Years before Adam Smith penned The Wealth of Nations in 1776, the venerable father of natural law, John Locke, set forth a simple notion which is now known as the “Quantity Theory of Money.” The year was 1692. The concept was refined by the great Irish economist with the Spanish name who wrote in French, Richard Cantillon, in 1732 and even further by Smith’s friend and mentor, David Hume, in the 1750s.
In its simplest form, the Quantity Theory simply states that the quantity of money (M) multiplied by the number of times it turns over in a year (the “velocity” of money (V)) is equal to the price level (P) multiplied by the number of transactions (T) in the economy (MV=PT). For some, like Milton Friedman, it is the key to understanding all there is to know about the economy—proof positive that increasing the money supply causes inflation. For others, it is a simple mathematical identity without much embedded knowledge—not unlike 1 + 4 = 2 + 3. In any case, it is now well into its fourth century of recognition (and several millennia of reality), and it’s still going strong.
One of the modern phenomena that we have observed within this framework is a notable increase in the velocity of money (V). Credit cards, debit cards, paying bills by phone and online, electronic transfers, and a host of other innovations have caused the financial system to become much more efficient. The result is that we can accomplish many more transactions (T) without increasing the money supply or prices. Much of our remarkable era of growth without significant inflation can be traced to this simple fact.
There is another part of this story, however, that to date has not been chronicled. I call it the “eBay Effect,” although it is really much more than that. The idea is that, for most of our history, a substantial part of wealth has been tied up in assets that were not liquid (easily convertible to cash). While many of these assets, such as machinery, are essential to productivity and progress, this freezing of available funds was an impediment to transactions. If you had furniture, machinery, or almost any other “used” asset that you no longer needed, you had a difficult time converting it to cash. You might run an ad in the local paper or a trade publication; you might even hire a broker; but it was almost always a slow and expensive process. Because of this lack of liquidity, such assets were also difficult to use as collateral for loans. The money was pretty well locked up.
Those days are gone! With the advent of the Internet, online auctions and specialty sites bring millions of buyers and sellers from around the world together on a non-stop basis. The search cost for finding the right purchasers has dramatically diminished, and virtually everything has become a liquid asset. Thus, more things are acceptable as collateral, more things can be quickly and efficiently converted to cash, and the entire financial system gains efficiency. As a result, more transactions can be accommodated, which in turn provides growth without inflation.
The Internet has affected our daily lives in many ways, and will continue to do so. Many of those are easy to see; others are more subtle. One which should not be overlooked is the eBay Effect. It goes beyond the ability to buy and sell online. It literally impacts the very essence of our economy. It allows more resources to enter our increasingly efficient financial system, thus providing more transactions and enhanced potential for prosperity. The equation may be over 300 years old, but its relevance to the modern world continues to be manifested.