Money – What is it?


What is Money?

What is Money?

Ask 10 people to define money and you will probably get 10 different answers!  Similarly listen to the different answers when asking people how money comes into existence.

Without appropriately defining terms, any serious discussion about money is open to misinterpretation and misunderstanding.  These definitions may be familiar to you, and will be used in these “Economic Alchemy” discussions.

Attributes of Money

Money is a human invention originally created as a representation of the quantification of value for the purpose of facilitating trade.

The ideal attributes of money are:

  • A common medium of exchange
  • A unit of account
  • A stable store of value – over the short and long term.
  • Portable
  • Durable
  • Divisible
  • Interchangeable
  • Tamper proof

Throughout time societies have chosen various things (instruments) as money.  For Example: shells and stones, various grains, salt, coins of various metals, printed notes and bills, and numbers on a computer screen.  No monetary instrument, past and present, has been able to satisfy all these attributes.

There are two degrees of separation between the value of things and money:

Value (of things) –> Numbers (quantification) –> Money (tangible instruments)

Much of the problems the world is experiencing with money has been with the manipulation of the “Numbers”.  But because we normally see money as directly representing the value of things (that is one degree of separation), we find it difficult to understand the money / value relationship.

Common Medium of Exchange

Any  group of people wishing to trade could agree on an instrument to use as a common medium of exchange.  This agreement could be by mutual consent or by legal decree.  Mutual consent is where everyone in the group agrees to the instrument being used as money.  Legal decree usually occurs where the instrument (usually coins and notes) are legislated and created through the government or central bank and the instrument’s value is enforced by law.

Legal decree instruments mostly have fractional or no intrinsic value.  That is why they require laws to enforce their value.  Their value is usually recognized differently by other groups of people.  Currencies currently in use around the world are examples of legal decree instruments.

Unit of Account

Money has a denomination printed or stamped on it, indicating the units of account it represents.  Weighing grain or salt served the same purpose in earlier times.

Stable Store of Value

Money retains it’s value over time.  The same amount of money buys the same amount of goods and services now, as it did a thousand years ago, and will do in a thousand years time.

Inflation reduces the purchasing power of money, requiring more money to purchase the same amount of goods and service in the future.  Commodity items used as money such as gold, grain or salt can fluctuate in value due to external situations.  Items that are susceptible to inflation or fluctuations over time are not stable.  The US dollar has lost about 97% of it’s value since 1900 in relation to gold.

[ASIDE]  Is is important to recognize that inflation is the reduction in purchasing power of money and not the increasing value of things.  An apple that cost a penny in the 1920’s and costs a dollar in 2017, is the same apple with the same nutritional value and availability.  It is the reduction in the purchasing power of the dollar that has caused the illusion of the value of the apple to increase.  The apple has not increased in value, because of the reduction in the dollar’s purchasing power, it takes more dollars to buy amount of goods as before.

Portable

Money is easy to carry and transport.  In modern times things are much easier where we carry the value of money in our debit and credit cards.

Durable

Money does not wear out, breakup, disintegrate or decompose.

Divisible

Money can be divided into different denominations without any change of value.  For example a single $100 bill, five $20 bills and twenty $5 bills all represent the same value.

Interchangeable

A dollar in your hand is worth the same as a dollar in my hand.

Tamper Proof

It is impossible to debase, forge or counterfeit money.

What is Currency?

Currency is simply the money of a country.

Types of Money

All the money that has been and is in existence falls under into one of the following types:

  • Commodity Money
  • Receipt Money
  • Fractional Money
  • Fiat Money

A short fable (which somewhat matches history) tells about the evolution of money.

“The Goldsmith Dynasty”

Commodity Money

A long time ago, Mr. Goldsmith observed people people using gold and silver as mediums of exchange.  This was much better than bartering, or using other commodities like salt, shells or stones.  However without an accurate scale and assaying ability, the amount of gold in a trade often was in question.  Being an astute enterprising man, Mr. Goldsmith realized that trade would be a lot easier if gold was standardized in weigh and purity.  Mr. Goldsmith started minting coins in various denominations with guaranteed purity.  These coins were very attractive to traders who gladly exchanged their gold for the gold coins.  Mr Goldsmith had created a new revenue stream for himself, charging for the service of minting the coins.

Receipt Money

The easy to use gold coins were also vulnerable to theft.  People new that Mr. Goldsmith had a securely guarded vault, and for a small fee, stored their money there.  Thus creating another revenue stream for Mr. Goldsmith.  Mr. Goldsmith issued deposit receipts (effectively claim checks or I.O.U.’s) to the people for the gold stored in the vault.  The bearer of the deposit receipt could always redeem the amount of gold specified on the receipt.  Soon people started using deposit receipts as a medium of exchange.  These receipts were “as good as gold”.

