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Friday, July 2, 2010

What is Money?

Everything I am about to say can be found in Adam Smith's "Wealth of Nations". I wanted to make a post about what money is because it is an important and interesting concept. It is also one of the more interesting chapters in the Wealth of Nations (if you ignore the long boring digression on the different value of English currency preceding 1776).

Before we can get into understanding what money is we need to understand what the division of labor is (which is actually what the Wealth of Nations starts out with the pin makers). Basically, to keep things short, division of labor is the specialization of labor for different people. For example, consider a very primitive economy that consists of a few hunter-gathers. One man hunts for animals, another one makes the weapons, one prepares the meat for consumption, another one makes fur clothing, one builds tents for the tribe to sleep at. Each man depends on his fellow. If every man was by himself he would have to make the weapons, hunt for animals, prepare the meat, make the clothing, and build a tent all by himself. That is a very complicated task. So people realized that if they divide their labor among themselves they can improve the efficiency of their labor.

Trade is one of the most important tools man has, perhaps even the most important, though it is hard to say, maybe language gets the first spot, though one can argue that language evolved from the necessity for trade itself, but whatever, trade sits all the way on top of the list of human tools. Division of labor exists precisely because of trade. Division of labor entirely depends on having trade. What good does it do to the hunter-gatherer to make weapons if he does not get clothing, housing, or food? And what good does it to to the hunter-gatherer to hunt if he was no weapons? None at all. So these men have to depend on one another. Each one depends on his fellow by trade. The weapon maker gives the weapons and receives back food, the tent maker creates the tent and receives the clothing, and so forth. Trade is what leads to the division of labor, and it is division of labor that makes more complex life possible.

But the hunter-gather society described above is a very simple society. It is known as a "barter society". Barter is when two people have to trade directly what they want. If I want a spear to gather food I need to find the spear maker and offer him my food for the spear. The problem with barter is that trade has inefficiency. Consider the following modern world example. I want to get myself a sex toy because I am a loser who cannot find myself some pussy or butt. So I need to find a person who has a sex toy he is willing to trade (hopefully it is not a used sex toy). I have a computer that I am willing to give away. So I find the sex toy trader and tell him I am willing to exchange my computer for a sex toy. He tells me he has an excess of computers and is not interested in computers, he wants a iPoD. So I need to find someone who owns an iPoD and is willing to accept my computer for it. I trade my computer for his iPod and then and only then I trade this iPoD for the sex toy. This is rather complicated. And it can gets even more complicated if I need to go through more than two people to complete my trade.

Hunter-gatherer societies were able to be barter societies because they were very simple. A few men who knew each other and worked together for their own survival. But once man has settled and developed more complicated societies with more people trade ran into the problem of this inefficiency that I described. There can be hundreds or thousands of people, many of whom you do not know, with different preferences. Barter is inefficient. It will work, but it will be inefficient.

So humans came up with a very smart idea. They introduced a medium of exchange. What the medium of exchange was really depended on particular societies and their preferences. A medium of exchange is what people traded for to trade for what they wanted. Let us consider a bronze-age society that highly valued cows, sheep, and other life stock. Say I want to get a bow but I only have bread. Instead of finding a bow maker who is willing to accept my bread, I rather exchange my bread to a farmer who will give me cows or sheep or chickens. The reason why I exchange for life stock is because in this bronze-age society life stock is something valued by every member and so I know almost everybody will be willing to exchange for life stock. Once I have life stock I go to the bow maker and exchange life stock for his bows. The problem of barter is eliminated from this society. I believe the term for such a society is a "commercial society". Trade is a lot more efficient in such a society because I no longer have to find a third or possibly fourth trading partner as in a barter society, now all I have to do is exchange what I have for life stock. By the way, this is a little of topic, if you read the Bible a lot of exchanges take place in terms of life stock. Life stock was very valued back then.

Other societies can have different mediums of exchanges depending on what they value or prefer. Salt was used as a medium of exchange too. Salt is actually more effective than life stock. Because life stock cannot be divided into smaller units. I cannot buy something for a half-a-cow. Or if I want something really cheap I cannot sell thousandth-of-a-cow. I must sell cows or chickens or whatever other life stock alive and so I cannot divide them. Salt has the division property. We can divide salt into various proportions to make more accurate exchanges. But a potential problem of salt is that salt might have really low value. So if I want to exchange something of considerable value I must trade mountains of salt, which is quite a big problem. So salt can only be valuable in societies were salt is scare and therefore highly valuable for people. So as I said what the medium of exchange is depends on a society. If a society highly values salt it can be their medium of exchange, if it has an abundance of salt it will not use salt as a medium.

