bad News, Congress granted a 20 year charter to the second Bank of the United States in 1816. The second Bank decided to regularly present state banks with their notes in exchange for metal, which effectively reigned-in the banks' desire to over-print notes. The second Bank also acted more systematically as lender of last resort preventing several banking panics from building up.

Unfortunately, Andrew Jackson hated the Bank. Possibly because Jackson was a player-hater. He vetoed the Bank's charter renewal on the grounds that the Bank (A) was unconstitutional, and (B) was too influenced by foreigners and people from the north-east. The Bank, Jackson thought, helped the rich at the expense of the poor, as evidenced by the fact that interest rates were too high and inflation rates too low. Ironically, Wall Street helped Jackson oppose the Bank, because the Bank had been raining on Wall Street's parade. Inflation did rise near the end of the second Bank's charter (brought on by gold and silver inflow from Mexico, mostly), though. This, combined with new federal laws requiring payments for government lands be in gold, led to runs on the gold and silver reserves of the state banks. In the absence of a lender of last resort, this led to the depression of 1837, which lasted at least two years, and by some accounts until 1843.

The government maintained the bimetal standard until the Civil War, when both north and south quickly abandoned it in favor of unbacked paper to pay war debts. After the war, the government decided to return to a metal standard, this time just using gold. A few states experimented in free banking, meaning anyone who met some simple standards could start a bank; it worked well as long as the gold requirements for starting a bank fell into a narrow band, but worked more disastrously if the state required too much or too little of new banks. The gold standard led to a steady deflation from 1865 to 1896, but only a few years in the mid-1870s and early 1890s were recession years.

Of course, that didn't stop the poor, especially in the South and West, from favoring increased inflation through coining silver, which became a major issue in the Presidential election of 1896, between William "I like northern factories and my front porch" McKinley and William Jennings "You shall not crucify mankind upon a cross of gold" Bryan. You can read all about it in a little book called the Wonderful Wizard of Oz.

Front porch won.

At this point, you can begin to see some of the ups and down the monetary system in the US has taken. I apologize for the length of this post, but I think it's important to get the broad sweep of how money and banking worked pre-Federal Reserve. Next week we'll consider some of Ron Paul's claims as mentioned in the review, thinking about the claims in terms of our understanding of the nature of money and the history of the US monetary system.

How to AVOID Deception with Statistics

For those who find my blog interesting, if you're not already reading PHD Comics, you should be. Here's one reason why:

The first one is especially important. When a candidate's approval rating drops by 3%, it didn't drop.

Three Views of Education

My original plan for this post was to quote from and link to an article on education, and debate the pros and cons of that article's position. I have done this before here and here, both of which were worthwhile exercises in my view.

However, I've recently come across two other articles I want to deal with, and rather than rehashing my thoughts on the subject three times, I thought I'd try to let the articles interact themselves. The three are as follows:

Critical Thinking? You Need Knowledge by Diane Ravitch, education professor at NYU
Things You Really Need to Learn by Stephen Downes, researcher with a background in philosophy at the National Research Council of Canada
'If You've Got a Trade, You've Got It Made' by Mike Rustigan, professor emeritus of criminal justice at San Jose State University

All three express dissatisfaction with the current American educational system, but for (seemingly) different reasons.

Ravitch believes that so much emphasis has been put on 'how to think' that students don't have any meaningful facts to think about:

Inevitably, putting a priority on skills pushes other subjects, including history, literature, and the arts, to the margins. But skill-centered, knowledge-free education has never worked.

Downes, on the other hand, thinks that an over-emphasis on facts is precisely the problem:

Your school will try to teach you facts, which you'll need to pass the test but which are otherwise useless. In passing you may learn some useful skills, like literacy, which you should cultivate. But Guy Kawasaki is right in at least this: schools won't teach you the things you really need to learn in order to be successful, either in business (whether or not you choose to live life as a toady) or in life.

Rustigan doesn't have a problem with facts or critical thinking in themselves, but feels that for many students they're simply a waste of time:

There are plenty of high school kids who find college-prep classes boring and irrelevant. Many drop out because they feel school is not preparing them for anything practical. Most of these kids are not lazy or defiant; they just want to work with their hands, learn a skill and pursue a solid, honorable, blue-collar trade after high school.

Downes believes that, rather than learning providing facts or skills like "how to be a business toady," learning should be about things like how to predict consequences, communicate clearly, stay healthy, and live meaningfully.

Ravitch seems to object to this idea, listing several movements in education that have had similar goals. According to Ravitch,

None of these initiatives survived. They did have impact, however: They inserted into American education a deeply ingrained suspicion of academic studies and subject matter. For the past century, our schools of education have obsessed over critical-thinking skills, projects, cooperative learning, experiential learning, and so on. But they have paid precious little attention to the disciplinary knowledge that young people need to make sense of the world.

