Introduction to Economics Part 3 - What is Money?

In my conversations with people on economic issues I have found a frequent misunderstanding regarding what money actually is.  For this reason I feel it's important to clarify this issue early on in my Introduction to Economics series.

Let's say you're a farmer with a cow.  You milk your cow and go to the market to exchange it for bread.  If the baker wants milk, you can negotiate how much milk is worth how much bread, and the exchange can take place.  But what if the baker does not want milk?  What if the baker needs a new shoe for his horse?  You will have to go to the blacksmith to see if he is willing to accept your milk in exchange for shoeing the horse of the baker who will then provide you with bread.  But what if the blacksmith does not want milk?  You will have to figure out what the blacksmith desires, and continue around town until you find someone who desires your milk and is providing something you need, and do so before the milk spoils!  You can understand how this is a troublesome and inefficient process.  There's GOT to be an easier way!

Money is the solution to this problem.  Money is a commodity that is universally valued.  If you have a product everyone values, you can exchange your milk for this commodity, and then exchange this commodity for the bread.  In order to properly fill this function, money must meet four requirements.

1. Medium of Exchange
2. Unit of Account
3. Store of Value
4. Standard of Deferred Payment

1. The medium of exchange is the most important characteristic.  Every individual participating in the economy must be willing to exchange this money for their good or service.  Why would they be willing to do this?  Every once in a while I hear someone say "money is just something people project value onto."  It's not quite that simple.  Money must meet five separate characteristics in order to be a medium of exchange.

a. Transportable - It must be portable, so the dairy farmer can take it from his home to the baker, for example.
b. Divisible - If the value of the bread is less than the value of the milk, he must be able to divide the money and keep the surplus for another good or service.
c. High market value in relation to its volume and weight
d. Recognizable as money
e. Resistant to counterfeiting - If people can simply create the medium of exchange at will, it is valuable to no one.

2. The unit of account is related to the money being divisible.  By having a standard unit, it's easy to tell how much value you possess.  By being divisible, it can be broken into smaller units without losing any of its overall value.  This is why diamonds make bad currency, since a large diamond is worth more than it would be if split into two pieces.  It must be fungible, which means that all units must be seen as equivalent to all other units.  Lastly, it must be verifiably countable.  If one person counts a pile of money, anyone else who counts that pile of money should come out with the same result.

3. The store of value is extremely important.  Money must be savable, storable, retrievable, and of the same value when it is retrieved.  This is why food products make bad money, even though they are demanded by everyone.  A pile of rice stored in a barn is worth less after fifty years than when it was first deposited.

4. Lastly is the standard of deferred payment.  Individuals must see money as a means of managing debt and credit.  If the baker is going to give us bread in exchange for money, he must be assured that he will be able to collect milk in exchange for this money at a later point in time.

So what makes good money?  Historically precious metals have filled the role very nicely, as they meet all four of these requirements.  Gold has been universally recognized as valuable all over the world, and all ounces of gold are equivalent to all other ounces of gold.  When divided in two, the two half-ounces of gold are worth the same as the combined one ounce.  It is a fantastic store of value since it does not deteriorate, rust, or decay.  Since it is good at holding its value, it is a good standard for deferred payment.

But what about paper money?  Is it not the same as gold?  Gold cannot be eaten as food after all, and it has limited practical uses.  Do we not simply project value onto gold, and can we not simply project value onto paper money in the same way?  The answer to this is no, for a reason you may find somewhat shocking.

There is no such thing as paper money.  Paper is not a medium of exchange.  In our system, there are different types of paper that have different values.  A $100 bill has the same amount of paper as a $1 bill.  Paper is not a store of value, nor is it a standard for deferred payment.  People do not actually believe there are $100 worth of ink and paper in a $100 bill.  The paper is acting as a proxy for a different kind of value.

This is a $20 gold certificate from 1905.  If you lived in any time before the United States got off the gold standard, you could take this $20 certificate to any bank or assayer's office and exchange it for 32 grams, or one troy ounce, of gold.  The $20 would then be taken out of circulation.  Similarly, you could take your gold to a bank and exchange it for certificates equal to the amount of gold you gave up.  This would be new money in circulation.

So what about today?  If paper money is a proxy, but is not a proxy for precious metals, what do we use for value now?

Our monetary system is known as fiat money.  That is, the money is declared to be valuable by government fiat.  It has value because the government says so.  That's all.  This mandate is used to enforce a standard of deferred payment.  All individuals living in the United States are legally required to use fiat dollars as their means of resolving debts, or be arrested.

What has been destroyed in this process is its store of value.  If you have $10 in your pocket, it is not worth the same it was 10 years ago, or even five minutes ago.  The reason why is because the Federal Reserve has complete power to print however much money it wants, and it doesn't cost much to run a printing press.  If you had the power to print $100 bills for 3 cents each, wouldn't you do it?  A lot?

The printing of money indicates to the economy at large that more goods and services are being provided when in fact the money is merely a representation of a fraction of the goods and services that already exist.  This sends false information into the economy, and since the money is moved into the economy via the banking system, the problem is exacerbated by fractional reserve banking, which we will discuss in a later note.  These false currency signals cause misallocations of resources, for which all economic participants eventually pay the price.

In conclusion, the most important thing to understand about money is that it is a representation of value.  There is nothing powerful or supernatural about it.  It is a stand-in for goods and services, and serves primarily as a medium of exchange for people to acquire that which they desire.  When people seek monetary profits, they are simply seeking to acquire more of what they value in life, which is completely subjective.  This is why it is important not to confuse monetary profits as something different from any other sort of gain in life.  There is nothing inherently evil or dishonest about money.  It is the means through which people acquire money, or the means through which they get what they want, that is problematic.

Thanks for reading!