What is money?

The primary function of money is that of a medium of exchange, and secondarily as a store of value. It allows us to progress beyond barter, and buy and sell goods we otherwise not be able to. Money is a good that forms one side of all transactions.

Throughout history, money has tended to be gold or silver, although it has been many other goods too – perhaps most famously cigarettes in POW camps. If you had gone to a market in ancient Rome, and presented a colourful piece of paper with Caeser’s head on it, you wouldn’t have been able to buy anything.

Our modern money systems have evolved from a pure commodity system, where gold and silver are used directly in payments, to a system solely based on paper, with nothing to back it up. In the past, you (in theory at least) could take your ten pound note to the Bank of England, and get gold in return. Try doing that nowadays!

In a barter exchange, both parties are exchanging useful goods – perhaps a butcher and a baker are trading beef and bread. Gold became accepted as a medium of exchange because it is rare, difficult to produce, and is a very good store of value. Items of food wouldn’t last long enough!

As banking developed in Europe after the Renaissance, it became common for banks to issue receipts to gold, to save hauling around all that heavy metal. Over time, such pieces of paper became accepted as money itself, and gold was used less and less. However, the only reason these banknotes were trusted was because they were backed up by a tangible asset. This process was abused, but nonetheless was largely successful. Governments increasingly decided to take over the issue of paper money, but retained the backing of gold. Although governments often manipulated the gold standard, it was able to keep control of inflation very well.

In the 20th century, the gold standard was gradually removed, and came to a complete end in 1971, when the system known as Bretton Woods was ended by Richard Nixon. Since then, as seen in the graph in my earlier post, Why are Central Banks Harmful, inflation has gone through the roof.

Our current fiat money system is based solely on paper, with no commodities to back it up. It only exists because of legal tender laws – without these, the market would rapidly switch to commodity based money. Governments can now print money without limit, and the effects have been devastating.

Can we trust government to control their printing presses? Are recent rounds of quantitative easing just the beginning? We’ve been on a worldwide paper money experiment for 40 years, and the strains are now clearly showing.

As stated at Freedom at Bethsaida:

What does this say about our fiat money system? Currency is a store of excess production (you have produced but not yet consumed, and are storing it as an agreed-upon medium of exchange – the currency). If the government can create mounds of this stored productivity out of thin air (whether by traditional printing or just by changing a couple of lines in a balance sheet), then what does that say about our measures?

It’s not like they actually produced anything when they created this excess store of production, right? They just printed paper money. They just changed the scales, the measures, the standards.

Why such creation of money is so dangerous, as well as immoral, we’ll explore in future posts on inflation.

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6 Responses to What is money?

  1. Torn Halves says:

    I know diddley squit about economics, but I am trying to understand the problem with fiat money. I find myself imagining an alternative scenario in which fiat money seems fine and dandy. People do useful labour. They create something of value for society – let’s say they build a school, a hospital, a dam or start producing a new touch-screen gadget. Instead of giving them food and shelter, a spare shirt and trousers in return, the central authority prints a few more notes and hands them over to the labourers. The face value of the notes corresponds reasonably well with the (arbitrary but socially accepted) value of what their labour has produced. Through their work the sum total of real (arbitrary but socially accepted) value in society went up, and then the money supply rose by a similar proportion.

    In a system like that I can’t see why it matters if the money is only difficult to forge pieces of paper, or even just binary numbers in a digital bank account in a completely electronic economy in which there is no physical currency whatsoever.

    • andyfrith2 says:

      By printing more notes over time, the value of the individual notes then decreases, causing price rises and (as will be discussed more in later posts) causes problems in the structure of the economy, and leads to business cycles. Unbacked fiat money has never been accepted in history voluntarily, it has always required legal tender laws to force unwilling populations to accept it. This, and the fact that societies have tended to use commodities (gold, silver or other goods) in history, suggests that people have always preferred something to back up the currency. This is not to say that we need to carry around physical gold coins all the time – it is enough to allow the paper or digital currency to be redeemable in gold, and we can continue to enjoy the benefits of internet banking, debit cards etc.

      Your scenario paints a rather worrying picture of a society where a ‘central authority’ pays everyone for their work – this would be a bureaucracy with fearsome power. Do they determine what the value of your work is? How would this authority be held to account?

      In practice, giving central banks authority to print money has resulted in numerous hyperinflations (Weimar Germany and contemporary Zimbabwe probably the most famous examples), which utterly destroy the economy, resulting in mass unemployment and destroying the savings of millions. There is nothing to stop the Bank of England doing this today, apart from trusting them not to! It doesn’t exactly inspire confidence…. The other key problem, as seen in recent Quantative Easing programs, is that the printing of new money goes to banks and the government, who can profit and spend money at virtually no cost, whilst everyone else in society sees prices rise. It’s a stealth tax. As central banks were created by governments and the banking industry for the benefit of themselves, this is no surprise.

