The Exchange Economy, Part I
Jude Wanniski
January 28, 2006


This lesson begins with the exchange economy as it is understood in the classical economic model. Beginning with two producers, a baker and vintner, and an intermediary who draws up contracts under a stable unit of account, we arrive at an exchange economy in its basic form. But throw in a fluctuating unit of account and all sorts of problems arise, leading to a decline in overall living standards. Of course, the examples are simplified reflections of what has actually occurred since 1971, when President Nixon delinked the dollar from gold. Next week, we will take this concept of the exchange economy and apply it on a global scale.

Polyconomics Staff

Memo: To SSU Students
From Jude Wanniski
Re The Exchange Economy, Part I (January 28, 2005)

Today’s lesson is almost as basic as last week’s general introduction to economics. We will discuss "the exchange economy" as it exists in the classical economic systems. This should enable you to more clearly see how production or "supply" must inevitably dominate consumption or "demand" functions. To simplify, we begin by stripping away what economists call "the veil of money," so you can grasp the essentials without thinking in terms of money changing hands in the marketplace. Way back, there was no money, with producers bringing their sheep and goats and butter and bread and wine to the market and making a deal with other producers who came with other attractive goods. The point is hammered home about the bridge from "barter" to a "money-exchange" economy when we note that the first "monies" that changed hands were bits of base metal with pictures of rakes or shovels or hoes carved into them. It was easier to change the bits of metal than carry around the tools.

Almost all the analytical discussions you are likely to hear on the financial news programs or in the newspapers use "cash flow" arguments to describe what they believe is happening in the U.S. economy, the world economy, or on Wall Street. If you begin your education in economics by trying to follow the movements of dollars from one place to another, you will always be burdened with complexities that inevitably lead to erroneous conclusions. In the "exchange economy," goods and services are produced here and there and elsewhere. They come into the general marketplace and are traded – "exchanged" -- for other goods and services or for pieces of paper called stocks or bonds. Hence, "the exchange economy."

Notice that there are no "consumers" in this conceptual system. In the simplest example, Smith makes bread and Jones makes wine. Each makes more than he needs and each would like some of what the other produces. They come together in the marketplace and decide to exchange one loaf of bread for one bottle of wine. If this were a "spot" market, the exchange would be made then and there on these "terms of trade." (A term you need to understand to get very far in economics. It is simple enough: How many apples do I need to offer to acquire an orange? When it is decided, those are the terms.)

But bread is made for immediate use or it becomes stale and of course Jones needs his daily bread. Wine takes time to make and does not have to be consumed as soon as it is produced. An agreement is made that Smith will supply Jones every day with a loaf of bread and Jones will deliver to Smith 365 bottles of wine at the end of a year, when it is ready to be consumed.

In a primitive "barter" economy, the agreement is verbal and Jones gets his daily bread and delivers the wine at year’s end. In the modern exchange economy, the concept of "money" is introduced, not as "a medium of exchange," but as "a unit of account." Because Smith and Jones live in different parts of town, and probably do not even know each other, they have a "financial intermediary" help them make the exchange. The term applies to someone, perhaps Brown, who provides the service of go-between – "intermediation." The financial intermediaries include bankers and brokers and those who serve the intermediation process. In that sense, Polyconomics is an intermediary, an indirect intermediary in that we advise bankers and brokers who are right in the middle. In the real economy, the intermediaries include the wholesalers and the retailers, those who buy the goods in large amounts and then sell them in small amounts.

Within the system, a contract is drawn up whereby Jones agrees to provide the 365 bottles at year’s end, but instead of bottles, he agrees that each loaf of bread is worth a bit of gold and the wine is worth 365 bits. Gold becomes the "unit of account." Instead of agreeing to 365 bottles, Jones agrees to give Smith 365 bits of gold at the end of the year, and each of those bits will buy a bottle of wine.

Why is this done? It is because the market is more complex, with Smith wanting to exchange his bread for more goods and services than wine, and Jones also wanting to trade his surplus wine for a variety of goods and services. Chicken legs, aspirin tablets, movie tickets, haircuts, a new home, i.e., the whole galaxy of things available in the broad marketplace. In the transition from primitive barter to civilization, as I mentioned earlier, a tradition began of using precious metals like gold and silver as "big money," base metals like copper and iron as "small money." Over the epochs gold became the leading "proxy" for all other goods. In other words, a bit of gold became the unit of account in the exchange-economy contracts. I say "bit" only to indicate in all parts of the world the different national units of weights and measures translated into different terms for this proxy. Ounces and grams, to name two.

