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Further to my previous article on a transactional economy which I built inductively from simple assumptions. So far I have only demonstrated simple transactions between two or three people (nodes) and have used that to provide some illustration of a generalized system. The previous article is only the start and is, of course, overly simple. Naturally, there are problems with inductively finding metrics for a generalized system when you start from one or two nodes. What I want to do is to create this model and refine with new insights as I read/think about them, and I hope that I can develop the strengths and pick apart the problems. One key problem, or line of thought, that needs to be addressed is the concept of value. There can be some interesting debates on the concept of value, much of which I'd like to maintain or debate, but I think it is necessary to find a pragmatic or practical working definition of value.

Value is not price

"Price is what you pay, value is what you get." Warren Buffett

I start from this simple quotation and use it to illustrate the concept of value. Ideally we should start from the point that nothing has value, until we give it value. That is to say that value is not truly intrinsic but rather a human construct. This is a nihilistic deconstruction of the concept but is only the starting point rather than the end-point. While this philosophical point of view is necessary to underpin the legitimacy of my thought processes I will urge for a more pragmatic and empiric use of the word "value". I will swiftly ignore all solipsistic concerns.

When I talk about price I have an internal heuristic (that I will assume is true in other humans) that associates it with money, or monetary value. Concisely: money is a valueless construct when it does not relate to price. A blank piece of paper with some nominal amount upon is not money without a greater construct. Re-stated: a piece of paper with the number 10 or 100 does not instantly become money without a set of rules that allows the facilitation of trade (transactions). I shall return to this later but I am highlighting my point of view paper money does not have intrinsic value, or necessary any concept of value in a prima facie sense. Likewise for the nominal figure upon a coin although this example is in a slight grey that I will return to later.

Apples

Value is what you get. An apple is a piece of food; that's an inherent property to its value. There are many physical properties that we can attribute to an apple, all of which are related to the apple's value. Humans desire (economic demand) apples and make the decision of whether they will eat one based upon its physical properties. A bigger apple may be more desirable (there can be many reasons), so we might associated mass and or volume of the apple with a greater or lesser value.

At this point value is still somewhat abstract but there is currently no relation to price. Humans could decide to list the value of the apples in their crop based upon a physical property such as weight. A greater value indicates a greater desire to own or consume the apple, and in some cases a greater desire may relate to a heavier apple. However, a child may desire a small apple more than a large apple and so they will assign a higher level of desirability and hence value to apples of lesser weight. That isn't the most important point to make but one that is always worth baring in mind -- value for the individual is not necessarily the same for the whole society.

A similar thought process can be done for wood. It has a weight, thickness, length etc and if we are to sell wood on a regular basis then our clients would perhaps want a standardized amount of wood each time. That way they know what to expect, eg a craftsman will know how many chairs (or whatever) he can make with each batch of wood. The wood has intrinsic physical properties which I am going to state that these properties are the empiric value of the wood, and will ignore ensuing philosophical debate (nb: we are working within a construct and the definitions hold fine and well within a construct. Solipsism and nihilism are over-kill in terms of economy of thought). Wood's desirability to an individual or a society is due to its physical properties that allow it to be used to create something, say a chair or a table. Chairs are useful, and are in fact more useful than the wood itself. Therefore a craftsman is adding value to the wood by creating a chair (follow that line of logic through to arrive at the meaning of value-added tax (VAT)).

Wooden Money

Given that a chair is more useful than wood, and I've just shown that it can have greater, then you might naively be drawn to thinking that all wood should be made into chairs (or tables or something of use). The problem is that while wood is desirable it isn't always in needed in a final form (eg a chair). Stockpiling wood might save you going to town everytime you need a new supply. If we work on the assumption that wood is always exchange in known quantities, i.e. units of a given mass, then we can set up a system of exchange where we price everything in terms of wood. If I know that a contract of wood is always 1 kilogram then I have basis in which to price everything else. If I have neither chicken or apples but wish to purchase both: for example I could offer 5 contracts of wood (so 5kg) in exchange for one contract of chicken. I know exactly what I am getting (one contract of chicken) and the chicken seller knows exactly what they are getting in exchange (1 contract of wood). Both the wood and the chicken have obvious physical properties that we can envision as humans, we have heuristic knowledge of both quantities so the exchange is simple and clear.

In my previous article on transactional economics I allude to the fact that prices can change due to supply and demand. I didn't define price, nor value, but made the assumption that the reader would have a heuristic (common sense) definition of both. Here I can make the relationship more solid. If wood has been created in great abundance, far greater than the community (society) needs, then we will find the desirability of wood will decline. That is to say that people have enough wood right now and are not looking to acquire any more. If you try to give them more than they need, or want, then they will ask for more in return. This is a simple explanation of supply and demand. If wood is less desirable then its exchangeable value relative to chicken will decline. The wood itself has not changed, nor has the definition of the contract but the desirability has dropped. Intrinsic value is constant but price has fluctuated (key point).

Recall the quote: price is what you pay, value is what you get. The value of the wood is what you get, or what you can use. The price is the exchangeable value. In these simple examples the value is fixed but real life doesn't tend to be so simple. Commodity contracts are created in a standardized manner such than a barrel of oil is a fixed quantity and grade: id est, the value is the fixed.

A further important point is that the value of wood can be viewed as a proxy for the value of apples of chicken. I can exchange some contracts of wood with someone else and know how many chickens I could buy at some point later in time. This is a necessary part of any economy that allows society to evolve from simple bartering where the two people must both have an item that the other desires, with my wooden money example it isn't necessary that both people have items that the other desires. One desires chicken and the seller is willing to accept wood as that can be exchanged later for fish (or whatever).

