Wednesday, October 21, 2015

What is money?

joão pestana

During my first year as a student of the Master in Economics, I had a course on the History of the Economic Thought and one of the assignments was to write about what is money? I had a very low grade. Nevertheless, I want to share my insights with you. I firmly believe it can be instructive to anyone. I started with an abstract — as any good essay must — and a quote. I'm skipping the introduction and minor sections.


Everyone knows what money is, even if they know nothing of financial, monetary or basic economics. In this essay, I explore an overview of money from its origins as an almost natural evolution from the barter system to the practically invisible medium of exchange that it is today. Then, I give a brief description of the modern creation of money. Finally, I try to get a sense of what money means besides its nature as an object of trade.

This planet has — or rather had — a problem, which was this: most of the people living on it were unhappy for pretty much of the time. Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which was odd because on the whole it wasn’t the small green pieces of paper that were unhappy.

— Douglas Adams, The Hitchhiker’s Guide to the Galaxy (1979), Introduction.

The barter system

In a subsistence economy, each individual consumes what he produces himself. But what if someone wants what another individual produces? Let us imagine we are born into a society which uses a barter system in which undesired goods or services are traded directly between agents for other desired goods or services.

At first, it might seem simply enough. In fact, it’s the most basic system and — even in commercial economies — it happens all of the time. Individuals often trade commodities directly with each other, mostly between friends and family, but not restricted to those. Over the internet, an individual will easily find another which is interested in some direct trade.

A barter system may be best indicated for closed communities that are self-sufficient, but it becomes rapidly cumbersome in a larger society. Let us suppose there is a village with five people and their possessions and desires are described in Table 1.

Name Possession Desire
John Cows Honey
Peter Honey Carrots
Sara Chickens Fish
Kate Carrots Milk
Adam Fish Pork
Table 1 — Description of the possessions and desires of some individuals.

Suppose now that Peter wants some carrots and Kate is the one who has some to trade, but she has no desire for the honey that Peter has. How can Peter acquire the carrots? He must trade his honey for milk with John and only then can he trade the milk for Kate’s carrots. But think about Sara who whats fish but Adam, who has fish, doesn’t want Sara’s chickens. Sara would need to search for some pork to trade with Adam and that could take a long time — long enough that Adam might have no fish left and must wait for the next fishing season.

Sara’s solution would involve being in debt with Adam and promise to repay him at a later time — this is the basis of all modern currency, everyone is always in debt with everyone else. The barter system is thus very restrict and does not allow for many things such as the measure of value and accumulation of wealth. In the first case, when Peter acquired milk to trade with Kate, milk had become commodity money.

Commodity money

In pre-revolutionary America, beaver fur, wampum, fish, rice and, in particular, tobacco have been used as commodity money, according to Rothbard (2002). Another famous example is the economy of a prison, where there small society of inmates must abide to the laws of the prison and commodity money is a vital part of that. In Prisoner of War (POW) camps, Radford (1945) documented cases of cigarette currency that was subject to Gresham’s law, inflation, and especially deflation.

Commodity money are goods that can be used as a medium of exchange, but also hold value in themselves and can be consumed. Some examples include gold, silver, copper, salt, shells, alcohol, cigarettes, cannabis, candy and cocoa beans. The individual recognises the utility in the commodity as constant and it gains several advantages over the barter system, because it creates a benchmark. Take the economic principle of metallism, a term coined by Georg Friedrich Knapp to describe a monetary system in which the money derives its value from the type and quantity of metal of which it’s made.

For example, a gold coin holds the same value either in coin form or if it’s melted. On the other hand, Friedrich Freiherr von Wieser says that even metallism isn’t as simple as it seems, because the actual value of the commodity on which the money is based is a duality between its industrial value and its exchange value, according to Von Mises (1954). In January, 1999, Portugal was one of the first countries to adopt the new Euro currency. Even if coins and bills only began to be physically exchangeable in January, 2002, the Euro was already used in non-physical money exchange.

Throughout the history of civilization, there have been several attempts to unify several countries into a single currency. Europe is no exception, with the 19th-century attempt called the Latin Monetary Union (LMU). According to Bae and Bailey (2011), the first treaty was signed between France, Belgium, Italy and Switzerland in 1865. Even if, at first, accomplished very little, it lasted for 60 years and reached an end in 1925.