Upon observing people trading with deposit receipts, the astute Mr. Goldsmith realized that if deposit receipts were made in similar denominations as gold, trade with deposit receipts would be much easier and convenient.  Thus the evolution of deposit receipts into receipt money.

Mr. Goldsmith, also had a loan business division, where he lent gold charging interest.  As receipt money came into acceptance borrowers began asking for their loans in the form of receipt money rather than gold.  There was an implied relationship that the receipt money issued as debt was backed by the same representative amount of gold in Mr Goldsmith’s vault.

Fractional Money

Mr Goldsmith noticed that depositors very seldom redeemed their gold, and he was holding much more depositor’s gold than his own.  He reasoned he could earn a whole lot more interest, if he also issued deposit receipt to borrowers against his depositors’ gold.  Although duplicitous (2 gold receipts issued against the same gold), the rewards greatly outweighed the risks.  To cover his risk, he took steps to ensure the credit worthiness of his borrowers and that he had small reserves set aside for loans that defaulted and depositors wishing to withdraw their gold.  His depositors were none the wiser.  Thus the evolution of deposit receipts into fractional money.

A deposit receipt is a financial instrument, it only represents a item of value, and is not the item of value itself.  This makes it possible to create more than one deposit receipt against the same gold deposit.  Just because it is possible to do, does not necessarily make it right to do.  This is a covert “money magic trick” by the bankers.  Without an internal audit of Mr. Goldsmith’s accounts, it is impossible to determine that a deposit receipt has been issued against Mr. Goldsmith’s gold or the gold of his depositors.

In time Mr Goldsmith became exceptionally wealthy.  His depositors became suspicious, thinking he was spending their gold.  The depositors demanded their gold back, fearful that Mr. Goldsmith would not have their gold.  Mr. Goldsmith showed the depositor that he indeed still had their physical gold.  The truth (or illusion) of the situation was that Mr. Goldsmith had twice issued deposit receipts against the gold, one to the depositor and the other to a borrowers as interest bearing debt.  That is, for example Mr. Goldsmith has issued $2,000 in deposit receipts to Mr. Depositor, and $2, 000 to Mr. Borrower (i.e. $4,000), backed by only $2,000 of Mr. Depositor’s gold.  Thus the deposit receipts are fractional money backed by 50% reserves.

The depositors insisted they get a cut of the interest that Mr Goldsmith was charging borrowers rather than paying a fee for the safe keeping of their gold.  This worked out quite well for Mr Goldsmith, who could have been mauled by the depositors.  Although he was earning less net income on depositors’ gold, he gained access to more gold from depositors by paying them interest for their deposits.  This outcome may appear more fair, but it also makes the depositors accomplices to Mr. Goldsmith’s deception.  Both the depositors and borrowers still have deposit receipts in hand for the same physical gold.

Mr Goldsmith had created the first bank, paying a lower interest on the deposits of other peoples’ money and lending the money at higher interest to borrowers.  The difference in the interest received and interest paid, covered Mr. Goldsmith’s operating costs and profits.

Fiat Money

The more Mr. Goldsmith’s wealth grew, the more he wanted and the more more brazen he became.  Demand for credit was increasing as the world was becoming industrialized and Europe spread out across the world.  Mr. Goldsmith’s bank continued issuing deposit receipts as interest bearing debt against nothing.  He reasoned that so long as all the deposit receipt holders did not come to the vault to redeem their gold at the same time, no one would be any the wiser.  All this debt being issued backed by nothing continued to reduced the fractional reserve of the bank until it all but vanished.

Over time Mr. Goldsmith’s ostentatious wealth again attracted the suspicion of the deposit receipt holders, who on mass demanded their gold.  The sea of deposit receipts being claimed depleted the small amount of gold at the bank.  This was the very thing Mr. Goldsmith dreaded, unable to honour the deposit receipts, Mr. Goldsmith had to close the bank.  This is known as a run on the bank.  Not only did it put Mr. Goldsmith’s bank out of business it ruined the livelihood of the deposit receipt holders who saw their wealth evaporate.  The deposit receipts were worthless as there was no bank to honour them.

Being burned by the run on Mr. Goldsmith’s bank, the people lost confidence in banks and bankers. This could have been a good time to outlaw the practice of creating money from nothing.  But because the success of the European continental expansion needed the volumes of credit the banks were extending, governments intervened legalizing and regulating the banks.  This is still the current state of play in most of the banking world.

 

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