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April 13, 2011

Economics at AoSHQ U: Part 2 - Money

(Part one of this series can be found here.)

It's a deceptively simple question: "What is money?"

Classically, the answer comes in three parts: it is a unit of account, a store of value, and a medium of exchange.

But what does that really mean? And there seems to be so many different ways of describing money -- are they all the same thing? Note: we are not talking about finance, which is a different and vastly more complicated subject. We are simply talking about money, as both an idea and an economic reality.

Let's begin by defining our terms.

Money: An abstraction, an expression of an idea of a "medium of exchange". A general description of trade-units that are used in the buying and selling of goods and services in an economy.

Currency: A manufactured good specifically intended for use as money, an actualization of the "money" idea. ("Currency" is to "money" what "house" is to "home".) Many people use "currency" and "money" interchangeably, though. Currency can be made of something with intrinsic value, like gold or silver; this is called "specie" currency. Or it can be a "fiat" currency, where the the currency is backed by nothing more than the say-so of the issuer (usually a sovereign). In our age, nearly all currency is fiat currency.

Legal Tender: Not all money is currency, and not all currency is legal tender. "Legal Tender" is a special kind of currency recognized and sanctioned by a ruling sovereign or government, and bound in law as the "official" currency. In most modern nations, national governments hold monopoly control over issuance of the currency and generally declare the national currency to be the only "legal tender" currency in use. Thus, an American shopkeeper must accept US Dollars as payment for goods or services. He can accept, say, British Pounds or Euros or Japanese Yen instead -- these are negotiable currencies, after all -- but they are not legal tender in the United States. A shopkeeper is not obligated to accept any other currency as payment; only the authorized legal tender (US Dollars).

Gold and silver have proven popular as currency over the ages because they have useful properties for that purpose. Gold and silver are elements, and thus eternal for all intents and purposes; they don't rot, degrade, evaporate, or waste away. They are malleable and can be easily worked, and any tampering or debasement can be gauged fairly easily. Conventions have come about that standardize the weights and measures of gold and silver, making their use more universal. (A Troy ounce of gold is the same in America, in Russia, or in China.) The metals are scarce but not too scarce. They are aesthetically pleasing to look at, and have alternate uses in industry and culture. Gold and silver are considered by many people to have intrinsic (i.e., "specie") value, and this perception has remained constant over many thousands of years of human history. (The United States still issues specie currency in small amounts. A 1oz "gold eagle" coin is legal tender, though the legal tender value of the coin is only $50, while the bullion value of the metal is much, much higher -- around $1460/oz at this writing.)

The main thing to remember about currency, or money in the abstract, is that it is valued relative to the goods and services it can purchase rather than at some fixed benchmark rate. When someone asks, "What's a dollar worth?", they're really asking what you can buy with a dollar. And the answer is: "A dollar is worth one candy bar. Or 5% of a decent shirt. Or one-fifth of a gallon of gas. Or about one-third of a loaf of bread. Or...." And so on. A dollar doesn't have a fixed value to which goods and services are pegged; rather the reverse. This is especially true of a fiat currency (though the "innate value" of specie currencies is a matter of debate -- gold, after all, is only worth something because we agree that it is; it's just metal).

Physical currencies can be adulterated or debased to artificially inflate their value. With a metal coin, for example, this can be done either by making the physical coin smaller but leaving the denomination the same; or by adulterating the gold or silver with baser (and hence less precious) metal. Sovereign issuers of currency have found this to be an attractive avenue for paying for foreign adventures or projects at home when they find themselves embarrassed for funds and cannot borrow. But too much of this kind of thing leads to inflation: when the amount of currency in circulation outstrips the ability of the economy to absorb it. Deflation, in contrast, is a general decrease in prices for goods and services, which sometimes can mean that producers are having to sell their goods at or below the cost of manufacture -- which means deflation is a symptom of deeper economic ills.

Too much inflation or deflation is bad, but generally inflation is viewed as the lesser of the evils. In fact some currency inflation is necessary because the money-supply must keep pace with the growth of the economy. It is only when the money-supply outstrips the growth of the underlying economy that inflation gets to be a problem. But the trick of finding that "sweet spot" has escaped every sovereign issuer of currency in the history of the world. The siren song of currency inflation is just too strong for most sovereigns to ignore.

Currencies are also manufactured goods, and are thus prone to the same laws of supply and demand as other goods. Until fairly modern times, shortage of physical currency was a real problem in most money-based economies (thus the terrible pull towards debasement of said currency). This is why barter often operates side-by-side with money in an economy -- often, money is simply not available to facilitate transactions.

There are other kinds of "money" that are not legal tender or even currency. Generally, anything that can be used as money is money.

Forms of "money" include: Personal checks (drafts against bank accounts, technically), gemstones, subway tokens, Skee-Ball tickets, box-tops, stamps, coupons, gift-cards, and all manner of other things. Prior to the 20th century in America (and elsewhere), banks would often issue "bank notes" -- a kind of private currency backed by the individual banks. In early times, "warehouse receipts" prefigured paper currency -- a tradesman would store his barter goods in a warehouse, and receive a receipt in return for his deposit; this receipt would then be used in lieu of the actual goods for conducting transactions. (The warehouses themselves would in due time morph into banks.)

Historically, the line between barter and money-driven economies is blurred because certain commodities (salt, grains, etc.) are used as money. Technically their use was in a barter context -- a one-to-one transaction between counterparties, trading salt for butter or sugar, for example -- but e.g. salt was often used as a generic medium of exchange, so it should be considered "money" in that context. (Salt was scarce in many areas, and thus had real intrinsic value, which made it useful as a kind of money. It was also durable, portable, and easily weighed and measured.) Barter and money exist side-by-side in many economies even to this day.

The whole concept of "money" is undergoing a transformation in this digital age, because physical manifestations of money (currency, legal tender) are becoming less important as transactions move into the digital realm. Not many people in modern economies have the bulk of their income in actual currency; most of their income exists as digital bits in a computer somewhere. And to buy things, people write checks or use check-cards or use automatic bank-withdrawal. Most of our "money" never exists in physical form at all; it's simply a stream of electrons moving to and fro in cyberspace.

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posted by Monty at 09:09 AM

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