Wooden problems

It is clear that wood (more precisely a wood contract) could be used as the sold medium of exchange: it has a well understood and standardized value that the whole community can agree upon. The problem with wood as a medium of exchange is its bulkiness (size) and the ease of degradation. We could find a particular type of wood which is particularly hard and dense, such that a contract of this new wood can be exchange for 10 times that of an old contract of wood but is actually smaller in size. That way you could carry around a great number of contracts with the same exchange-value with greater ease.

Historically, metal has been the favoured material for creating money as it has well understood properties that are amenable to exchange as I've described. Metal is not biodegradable etc. Naturally, the exchangeable value can fluctuate such that the new wood may not be exactly 10 contracts of the old wood: this would reflect their relative desirability which is derived from the supply and demand (availability versus desirability).

All of this can be intuitively grasped by any human, it is so intuitively obvious to grasp that a child will have no problem understanding the concept of one type of wood being more desirable than another. Now let's suppose that carrying around a weighing scale is a pain then let's consider a way of avoiding that. We could now paint a number upon the metal and claim that the number denotes how many contracts it is worth. It would work by taking a fixed size of metal and painting a number on it (could be 5, 10, 20 or whatever). This can be replicated such that we have metal pieces for a variety of contract amounts. What I describe here are coins. The intrinsic value of the metal is essentially ignored while the face value is the accepted value in an exchange. If I have a coin that says 20 on it then it is understood that the coin is worth 20 contracts of wood. It could be the case that the coins all have the same weight and size but have different numbers for their face values: that is that a coin for 10 contracts has the same size and weight as a coin for 20 contracts.

This grants the ability of creating any size of contract you want, so in theory you could create a coin that has a face value of 1000 contracts of wood. Naturally, we can see how this would be useful as it allows us to 'condense' a lot of wood into a small space ready to be used for trading. However, such a system of money requires that everyone shall accept these coins in exchange for items (or services) that they own. That is to say that such a type of money requires a universal set of laws that grant them the ability to be endowed with such values. If people were able to reject the laws then the money would not be accepted as a medium of exchange.

Condensing and storing

Let's suppose that society was willing to accept this system of exchange and that coinage would make their life easier. The caveat here is that they understand the coins to have fixed values as shown on the face of the coin. A coin with a 10 written on it means that it can be exchange for 10 contracts of wood. Equally well we could use pieces of paper instead of pieces of metal. What hasn't been stated is who creates such coins, but with knowledge of a modern economy we know that this role now falls to a country's central bank. Before central banks existed one could deposit gold at a local bank and receive a receipt of deposit. At any time I would be able to enter the bank and exchange my receipt for the gold. In the scenarios I presented above I had replaced gold with wood but the idea is still the same: the receipt is used to facilitate exchange but it is only a proxy for an item that has physical value.

What I describe was the original function of a bank. It was a place of storage. Typically charging a fee in order to keep one's items safe. In a a more complicated set up the bank could lend out the gold and generate a fee upon that loan (debt) which it could then in turn use to credit the deposit as a form of interest. The bank would keep the difference between the interest paid on the loan and the interest paid to the depositor. Straight away we can see a potential risk to depositing our items if the bank was to lend out too much and thus make it impossible for everyone to claim back their deposit: otherwise known as a bank run.

Now let's consider that someone has a coin from a different bank with the number 6 printed out it. How do we know what the value of that coin is? Is it worth 6 contracts of wood? How could we be sure? It won't necessarily be the case that another bank will issue coins denominated in contracts of wood, it won't make any sense to weight the coin either as its physical properties have no baring on the amount it represents. While it is easy for two people from different parts of the world to agree upon a kilogram of sugar or an ounce of gold it isn't necessarily going to be easy to accept one another's system of coinage. They would need to be able to relate it to their relative values, furthermore each party is further required to exchange that coin with another person who is also willing to accept it. To be clearer: if I exchange a British coin for a French one then I will need to find another person in the future who is willing to accept French coins. I will also need assurance that the French coin has the value written upon it. Again, this will require a system of laws.

If that sounded complicated enough now we are going to stipulate that such coins do not relate to any physical quantities at all. They are not backed by wood or gold, but people should just accept them anyway. So we now have coins that may or may not represent 10 contracts of wood despite their previous meaning where they were guaranteed to equal 10 contracts of wood. On top of this we are expected to trade our coin with a face value of 10 for a coin that has (say) a face value of 6. Neither type of coin is based upon anything physical so why should we feel confident that our coins have any baring to physical value? In short: we can't.

Abstruse conclusion

If it wasn't difficult enough to grasp such a concept of money I am now going to add the further complication which is that the total amount of such money is not fixed. I can't simply assume that 10 million coins are in circulation therefore I can relate that to the 10 million contracts of wood that are also in circulation. That is to say that the physical meaning of money, and more importantly the heuristic concept of exchangeable value, is now very abstruse. Despite this level of abstraction from meaningful value we deal with this type of money on a daily basis and have come to accept (wilfully or otherwise) a floating-value of money as it relates to the goods that we buy. Perhaps that is philosophically healthy as an exercise but it makes it very hard to relate money to anything that is real.

Dare I make it harder still by noting that all money which is deposited at a bank can be lent out or deposited at other banks, which can in turn be lent out and deposited with other banks? That is indeed the case which allows for a rapid increase in the supply of money. Not an infinite supply but certainly a greater supply of money that would otherwise be possible if our money today related to physical items in the simple manner that they used to be (as I described above).