The gold standard

The LMU was a gold standard monetary system in which the government sets a fixed conversion ratio for a direct conversion between currency and gold. The LMU began as both a gold and silver standard. Afterwards, the decreasing value in silver made the Union a de facto gold standard. This type of monetary system, even though it uses commodity money, has a fixed conversion ratio which makes it vulnerable to abuse. The actual value of the metal from which coins are made has fluctuations that depend on the overall available amount. As such, the value stamped may not be a true representation of the coin’s metal value.

If, for example, there is a large supply of gold, the value stamped may be higher that the intrinsic metal value per its weight. According to McLeay et al. (2014b), 16th-century Spain experienced this problem of high inflation after the imports of large amounts of gold and silver from the newly discovered Americas.

The LMU and other monetary systems alike are subject to attempts of abusing the system. Countries could, in theory, produce metal coins of a reduced purity and then trade them for standard coins, thus making a profit and, in fact, the LMU experienced problems like these, as described by Bae and Bailey (2011). Despite the clear advantages of the gold standard, specially for unions like the LMU that benefit from fixed international exchange ratios, nearly all of the modern monetary systems are based on fiat money.

Fiat money

Fiat money is money that is based on faith and is irredeemable. More precisely, its value is totally determined by some authority and has no use other than as a medium of exchange. Even metal coins can be fiat money, if its printed face value does not meet its real metal value. For that reason, it has a high risk of becoming worthless due to hyperinflation.

According to Hanke and Kwok (2009), the first recorded hyperinflation occurred during the French Revolution — monthly inflation reached values as high as 143 percent — and the 20th century witnessed 28 hyperinflations — mostly due to the world wars and the communist era. One of the most recent and known cases is the Zimbabwe’s hyperinflation — it has become the first hyperinflation case of the 21st century — of 2007-2008, reaching peak monthly rates of 79.6 billion percent — despite this astonishing value, Hungary still holds the top position at the world’s hyperinflation league table.

The inflation came to an end when people stopped accepting the Zimbabwe dollar and it became worthless. In general, if the issuing authority loses the ability to guarantee the value of its money, it loses all of its value. In reality, that may not always be the case, as Foote et al. (2004) noted. In northern Iraq, the Kurdish area used for its currency the so-called “Swiss dinars,” even though its value was not backed up by any authority.

The regional government had no access to the Swiss dinars’ printing plates and it refused to adopt Saddam’s currency, thus fixing the supply of money. This gave the region some inflation stability, before the dinars began to fall apart due to overuse. According to Schumpeter (1954), the idea of a monetary system based on paper money and disconnected from gold can be traced to the ideas of David Ricardo (Proposals for an Economical and Secure Currency, 1816), but it has taken us quite some time to achieve that.

What is acceptable as money?

We have been through an overview of what money is through a variety of situations, but money can be anything that someone accepts as payment for some good or service — it can even be just a debt, a promise of a future payment. McLeay et al. (2014b) suggest that money should meet three basic criteria, namely it should:

  1. Be a reliable store of value, some non-perishable good that retains its value over a reasonable amount of time;
  2. Serve as a unit of account, that is, serve as an absolute quantizer for the prices of goods and services to be described in;
  3. Be an accepted medium of exchange that people trust and hold on to in order to exchange it again later on.
As previously defined, this money can help resolve the problems of a barter system. Remember the village I described before. Sara wanted some fish from Adam, but she couldn’t afford it with the goods that she had nor by any kind of bartering with the rest of the people in the village. Her solution would be to enter in an agreement with Adam in which she would acquire a debt with him.

Imagine now that, later on, Adam wanted some honey from Peter but Adam lacked the carrots that Peter wants. Adam could, for example, transfer Sara’s debt to Peter — because everyone trusts everyone in the village, Peter knows that Sara would always honor her debt, should he ever desire chickens. In this situation, Sara’s debt has become currency — an accepted medium of exchange that fulfills the three requirements mentioned above.

