Money and Money Functionality: Part II Measuring Marketability

In Part I of this essay we introduced the challenges of understanding what makes something money. After offering critiques of two of the most common ways of understanding money, we submitted a third definition built upon the idea of marketability. We agree with Hayek that marketability is best conceived along a spectrum with some goods have greater or lesser marketability than others. The greater the marketability, the more suitable the good is to become a money good. We defined money as the most marketable good.

In Part II, we explore various ways to measure marketability.   

Three Ways to Measure Marketability

Thankfully, marketability is both observable and measurable in the real world. Let’s explore three ways marketability may be measured.  

1. Spreads
2. Stocks to flows ratios
3. The rate of declining marginal utility

Spreads

A spread is the difference between two prices for either; a.) the same good at the same time in the same place, or b.) different goods at different times in different places.

Perhaps the simplest and most common spread is the difference between the quoted price to buy (ask) and the quoted price to sell (bid) a good. Often known as the bid-ask spread, this will be familiar territory for traders, market-makers, dealers, brokers and maybe even some small business owners. However, for nearly everyone else this is likely to be a foreign concept, despite daily participation in markets.¹ If I had to guess, this is because we are typically only engaging with one side of a transaction (the buying or the selling). Rarely do we engage in or see both sides. Regardless, whether you know it or not, behind every price there is a spread. ²

It is an axiom of markets that the more marketable the good, the narrower its bid-ask spread will be. Less marketable goods will have wider spreads. Narrow spreads indicate a broadly and deeply traded market because the increased activity of buying and selling one good over compresses the bid-ask spread for that good. The opposite is also true.

If money is the most marketable good, it follows that money must have the narrowest bid-ask spread relative to every other good. Money, by definition, must be less expensive to exchange with everything else, than anything else. Remember the example of salt for shoes and food in Part I. Since salt was more marketable than shoes or food, more and more salt will get exchanged. This increased exchanging of salt will cause the bid-ask spread of salt to narrow. This is what we would expect to see in a money good. At a certain point, once a good demonstrates its superior marketability, then every price and every spread in an economy becomes measured in terms of the money good, making the money’s bid-ask spread essentially zero.

Stocks to Flow Ratio

The stocks to flow ratio measures the total stock of a good against the flows for that good over a given time period. Like narrowness in bid-ask spreads, higher ratios are indicative of greater marketability. A lower ratio almost ensures the good could never be a money. Let’s take a closer look at why that’s true.

Most economic goods are demanded to be consumed. By “consumed” we mean “to be used up” or “exhausted” in such a way that the good goes out of existence. These goods tend to have a very low stocks to flow ratio. Take oil for example. It’s bought to be consumed for energy, and once used it goes out of existence. Therefore, its total stock is never permitted to accumulate beyond what’s needed to meet its near term demand. A number which happens to be measured in months, not years. Even though oil is a large market with constant demand and a narrow bid-ask spread, it has a very small stocks to flow ratio.

There are some goods (rare as they are) which are demanded not to be consumed like oil, but rather  simply to be owned or held. The utility of owning the good is derived from holding it in order to exchange it for something else later on. You may begin to see where this is going. Economists sometimes call this “reservation demand.” It might as well be called monetary demand, for that is precisely what it is. We demand money not to consume it³, but to hold it for a time (sometimes long periods of time) in order to exchange it for something else later or as the opportunity arises.⁴

So what happens when you have near constant demand for a good that is never ultimately consumed (goes out of existence) when acquired? Well, you end up with a very large supply (stock) of that good! Which is why a large stocks to flow ratio is a monetary tell of sorts. The historical monies of gold and silver provide a good example as the following chart illustrates:

It’s worth noting that a large stocks to flow forms a kind of monetary inertia for the good. The greater the stock, the more resilient the good becomes to unexpected volatility shocks.⁵ The market knows there is plenty of supply available to meet unexpected increases in demand and vice versa – that there is plenty of demand available should someone want to unload a large position. This creates a virtuous cycle and ultimately serves to increase the marketability for that good.

