Sat, 20 Dec 2003

Money

What is money, anyway? Like fish and water, we deal with money every day, but we have so little understanding of its nature. To understand money, let's start without it. Some people don't like money, because they think it's the root of all evil. (Note: that is NOT a quote from the Bible. It's a MISquote. It's actually "the love of money".) Let's say that they got their way, and money was abolished.

No money, so how do we get the things we need for daily life? Food, clothing, shelter, not to mention water and sanitary facilities. We could all be experts at providing all of them -- jack of all trades, master of none. That is the problem with trying to do everything. You don't have the time to become an expert at any one of them, so everyone ends up having to spend a lot of effort learning to do the things that are needed to keep themselves. A world of Robinson Crusoes. Doesn't sound like fun, but that's why people trade.

In tribes, or bands, people tended not to use money, but instead relied on each other. Call it a primitive communism. From each according to their abilities, to each according to their needs. It worked, but only because the tribe was small enough for a person's reputation to be known. In essence, everyone kept a balance sheet in their heads for who owed whom what.

As societies grew, and people started to trade between tribes, they would barter. Barter is a perfectly fine way to trade except for one thing: the transaction cost. Barter markets are terribly inefficient, because for everything you want to sell, you have to find someone who has something you want to buy. This is not easy to do, because you have to find the perfect match. In essence, marriage is a barter market -- you have to find someone you love, and they have to love you back. Every lonely person can attest to the difficulty of making a good match.

Money is a human invention to get around the inefficiency of barter markets. Money is any kind of thing that people agree it is. Money is the universal commodity. Money is that thing which anyone wants, because they know they can barter it for anything else. Money is a half barter. Most often people don't want money because of the qualities of the commodity which serves as money (although it will have its own qualities). They want money because they know they can trade it for other things they *really* want.

Even if we were to abolish money, as those non-economists would have us do, we would eventually reinvent money. It might not be dollars, pounds, or lire, but it would have the same characteristics of money: something that nearly everybody will give or accept in trade. In wartime and in prison, it has often been cigarettes. Money is not a particular thing. It is an idea.

The Value of Money

Everybody wants more money, right? WRONG! People always want more wealth, but they don't necessarily always want more money. Imagine, if you would, that you could hold all of your wealth in something that you could easily sell. That is, you could barter it for money. That would mean that you need never hold any money, because you could always have your wealth in the form of money.

People hold money because they value its characteristic as the universal commodity (or because, in the case of numismatists, they value it for its intrinsic characteristics). They hold money because they fear that they won't be able to trade goods or services for money. It follows, then, that people's desire for money will rise and fall as the circumstances of their lives change.

If people want more or less money in their lives, it follows that there will be a demand for money, and a supply of money. Similarly, there will be a price of money. If people want less money, the price of money will fall. If people want more, the price will rise. If there comes to be more money, the price of money will fall. If there comes to be less, the price of money will rise. The term for the former is inflation, and the latter deflation. Yes, I realize that in popular language, inflation means rising prices, but there's a reason why the Economist is Angry. When the people fail to understand that inflation is directly related to the supply of money, those who have the power to create money have the power to steal from the people.

If you have trouble understanding the previous paragraph, imagine that dollars are not money, but are instead simply collectible presidents' portraits. Money is ... instead, eggs. You can see that if there are more chickens laying more eggs, then the supply of eggs increases. Eggs will be less dear. Greater egg availability means you want more eggs to sell your dollars.

Fungible

One of the desirable characteristics of money is that it should be fungible: Anyone holding a pieces of money will trade it for any other equally-valued piece of money. Most money that people handle these days truly is fungible. It didn't used to be the case. Coinage, being made from a precious metal, might be debased. That is, the coins themselves might be modified so as to reduce their value. The classical method of doing this is to shave them so they are slightly smaller in diameter. That's why the US quarter has milled edges -- to make shaving harder. Of course, they're not currently made of a precious metal, but their predecessors were, and they needed milled edges.

What if money is in fact not fungible, and yet is forced to be so by legal tender laws? Now you see the action of Gresham's Law: bad money drives out good. If not all money is of equal value, people prefer to hold onto the money which is worth more, and spend the money which is worth less. Since it still has the function of money, people will do better by spending the money which has the least value. In this manner, good money gets quickly driven out of circulation.

To see an example of this, consider what happens when you have a group of people, all of whom want to do laundry. Suddenly, quarters (to put into the washers and dryers) become more valuable than bills. People will tend to pull quarters out of circulation, preferring instead to pay with bills or dimes.

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