What is Money?
Money is just a generally accepted IOU. In other words many people will accept it as a general IOU that which they can “redeem” from most people.
There are a lot of misconceptions about money and banking. Often people either think these are the root of all our problems or the solution to all our problems. Both seem to believe that once money enters the equation in economics, magic happens. This article will focus on how money and banking work in a free market and then examine the distortions caused by government manipulation of money and banking.
Money
If you examine an economics book on money it will tell you money is a medium of transaction, a store of value, and a unit of account. Some economists say that money being a medium of exchange is the real function (definition) and the other two functions follow from money’s primary purpose. I agree and therefore in this paper the definition of money is “a medium of exchange.”
All sorts of things have served as money including sea shells, tobacco leaves, grain, large immovable stones, tea leaves, cigarettes, silver, gold, paper, and computer bit (entries). As to why money is a useful invention is usually explained by way of an example. Suppose that you raise cows for a living and you wanted to buy a loaf of bread. If you tried to trade your cow to the butcher, you would want several hundred loaves of bread in return. Most of the bread would spoil before you can eat it, so you only want two loaves of bread now. On top of this, the baker wants chickens, not a cow. Under a bartering system, these transactions will not occur, however, with the addition of money you can sell your cow to the butcher and he will give you money. You can then use the money to buy two loaves of bread, while the baker can use the money to buy chickens.
It is likely that money originally grew out of an IOU (I Owe yoU) system. For instance, in the example above it is possible that once the rancher and the baker agree that the cow is worth 300 loaves of bread, then the baker would give the rancher two loaves of bread and an IOU for 298 loaves of bread. The rancher intends to present the IOU to the baker every week for two loaves of bread. At which time the baker will give him two loaves of bread and an amended (new) IOU.
Unfortunately, the rancher gets sick and needs a doctor. The doctor agrees to accept the baker’s IOU in payment for his services. Now the baker’s IOU has acted as medium of exchange, which means it is money.
Money is just a generally accepted IOU. In other words many people will accept it as a general IOU that which they can “redeem” from most people. In the example above, the doctor would have to worry that the baker might not make good on his IOU. Now some people will argue that only paper fiat money is a generalized IOU. However, even gold functioned as a generalized IOU. It is commodity money and as a result may have value in the market separate from its use as an IOU, but the person accepting it as money does not need it as a commodity. He is planning on trading it with other people for goods and services. On a deserted island (with no hope of rescue) you could have a ton of gold, but it would be useless and you would not be better off with it than without it. This also shows that wealth is not the same thing as having money.
People often argue about the differences between money, currency, real money, commodity money, debt money, paper money, and fiat money. Currency is generally defined as something that is specifically designed to function as money, such as coins. Commodity money is when the money is a commodity such as silver, gold, grain, or is backed by a commodity. Now real money can mean several different things, however I am talking about people who argue that only gold (silver) is real money. By this they seem to mean that gold is commodity money and all other currencies are to be measured against gold. All commodity moneys have the advantage that they are more difficult for the government to devalue, however bitcoin, which is not commodity money, also has this feature. The other point is that gold has a long tradition as a widely recognized money. This is true but does nothing to illustrate what money is or what its function is.
Fiat money is money that is not backed by a commodity. Usually it is paper money although more and more it is just electronic entries in a computer and often it is legal tender.
Fiat money is money that is not backed by a commodity. Usually it is paper money although more and more it is just electronic entries in a computer and often it is legal tender, which will discuss in more detail shortly. Paper money is self-explanatory. Debt money can have several meanings, but usually means the money “created” when a person (entity) takes out a loan. Many people argue that debt money is evil or somehow costs us interest just to have money. Since all money is essentially an IOU, all money is created by a debt, i.e., a claim to future goods and services.
Proto Banking
Banking and money have been closely linked at least since the Agricultural Revolution about 11,000 year ago. The Agricultural Revolution was a series of inventions that provided man with access to a huge increase in the number of calories per acre. As a result, the human population expanded enormously and the territory occupied by humans also expanded. These excess calories were converted into population increases until the number of calories collected/created by the human population were roughly equivalent to the number necessary to support that population.
