What is money? (Part I)January 24th, 2012
Oh yes, we’re tackling the big question today. No more subtly alluding to a certain view of money and economics while assuming you “get it” too. I’m going to break it down to the fundamentals here and do so as painlessly and simply as possible. If you’re an advocate of “sound money” or “honest money” and you want to understand your own views better or find an easier way to explain them to others, read on! If you have a friend who is new to this kind of economic thinking, this might be a good article to share with them. Economic thinking isn’t hard. In fact, it’s quite natural and intuitive in a lot of ways. People who make it more complicated than it really is are doing so to keep you from thinking about it and to convince you that you can’t really understand it like they can. Knowledge is power. So the less honest stewards of economic thought have decided to keep that power to themselves by making the knowledge seem unattainable to people without advanced degrees or Nobel Prizes. Don’t be intimidated! Finance and economics are for everyone.
Here are just a few of the basics:
What is money?
Money serves three purposes:
1) Money is a medium of exchange. People use money to exchange things with each other. Without money, the only way you and I could exchange is by barter. I give you something you need and in exchange, you give me something I need. The only problem with bartering is you would have to have exactly what I need and I would have to have exactly what you need, which doesn’t always happen. In fact, it doesn’t often happen. If I’m a farmer who needs metal farm tools because my old ones rusted, and you’re a baker who needs my wheat to bake bread, you don’t have anything to offer me that I need in return for my wheat. But with money, we can solve this problem. You can give me a small gold coin for my wheat so that you can make bread. I can take that gold coin and give it to a smith who makes metal tools and then I can use those tools to cultivate more wheat. After a hard day’s work making tools, the smith can put that gold coin in a safe where he keeps the rest of his money, then pull out a silver coin from his safe and give it to the baker for a few loaves of bread to feed his family.
Money allowed the three producers in the illustration above to transcend the linear, two-way barter system and create an entire ecology of exchange. Of course this is just a simple illustration. Imagine in a modern economy, all the hundreds of different occupations that serve various human needs and interests and how a money system (or monetary system) unites their collective effort and helps them to cooperate as a whole simply by spending their money on whatever things each producers wants. Money acts like a clearing house, making sure everybody’s product gets to everybody who uses that product, even if the end user doesn’t create something that the producer wants in exchange. They can simply accept payment in money and give it to another produce who does make something that the first producer wants. Money allows for (and inherently assumes) economic specialization: that individuals will specialize and produce goods in their own area of passion and expertise.
In his book, The Wealth of Nations, Adam Smith demonstrated that specialization and exchange allows human beings to produce far more than they ever could if they never specialized and every person simply made all the things that he or she needed his or herself. I cannot recall which economist said this, but I remember hearing once that an economist estimated that in a modern economy like ours, you consume more in one, single day than you could ever produce in an entire lifetime all by yourself. By specializing, we become better producers. By exchanging the surplus product of our specialized efforts with each other, we make sure that all our needs are met even though we may only produce one thing ourselves. Money facilitates this process and, by its very nature, assumes this process is happening. Money acknowledges that we’re individuals with different interests. It also acknowledges that we’re social and cooperative– that we can work together and use our different interests collaboratively to achieve a resulting lifestyle that none of us could ever create all alone on a desert island. Money does all that, simply by being a medium of exchange.
2. Money is a unit of account. Money helps us measure. It is the yard stick of economic activity. Just as it is important in the course of human activity to measure things like height and weight, it is important to measure economic value, or market value. By using money as a medium of exchange, humanity graduated from a simple, linear, two-way barter system as explained above, and created an entire ecology of exchange. We can call this network of specialized producers collaborating to serve each other’s needs through a monetary system: a market. What is a given product’s value in the market place? Which is to ask: What is the value of a product relative to all the other products in the market? How many barrels of wheat is a metal farming implement worth? How many loaves of bread is it worth? How many freshly caught fish is a handful of metal nails worth? How many rolls of cotton fabric is finely-crafted, wooden chair worth? The number of comparisons is bewildering to the imagination. Money can solve the problem. Just as it is a clearing house for the differing wants of specialized producers, it is also a clearing house for the differing relative values of all those producers’ many products.
