Monday, February 25, 2013

Modern economies are somewhere between barter and monetary

In his broad account of monetary economics, Nick Rowe points out that most modern economies are closer to being pure monetary exchange economies than pure barter economies. I'll argue that we're about half way between the two poles, although it's impossible to say for sure.

A helpful way to determine whether an economy is barter or monetary is to look at all trades made over a period of time and count the frequency of occurrence of each good in trade. In a pure barter economy, no good will appear more than any other. We'll see a flat, or uniform, distribution of media used in trade. In a pure monetary economy, a single good should appear in all trades. The distribution will be uneven. Nick describes it a bit differently but it's the same idea:
You could make a table, with a list of all the different goods for the columns, and the same list of all the different goods for the rows. So it's a square table, with n columns and n rows, if there are n different goods. If you observe someone exchanging apples for bananas, you put a tick in row A column B. (Obviously you can ignore the main diagonal, because people don't exchange apples for apples, unless they are different varieties of apples, and you can ignore everything North-East of the main diagonal, because it's just a duplicate.)

In a pure barter economy, where any good can be exchanged against every other good, you would have ticks everywhere. With n different goods, there are n(n-1)/2 functioning markets.

In a pure monetary exchange economy, where apples (say) were the medium of exchange, there would be ticks everywhere in the A column or row, and no ticks anywhere else. With n different goods, there are n-1 markets, where in each market apples are exchanged for one of the other goods.

A monetary exchange economy has a lot fewer markets operating than a pure barter economy, for n > 2. Most economies are a lot closer to the pure monetary exchange economy than they are to the pure barter economy.
If there was such a thing as a universal dollar and all trade in an economy contained this item, then we'd certainly be living in a pure monetary economy. But in the real world, there is no such hypothetical item as "the" dollar. Dollars are heterogeneous. There are multiple types, brands, issuers, and denominations.  To get to where we want, we often have to engage in a long chain of dollar-for-dollar barter transactions. Only when we've managed to acquire the right form of dollar can we buy the things we want.  This means that no single type of dollar appears in 100% of an economy's trades. Using Nick's wording, we have ticks everywhere, not just in the A column/row.

Types of dollars

In Canada we have the $1 dollar coin, or the loony, which is issued by the Royal Canadian Mint. If you try using loonies to pay for something worth over $100, say a washing machine, there's a good chance that you'll be turned away by the shopkeeper. To buy the washing machine, you'll first have to barter your loonies for larger-denomination paper dollars. Banks typically engage in this sort of barter. They'll either sell you paper dollars for your coins, or they'll sell you an electronic bank deposit. If you buy the paper dollars you can head back to the store and get the washing machine.

Canadian paper banknotes, created by the Bank of Canada (BoC), are accepted in a wider range of trade than loonies. But like the Mint's coins,  BoC notes are not generally accepted. Say you need to get your clothes washed at the local laundromat. Since the washing machines are coin-operated, you'll have to sell notes and buy loonies in order to get them to work. Alternatively, say you want to buy the local laundromat, which the owner is selling for $2 million. The laundromat owner won't accept your offer of notes since having a few suitcases full of paper is awkward. Rather, you'll first have to barter away your notes for some medium more appropriate to the context. If you take your notes to a bank and purchase deposits, then you can transfer your deposits to the owner in return for the car wash. The owner will likely accept deposits, since holding $2 million at the bank will be safer for him than $2 million under his bed.

You could also offer to pay the owner with a personal IOU. If the laundromat owner accepts your IOU, he'll want to barter it away at some point. In the old days, he might have sold it on to another merchant in return for, say, a convenience store (see bills of exchange). Nowadays, the most popular form of IOU is probably the cheque. If the laundromat owner accepts your offer, he'll take your cheque to his bank and sell it for $2 million in deposits. His bank will in turn sell your $2 million IOU back to your bank in return for a $2 million deposit. Your bank will in turn sell your IOU back to you in return for a deposit.

You're in trouble if you don't have a sufficient deposit balance to buy back your IOU. It's for this reason that cheques are not generally accepted. If the writer of the cheque fails to settle their end of the bargain, the entire chain of dollar-for-dollar trades risks being unwound.

Nor are direct transfers of bank deposits generally accepted in trade. In order to purchase an exchange-traded stock or bond, for instance, you'll have to first sell your bank deposit for a deposit at a brokerage house. Now you can buy the stock. You're in trouble if you change your mind and decide that you want to buy a couch instead of a stock. Dollars in your brokerage account are useful only in financial market transactions, not retail transactions. You'll have to sell your brokerage deposit for a bank deposit, and only then will you be able to buy your couch.

I've left out another major type of dollar—deposits held at the Bank of Canada. A commercial bank that owns a deposit at another bank will often sell this deposit back to the issuer in return for a deposit held at the Bank of Canada. Deposits at the Bank of Canada can be used by banks to engage in all sorts of transactions with other banks.

But Bank of Canada deposits are not generally accepted. A bank, for instance, can't purchase a box of donuts from Tim Hortons with a central bank deposit—corporation or individuals aren't permitted to have accounts at the BoC and therefore can't accept BoC deposits as payment. To buy the box of donuts, the bank will have to sell some Bank of Canada deposits to Tim Hortons's bank, say the Royal Bank of Canada, in return for RBC deposits. It can then sell these deposits to Tim Horton's and get donuts.