The best medium of exchange turns out being precious metals like silver or gold. Rome used copper and bronze, I believe, but they are not so precious. Metal is such an excellent medium because of its properties. It can be divided into correct proportions, it is valuable, and it lasts for basically forever. It can be stored for excessive periods of time. The main problem with metal, like gold, is the problem of purity. How do you know when someone exchanges gold it really is gold? Perhaps it is pirate? Or perhaps it is a mixture between gold and other less precious metals? There are checks for this. You can do the old Archimedean trick of computing its density and confirming if it matches the density of gold. But one way to achieve this security against false purity is by introducing currency. Instead of carrying gold around with you, you have currency which represents gold, this currency can be exchanged for gold in a bank. The banks check for consistency and purity to improve the security of knowing that gold transfer is honest by giving you a note from the bank, that is currency. Currency is also easier to use than carrying heavy gold around with you.

In the past people used coins. Coins are not the best form of currency, paper currency is better because it is much more difficult to counterfeit paper currency. And this is what money is. Money is the paper currency that is used which represents amounts of gold that can be exchanged for in a bank. Currency is the most secure and efficient means of trade. People who trade with one another do not have to worry about impure gold and they do not have to deal with the barter problem. Besides money is easy to carry around with you.

I do want to make an important note here which is a little relevant. Today in the United States money operates differently. From 1776 to 1913 the United States was based on the gold standard as I described above. In 1913 the Federal Reserve was set up. The Federal Reserve is a private bank that uses "fiat currency". Money no longer represents gold. Rather paper money is kept in circulation but the gold standard is removed. Now what money is paper that maintains it value from the past existing value it obtained from the value of gold. The idea behind the Federal Reserve is to inflate or deflate the money supply of the country. Inflation is a form of a tax. If the government needs more money it can tax its citizens. But it can do it in a hidden manner of inflation. It can inflate the money supply by printing more money through the Federal Reserve, as much as it needs and spend that money in the economy. This does reduce the value of money because there is more money now in circulation. I bring up the Federal Reserve to explain how the current money system differs from the gold or silver standard system described above.

The point of all of this is to say that money is good! There is absolutely nothing wrong in and of itself with money. Money is exactly what makes trade efficient. Without money we would be living in barter societies with really slow trade. I know it is popular with some Marxists or communists to talk about their kind of society that is not obsessed about money. But these people are ignorant of basic economics. Even me, who is a semi-retard when it comes to economics, is capable of understanding what money is. Money is fundamental to a developing society. Get rid of money and destroy its economy. It is stupid to blame money as evil if bad people strive for money. It is not money that is inherently the problem, it is people who act wrongly. Calling money evil is like saying gravity is evil because it was responsible for a plane crash. Or calling guns bad because some insane guy went on a killing spree. No guns are not bad, it is people who use them wrongly. Money is the same. Money is not bad, in fact, it is good from the above explanations. Money is the result of trade. Being against money is to be against trade. If you think money is evil you must then explain why trade it evil, but I doubt you will ever be able to do that.


  1. The often-quoted phrase, “Money is the root of all evil,” is from a verse in the New Testament which reads in full, “The love of money is the root of all evil.” As you say, money is a good thing. It’s an excessive obsession with gathering more and more of it that’s bad. Apparently whoever wrote that bit of the New Testament nearly two thousand years ago agreed with you.

  2. Excellent post. This is a too-often ignored topic, and leads directly into the evils of central banking (or any uncompetitive issue of money) and the regression theorem - that fiat money is only introduced by reference to a prior commodity standard.

  3. G*3: You make a good point. The New Testament, surprisingly for once, teaches us a valuable lesson. However, I do want to mention that sometimes excessive obsession with more money is not so bad from the economic point-of-view. Sure you can condemn greedy capitalistic-pigs for their selfishness but these capitalist-pigs sometimes turn out being the strength of the economy, this is a little paradoxical, I know. Note, I am not saying we should turn into selfish capitalists now, just saying that capitalist pigs, sometimes, indirectly, lead to much economic growth.

    Puzzled: I did not want to say anything more about the Federal Reserve because that would be a separate topic. Also I am not very comfortable talking about the Federal Reserve because I still do not understand how the Business Cycle operates with central banking. I understand the basic ideas but how they all come together I still need to work on.