There certainly seems to be something to that. As a professor of education, Ravitch is uniquely qualified to point out how the zeitgeist in her profession has gone astray.

Of course, Rustigan argues that it is the political and social attitudes toward education that matter most, rather than just how teachers are trained. In his view, the problem is not that we focus on a particular set of facts (or facts in general), or on a particular set of thinking skills (or thinking skills in general). Rather, Rustigan argues that in conducting this debate we have forgotten the practical education needed by so many students who have no interest in college:

For too long, academic elites and politicians -- both Democrats and Republicans -- have oversold us on the necessity of getting a college degree. We have reached the point at which it has become almost un-American to admit that for a sizable number of our young people, college is a waste of time.

According to a growing number of demographers and labor experts, the U.S. soon will be experiencing a severe shortage of skilled workers. Blue-collar baby boomers are retiring, but schools aren't preparing the next generation to take their place. Our nation needs blue- collar workers -- skilled mechanics, machinists, welders, carpenters and electricians, as well as computer, solar and cable technicians, etc. -- just as much as it needs college grads.

As one retired plumber told me: "No one is going to outsource your local repair guy.[...]"

I have to admit they both make good points. A student cannot develop skills without a context grounded, to a large extent, in either data or practical problem solving. I'm still inclined toward the Downes piece, partially because the list format suits my mechanic nature, and partially because the article (although including some admittedly strange comments) is full of gems like these:

Creativity, in other words, often operates by metaphor, which means you need to learn how to find things in common between the current situation and other things you know. This is what is typically meant by 'thinking outside the box' - you want to go to outside the domain of the current problem. And the particular skill involved is pattern recognition. This skill is hard to learn, and requires a lot of practice, which is why creativity is hard. [...]

Communicating clearly is most of all a matter of knowing what you want to say, [...] it is better to spend time being sure you understand what you mean than to write a bunch of stuff trying to make it more or less clear. [...]

Indeed, you should view the study of mathematics, history, science and mechanics as the study of archetypes, basic patterns that you will recognize over and over. But this means that, when you study these disciplines, you should be asking, "what is the pattern" (and not merely "what are the facts"). And asking this question will actually make these disciplines easier to learn. [...]

[...] what you are doing right now is the thing that you most want to do. Now you may be thinking, "No way! I'd rather be on Malibu Beach!" But if you really wanted to be on Malibu Beach, you'd be there. The reason you are not is because you have chosen other priorities in your life - to your family, to your job, to your country.

It's hard to argue with someone who can say all that clearly and succinctly.

In the end, I think the three articles differ in what they see as needing the most improvement rather than in what ideal education should look like (in the broad strokes, anyway). I think the following represents some take-away points all three authors would support:

Education should be holistic. In order to learn effectively, we need the right blend of facts, cognitive skills, and practical skills all developing together. All students need to know certain things in order to have a common context; they need to use these facts to learn how to think through the situations and arguments they will be confronted with throughout their lives; and they need to grow the aspects of their identity like practial labor skills and health, not just the topics that make them better thinkers or (with due respect to Joel's view of education) conversationalists.

Education should take the individual student into account. The right blend will vary from student to student, emphasizing each student's particular interests and talents as they develop. All students probably need to learn some basics of statistical reasoning, but then they should be able to move on to great literature and the works of ancient thinkers like Cicero or Confucius (leaving the trigonometry and calculus for future engineers and economists). Many students need to skip training meant to lead into college and spend more time on things like how to bake bread, clean blood off of silk, fix plumbing and repair cars. None of these tracks should be more prestigious than the other, regardless of the average salary figures of those who go through them.

Education should be purposeful. All three authors make the point that improving education is worthwhile because of the effects of education. Education is a means, not an end in itself.  Ravitch says "Until we teach both teachers and students to value knowledge and to love learning, we cannot expect them to use their minds well." Rustigan says "I'm betting we would then start to see fewer dropouts and more young adults with a chance to become productive members of society." Using the minds God has given us well and being productive members of society both reflect fulfilling our callings and honoring God with what He has given us. As Downes put it,

If you don't decide what is worth doing, someone will decide for you, and at some point in your life you will realize that you haven't done what is worth doing at all. So spend some time, today, thinking about what is worth doing. You can change your mind tomorrow. But begin, at least, to guide yourself somewhere.

As you may have guessed, I tend to favor these ideas. I'd like to hear your thoughts, though, whether on this or on the articles.

