"The fateful errors of popular monetary doctrines which have led astray the monetary policies of almost all governments would hardly have come into existence if many economists had not themselves committed blunders in dealing with monetary issues and did not stubbornly cling to them."
—Ludwig von Mises, Human Action.
I was chatting on the phone last week with Peter Coy, who was working on an article about money for The New York Times Magazine, when he mentioned the old, three-pronged textbook definition of money: you know, the one that says money is a medium of exchange, a store of value, and a unit of account. It's the first thing most econ students learn about money. For many, I suspect, it's all they remember.
Which is a shame, because it's wrong.
In this post, I explain why it's wrong. I trace the mistaken definition to past economists' careless reading of that definition's locus classicus, in William Stanley Jevons' great work, Money and the Mechanism of Exchange. I next show how Jevons' actual understanding of the meaning of "money" was shared by Carl Menger and later Austrian-school economists. I conclude with a plea for dispensing, once and for all, with the three-part textbook definition of "money," in favor of the definition Jevons favored all along.
Money's "Three Functions"
In his Principles of Economics textbook, Ed Dolan writes that "Money is an asset that serves as a means of payment, a store of purchasing power, and a unit of account." Greg Mankiw likewise says, in his Principles of Macroeconomics text, that "Money has three functions in the economy: It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets in the economy." I might supply any number of similar examples of this conventional way of defining money.
Nor does the tripartite definition of money only occur in textbooks. According to a St. Louis Fed publication, although "Money has taken different forms through the ages," all of them "share the three functions of money":
- First: Money is a store of value. If I work today and earn 25 dollars, I can hold on to the money before I spend it because it will hold its value until tomorrow, next week, or even next year. In fact, holding money is a more effective way of storing value than holding other items of value such as corn, which might rot. …
- Second: Money is a unit of account. You can think of money as a yardstick—the device we use to measure value in economic transactions….
- Third: Money is a medium of exchange. This means that money is widely accepted as a method of payment.
Money Isn't "A Store of Value."
What's wrong with the standard definition? The trouble is that it often happens, even in indisputably "monetary" economies, that no single good or asset performs all three functions that, according to it, "money" is supposed to perform. In all such instances, the conventional definition begs the question: when nothing performs all three functions, how can "money" possibly exist? If it does exist, it must be the case that not all of the three supposed "functions" of money are actually functions money must perform, let alone perform well.
Take the store of value function. Of course something that is of no value at all, or of very ephemeral value only, is unlikely to serve any of the three supposed monetary functions; and many things that have served as money in the past were also reasonably good stores of value. For this reason it's not hard to understand the temptation to assume that, whatever other functions it might perform, money must serve as a store of value.
But while it's true that a spectacularly bad store of value—like ice cream cones in summertime—isn't likely to ever serve either of the remaining two supposed functions of money, it's quite common for stuff that everyone considers "money" to be a mediocre if not a poor store of value. Fiat monies, for example, always tend to depreciate; and it's notorious that they sometimes lose value quite rapidly. Yet even in extreme cases of hyperinflation, such fiat currencies continue to be regarded as "money," and continue to serve as both media of account and generally accepted exchange media. (It is, after all, only when prices are expressed in terms of some fiat unit, where the number of representatives of the unit being spent in any given period is rising rapidly, that hyperinflation can take place.) To insist that money must serve as a "store of value" in such cases begs the question: in what meaningful sense could Papiermarks be said to have served as a "store of value" in Germany during the autumn of 1923? And if they were an abysmal store of value, weren't they money nonetheless?
If something can be money despite being an abysmal store of value, the opposite is also true: something can be an exceptional store of value without being, or ever becoming, money. To his credit, in the original (1948) edition of his famous textbook, Paul Samuelson assigns money only two functions: it is, he says, a medium of exchange and unit of account. Although he recognizes that "a man may choose to hold part of his wealth in the form of cash," Samuelson notes that "in normal times a man can earn a return on his savings if he puts them into a savings account or invests them in a bond or stock. Thus it is not normal for money to serve as a 'store of value'."
So Samuelson improved upon the conventional three-part definition of money. Yet he still assigned "money" one function too many.
Nor is It a Unit of Account
While it's relatively easy to point to things serving as both generally-accepted exchange media and media of accounts that were crummy stores of value, it's not so easy to find instances in which an economy's unit of account didn't consist of a standard unit of its preferred medium of exchange. There's a perfectly good reason for this: it just makes good sense for people to price things, and keep accounts in, units based upon the stuff they prefer to receive, or insist upon receiving, in payments.
Still, it sometimes does happen that an economy's unit of account is not based upon, or is "separated from," its most popular exchange media; and in such cases we are again compelled to ask, which thing is "money"? Is it the unit of account, or whatever stuff defines it, or is it the medium of exchange? The answer to this question takes us one more step closer to answering the question, "What is 'money,' really?"