So long as Sara lives and raises chickens, her debt will retain its value and it can even be used as a unit of account and a medium of exchange. Peter could say to Adam that 10 liters of his honey is worth 3 chickens from Sara. If Sara owed Adam for 10 chickens, he could split her debt with Peter and Sara would now owe Adam 7 chickens and Peter 3 chickens. This could carry on for a long time — between more people — and even though Sara backs up her debt, she hasn’t actually paid anything to anyone yet.

This kind of debt exchange is behind the gears that drive the modern monetary system and what we are so used to call money. Since modern currency is not tied to gold, the central bank won’t trade it for anything other than more currency — should the banknotes suffer from wear and tear, for example. Money is just debt from the central bank to the consumers.

The creation of money

As McLeay et al. (2014a) put it, there is a misconception on how money is created. This misconception is as follows: every time someone makes a deposit in a bank, the bank uses it to make a loan for someone else. In practice, thought, the loan is itself the creation of money and that power most often falls onto a commercial bank.

This does not depend on the deposits that some particular commercial bank holds, but there are limits to the loans that it can make — or to the amount of money it can create. As I’ve explained before, modern money is debt, in this case to a particular bank. Money can thus be as easily destroyed as it can be created by using it to clear out the debt to the bank. Bank deposits are debts from the bank to its costumers and bank loans are debts from the costumers to the banks.

A bank cannot use its debt to someone to make a loan, it just creates a new deposit — with the same amount as the loan — and increases the overall available money — also known as broad money. The central bank then makes sure there is always enough money for everyone and supplies reserves to commercial banks as they provide loans. If, in the village example, Sara were to pay her debt to everyone in the chickens that she owed, all money would be destroyed and the whole village would go back to the barter system.

The meaning of money

Throughout this essay, I’ve been talking about what money is as a human creation in the economy. The criteria to define something as money is so flexible that most anything can be money. Money makes no sense without human society, be- cause it’s a consequence of the convergent ideas of different people. It may be hard for one person alone to fully understand the idea of what money is, because not everyone sees it the same way. What is money? What does money mean to us?

To Mitchell and Mickel (1999), money is more than just an inert thing based on the idea of barter, but rather possesses subjective and affective meaning as well. This interpretation is not without foundation, because we are so used to hearing the stories of people who’ve done both amazing and horrible things in the name of money. Why is something not essential to our basic survival so important that it can even overcome our most primitive instincts?

Money was created, even if it seems to have spanned naturally, to ease trans- actions — both present and future. As a side effect of an accepted medium of exchange, that everyone takes for granted, people know that it is what everyone has come to value. It doesn’t matter where it came from: if you worked for it, inherited it or took it from someone else, because some merchant or bank will still accept it as credit — ignoring the fact that there are ways to discover if certain banknotes were stolen such as the serial number.

Back to the Village example, imagine that Kate stole some of Sara’s debt from Adam. She would now have money to trade with someone else, ignoring that in such a small community she’d be easily caught.

If we were to attribute an expected utility value to human life and money, there should be no argument against the fact that the first should be larger than the second or `E["human life"]>E["money"]`. The work of Fagley and Miller (1997) suggests that, when presented with a gamble, subjects were more risk adverse to- wards money and made riskier decisions when faced with human life. This is some- what counterintuitive, but it parallels with the findings14 that financial planners take more risks with their own money than with their clients’. We can put it as `E["own money"]>E["client money"]` and it seems that as the expected utility grows, so does the willingness to take risks.

If we take a moment to think about it, one common idea is that wealthier people are less willing to part with their wealth than those who have substantially less. Whether this is true or a misconception is hard to tell. It remains to say that money means a lot to us. Even if we don’t understand it or its significance, we know its usefulness.

Final thoughts

Money can have an overwhelming impact on our lives and we take great risks to have more of it. We have casinos and the lottery, because the idea of instantly becoming extremely wealthy is intoxicating to the point of making us forget our most basic survival instincts such as food and sex (Krueger, 1986 quoted by Mitchell and Mickel, 1999).

Even if the concept of money emerged as a purely inert entity that gains its meaning from transactions — as it flows from one place to the other and back — it quickly became something that affects our own behaviour and emotions. The study of money should also include those factors, as it has become an essential part of any modern human society.

We’ve seen the evolution of money from commodities to the hard to define thing that it has become nowadays, mostly invisible and still everywhere around us — we’re now allowed to carry huge amounts of currency summed up in a plastic card.


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