arjun on Nostr: THE CONSTRAINTS OF MONEY We typically think of constraints as limiting factors to ...

THE CONSTRAINTS OF MONEY

We typically think of constraints as limiting factors to something we want to achieve. This conception is too narrow. Progress often comes from discovering constraints, and from further refining them. Moreover, the discovery of constraints is just another way to describe the growth of knowledge, and knowledge growth is the backbone of all progress. This is why constraints, when applied non-coercively, are catalysts for progress.

This process is most evident in the history of science, which is a story of successive discoveries of the constraints of the natural world. Another example is poetry: without constraints, poetry becomes prose. So why does anyone ever write poetry? Because working within constraints can paradoxically help the poet be more creative.

But this post is about money. Money is a constraint on transactions. To see how, consider life before money. People would barter goods and services directly. Imagine a shoemaker who wanted to purchase apples. Under a barter system, he would have to find an apple seller willing to trade apples for shoes. But what if the apple seller had no desire for shoes? Or perhaps he did want shoes, but didn’t agree with the shoemaker’s valuation, or didn’t have enough apples to match the valuation in the first place. Economists call this the problem of the lack of double coincidence of wants. Barter economies drastically limited the set of viable trades, even though the constraints of monetary prices didn’t even exist! This is quite unlike today when money accounts for roughly half of all human transactions (excluding barter exchanges among family and friends). Before money, anything could have traded for anything—in principle. Further, any possession could have become its own kind of one-time money, purchased solely to be used in a future trade.

But, paradoxically, when we constrain ourselves to use only one good as money we can do more, and new possibilities emerge.

By limiting choosing only one good to serve the role of medium of exchange, all the participants in an economy can immensely reduce their expenditures in terms of time and effort. That is, when the double coincidence of wants is solved, they can directly produce goods and services for immediate conversion into money.

When we are constrained by the use of a single medium of exchange the crucial pricing system emerges. Now prices—as determined by the value judgments of consumers—can be expressed in a single denominator. Prices enable vast networks of people to cooperate by producing, allocating, and consuming resources efficiently. Prices are signals, and they facilitate the transmission of knowledge about people’s wants in a world of scarcity much as language facilitates the transmission of thoughts. Amazingly, prices potentiate cooperation between people who know nothing about each other’s circumstances. This characteristic is often presented as a negative, casting the entire network of prices as a cold and dehumanizing system of money transactions that commodifies and objectifies. However, the mutual ignorance afforded by money enables participants to focus on their specialty without becoming entangled in various cultural or personal considerations of their trading partners. This abstraction allows for transactions across very different cultures and even between adversaries.

The emergence of money as a constraint has supported gains in every aspect of human endeavor. On the other hand, manipulation of this constraint has likewise impaired productivity.

Prices enable several crucial advantages not present in barter systems, but here we focus on two: supply chains and profit-and-loss statements.

In a supply chain, raw materials are converted into a final product through a series of steps. These chains can become incredibly long and convoluted, with many steps stretching and splitting across the globe, relying on processes initiated decades ago. The mind boggles at the complexity involved in even the most mundane of items. To take a famous example, the construction of a pencil requires coordination between loggers in the Pacific Northwest and graphite miners in Sri Lanka. Since manufacturers approximately know how much consumers are willing to pay for pencils, they can build factories and place orders for wood and graphite years before the final product reaches store shelves. Even though the raw materials for a pencil are sourced from across oceans, they are produced at such a scale that their price is almost negligible.

As implied above, entrepreneurs have to guess how much of what consumers will value in the future when making decisions about the production process. Clear, accurate price signals are integral to these entrepreneurs’ ability to forecast and earn profits, and hence to economic progress in general. And because prices are conveyed by money, an increase in the supply of money will decrease its purchasing power, i.e., the money prices of all other goods and services will rise (all else being equal).

That’s why unpredictable creation of new money causes serious problems for supply chains (and thus the entire economy). In such a monetary environment, entrepreneurs are less able to calculate costs of production and potential returns on investment, facing instead a haze of uncertainty that may last for years.

In the unhampered market, the price of a commodity tends to equalize supply and demand. If the price moves away from this balance point, the market will automatically correct itself, bringing the price back to where supply and demand are approximately equal again. But when the government sets prices at a level different from what they would naturally be in a free market, this equilibrium of supply and demand is disturbed. As Thomas Sowell put it, “Reality doesn’t change when the government changes price tags.” Price control simply hides costs, rather than reducing them.

We’ve seen that the constraint of money can get manipulated via increases in its supply. When the money supply rises artificially, it sends wrong signals to entrepreneurs about what people want. They respond by investing in things that do not match actual consumer preferences. In the gold standard era, technological advances made mining gold easier, thus expanding the supply of gold. As society acquired more wealth, which was stored in gold, this wealth could be used to rapidly extract large sums of gold, destroying much wealth in the process. The story of fiat money is similar in this regard—advances in solving coordination problems (related to political and banking systems) enabled groups to enforce a fiat monetary system and degrade the value of money via inflation.

We need a constraint on trade that isn’t subject to manipulation and distortion. We need Bitcoin.