From the Lectern: Week 1

This semester I'd like to present some of the basic ideas I'm teaching in my class week by week. I'm teaching Principles of Microeconomics using a text by Paul Krugman and Robin Wells. There's a lot more detail (technical and otherwise) that I'll go into in my class, so this isn't anywhere near a substitute for the real deal. That said, I think the economic concepts and reasoning that we cover are things everyone needs to know and understand, so I'd like to start you all thinking about them here.

This week only had one lecture due to Martin Luther King, Jr. day. The opening lecture is an important one, since it's the key to (1) catching the attention of the students who might be interested, and (2) frightening off the students who don't want to work. I opened by asking students to think about why they were here. There are really only three kinds answers (and their combinations): Consumption, Productivity, and Signaling. Over the course of the semester I'll discuss each in more detail.

The main topics on the first day, though, deal with answering two questions. The first is "What is economics?" Every textbook and every instructor has their own way to answer this, and I'm no exception. In a nutshell, here is my definition of economics:

Economics is the science of choice.

'Choice' means that there are many desirable options, but not all can be pursued. Most textbooks represent this idea with the term scarcity, which is a technical term meaning "you have to pick one." The fact that individuals must make a choice also indicates that they have to compare the benefits of each different option. The best choice will the the one for which the benefits outweigh the benefits of all the other options. The benefits given up when a choice is made are called the opportunity cost of a choice.

'Science' is key because it indicates how we will learn about choice. Economists don't just sit around giving their opinions about choices, events, and incentives. I mean, we do that, but we don't just do that. In order to say something meaningful, we have to be systematic and rigorous in developing our theories and testable hypotheses. We use a lot of graphs and a lot of math in order to keep our arguments logically consistent. It's true that some of the greatest economists in history didn't use math. It's also true that we still aren't sure what they meant. So we're gonna use math.

The definition of economics is remarkably broad. It includes a lot of human behavior we don't really think of as economic activity (that is, trade). This is intentional. Nobel Prize winning economist Gary Becker extended economic reasoning to such questions as who to marry, how to divide up household chores, and other areas typically not considered economics. Some fascinating examples of economic thinking applied beyond simple trade can be found in the books Freakanomics and its sequel SuperFreakanomics.

Nevertheless we will spend most of our time talking about what is typically thought about as economic activity. This brings us to our second main question: "What's so special about trade?" The short answer is that by engaging in trade, everyone can gain something for nothing.

Let me illustrate. Suppose there are two cave men, Nog and Pog. These cave men do what all cave men do: collect sticks and rocks. In a given day, Pog can collect 40 sticks and 40 rocks. Nog is a bit slower, especially when it comes to rocks; he can pick up 10 sticks and 4 rocks in a day. So far, so good, but they can both do better. If Nog just focuses on picking up sticks, he can get 20 in a day, although he'll have no rocks. However, what he has to give up to get 10 more sticks is only 4 rocks (that is, his opportunity cost of specializing in sticks is low; Nog has what we call a comparative advantage in sticks). Similarly, if Pog specializes in rocks, he can collect 50 rocks, but only 35 sticks (Pog's comparative advantage is in rocks).

Now that they've specialized, they can trade. Suppose Nog offers 8 sticks to Pog in exchange for 7 rocks. Pog agrees. Now Pog has 43 sticks and 43 rocks, while Nog has 12 sticks and 7 rocks. Compare those numbers to what they have before: they both have more of both. In total they are splitting 5 sticks and 10 rocks that neither would have had if they hadn't specialized and traded. These 5 sticks and 10 rocks represent the gains from trade. These gains are benefits to everyone: everyone is better off in every dimension. These are benefits that exist solely because Nog and Pog decided to engage in economic activity.

Economic activity is fascinating to economists because trade can create something from nothing. That doesn't happen in Psychology. It doesn't happen in Physics. Only in economics.

We'll talk about these ideas in more specific contexts throughout the semester. But everything we do in Principles of Microeconomics is going to be made up of these few, powerful ideas.

Why A Central Bank? Part 1: Why Money?

This post was prompted by this review of Ron Paul's End the Fed and a subsequent online discussion. By virtue of my economics background, a friend asked me to chime in on why Ron Paul's solution to various economic problems should be discarded as easily as his opponents suggest.

In order to understand how a central bank affects the economy through its control of money, we first need to understand money itself. Therefore, this first post will explore the nature of money, as well as some historical facts regarding modern forms of it. Much of what follows builds on Walton and Rockoff's History of the American Economy tenth edition.

The first thing we need to realize about money is that money is not paper and coins; in the 1930s Germany had paper and coins that failed as money. It is not something that has "intrinsic value" (whatever that means); if anything has intrinsic value, it would be human lives, but using them as money is generally frowned upon. Money is also not "legal tender"; legal tender is just a nice label by governments to indicate what sorts of goods they'll help you try to use as money by getting Big Brother on anyone who disagrees about whether it's money.