The grains that were the major source of these extra calories had to be stored, because the grains ripened all at once and then were consumed over the year. The grain had to be protected from water and vermin. If the grain ran out before the next harvest, people starved to death. Efficient, effective storage of grains reduced the chances of running out of grain before the next harvest. A centralized grain storage (grain silos) was more effective at protecting the grain and more cost effective than individual storage of grains. When a farmer deposited their grain they received a receipt (clay tablet) for the grain. Eventually people started to use these receipts to pay for other goods (services). For instance, if you wanted to buy a chicken instead of going to the grain silo and taking out enough grain to pay for the chicken, you just handed over some of these clay tablets to the owner of the chicken. In other words, these receipts, i.e. the clay tablets, became money.
In ancient Mesopotamia, as long ago as 5000 B.C.E., clay tablets were used to represent beer or grain.[1] These clay tablets functioned as money. Gold also started functioning as money about the same time, but was probably only used for large or long distance payments and therefore was not used by average people.[2] These clay tablets were “created out of thin air” in the vernacular of today. After a harvest there would be a lot of these clay tablets around and we would say the money supply increased. As people withdrew grain the grain bank would redeem these receipts. We do not know if the “bank” destroyed these clay tablets, which would have been the logical thing to do or if they stored them for the next harvest. Either way the money supply would shrink until the next harvest. In fact the number of clay tablets (in circulation) would have shrunk to almost to zero just before the next harvest. This is because population expands until it takes up the available food supply, which is known as the Malthusian Trap. This means the grain would be almost gone by the time the next harvest rolled around.
Many things can function as money and only the market should “decide” what is money.
If you eliminate money (clay tablets) this does not change the economic situation. Until the Industrial Revolution people lived on the edge of starvation and it was common for families to have to ration their food and even pick who would get food and who would not. Because the healthy adults were the only way any of them would survive through the next year, the old, the young, and the sick were among the first whose food was cut off. This is a grim reminder that economics is not just a game, but has real world consequences.
If we replaced the clay tablets with coins (e.g., silver, gold), then the money supply would not go up and down. However, the price of food (and other goods) would go up and down. After a harvest the price of food would be cheap and just before the harvest food would be very expensive. The monetary system would not change the underlying economic situation one bit.
This is what we have learned about money in a free market:
1) Money is a medium of exchange;
2) Money is a generalized IOU;
3) The money supply can vary in a free market without fractional reserve banking;
4) Many things can function as money and only the market should “decide” what is money; and
5) Money is not magic and does not allow magic to take place in the real world.
Now we are going to introduce some government (non-free market) distortions to money. Going back to our clay tablets, someone probably realized that it did not make sense to destroy the clay tablets when people withdrew grain, since they would have to make new clay tablets after the next harvest. The “bank” probably started storing them and this of course led to the temptation of stealing the clay tablets. Also the government probably decreed that taxes had to be paid in these clay tablets, which was the first step to making them legal tender.
We are going to skip forward to Roman times. The Romans used silver coins as their currency. The main unit of money was the denarius, which was between the size of a modern nickel and dime and equivalent to a day’s worth of wages for a skilled laborer.[3] As late as 68 C.E. the silver in a denarius was almost 100%, but then it started to decline. People balked at using this debased money, however the government declared the new, lower silver coins legal tender. By 265 C.E. the silver content in coins was down to 0.5%. Not surprisingly the Roman Empire suffered huge inflation. The Romans minted so many coins that even today you can buy several Roman coins of standard quality for twenty dollars or so.[4] For clarity later on I am going to call this “simple inflation.”
An important point here is that legal tender laws are always the first step towards inflation. The only reason for a government to pass a legal tender law is so that they can control money. In other words, the government is undertaking an endeavor that would get any private citizen thrown in jail. With the end of the Roman Empire legal tender laws and banking died out during the Dark Ages. Coins were mainly used by the rich during this period.