High inflations once again come to the rescue here, for these often lead to the separation of accounting units from prevailing exchange media. Consider the case of Brazil in 1992. In that year alone prices expressed in Brazil's official currency unit, the cruzeiro, rose more than tenfold. But rather than express prices in cruzeiros, which would have meant changing them daily, if not more than once a day, hotels, restaurants, and many other businesses switched to posting prices in dollars. Many also kept accounts in dollars. Cruzeiros nevertheless remained Brazil's most widely used medium of exchange. So which was Brazil's "money"—dollars or cruzeiros? And, if it was dollars, what exactly were cruzeiros?
The last question is meant to be rhetorical: cruzeiros no longer supplied Brazil with a useful unit of account; and they were certainly nobody's idea of a decent story of value. Yet they were still that nation's most widely-accepted medium of exchange; and few doubt that they, not dollars, were therefore Brazil's "money."
Or consider another case: the British pound sterling. Long before Great Britain ever had such a thing as a pound coin, the pound sterling had served as its principal accounting unit. On the other hand, the gold "guinea," which for most of its existence was worth 21 shillings, or one pound and 1 shilling, was an actual coin that circulated, along with fractional counterparts, in Great Britain between 1663 and 1814 (when it gave way to sovereigns). Yet it saw only very limited use—in contracts between "gentlemen"—as an accounting unit. Yet who doubts that guineas were British "money"?
Going back still further, to medieval times, we find still more compelling grounds for rejecting the "unit of account" definition of money, for the motley condition of coins in those days caused merchants to resort to accounting units that had no actual coin counterparts. In some cases these units were based on what the late John Munro called "ghost" monies—past coins that no longer circulated. It should be obvious such "ghost" monies could not be actual money. That is, there was no longer any countable stuff to which they referred. They were "pure" accounting units, and as such completely separated from any actual exchange media. The medieval situation therefore supplies an especially clear case in which the term "money" might refer either to the actual exchange media in use, or to the media upon which prevailing accounting units were based, but could not refer to anything that was both. So, which was it?
Once upon a time, few economists would have hesitated to say that "money" meant the coins actually in use, not the "ghost" coins no longer extant. Many today will think so as well. But if some aren't so sure, you can blame it on some past economists' careless reading of William Stanley Jevons's great work.
What Jevons Really Said
Chapter III of William Stanley Jevons's Money and the Mechanism of Exchange (1875) is generally understood to be the locus classicus of the treatment of "money" as something that serves several distinct functions. In fact, Jevons refers not just to three but to four functions of money: the three now referred to in most textbooks, plus a fourth "standard of deferred payments" function.
By 1919, Jevons's treatment had already become so popular that it was summed up in a then-popular couplet:
Money's a matter of functions four,
A Medium, a Measure, a Standard, a Store.
Eventually, "Measure" (of value) and "Standard" (of deferred payments) were combined into "Unit" (of account), giving rise to the now-standard three-function definition, though one still sees occasional references to money's four functions.
But while the various functions of money Jevons identified have given rise to today's conventional wisdom, his appraisal of each function's significance has been all but forgotten. A close look at that appraisal reveals that Jevons actually considered only one of money's functions essential, hence definitive.
In fact, Jevons makes clear from the onset of his discussion that he considers only two of money's four functions to be of "high importance." "We have seen," he writes,
that three inconveniences attach to the practice of simple barter, namely, the improbability, of coincidence between persons wanting and persons possessing; the complexity of exchanges, which are not made in terms of one single substance; and the need of some means of dividing and distributing valuable articles. Money remedies these inconveniences, and thereby performs two distinct functions of high importance, acting as—
(1) A medium of exchange.
(2) A common measure of value.
Money's remaining two functions are for Jevons of secondary importance only. The "standard of value" function, he says, develops only as an offshoot of money's other roles. As for the "store of value" function, although a country's money may be a useful means for storing and conveying value, "diamonds and other precious stones, and articles of exceptional beauty and rarity," might serve the same purpose. Jevons also recognizes the link between non-monetary stores of value and early monies:
The use of esteemed articles as a store or medium for conveying value may in some cases precede their employment as currency. Mr. Gladstone states that in the Homeric poems gold is mentioned as being hoarded and treasured up, and as being occasionally used in the payment of services, before it became the common measure of value, oxen being then used for the latter purpose. Historically speaking, such a generally esteemed substance as gold seems to have served, firstly, as a commodity valuable for ornamental purposes; secondly, as stored wealth; thirdly, as a medium of exchange; and, lastly, as a measure of value.
Finally, in a subsection specifically addressing the "separation of [monetary] functions," Jevons explicitly recognizes the inadequacy of any definition of money that insists on its serving all four of the functions he names. It is, he says, only because people are "accustomed to use the one same substance in all the four different ways" that they
come to regard as almost necessary that union of functions which is, at the most, a matter of convenience, and may not always be desirable. We might certainly employ one substance as a medium of exchange, a second as a measure of value, a third as a standard of value, and a fourth as a store of value. In buying and selling we might transfer portions of gold; in expressing and calculating prices we might speak in terms of silver; when we wanted to make long leases we might define the rent in terms of wheat, and when we wished to carry our riches away we might condense it into the form of precious stones.