In summary, a higher stocks to flow ratio indicates a more marketable, and therefore, a more monetary good.

Zero Declining Marginal Utility

The rate of decline in the marginal utility of a good is another measure of marketability.

Marginal utility refers to how much utility the next unit of the same good provides. All goods have a marginal utility slope or grade. For most goods, that slope is declining more or less steeply. See the following chart for a perfectly linear (read: imaginary) example.

A chart showing a mock slope of the declining marginal utility as each additional commodity unit is acquired. Of course in real life it’s rarely a perfectly linear relationship.

Think about it. There are only so many TV’s, cars, houses, microwaves, refrigerators, laundry detergents etc. one may want to own at any given time. For such goods, the marginal utility slope rapidly declines after the first unit is acquired. The relationship can be expressed as follows: I value my first microwave by X, the next one as X-Y, the third one as  X-Z so on and so forth. Keep in mind these are ordinal not cardinal rates. To say I value the second microwave by 7.5 is meaningless. To assign a value of 7.5 within a scale of 1-10 is getting a little closer to understanding how this principle works.

Most people don’t undergo a rigorous expected value (utility) calculation assigning numerical values to different options and then coming to a decision.⁶ Real life is far more dynamic and fluid.⁷ It’s more common to find people that think in terms of “I value this more than that, that less than this, and these more than those etc.” Regardless of how it’s done, there’s no getting around the fact that people are constantly “valuing” things and alternatives. Humans are “evaluators.” And while the actual values may differ person to person, the act of valuing itself is inescapable and embedded in our very nature.⁸ It accounts for both the marginal utility of a bottle of water while crossing the Sahara desert and the marginal utility of a bottle of water while crossing your air-conditioned living room on the way to the kitchen to make a sandwich.   

Why am I looking at an image of Halo:Combat Evolved? See this footnote⁹  

Applying this idea to money and we observe a curious anomaly. Money goods have either a zero or very near to zero declining marginal utility rate. Expressed graphically, the slope of a monetary good would be flat or declining ever so gradually as to be nearly imperceptible. See the chart below for a rudimentary example.

This is because if given the choice, we would prefer owning an additional unit of the money good as much as we prefer owning the first one. That proves true for the 100th unit as it does the 1000th unit as it does the 10,000th unit etc. To put it another way, at what additional amount of dollars in your bank account would you stop and scream, “OK that’s enough! No more dollars! I absolutely cannot accept not one more!” The number should be very high, maybe even infinitely high. And that’s the point.

A zero (or near zero) rate of decline in marginal utility is characteristic of monetary goods because it implies superior marketability compared to other goods whose marginal utility declines as more and more units are acquired.  

This concludes Part II of our essay Money and Money Functionality. In part III, we will go back in time and look at what has been forgotten in the history and study of money and why it’s so important for today. Click here to read Part III: What’s Forgotten isn’t Remembered

Thank you for reading. I hope you found this article helpful and maybe even enjoyable. I am a student of markets, not a master. If there’s anything in this essay you disagree with, I’d love to hear what and why in the comments below. Thanks again for reading.