Money is a good that provides certain functions to those in an economy who want to engage in trade. If you live by yourself, surrounded by no one, and you subsist on your own produce, then money doesn't mean anything to you. Money only becomes useful when you have something someone else wants, or they have something you want. That is, money functions as a medium of exchange. To get a sense of why people might use a good as a medium of exchange, consider an economy in which there are a several goods you might want.

Yes, like that. Now, suppose you want all of these, but all you have right now is the wheel of cheese. You've got plenty of cheese. More cheese than you could possibly want for yourself... as if that were possible. Maybe you'd be willing to give up some of your cheese if you could have some bread instead. You can then engage in a direct trade of one good for another, barter. Or rather, you could, if you could find someone with bread who would rather have cheese.

It turns out, you can't. You find a guy who would rather have a stylish hat than his bread, though. Problem is, you don't have a hat, you have cheese. Despite the best efforts of Wisconsin, cheese doesn't work well as a hat. What you're missing here is what we call a double coincidence of wants: for the trade to happen, you have to have what the other guy wants, and the other guy has to have what you want. Otherwise, no deal.

Now, you could try to get what the breadman wants--a hat. Now instead of looking for a market between bread and cheese, you need to look for a market between hats and cheese. Maybe you find a guy with a hat who wants beer. So you look for a market between beer and cheese. This continues until you find someone who wants your dang cheese, then you trade your way back to the guy with bread. It's like a convoluted video game.

In fact, in order to successfully barter, you need to be able to participate in a market for every combination of two goods. If there are 6 goods in the world, that's 15 different markets. If there were 100 goods (and of course there are a lot more than that), that's 4,950 separate markets!

It gets pretty ugly.









This is a pretty good description of early colonial America. Traders in furs, corn, cows, whiskey, and any other good tried to trade back and forth with everyone else. It got pretty annoying, especially since you had to travel from on buyer to the next, making the act of getting from cheese to bread quite costly.

For this reason, people started to convert goods into a common good, which would then be easily exchangeable for any other goods you could think of. One of the earliest monies used was polished beads called Wampum, although a number of other goods were used, especially (in Virginia and Maryland) tobacco. Everyone generally agreed that they would trade their goods for tobacco, thus making it the medium of exchange. Why did everyone agree to this? Paradoxically, because they believed they would be able to exchange it for any other good they wanted. That's right. Tobacco (and any other good, actually) became money because people believed it was money. And having money made life a lot easier.

But using tobacco as money presented problems, because money does more than just function as a medium of exchange. Because it is generally accepted in exchange, money also functions as a convenient unit of account, or numeraire in economics jargon, for representing the value of all other goods. You know how much a hat costs because you know how much money the seller wants to exchange for it.

Tobacco presented a problem here, because not all tobacco is created equal. And that's bad, because if you use a good for money that others use as the good itself, then what the money will buy is related to (but not necessarily the same as) what users of the good would trade for other goods. If the goods that function as money aren't all the same, this can cause serious trouble and confusion in trading (we'll come back to this at a later date). In order to use money as a unit of account, you need to be able either to easily differentiate the quality of the good or to only use a good which is standardized.

Tobacco also presents a third problem, because part of the reason you might sell a good for money is so that you can spend the money tomorrow. In this way, money acts as a store of value, particularly one that is easily and quickly converted into any other good you want. Goods used to store value that are better at being converted into other goods are said to be liquid: they flow easily. Money is as liquid as you can get, so tobacco (as money) should make a great liquid store of value. The problem is, tobacco goes bad after a while. It rots, or to use a more general term, it depreciates and loses value.

In order to find a good that would work well as a medium of exchange, unit of account, and store of value, the American colonies eventually came to accept the Spanish dollar, or "piece of eight" (so called because it was worth eight Spanish "bits"; that's where the phrase shave and a haircut... two bits comes from), as money. They chose Spanish over English money because the Spanish dollar was made of silver, while the British pound was made of gold, a metal in very short supply in the colonies (it's hard to have a medium exchange if no one has any to exchange).

However, because the British colonial system was essentially designed to extract precious metal-based currencies from its colonies, even the silver Spanish coins became difficult to come by. It was around this time that many colonial governments (and private citizens to some extent) decided to reinvent something previously created by the Chinese: paper notes that could be exchanged for money. Because these notes could supposedly be exchanged for money at any time, people began to use them in exchange instead of silver coins. They also held onto the notes as a store of value, and since the notes had numbers written on them indicating how much money the were worth, they were held as a store of value.

That's right, folks: paper money is an All-American invention.

Next week we'll look at some of the problems of this new paper money, as well as some of the attempts to solve these problems in the history of banking in the US.