But didn't Jevons nevertheless say that money has not one but two functions of "high importance"? He did. But if we look at how the paragraph in which he says this continues, we find that only one of those two important functions is really important—that is, important enough to be essential or decisive. "In its first form," Jevons says,
money is simply any commodity esteemed by all persons, any article of food, clothing, or ornament which any person will readily receive, and which, therefore, every person desires to have by him in greater or less quantity, in order that he may have the means of procuring necessaries of life at any time. Although many commodities may be capable of performing this function of a medium more or less perfectly, some one article will usually be selected, as money par excellence, by custom or the force of circumstances.
In other words, money is, first and foremost, a generally recognized medium of exchange. The use of a standard money unit as a common measure of value, though it, too, is ultimately of "high importance" in the sense that it further helps to simplify and expedite exchange, is yet another offshoot of its one, fundamental role. Whatever first comes to serve as a generally accepted medium of exchange
will then begin to be used as a measure of value. Being accustomed to exchange things frequently for sums of money, people learn the value of other articles in terms of money, so that all exchanges will most readily be calculated and adjusted by comparison of the money values of the things exchanged.
It follows that, in those relatively rare instances in which the two functions commonly performed by the same stuff are instead performed by different things, the stuff that is generally accepted in exchange alone qualifies as "money."
That the man who coined the expression "double coincidence of wants," and who first represented money as something capable of making up for the lack of such "double coincidences" in barter economies, should have given pride of place to money's medium of exchange function, should not surprise us. But Jevons was hardly unique in this regard. The same view was held by other outstanding monetary theorists of the late 19th and 20th centuries, including Carl Menger.
Menger on Money's Functions
Anyone familiar with Menger's famous theory of the evolution of money will know that he identifies it with the most readily accepted or "saleable" of an economy's goods or assets. Like Jevons, Menger recognizes that money typically performs other functions, but these he regards as secondary. Thus, when Menger observes, on p. 276 of his Principles of Economics, that "Under conditions of developed trade, the only commodity in which all others can be evaluated without roundabout procedures is money," he isn't defining money as a medium of account: he's merely observing, as Jevons does, that an established money will also tend to be an economy's most convenient medium of account. Menger recognizes, furthermore, that
this outcome is not a necessary consequence of the money character of a commodity. One can very easily imagine cases in which a commodity that does not have money character nevertheless serves as the "measure of price" … The function of serving as a measure of price is therefore not necessarily an attribute of commodities that have attained money character. And if it is not a necessary consequence of the fact that a commodity has become money, it is still less a prerequisite or cause of a commodity becoming money.
As if anticipating the present critique, Menger goes on to note how "[s]everal economists have fused the concept of money and the concept of a 'measure of value' together, and have involved themselves, as a result, in a misconception of the true nature of money."
Menger disposes of the "store of value" view of money in much the same fashion:
The same factors that are responsible for the fact that money is the only commodity in terms of which valuations are usually made are responsible also for the fact that money is the most appropriate medium for accumulating that portion of a person’s wealth by means of which he intends to acquire other goods (consumption goods or means of production). …But the notion that attributes to money as such the function of also transferring "values" from the present into the future must be designated as erroneous. Although metallic money, because of its durability and low cost of preservation, is doubtless suitable for this purpose also, it is nevertheless clear that other commodities are still better suited for it. Indeed, experience teaches that wherever less easily preserved goods rather than the precious metals have attained money-character, they ordinarily serve for purposes of circulation, but not for the preservation of "values."
Later Austrian economists were if anything even more emphatic on these points than Menger. According to Ludwig von Mises, "Money is the thing which serves as the generally accepted and commonly used medium of exchange. This is its only function. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, that of a medium of exchange." Murray Rothbard likewise observes that, although "Many textbooks say that money has several functions…it should be clear that all of these functions are simply corollaries of the one great function: the medium of exchange."
Money is a Generally Accepted Medium of Exchange
So, can we please junk the stupid three-function definition of money? So what if textbook writers keep repeating it? It's incoherent. It's based on some earlier economists' sloppy reading of Jevons's uber-treatment. It encourages people to say silly things. In short, it's good for nothing but confusion and mischief.
Yet there's a perfectly sensible alternative definition—the one that heads this section. It's been endorsed by many of the greatest monetary economists of all time, including the one who is wrongly understood to have given us the silly three-part alternative. It avoids all the shortcomings of the three-part definition. And it's easier to remember.
Show me someone who doesn't find these arguments persuasive, and I'll show you someone who badly wants to call something "money," that isn't.