What is money
Money matters. As a father, I would like my children to understand money so that they can make informed choices later in life. Everyone understands it intuitively, to some extent, but few people have a complete understanding. For example, many people confuse money with bank notes (cash), even though each of us uses far less cash than the amount of money we keep in our bank accounts. Even “learned” economists don’t have the answers to simple questions like what money is and where it comes from.
In my younger days at school, I happened to be very good at math. I pursued a math degree in university and joined a bank afterward in a role that required a strong command of math. Still, not once in my professional life did I get to use geometry, trigonometry, complex numbers, integration, or even a quadratic equation — all parts of the standard math curriculum that every high school student in the country had to muddle through, even though most of them would never use them in life.
Isn’t it strange that the education system, not just in the country I grew up in but practically everywhere else, would force years of difficult and absolutely impractical learning upon every growing adult, for 12 years straight, yet it never teaches them anything as practical as money matters? After all, each of us would inevitably have to deal with money throughout our lives. Learning about interest rates, time value of money, savings, or how a mortgage loan works would have been infinitely more useful and practical to every single person. Yet no government in the world teaches its citizenry about money, choosing instead in favor of complex mathematics, nuclear physics, organic chemistry, and what have you… Every day I read articles about people getting scammed financially or running into debt. I see friends and relatives make disastrous decisions with their money, even if they are otherwise smart and professional in their respective area of expertise. But somehow, no priority is given to educating the public about money.
Coincidence? No, there is no accident. Governments don’t teach their populace about money for one simple reason: if the people figured out how money functions and who causes the inflation that they suffer from, they would realize who the culprit is. Let me try to remedy that, for my children’s sake and for the benefit of anyone reading this.
Origins of money
So back to the question: what is money anyway? A simple definition would do:
Money is a commodity commonly used in the exchange of goods and services
Human civilization truly began when people began to trade, that is when people began to exchange the fruits of their labor for that of others. For example, a hunter and a farmer might exchange meat for apples. Such a direct form of exchange, called barter, would have initially sufficed for simple transactions but would have been found inconvenient for anything beyond that. What if the hunter wanted apples but the farmer needed shoes instead of meat? The hunter would first need to exchange his meat for shoes with a shoemaker and then bring the shoes to the farmer — not very convenient. And furthermore, a pair of shoes may be equal to 100kg of apples, far more than the hunter needs.
So soon enough, people must have begun using an intermediate commodity for the purpose of exchange. Throughout history, many such commodities have been used, like sea shells, fish hooks, grain, opium, various metals (gold, silver, copper), and even cigarettes (notably among prisoners). That commodity is what was effectively considered money at that time and place. The features that make a commodity well suited for the purpose of money are as follows:
- It must be acceptable by all people, which is greatly helped if a good majority of them consume that commodity. For example, cigarettes in prison work well because a number of them, namely the smokers, consume them, so that even non-smokers are comfortable accepting cigarettes as payment knowing they can exchange them down the road.
- It must be uniform (homogeneous), i.e. every piece of money has to be the same as all the others, else if they differed, inferior samples would be shunned. Metals are a good example because every 1 gram of silver is the same as any other 1 gram of silver.
- It must be divisible into small units (denominations) so that it would work for small transactions, but it must also be valuable enough so that you wouldn’t need to carry too much of it for larger transactions. For example, gold is a good example because it can be split into very small pieces for small transactions, yet you don’t need to carry too much of it either for purchasing something bigger. Conversely, iron would be a bad commodity, because one would need to carry a ton of it in order to pay his dentist.
Over time, gold and silver emerged as the most suitable commodities to serve as money as they fit the above criteria reasonably well. But people went one step further: instead of carrying pieces of gold in their pocket everywhere, and having to prove that it is not diluted with other alloys, they chose to deposit the gold with a goldsmith (or a jeweler or a warehouse) in exchange for a warehouse receipt. Such a receipt was as good as the gold itself, as any recipient would easily be able to go to the goldsmith and exchange it for the original gold. In fact the receipts were even more convenient to carry and exchange than the underlying gold, so they became the dominant form of money. Few people bothered to go and exchange them for gold after they received them, because they would likely spend the money long before that.
When the goldsmiths discovered that most of the gold was lying around unclaimed most of the time, they got the sneaky idea to use it themselves, e.g. by lending it for interest. But once they lent the gold to borrowers, the borrowers — just like the original depositors — would naturally opt to deposit the gold back with the goldsmith in exchange for receipts. That way the same gold was pledged twice and there ended up being more receipts floating around than actual gold lying in the vaults. That was the “original sin” that gave rise to the concept of banking, notably fractional reserve banking. The term fractional derives from the fact that only a fraction of the free-floating money out there is backed by gold, which is all fine and dandy as long as only a small number of people ever bother to claim their gold back. But if enough people lost trust in the goldsmith and went down to ask for their gold, most of them would have to return empty-handed because there simply wasn’t enough gold in the vault. We will expound on that in later section on banking.
Money today
Money has evolved since the middle ages, but this evolution would not make sense without first understanding how governments have hijacked the monetary system for their own nefarious purposes, a discussion reserved for a later chapter, For now, we will skip over and jump straight to the present-day monetary system.
In today’s world, under almost all monetary systems in existence (they copy from one another anyway):
Money at present is simply a number stored in the memory of a computer.
That is all. Very anticlimactic, isn’t it? And how is money created, i.e., how does that number change up or down? Brace yourself, for the answer is even more disappointingly bland:
Money is created when a bank issues a loan; money is destroyed when a loan is repaid.
Read that again and try to understand its beautiful simplicity, especially if you are an economist by education who think they know better. I hold an undergraduate degree in economics from MIT, and I can swear they never taught us that simple truth. Contrary to what many believe, money is not created by a central bank (not directly anyway); money is not created when gold is deposited; money is not created by the government; money is not printed! Money is created when Mrs. Jones enters a bank and asks a bank official to extend her a loan for her home renovation.
Since money is created and destroyed on the back of the creation and redemption of loans of the same amount, a corollary ensues:
All the money in circulation totals up to all the loans in existence.
So it is not quite right as they say that “money is debt”, but in all fairness, there is an element of truth there: money and debt are two facets of the same coin. Money is created when debt is created, thus money is backed by debt. The blind leading the blind. Therefore the only “true value” of money could only possibly be derived from the trust that society places in that money, trust that can be easily lost and that must often be defended by weapons and violence on the part of the one issuing money1.
To gain further insight into how money powers the economy, we need to look at the cardiovascular system of the economy: its banking system.
Footnotes
- A good example on the loss of trust in a currency is given in Lee Kuan Yew’s book “From Third World to First: The Singapore Story: 1965-2000”, where he reminisces the Asian financial crisis of 1997. ↩︎