In sum, the dollar is not some homogeneous entity. There are hundreds of thousands of implementations of the dollar. A list of all trades done in Canada over a period of time will show various types of dollars being exchanged for various goods & services and also being exchanged for each other. The distribution of appearance of each type of dollar in total trade is probably flattish, much as in theoretical barter. Liquid stocks and bonds and popular goods like coffee could very well appear in more trades than various types of dollars. The occurrence of cell phone minutes in trade, for instance, probably exceeds that of travelers' checks. The market value of transactions in which coins participate is probably exceeded by the market value of transactions in which S&P/TSX60 stocks participate. Our economy is less monetary and more barter-like than we commonly suppose.


  1. Hmmm. Interesting post as always.

    Some dollars are written in ink on paper (OK, plastic), some engraved on metal, some are electrons on computer disks; some are liabilities of the govt, some of the BoC, some of the commercial banks; some are worth $1, some are worth $2, some are worth $5, some are worth $10, etc. Does it matter? They are all inter-convertible at fixed exchange rates.

    Consider a list of all the millions of other goods, like apples, bananas, carrots, dates, eggs, fish, grapes, haggises, ink, jam, etc, that trade at varying prices, and almost never get used to buy each other.

    It's a very very big triangular table. All the ticks are incredibly bunched up among a set of goods that are very similar to each other.

    If you really wanted to, you *could* say that a 2011 loony is a different good from a 2012 loony.

    1. "They are all inter-convertible at fixed exchange rates."

      Many are not inter-convertible. You can't buy deposits at a brokerage with paper banknotes. You can't sell credit card dollars for coins. And a non-bank can't turn a bank deposit into a central bank deposit. Many dollars rarely get used to buy each other even though they share the same name.

      According to the bar you've set, a fixed exchange rates is sufficient to amalgamate goods. Yet banknotes have circulated at floating rates in the past. See for instance Reputation Formation in Early Bank Note Markets by Gorton. In Angola, US$ and kwanza circulate at floating rates. Why does a fixed x-rate matter?

    2. I think we are too accommodated to the current world and take acceptance at par for granted. Based on my limited historical knowledge, for example, paper notes more often then not were only traded at a discount. As another example, some shops that I use charge a premium of you want to use a Visa/Mastercard instead of cash or Maestro. Ryanair also charges different fees based on what payment method you use.

      After being exposed to this blog, I became more aware of this issue (as an economist). I also started to realise that a low/no premium/discount size can be a very fragile thing, and if something goes wrong, it can screw up faster than you can blink.

    3. The Visa/Mastercard point is good. Should have thought about that myself. Won't such premiums become more common now that laws are changing? For instance.

      In times past the premium always existed. At small shops, I could negotiate a better price if I paid cash. But now its getting more formalized, it would seem.

  2. So just to pin it down, your conception of a pure monetary exchange economy is a single exchange media transacted universally?

    Even with that definition, I tend to agree with Nick that we're off the half-way mark to a monetary exchange economy.

    1. Sure, I can be pinned down on "pure monetary exchange".

      In a previous post, I've characterized the "pure barter" economy as a basic monetary economy, since even then people value goods for their monetary services. All that changes as we move from this basic monetary economy towards a pure monetary economy is an increasing concentration of transactions towards certain items.

    2. I wrote a short post in response here. My main objection being that most people think in terms of homogeneous money nearly all the time. That might be a little squishy of a concept, but I think it's important.

  3. What you are describing used to be called "bookkeeping barter". In the American colonies, for example, people would pay the grocer 5 shillings worth of tobacco for 5 shillings worth of groceries. People used all kinds of things as money, but their books were all kept in shillings.

    1. Like this? That's a good example.

      As I pointed out to Niklas on his post, I'm experimenting with Ripple, which allows you to create and trade personal online IOUs denominated in USD, bitcoin, whatever. What quickly becomes apparent is that not everyone's IOU is the same. It's "bookkeeping barter" all over again.

      [Note to Mike... the system for transferring these Ripple IOUs harnesses the same technology as bitcoin. A bitcoin IOU will have the same fluidity and transaction speed as a bitcoin. If Ripple gets popular, what happens to the bitcoin price?]

  4. If ripple becomes popular, I see two possibilities for bitcoin:

    1) To the extent that bitcoin gets its value from its moneyness, ripple will reduce the demand for bitcoin and thus reduce its value. Any issuer of an IOU denominated in bitcoin is short in bitcoin, so these issuers would profit from the very bitcoin inflation that they caused.

    2) To the extent that bitcoin has 'curio value' (like baseball cards), ripple will not affect bitcoin's value.

    1. Ok. What about if Bitcoin IOUs are not fractionally backed? How does that change things? Fully-backed bitcoin IOUs won't reduce the demand and value for bitcoin, it would seem to me.

  5. If bitcoin IOU's have 100% bitcoin reserves, like the old Bank of Amsterdam had 100% coin reserves, then you're right. It seems much more likely that bitcoin IOU's would be issued on fractional reserve principles. After all, I could make a promise to you right now that I will deliver 1 bitcoin to you tomorrow, and I would have issued a bitcoin IOU against 0% bitcoin reserves.

  6. JP,

    have you read my thesis yet? I explain there that Bitcoin can exist in almost any form natively. The problem with the convertibility of various forms does not arise, anybody can do the conversion themselves. So with Bitcoin, a fully monetary economy is possible.

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