The Three States of Money

At the core of most stories in the news media that have to do with politics is the issue of money. There is debate about its generation, it’s expenditure, how much should be raised in taxes, how much executives should be allowed to earn, how much pension people should expect in retirement and so on. There is an assumption among journalists that everyone understands the basics, after all, we all have a few coins in our pockets don’t we? But, of course, many consumers of news feel that they do not understand much of what they are being told and skip over the economics stories until they find something which has more readily accessible content. Journalists see their role as being disseminators of information but, in the main, they make very poor teachers.

 The trouble is that money is a strange substance though it is with us all the time. It is a bit like water. When water is cold, water it is a solid. Normally, we experience it as a liquid. And when it is very hot, it turns to steam and becomes gaseous. I would like to suggest that just as water has three states which vary according to its temperature and pressure, it is helpful to think of money as having three states which vary according to its quantity and use.

For want of more elegant terminology, let us call small amounts of money ‘Money 1’, middling amounts of money ‘Money 2’ and large amounts of money ‘Money 3’. Economists have the terms ‘micro economics’ and ‘macro economics’ and in this suggested classification ‘micro economics’ roughly corresponds to Money 1 and Money 2 whereas ‘macro economics’ corresponds to Money 3. I suggest that the three states of money model paints a clearer picture.

Money 1 is the money that individuals and families spend on an everyday basis. It falls within the limits of their income. It is the money that is used for daily expenses such as food, travel, mortgage payments and so on. The wisest approach to managing Money 1 is not to allow expenditure to exceed income. If it does, there is an extra cost which reduces spending power in the longer term. The time horizons of Money 1 are short and the amounts are small. The emphasis is on income, directly or indirectly arising from labour. Risk is to be kept to an absolute minimum and, if possible, eliminated altogether.

Money 2 covers a range from amounts required to buy domestic properties and small businesses up to amounts turned over by large commercial organisations and may run into billions of dollars. The keynote of this state of money is investment: it is money used to make money.

The aim of a purchaser of a domestic property in taking out a mortgage loan, in preference to renting accommodation, is to pay it off so that housing ceases to be such a significant cost and to acquire an asset which stores value and, perhaps, increases in value. For a business, Money 2 is an input which is used to invest in means of production which, in due course, generates wages and dividends – Money 1 – paid to employees and shareholders. Without Money 2 there would be no Money 1. Money 2 is money for investing.

Money 3 is money in such large quantities that its use affects the nature of reality. It is money spent by government. It cannot be seen as investment in the same sense as Money 2. In Money 2, for example, two commercial organisations engaged in similar activities could decide to invest similar amounts of money in different ways. Shareholders or commentators can then compare the effects over a period of time and make a judgement on which organisation made the wisest choice. This cannot be with Money 3. By applying Money 3 the nature of the whole situation is altered. For example, there was a time when the British Government was faced with a choice of building a tunnel under the Channel or building a bridge over it. Once the tunnel was built the nature of the situation had been altered so there could only be a theoretical comparison made. Governments cannot own money; they can only direct its flow from taxes into expenditure. Money 3 is money for spending.

The essence of Money 1 is ownership, the nature of Money 2 is investment and the nature of Money 3 is expenditure.

The fundamental structure of our society (capitalist) is tripartite. The terminology varies from writer to writer. We could, for example, use Hegel’s terminology from the ‘Philosophy of Right’: ‘Family, Civil Society and Government’. In this schema ‘Family’ is the realm of the private where people know each other and are mutually dependent. ‘Civil Society’ is where people meet as strangers, for example, to take part in market activities. It is the realm of business. ‘Government’ is where the common interests of all individuals and groups come together and its function, which may be achieved with varying degrees of success, is the maintenance of the common good and its realm is that of justice. We could make a parallel here and say, roughly, that Money 1 is the money of Family, Money 2 is the money of Civil Society and Money 3 is the money of Government.

I suggest that this idea of the three states of money is a simple model and easy to grasp. For example, politicians over recent months have frequently used the analogy that the British economy is like ‘a credit card that has been maxed out’. Now a credit card is Money 1 and the British economy is Money 3. They are fundamentally different so the analogy is obfuscatory and confusing.

I would also like to suggest that the model is helpful for understanding other issues. For example, social class or whether or not experience in business is useful for a politician.

Let us take social class. Everyone is familiar with Money 1. It is not possible to be a fully functioning adult and not have a thorough grasp of Money 1. It’s laws are simple: don’t borrow unless you must; save for a ‘rainy day’; if you want to spend more, you must earn more. However, the degree to which a person is middle class depends on their grasp of Money 2. If you see all expenditure as just expenditure you cannot grasp the concept of investment. Middle class people think in terms of making investments: in buying houses, businesses, investing in education and training. Thus, they are able, to some extent, to escape the cycle of income and expenditure which working class people are trapped in. Class is a state of mind and it is, essentially, a state of mind about money.

In order to understand how the world works and make good decisions about our lives, how to vote and how to plan for the long term, it is essential that people should come to understand much more about economics than they do. An understanding of the three states of money would be a good starting place.

2 thoughts on “The Three States of Money

  1. It appears to me that your description doesn’t coincide precisely with the way in which the three types of money are usually talked about by economists (if wikipedia is at all accurate). Firstly, in economics, M1, M2, and M3 are different measures of the money supply, with each successive measure including the previous measure (so M3 includes M2 and M1). Secondly, it’s all about the liquidity (or ready circulability) of the types of instruments measured: each successive measure includes increasingly less liquid types of “money.”
    It seems to me that either you need to use different terminology to put forth your argument about different uses, users, and effects of money expenditures (so as to reduce confusion), or you have to think it through more clearly and fully. For example, it seems to me that a lot of government’s money is actually M1 money (highly circulable) and always stays in that realm: I pay taxes and the government spends that money on welfare benefits that the recipients spend for food.
    Going back to our earlier discussion about how government employees’ pensions are handled: as the UK currently manages pensions, the money basically stays in the government’s current account as M1 money, the employees’ pension contributions going into general revenues and being spent on all sorts of services including pension payouts to retirees. Thus no wealth is created (though perhaps retiree poverty is reduced). As Ontario manages pensions, the employees’ contributions are being invested in various markets to become M2 and, perhaps, M3 money, generating new production and wealth, not only for the pension-holders, but also for society at large. How is that a bad thing, except insofar as it reduces the amount of ready cash the government has to disburse?
    In the model you present in this post, it isn’t clear exactly what money 3 is: Is it solely the money spent by governments, or is it any large amount of money expenditure that “changes the nature of the game” or is spent on behalf of society as a whole? Can businesses (or even very wealthy individuals) spend money as money 3? For example, when E. P. Taylor, the head of O’Keefe Breweries, builds a performing arts centre in Toronto in 1960 (the O’Keefe Centre, then the Hummingbird Centre, now the Sony Centre) as a purely philanthropic gesture, is that money 3?
    Anyway, a thought-stimulating essay; the ideas simply need some clarification and honing…

    • Rick. This is not about money supply so what you have to say about M1 etc is not relevant. I agree that the labels ‘Money 1’ etc. are not great but I haven’t thought up anything better yet and I am open to suggestions. I agree that the 3 states need more clarification than I have tried to give them here. Briefly, an arts centre is Money 2 and it is unlikely that any entity except a government or a bank would be able to come up with anything big enough to be more than Money 2.

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