The Yardstick — The Money, Plate iii

Money's first work is to be the medium of exchange; its second is to be the measure of value — and the measure is, in a way, the more remarkable, for it is the thing this whole table is named for. To price a good is to say how much money it trades for; and money, the good in terms of which all other goods are priced, is the universal measuring rod of worth, the common denominator of the entire economy. But a measuring rod whose own length can change is a strange instrument, and money is exactly that: the yardstick of all value, whose own value shifts with its quantity.

Consider what it means to have a measure of value at all. In a barter world there is no single measure: shoes are worth so much bread, bread so much meat, meat so much cloth, and the worth of each thing must be reckoned separately against every other, a tangle of cross-rates with no common term. Money cuts the tangle by providing one good against which all others are priced — the unit of account, the numéraire, in which every value is expressed. Once money is the measure, a thing has not a hundred prices, one in terms of each other good, but a single price, in money; and the worth of any two things can be compared at a glance, by comparing their money prices. This is money's function as the measuring rod: to reduce the chaos of relative values to a single scale, so that all worth is told in one number. The numéraire — the reference good in terms of which all prices are quoted — is the spine of every economy, and in a real economy that numéraire is money. To name a price is to measure a thing against the universal money-rod; and the table you are reading takes its very name from that rod, the numéraire in which all value is reckoned.¹

1. Money's second function is unit of account — the numéraire, the single good against which all others are priced. Barter has no common measure (each good's worth reckoned separately against every other); money provides one scale, so each thing has a single money-price and any two can be compared directly. The numéraire (the reference good in which all prices are quoted) is money in a real economy — and the term gives this table its name.

But here the strangeness appears. A yardstick of length has a fixed length; a pound-weight a fixed mass; the measure does not change with how many rulers exist. Money is not like this. The money-rod measures the value of all goods, but its own value — how much it will buy — is not fixed, and depends, the quantity theory holds, on how much money there is. Irving Fisher gave the relation its classic form, the equation of exchange: the quantity of money, times the speed at which it circulates, equals the price level, times the volume of goods traded — so that, holding circulation and goods roughly steady, the price level moves in proportion to the quantity of money. Double the money in an economy, and you do not double its wealth; you halve the value of each unit, and every price doubles to meet the doubled money. The measuring rod has shrunk: each dollar buys half what it did, and the same goods cost twice as many dollars. The value of money, alone among measures, is set by its own abundance — and this is the deep reason money must be managed, for its quantity governs its worth.²

2. Irving Fisher (The Purchasing Power of Money, 1911) gave the quantity theory its classic form, the equation of exchange: MV = PT — money times velocity equals the price level times the volume of transactions. Holding velocity and output roughly constant, the price level is proportional to the money quantity, so doubling the money halves each unit's value and doubles prices. Unlike a true measure (fixed length), money's own value depends on its quantity. Hence money must be managed.

⁂

The shrinking of the money-rod has a name: inflation, the general rise of prices that is the same thing, seen from the other side, as the fall in the value of money. When prices rise across the board — not this good dearer because scarce, that good cheaper because plentiful, but all goods dearer at once — what has happened is not that goods have changed but that money has: each unit buys less, so more units are needed for the same thing. And the quantity theory locates the usual cause: too much money, chasing too few goods. When money is created faster than goods, the excess money bids up prices, and the measuring rod shrinks. This is why inflation is, in the famous verdict, fundamentally a monetary matter — a phenomenon of the quantity of money more than of greedy merchants or rising wages, which are its symptoms rather than its source. A government that prints money to pay its bills does not create wealth; it dilutes the money already held, taxing silently every holder of the currency by shrinking what each unit will buy. Inflation is the measure of value losing its own value — and at the extreme, when money is printed without limit, the rod shrinks to nothing, and the money dies.³

3. Inflation — the general rise of prices — is the fall in money's value seen from the other side: each unit buys less, so more are needed. The quantity theory locates the usual cause in money created faster than goods ("too much money chasing too few goods"). Hence inflation is fundamentally a monetary matter (Friedman), with rising wages or merchant greed its symptoms, not its source. Printing money to fund spending dilutes existing holdings — a silent tax on money-holders. At the extreme, hyperinflation (The Debasement).

Yet the money-rod is not a mere veil over real values, changing all prices together and nothing else — or not always, and not at once. If a doubling of money instantly doubled every price and wage, money would be neutral: the measuring rod would shrink, but every real quantity — what each person could buy, what each good was worth in terms of others — would be unchanged, and only the numbers would differ. In the long run, the classical economists held, money is roughly neutral in just this way: its quantity sets the price level and nothing real. But in the short run, prices do not all move at once — some are sticky, fixed by contracts or habit, slow to adjust — and so a change in money does move real things for a time: new money, spent before prices have risen to meet it, can quicken trade and output, or, withdrawn, can choke them. This is the hinge of much macroeconomics, and the volume on the cycle will turn on it: whether money is a veil, touching only prices, or a lever, moving the real economy — and the answer, that it is a veil in the long run but a lever in the short, is why the managers of money can do both great good and great harm.⁴

4. Money would be neutral if a change in its quantity moved all prices and wages together, leaving real quantities unchanged — only the numbers differing. Classical theory holds money roughly neutral in the long run (quantity sets the price level, nothing real). But in the short run, sticky prices (fixed by contract or habit) adjust slowly, so monetary changes move real output and trade for a time. Whether money is a "veil" or a real "lever" (The Veil) is central to macroeconomics — and The Cycle.

The yardstick, then, gives money its second great function and its central difficulty together: money measures all value, but its own value is unfixed, set by its quantity, so that the measure of worth is itself worth more or less as money is scarce or abundant. This is why money cannot simply be left alone, as Menger's spontaneous account might suggest — why every modern economy entrusts the quantity of money to a manager, a central bank, charged with holding the measuring rod steady, neither letting it shrink into inflation nor letting it lengthen into the slump that too little money brings. But to manage the quantity of money, one must first ask where money comes from — who makes it, and how its quantity is set. And here the volume turns to its most surprising finding. We imagine money is made by the state, stamped at the mint or printed at the treasury; but most money, the next plate shows, is made by banks, conjured into being when they lend. The quantity of money is not a dial the state turns but a flood the banking system creates and drains, expanding when credit expands and contracting when it contracts. The next plate is the loan.⁵

5. Money's quantity sets its value, so it cannot be left alone — modern economies entrust it to a central bank charged with stabilizing the measuring rod (The Governor). But managing money's quantity requires knowing its source. The surprising finding (The Loan): most money is created not by the state (mint, treasury) but by banks, when they lend — so the money quantity is largely a flow the banking system creates and destroys with credit, not a dial the state turns.

The yardstick is money in its second function: the measure of all value, the numéraire in which every price is told and every contract written, the single scale that reduces the chaos of relative worth to one number — and the rod from which this very table takes its name. But it is a measuring rod whose own length can change: its value, alone among measures, is set by its quantity, so that an excess of money shrinks the rod and lifts all prices, in the silent dilution we call inflation. Fisher gave the relation its form, and the lesson is that money must be managed, its quantity held steady lest the measure of value lose its own worth. Whether money is only a veil over real values or also a lever upon them — neutral in the long run, potent in the short — is a question the volume on the cycle will press. But to manage money one must know its source, and the source is not the mint. The next plate turns to where money truly comes from: the bank, and the loan that conjures it into being.