Section 2.1 – What is Money?

In the 16th century when the Spanish and Portuguese privateers looted millions of pounds worth of gold from the Incas and the Aztecs, they carried it back home, imagining that it would make their country rich. But it had the opposite effect. In reality they suffered from rampant inflation which undermined the functioning of their economy and both countries went into a decline from which they had still  not recovered in the 20th century. This neatly illustrates the point I made in Section 1.4 that money is not the same thing as wealth. If money is not wealth then what is it? The definition of money is that it is “an item or record that is generally accepted as a payment for goods and services”. Since those goods and services are forms of wealth, money can be regarded as a token which represents a claim on wealth. Seen in that light, it is clear why carrying gold back to Spain and Portugal did not increase the wealth of the country. Gold in that context can be regarded as a form of money, but no new goods or services were created by this activity. Therefore what happened was that there was more money chasing the same quantity of goods and services, and therefore the prices of those items rapidly increased. In every inflationary situation there is an element of the quantity of money available outstripping the supply of items to purchase with it. This was clearly seen, for example, in Germany in the 1920s when the Reichbank literally printed banknotes in ever greater quantities and ever larger denominations – possibly with a deliberate  intention of devaluing the currency to ease the intolerable burden of the war reparations which had been imposed by the victorious forces of World War I at the Treaty of Versailles.

Money is now such a pervasive aspect of our lives that we take it for granted, and we also take for granted the current form of the monetary systems within which we operate. Let us look at how this system has developed over time, and the various forms which money has taken at various times in history. Although we are currently going through a transition towards an entirely electronic system, the most familiar forms of money are coins and banknotes, but over time all sorts of objects have been used as money: seashells, bones, tobacco leaves, cigarettes, and so on. But the form of money that has been in most widespread use over the entire course of human history and pre-history is grain – wheat, barley or rice. This would have been the near universal form in which tribute was paid to local warlords, as we discussed in Section 1.6 on the origins of governments. And indeed it would have been the most common form of currency for the payment of taxes right up until the end of the middle ages. This is illustrated by the widespread appearance of tithe barns which are found all over the country. Looking at this example, it is clear that the lords of the manor did not imagine that their form of social structure was likely to change any time soon.

The local landowners would collect their taxes in the form of grain to be stored in the tithe barn, and gradually depleted over the course of the year until the supplies were replenished at the next harvest. The landowner would pay his guards and soldiers and his servants substantially in grain and he would also use grain to purchase items from craftsman and artisans. The tenant farmers themselves would also often pay for goods and services from their fellow villagers with grain, beyond what they required to feed themselves and their families. Grain was therefore serving the principal function of money, which is to act as a Medium of Exchange. The same function could be served by any commodity which has an intrinsic value itself and is reasonably durable. The use of goods to facilitate trade in this manner is called Commodity Money.

According to basic economic teaching, money has three functions: one, as just noted, is that of serving as a medium of exchange. The second function is as a Store of Value. Clearly this example illustrates that function too: when the tenant farmers have delivered the due portion of the harvest to the Lord of the Manor, and he has stored it in the tithe barn in August, it will remain there until it is extracted either for his household consumption, or to use as payment at some time later in the year.

The third function of money is to serve as a Unit of Account. For example, suppose the farmer has no spare grain in June, but he needs the blacksmith to shoe his horses: he could make a promise  to deliver a certain quantity of grain at a later date, after he has harvested the current crop.  This arrangement would be described as “delivery on account”.

In the ancient world, from about 5,000 years ago the three commodities most frequently used as money were gold, silver and copper.  The reason was that these were chosen was that all three metals could be found in a raw form on the surface of the Earth in limited amounts, and all three were regarded universally as being of value. Silver and copper were far more commonly used since the supply of gold was much smaller. There were several advantages to the choice of these metals rather than agricultural products for trading purposes:

  • They provided a consistent quality – one pound of silver is completely equivalent to another (subject of course to an assurance of purity), whereas one bushel of wheat may differ significantly from another.
  • They are stable and durable over time. Gold does not corrode at all, and silver and copper only marginally, in contrast to food products which may get eaten by pests or spoiled by fungus.
  • They are not in demand for consumption, as agricultural products obviously are.