A finely-tailored, brand-name suit is worth one ounce of gold? A restaurant dinner for two is worth one ounce of silver? By measuring the value of any given specialized product in terms of money, we can easily ascertain its value relative to other products by measuring them against the same money supply. Why does a certain good have a certain value (which is to say, a certain price)? Value in a market is a function of the scarcity of a given product and the preferences of those who produce the product (supply) and those who exchange money for the product (demand). The nice suit and the resources used to produce it (like the expertise of the tailor) might be more scarce than the restaurant dinner and the resources used to produce it, so it is more valuable than the dinner and the tailor will require more money or more scarce kinds of money (gold is more scarce than silver) in exchange for it than the restaurant will require in exchange for preparing and serving the dinner.
This is how money recognizes the principle that is at the foundation of economics: that human beings have scarce resources or means to fulfill potentially unlimited wants. Money, by acting as a unit of account, measures all of these various scarce means and wants against each other and determines their relative value in a market of exchange on the basis of their scarcity and the human preferences that shape supply and demand. By acting as a unit of account, money acts as a rationing mechanism to direct scarce human resources and actions toward their most productive ends. This is how money solves the problem of how much of each good is worth how much of every other good to facilitate exchanges of products in quantities that are profitable and fair to all producers.
3. Money is a store of value. Money allows us to save. In this way, money acknowledges that humans can produce more value than they can consume all at once, especially because money facilitates the process of specialization and exchange that maximizes human productivity as explained above. Instead of merely subsisting, or producing exactly as much as is needed to survive, human beings create surpluses– more than we need for bare survival. Specialized producers trade the surplus product of their efforts to each other for other specialized products that they need, but did not produce themselves. However a fisher can’t simply store his or her surplus fish and trade them away in a month. They would rot. The fisher instead takes the fish to market and exchanges them for money with everybody who wants fish that day and plans to consume it before it rots. The money then, such as pieces of silver, can be held for a month without rotting like the fish would.
In the illustration above, money allows the fisher to forgo consumption now in favor of consumption (or investment) later. Money allows the fisher to store value in a reliable medium that will not lose its value over time the way fish would by rotting. Money allows the fisher to save. This is important because it recognizes the principle that a human being might value the future means to fulfill wants more than present consumption of those means. The fisher might need an emergency store of value for consumption during an unexpectedly bad month of fishing, or may be saving up to buy a better boat in a year that will allow the fisher to catch more fish with fewer hours of work. In this case, the fisher would be saving to invest in capital (which would be the better boat in this case), instead of simply deferring consumption to the future.
Whichever choice the fisher makes, the ability to store value in a reliable and durable medium is what makes it possible. It also makes something else possible, something positively magical: By acting as a medium of exchange and a unit of account, money allows the specialization of a modern economy that has created such an explosion of material wealth and prosperity, but by acting as a store of value, money allows producers to collaborate in an even more productive way. They can pool their stored value together, the surplus product of their labor converted into money, and use it to acquire capital that increases all of their productive possibilities, but that no single one of them could afford alone with their own surplus savings. They could build a sky rise office building to cheaply rent out to businesses for profit. They could create a factory with an assembly line that allows workers to make ten times as many manufactured products in half the time it would take them to make the products by hand individually. They could start a new business together that would create a lot of valuable products, but which needs start-up funds until it becomes profitable. By functioning as a store of value, money allows producers to become investors or capitalists by pooling their money in joint ventures to acquire capital and chase down big ideas and possibilities that would be unattainable by any individual working alone.
Conclusion: Money is one of the most important innovations humankind has ever conceived. It has made possible the unprecedented standards of living enjoyed by modern human beings over our barter economy predecessors. By acting as a medium of exchange, money allows human beings to specialize and trade their specialized products in a market, which allows them to pursue personal interests while producing more than they ever could otherwise. By acting as a unit of account, money helps direct human action to its most productive ends by elegantly and accurately signaling the relative scarcity of all the various means and ends in a market. By acting as a store of value, money allows human beings to enjoy the surplus value made possible by their increased productivity by saving for future consumption, or by saving for investment, which allows them to become even more productive.
Something as important as money should be carefully studied and understood by everyone who uses it and profits from its unique and spectacularly empowering features. In this article, we examined the three purposes money serves and how it serves them. In Part II, which will be published later this week, we’ll take a look at what characteristics money needs to have in order to serve these purposes well and decide what kinds of money are “good” or “sound” or “honest” money, and what kinds of money are ill-suited to carry out the three purposes examined here in Part I.
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