Crash Course Chapter 6: What Is Money?

Before we begin our tour through the Economy, the Environment, and Energy, we need to share a common understanding of this thing called money.

Money is something that we live with so intimately on a daily basis that it probably has escaped our close attention.

Money is an essential human creation, and, were all money to disappear, a new form of money would spontaneously arise in its place, such as cows, tobacco, bread, a certain type of nut husk, perhaps, or even nautilus shells.

Without money, the complex job specializations that we have today would not exist, because barter is so cumbersome and constraining. More importantly, though, is the concept that each type of money system has its pros and cons – each will enforce its own peculiar outcomes by promoting some behaviors while suppressing others.

Now, if we crack open a textbook, we’ll find that money should possess three characteristics. The first is that it should be a store of value. Gold and silver filled this role perfectly, because they were rare, took a lot of human energy to mine, and did not corrode or rust. By contrast, the US dollar pretty much constantly loses value over time – a feature which punishes savers and enforces the need to speculate and/or invest.

A second feature is that money needs to be accepted as a medium of exchange, meaning that it is widely accepted within a population as an intermediary, within and across all economic transactions.

And the third feature is that money needs to be a unit of account, meaning that the money must be divisible and each unit must be equivalent. The US “unit of account” is the dollar. Diamonds have much value, but are not good at being ‘money,’ because they are not perfectly equivalent to each other and dividing them causes them to lose value. That is, they fail at being a unit of account.

Blah blah blah….so what is money, really? I believe in a very simple definition.

Money is a claim on human labor.

With a very few minor exceptions, pretty much anything you can think of that you might spend your money on will involve human labor to bring it there. I say it’s a claim rather than a store, because the human labor in question might have happened in the past, or it might not have happened yet.

The concept of money being a claim on human labor is important, and we’ll be building on it later, especially when we get to debt.

As implied in the picture series earlier, literally anything can be considered money – cows, bread, shells, tobacco. A US dollar, like all modern currencies, however, is an example of a type of money called fiat money. “Fiat” is a Latin word meaning “let it be done,” and fiat money has value because a government decrees that it does.

And this brings us to the key question: What exactly is a US dollar?

Once, a dollar was backed by a known weight of silver or gold of intrinsic value. In this example, we can see that the dollar came from the US Treasury and was backed by a given amount of silver that was payable to the bearer on demand.

Of course, that was back in the 1930’s, and those days are long gone. Now dollars are the liability of the Federal Reserve, a private entity entrusted to manage the US money supply and empowered by the Federal Reserve Act of 1913 to perform this function.

You’ll note that modern dollars have no language entitling the bearer to anything, and that’s because they are no longer backed by anything tangible. Rather, the ‘value’ of the dollar comes from this language right here: The fact that it is illegal to refuse to accept dollars for payment and that they are the only acceptable form of payment for taxes.

It is crucially important that a nation’s money supply is carefully managed, for if it is not, the monetary unit can be destroyed by inflation. In fact, there are over 3,800 past examples of paper currencies that no longer exist. There are numerous examples from the United States, which may have some collector value but no longer possess any monetary value. Of course, I could just as easily display beautiful but no longer functional examples from Argentina, Bolivia, and Columbia, and a hundred other places

How does a hyperinflationary destruction of a currency happen?

Here’s a relatively recent example that comes from Yugoslavia between the years 1988 and 1995. Pre-1990, the Yugoslavian dinar had measurable value: You could actually buy something with one. However, throughout the 1980’s, the Yugoslavian government ran a persistent budget deficit and printed money to make up the shortfall. By the early 1990’s, the government had used up all its own hard currency reserves, and they proceeded to loot the private accounts of citizens. In order to keep things moving along, successively larger bills had to be printed, finally culminating in this stunning example – a 500 billion dinar note. At its height, inflation in Yugoslavia was running at over 37% per day. This means prices were doubling every 48 hours or so.

Let me see if I can make that more concrete for you. Suppose that on January 1, 2007, you had a penny and could find something to purchase with it. At 37% per day inflation, by April 3, 2007 you’d need one of these – a billion dollar bill – to purchase the very same item. In reverse, if you’d had a billion dollars on January 1st stuffed in a suitcase, by April 3rd you’d have had a penny’s worth of purchasing power left.

Clearly, if you’d attempted to save money during this period of time, you’d have lost it all, so we can safely state that inflationary money regimes impose a penalty on savers. The opposite side of this is that inflationary money regimes promote spending and require that money be invested or speculated, so as to at least have the chance of keeping pace with inflation. Of course, investing and speculating involve risks, so we can broaden this statement to include the claim that inflationary monetary systems require the citizens living within them to subject their hard-earned savings to risk.

That is worth pondering for a minute or two.

Even more importantly, since history shows how common it is for currencies to be mismanaged, we need to keep a careful eye on the stewards of our money to make sure they are not being irresponsible by creating too much money out of thin air and thereby destroying our savings, culture, and institutions by the process of inflation.

Wait a minute. Did I just say ‘creating money out of thin air’?

Yes. Yes, I did.

This is such an important process to your, our, my future that we’re going to spend the next two sections learning about how money is created.

If you’re ready, proceed to the next section.

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