1. Most people likely think they know and understand “price” at some basic level. But price by itself isn’t enough to really capture the whole of economic activity and behavior going on beneath the surface. Consider the following quote by Carl Menger: It is an error in economics, as prevalent as it is patent, that all commodities, at a definite point of time and in a given market, may be assumed to stand to each other in a definite relation of exchange, in other words, may be mutually exchanged in definite quantities at will…The most cursory observation of market phenomena teaches us that it does not lie within our power, when we have bought an article for a certain price, to sell it again forthwith at the same price. If we but try to dispose of an article of clothing, a book, or a work of art, which we have just purchased, in the same market, even though it be all once, before the same juncture of conditions has altered, we shall easily convince ourselves of the fallaciousness of such an assumption. The price at which any one can at pleasure buy a commodity at a given market and a given point of time, and the price at which he can dispose of the same at pleasure, are two essentially different magnitudes. (pg 23-24 in On the Origins of Money) While originally published in 1892, I’m willing to bet that the “error” Menger describes is as prevalent today as it was in his time. People (professional economists included) mistakenly think about prices in simple, singular, and uniform terms. Reality is much more three dimensional. Thinking in spreads gives us a kind of x-ray economic vision to see beneath the surface and better understand what’s really going on. See also Antal Fekete’s Disequilibrium Analysis of Price Formation; Disorder and Coordination in Economics
2. Antal Fekete says it well, “Whether recognized or not, arbitrage is the driving force of the market process. It is present in every market action, even though sometimes it may well be hidden…Arbitrage is a market strategy, shifting the emphasis from sales to straddles and from prices to spreads.” (pg. 2-3 in Disequilibrium Analysis of Price Formation; Disorder and Coordination in Economics) Indeed we are saturated today with talk of “efficient markets.” But what most people mean by efficient is “equilibrium price,” a non-reality in markets. A better definition of efficient markets, would be dynamically tight and tightening spreads across all goods (products) and services (labor). See Keith Weiner’s article Efficient Malpractice
3. Indeed goods that are easily consumable or perishable would by nature have a harder time becoming a money good.
4. Remember the salt. Surely in that primitive age some salt was always used as such, but a growing amount was used for the monetary advantages it conferred to the owner when exchanged for other goods.
5. A great example of this would be the large gold discoveries under the classical gold standard. In summary, the largest gold discoveries (California Gold Rush, Witwatersrand and Klondike) recorded only managed to increase the total supply of gold by anywhere from 2-3% above the rolling average from previous decades. Inflation rates too were little affected. The greatest change represented by a 4% swing (from 2% deflation to 2% inflation) in 1896. See Larry White’s Experts and the Gold Standard and George Selgin’s 10 Things Every Economist Should Know about the Gold Standard, particularly point #3 Gold supply “shocks” weren’t particularly shocking and seperate article A Rush to Judge Gold
6. Not to say you shouldn’t, especially if it’s an important decision!
7. For example, in real life, the value of a second microwave (after the first is acquired) is effectively zero. Meaning there isn’t really any economic calculation occurring because there is no perceived value whatsoever in getting a second microwave after the first is obtained.
8. This framework incorporates common economic concepts like opportunity cost, scarcity, dynamically changing external circumstances and internal desires.
9. Let me see if I can add clarity by way of an illustration. I grew up playing console video games. I was a big fan of FPS (that stands for First Person Shooters for all you noobs out there). Most FPS’s have an HUD – Heads Up Display. This image is an example of the HUD for one of my favorite video games, Halo: Combat Evolved. Since it’s a first person shooter you’re viewing the world through the eyes of the character you’re playing and controlling, Master Chief in this case. You see what they see. However, not all knowledge comes from seeing. And if you’re really to experience the world as the character, then you need to know what the character would know. This is what the HUD provides to you – helpful bits of knowledge like how much ammunition you have remaining, how many grenades are in your pocket, what other guns are you carrying, your health bar and where you’re located on a map. Most of these things would be quite tedious for you to try and find yourself in the middle of the narrative (imagine having to press a series of buttons to move the camera to check the player’s pocket to see how many grenades are there etc.) If you were the Master Chief in real life, you would know how many grenades you have (and how to perfectly place them over hundreds of yards). So, for a better gaming experience, this kind of information is provided for you in real time through the HUD. Got it? Now you could think of this economic valuation framework as a kind of internal, mental HUD which is constantly reporting a value dashboard to yourself based on a number of constantly changing and evolving inputs from both internal and external sources. In fact, for human beings, it’s an extraordinarily complex array of inputs coming from hundreds if not thousands of different places. And while these are constantly and dynamically changing we ourselves are constantly and dynamically changing what we value and how much we value it. This HUD would look like fireworks there would be so much going on. But the point is, regardless of what we value and how much, we all value and we can’t escape the fact that we value. Just like Master Chief can’t help the fact that he knows how much grenades he has (and how to perfectly place them on noobs from long distances).