One point about commodity money worth noting is that when used for its utility function, it ceases to be money. That is 100% true in the case of  foodstuffs – obviously if part of your wealth is in the form of wheat, and you eat it, you no longer have it to spend. It is partially true in the case of precious metals: if you make your silver into a bracelet or a candlestick for instance, you cannot both enjoy the use of the object and spend it in the course of trade. However, it will always have at least the intrinsic value of the weight of silver. It may of course have a higher value if the trader you offer it to appreciates the functional or aesthetic qualities of the object.

Around 2,500 years ago various rulers realised that they could facilitate trade by striking gold, silver and copper into coins of a standard weight and a guaranteed purity. In return for the convenience of not having to weigh ingots of arbitrary size, and for the confidence of the quality of the metal, traders were content to accept a slightly smaller metal quantity than the face value of the coin. The difference between the two was known as the Seigniorage and provided a profit for the ruler. This coined form of metallic commodity money became an almost universal standard for trade until the issue of Representative Money became common in the sixteenth century. Coined commodity money remained the normal form of payment for day-to-day transactions of modest size until the early 20th century, when it became progressively replaced by Token Money.

Until 1914, trade in Britain was carried out with copper pennies which contained about a penny’s worth of copper, silver shillings that contained twelve pennies’ worth of silver, and gold sovereigns that contained £1 (twenty shillings) worth of gold. At the outbreak of World War I gold sovereigns were withdrawn from circulation and replaced with banknotes. Over the next few decades, the silver coins were withdrawn and replaced by ones made of a silver-coloured nickel alloy worth much less than the face value of the coin. When Britain changed to a decimal currency system in 1971, the ‘New Penny’ (now 1/100 of a pound rather than 1/240) was a much smaller bronze coin. Some years later the coins were reduced to a smaller size still, and now the ‘bronze’ coins are made of steel with a thin bronze surface plating. Thus all physical money currently is token money.

Representative money consists of a document certifying the claim to a specified quantity of some commodity money (usually gold or silver). It originated when customers deposited gold with goldsmiths for safe-keeping and were issued with a receipt that would entitle the bearer to withdraw the gold from storage. Initially a customer who wished to spend some of his gold would return and withdraw it, but over time traders became accustomed to accept the certificate itself as a means of payment. Goldsmiths developed into bankers, and realised that they could issue more banknotes than value of the gold that they were holding, on the principle that it was unlikely that all the customers would come to claim their money at once. As recently as the 1960s, Bank of England notes used to say “I promise to pay the bearer on demand the sum of one pound in gold”, even though it wasn’t strictly true, since Britain had come off the Gold Standard in 1931. Now the notes just say “I promise to pay the bearer on demand the sum of ten pounds”. If you think about it for a moment you will realise that this is a completely meaningless statement. What are they offering to give you? Another ten-pound note? Two five-pound notes? In other words paper money has also – like coins – become token money. This type is sometime called “fiat money” from the Latin word fiat, which means ‘let it be’.

But notes and coins make up only a very small proportion of the money in circulation – most of it is Bank Money which has no physical presence at all, and consists of entries in the ledgers held by the banks. How this is created, and how this is related to the derisory value of your pension and the insane prices of houses will be the subject of the next segment in this thread. The creation of excess money by banks is correlated with inflation – the erosion of the purchasing power of money – which has been a persistent feature of the economies of all developed countries over the past sixty years. Inflation amounts to a swindle perpetrated against those holding assets in the form of money in favour of those holding other tangible forms of wealth. It also disadvantages those who have less power to adjust their incomes to take account of the reduced  value of money, compared with those who do have such power. It robs savers of the value of their savings, and allows borrowers to repay debts with money that is worth less than the original value of the loan. Clearly a currency which is undergoing inflation fails to serve two of the three functions of money described above; it is not satisfactory as a unit of account, nor as a store of value. The issue of inflation will be covered in greater depth in a future section within this thread.

This is Section 2.1 of my forthcoming book The World in 2100: What might be Possible for Humanity? within the ‘Finance’ theme. When we return to this thread, the next topic will be Banking and Stockbroking in a Sane World. 

If you haven’t already done so, you can register to receive a free review copy just before it goes on general sale later this summer. Registering will also take you straight to Chapter 1 – The Foundations which will give you more idea of what the book will cover.