If the unit of account fluctuates because the government that presides over the national economy chooses a floating unit, a "fiat" dollar that is not connected to gold or anything "real," problems arise for Smith and Jones. ("Fiat" is a term for "money" that isn't real in itself or connected to anything real, whose "moneyness" is simply dictated by an authority by fiat.)

Bakers and vintners will almost certainly find their legal contract to exchange bread for wine at specific terms of trade will cause one or the other to suffer with a fiat dollar. If the "dollar," for example, loses half of its value over the course of their 365-day contract, Jones will be delighted to find he only has to supply half the wine he contracted for. When a currency loses value, it "inflates," and as you see inflation favors the debtor, Jones, at the expense of the creditor, Smith.

It looks like a zero-sum game, but it is worse than that. In the second year, Smith has been so burned that he must take out "unit-of-account" insurance in dealing with Jones. He has to promise an insurer so many bottles of wine out of the 365 he expects to be delivered a year later. This is called "hedging in the forward market." Even if the dollar remains constant and he gets his 365 bottles, he has to give an intermediary some of that amount. Suppose the floating unit of account goes in the other direction, doubling in value. This is an "appreciation," which means the creditor gains at the expense of the debtor. It is a "deflation." Jones has to deliver 730 bottles of wine to Smith. If he can’t he must borrow wine from someone who has an inventory and is willing to part with it for cash or a piece of paper, a stock or a bond.

Now the third year comes along and both Smith and Jones are wary of what comes next, so both take out insurance against a change in the unit of account in one direction or the other. An intermediary must be guaranteed so many of the loaves of bread and so many of the bottles of wine. In our simple example, you can already see that if the economy is composed entirely of bakers and vintners at the beginning of the process, at the end of a few years there are fewer bakers and fewer vintners as some of their sons and daughters have to work as intermediaries. The national living standard must per force decline, as there is less bread to eat and less wine to drink by the producers, who must give more of their production to intermediaries and lawyers and accountants.

The costs of financial intermediation must also be borne by the production intermediaries, the wholesalers and retailers. They also have to guess on the direction of prices and the inventories they can hold. Those who guess right gain financial strength and those who lose may find themselves out of business, not because they are bad at what they are trained to do, but because they have been unable to anticipate the direction of the floating unit of account. [Polyconomics has been a successful intermediary for almost 27 years because we have consistently been able to tell our clients the monetary direction of the markets. I’ve often said my goal is to re-establish the dollar/gold exchange rate, even though that would remove one of our advantages in competing against other firms that serve investors.]

Over the last 34 years of a floating unit of account, what I’ve described here in a simple two-product economy has swept through the entire national economy. And because the dollar has been the key currency for the whole world, the changes have swept the world. By "key," we simply mean the money that is most respected by all other currency systems, for a variety of reasons, including the fact that the U.S. is the greatest military power on earth and its money cannot dissolve the way Confederate money did in 1865.

There is simply no question but that the global standard of living has declined in this period – if you subtract from the total the progress that has been made in recent years in the former Communist countries. In the United States, such a large fraction of the population has had to work in what I have come to call "the chaos industry" that the amount of bread and wine the exchange economy is producing has declined, per capita. The highest priced workers in the economy seem to be lawyers and accountants and financial intermediaries, producing only guidance to the producers of goods and services, or subtracting from the total real output by using government rules and regulations to win judgments for their clients who guessed wrong and claim they are victims entitled to millions to make them whole.

At the same time, the people who are hurt the worst as the unit of account swings from inflation to deflation are those at the bottom of the socio-economic pyramid. As the national living standard declines, they are the least able to protect themselves. Inevitably, a fraction turns to illegal activities in the underground economy where the costs of currency changes can be offset by tax evasion. Another significant fraction turns to outright criminal activity, which is why federal, state and local prisons are now overflowing with 2 million Americans, most of whom are black or Hispanic.

We have really only scratched the surface in discussing the mechanics of the exchange economy. This is enough for you to contemplate this week. I’ll extend this discussion in lesson #3 next week. Of course, I will welcome questions from SSU students on this subject, preferably posed in the TalkShop. If you find this topic helpful, please forward the lesson on to friends or relatives who will be welcome at SSU in this early phase of the spring semester.