By the 1700s legal tender laws were being seen again in Europe. France experimented with legal tender laws, allowing The Mississippi Company in the 1710s to have control over its legal tender with disastrous results. Supposedly, the French swore off paper money and modern banking for years afterward. Some historians have even argued that this backwardness in France’s finance system was part of why they were beaten by the English. This is a fascinating story, but beyond the scope of this article.
The British followed suit in 1833 making banknotes issued by the Bank of England (a private bank at the time) legal tender.[5] The United States had no legal tender laws (after the Constitution) until 1862 during the American Civil War. The North printed $450,000,000 of paper money under this law to help finance the war. Eventually this law was declared unconstitutional in Hepburn v. Griswold, 75 U.S. 603 (1870). The Court reasoned that the Constitution allowed the federal government to coin money, but not the power to make paper money legal tender. The government argued that since it had the power to carry out war, the issuance of the legal tender was necessary for carrying on the war, and legal tender laws fell under the “necessary and proper” clause of the Constitution. The Court rejected this argument and also pointed to the fact that the Constitution prohibited the states from interfering with contracts. The Constitution did not specifically prohibit the federal government from interfering with private contracts, but it would be against the spirit of the Constitution to allow the federal government to do so. In one of the stranger twists in history Salmon P. Chase helped push the legal tender legislation through as Lincoln’s Secretary of Treasury. Later he was appointed Chief Justice of the Supreme Court and led a 5-3 decision to declare the law unconstitutional. Unfortunately, this case was quickly overruled by the Knox v. Lee, 79 U.S. 457 (1871) Supreme Court decision.
Without legal tender laws, people would quit accepting the money government printed. The key point is that legal tenders are necessary to create inflation.
Multiple competing bank notes were the norm at that time. According to the Cato Institute, “the government did not entirely monopolize issuance of notes until 1935, but the laws that made the monopoly possible date from the Civil War.”[6] Today the legal tender law in the United States is 35 USC § 5103 which states:
United States coins and currency (including Federal Reserve notes and circulating notes of Federal Reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.
Legal Tender laws are necessary for government counterfeiting[7] to be successful. Without legal tender laws, people would quit accepting the money government printed. The key point is that legal tenders are necessary to create inflation. Any further investigation of money will require that we first examine how banks work, which we will defer to another article.
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[1] Peter Dockrill, This 5,000-year-old artefact shows ancient workers were paid in beer, http://www.sciencealert.com/this-5-000-year-old-clay-tablet-shows-ancient-mesopotamians-were-paid-for-work-in-beer; and
Rachelle Samson, History of money: From clay tablets to legal tenders
History of money: From clay tablets to legal tenders, http://www.versiondaily.com/the-history-of-money-from-clay-tablets-to-legal-tenders/
[2] Wikipedia, History of money, https://en.wikipedia.org/wiki/History_of_money, accessed 11 November 2016
[3] Jeff Desjardins, Currency and the Collapse of the Roman Empire, http://money.visualcapitalist.com/currency-and-the-collapse-of-the-roman-empire/, accessed 11 November 2016
[4] coins https://www.amazon.com/Lot-10-Uncleaned-Ancient-Bronze/dp/B001BMWATA?SubscriptionId=AKIAIKBZ7IH7LXTW3ARA&&linkCode=xm2&camp=2025&creative=165953&creativeASIN=B001BMWATA&tag=wwwbookcompar-20&ascsubtag=5820b98a48308f0454a513ac
[5] A. Andreades, History of the Bank of England 1640 to 1903, http://socserv2.socsci.mcmaster.ca/econ/ugcm/3ll3/andreades/HistoryBankEngland.pdf,
[6] Schuel, Kurt, Cato Journal, Vol. 20, No. 3 (Winter 2001) p 454
[7] Counterfeiting in an economic sense is any currency that is not backed by productive or creative effort that someone willing exchanged their creative effort for. Gold is clearly not counterfeit money, since it requires productive effort to mine gold. Buy paper money presents a problem. It takes productive effort to make and print paper, but no one would trade twenty dollars of their effort for someone who printed a twenty dollar bill. Economic counterfeiting is really a fraud where someone believes the other person has provided value that they did not provide and purposely withheld this fact from the other party.
About the Author: Dale B. Halling
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