What is money?
Well I promised I’d do a series on the money supply so here it is at long last. I hope you enjoy it. I’ve split it into 4 sections to make reading easier. As I’m still working on the others, albeit they’re almost done, I’ll post them one-by-one. I’ll start by discussing what money is, what it was and what it needs to do for us.
Money serves 3 functions:
- A ‘medium of exchange’, ie you can swap it for other things
- A ‘store of wealth’, ie you can save it up to buy stuff with in the future.
- A unit of account, that is a standard yardstick to measure transactions, debts and values
So why is it good to have a medium of exchange? I work as a banker and I’m starting to get a little hungry; pretty soon I’ll want to get some lunch. If I was going to barter my services I’d have to go round the local noodle joints until I found someone who needed a little banking doing and then swap that for some lunch. That would take time and effort on my part, time I could be using to do productive work….or surfing the net at my employers’ expense of course.
Instead of that, I can use money as a standardized way across the economy to exchange people’s labour and property for other things. Using money I can compare prices quickly and simply and I can buy from who I want rather than being forced to use the person who happens to want what I have to sell. I sell my labour to my boss in return for money which I can then spend.
What about the store of wealth bit then? I want to take the wife and kids away to the Gold Coast in October. Under a barter system, I’d have to work my way up there as an itinerant banker, offering banking services to people on the way. I might be able to get food by telling humorous banking anecdotes in restaurants (perhaps not on reflection). With a system of money, I can put a little away from each paycheck and store up wealth which I can then exchange for my holiday essentials: petrol, meals, hotel rooms, budgie smugglers and cold beer.
‘A unit of account’ means that it is a standardized way to measure transactions. All money in a system must be easily exchanged for other money in the system and divisible without loss of value, for example a pound coin can be swapped for 2 50pence coins and those 2 50 pence coins back to another quid. As an addition to that, money is helpful as a standardized way to settle a debt. If agree to sell you a car on credit, with a barter system I may agree to receive a tonne of wheat. What if the wheat is of poor quality? It complicates things. However, as all money is the same or ‘fungible’, it doesn’t matter which particular bank note or coin you use to repay me.
Many things have been used as money in the past: cigarettes and phone cards are commonly used in prisons as money (or so I am led to believe); the shekel, now the name of the Israeli currency, was a unit of weight (typically for barley); and precious metals were used through much of the world at times.
In time, the direct use of precious metals gave way in the
In time, banks realized that most of the time they wouldn’t be asked for more than a fraction of the money in their vaults to be returned. This meant that for each unit of gold lodged with them, several units of money could be issued. The biggest problem is that under the fractional reserve banking system, banks can have liabilities to their savers that exceed the cash assets held in the vaults. If everyone wants their money back at once, a so-called run on the bank, the bank can’t do it and will go bust. Fractional reserve banking is also a way to produce money from ‘thin air’, a topic to which I will return.
Mostly these days, people use a system of ‘fiat money’. Fiat (the Latin word for let it be done) means ‘by decree’ or ‘by order of the authorities’ so fiat money is money that exists by Government diktat. Rather than the money being exchangeable for something physical like gold or silver, it is backed by nothing more than a promise that the money has value because other people will take it in exchange for real goods and services.
Some people believe that all fiat money systems will fail in the end as all failed fiat monetary systems failed in the end! I have my doubts as this seems like a circular argument to me. Then again, the