  2. Torn Halves says:

    You make two points: one about inflation and another about totalitarianism. I think I understand the point about inflation. If the (arbitrary but socially accepted) value of stuff in society remains the same and we increase the money supply, prices will rise because shopkeepers will see that they can demand more for their goods, and so the value of the curency goes down. But in the alternative scenario I described the money supply is only increased once the sum of (arbitrary but socially accepted) value in society increases. Surely, for prices to be stable the money supply needs to keep pace with the growth (or decline) in the real value of the stuff and services that the labourers produce. I see no reason for inflation there.

    The application in relation to the current crisis would be to pay people for genuinely useful public works programmes (as an alternative to letting money enter the economy through the banks, thereby increasing the level of debt).

    About totalitarianism: That is a matter for political judgment. I am writing from Greece where public life has been stifled for a long time now by a pressing need to do whatever will please “the markets”. Effectively Greek sovereignty has been annulled. This doesn’t feel like freedom. I am all for elements of the free market system, especially insofar as it involves a devolution of power and allows for initiatives from below (from the grassroots rather than from the boardrooms of conglomerates). But freedom at the political level surely means democracy, and doesn’t that provide an answer to your question about how a central authority should be called to account?

    • andyfrith2 says:

      What is the reason for maintaing stable prices? As supply increases, we expect prices to fall, which allows everyone to enjoy a greater standard of living. By printing money to pay for new goods, prices no longer fulfill their key role of information. If we double the supply of tomatoes, and demand is unchanged, prices will halve (give or take). This change is price is very valuable information for consumers, producers and investors. If we maintain the price of tomatoes at their previous level, we are giving false signals to the market.

      Democratic accountability clearly hasn’t prevented the Federal Reserve, the Bank of England or the European Central Bank from causing significant inflation or causing business cycles by manipulating interest rates. The problem in Greece was caused by a population and government wanting to spend beyond their means by borrowing from other countries. Reality has now caught up with years of illusory wealth. Successive governments borrowing money to fund a large public sector is the primary cause of Greece’s current woes.

    • andyfrith2 says:

      Apologies for a double response, but there are two further points I want to make.

      Prices are not arbitrary but socially useful. They are determines by supply and demand. It is true that value at an individual level is subjective, but market prices are more objective.

      Printing more money, even if is does not result in price inflation, due to new goods being created, still devalues the currency from where it would have been. The new money benefits those workers who receive it, but to the cost of those who did not, as without the new money prices would have fallen, so more could have been purchased. This is why printig money is always a stealth tax on whoever does not receive the new money, regardless of the corresponding increase in goods.

      • Torn Halves says:

        There is nothing much else I can usefully add because as I said I have no expertise in this area.

        But to clarify:

        1. About the tomatoes: When talking about stability I was really just talking about the absence of inflation, not a world in which prices never changed or responded to variations in supply and demand.

        2. About democratic accountability of the body issuing the means of exchange: I have in mind the idea of publicly-owned banks, as argued for by Ellen Brown (if I understand her correctly). For you (I guess) that would be a totalitarian nightmare. For radical democrats, it might promise something a tad better than what we have now. But there are no guarantees in history, of course, and a democracy is only as healthy as its people and culture.


        3. Greece: The population (and perhaps the government) were persuaded and cajoled into spending more than they had. Of course they didn’t have to be cajoled much. But the telephone was ringing frequently with bank clerks offering credit cards, and the TV was full of advertising for easy loans, and there were lots of tax breaks.

        For market fundamentalists, Greece is an interesting case. People here are, by nature, illiberal. They do not compete in the way that rational agents in a market are supposed to compete. They are now being forced to dismantle everything that made for stability and security, and shape up for the market. It is still an open question whether this will be achieved without a nasty fight.

        4. Prices are abitrary: Aren’t they, at the end of the day? Of course fluctuations in prices can be explained by fluctuations in supply and demand, but prices remain relative and ultimately arbitrary. There is no absolute price of anything, is there? If so, I’d like to know what it is. Don’t confuse arbitrary with non-objective. Language, too, is ultimately arbitrary, but it is (socially) objective insofar as the meanings are shared among other members of our linguistic society.

        Your last point confuses me completely and that is where I realise I am out of my depth. “Without the new money prices would have fallen.” I build a house, and add something of value to our little community. Why should the price of your tomatoes fall? Why should the price of anything fall? Assuming of course that there was actually a need for that house. If there were already 5 empty houses and there are only 5 families who need houses, then I will have to offer my 6th house at a discount in order not to end up with the unneeded house.

        If you are right, and any increase in the money supply is bad for prices regardless of the extra value added by the labour that is getting paid with the new money, that would seem to apply to any means of exchange, regardless of whether it is flimsy bits of paper or coins with intrinsic value.

        Andy, Please don’t bother responding. I just need to find the article where you sum up the case for abolishing the Bank of England and describe what ought to take its place.

        I would also be interested to read your take on the http://www.moneyasdebt.com video. I thought that was arguing for the idea of money entering the economy as wages paid by a public authority (the point I repeated here) instead of the money entering the economy as debt, entailing a mad chase to pay back the debt with interest, creating a system that is ultimately unsustainable.

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