Scott Sumner says something interesting about money being the medium of account:
“I argue that money is the medium of account.”
I agree. We spent a lot of time ere at MR with the equation S = I + (S-I), and one of the conversations about this idea (Thanks again Steve R.) was about how there are tons of assets sitting on the balance sheets of the world, all valued using the medium of account, where the medium of exchange has very little impact on what happens with these assets. These assets all matter for S and I.
Many of our more important transactions in the financial world do not involve exchanging the medium of exchange. They involve the valuation of assets in the medium of account, and promises to provide (possibly) some medium of exchange later in compensation. For example, an interest rate swap doesn’t involve much or any exchange of the medium of exchange at the initiation of the trade. Yet, plain vanilla IRS define much of our financial world.
IRS are bookkeeping entries until something changes in the real world, so how can they be considered to be using the medium of exchange? IRS use the medium of account.
Then, taxing agencies don’t just tax transactions which use the medium of exchange. They also tax transactions which involve gifting of real estate, compensation received as options on corporate equity, or payment in kind. These transactions must be given values in the medium of account, which then require taxes paid in the medium of exchange.
Also, much of our current recession has been caused by transactions which did not involve the medium of exchange. The revaluation of ABS – clearly one of the precipitating forces of the tragedy in 2008 – were simply bookkeeping entries on non-traded bonds. The reason banks stopped lending the medium of exchange was due to changes in valuation on untraded bonds in the medium of account. Similar bonds may have traded, but some large majority of the ABS revaluation happened in a few dozen (maybe a few hundred) spreadsheets around the world, not in millions of recorded exchanges of these bonds for money. There were literally no trades for these ABS, no “exchange of medium” for specific bonds, so the valuation changes must have come from valuation changes which happened in the medium of account.
Note these spreadsheet-only valuation changes directly caused the lending problems in 2008.
My take is the accounting function of money dominates the exchange function. It’s hard to see when you don’t think about accounting much, but accountants rule our world, because they define it.
(Update: The internet bubble was an MoA driven phenomenon, and the mid 2000′s refi-boom was a MoA phenomenon.In the intenet bubble, many transactions were exchanges of equity with zero MoE involved. Any refi equity extraction involves guessing the market value of a parcel of real estate and then giving someone MoE in exchange for that new value. The MoE is available when the MoA valuation changes. )