Wednesday, January 14, 2009


What is Money?

With investments falling in price recently people have been looking at the whole concept of money and value more closely again. Money is a topic which has confounded thinkers for several thousand years, so I don't think I'll be able to explain it either. Instead I'll just ask some questions.

Until the invention of paper money, money was based upon some relatively rare tangible object. Silver and gold have been popular choices for a long time. Their virtue was that one can't counterfeit them, although there have been cases of adulteration and "clipping".

Having a governing body issue coinage was a way of simplifying trade since the provenance eliminated the need to verify each coin every time a trade was done. The problem with gold and silver is that the "wealth" of a society was based upon an arbitrary commodity which had insignificant purpose aside from as a medium of exchange. Jewelry is just another way to hold on to this commodity.

It was only in the past 100 years or so that gold and silver have been needed for actual industrial production. Silver in photography and some electronics and gold in electronics. Even today industrial use of gold is only about 20% of the amount mined.

With the rise of mercantilism and industrialization the limits on the actual amount of gold and silver acted as a barrier to trade. One might have a large amount of grain to sell, but if the buyer didn't have the gold to pay for it there was no deal. This led to the creation of credit. So "money" was now created without any connection to scarce commodities, but only based upon a promise. From letters of credit to central banks and the issuance of paper money has been a long path in time, but a short leap conceptually.

Once we permit trade to take place based upon credit then we have allowed money to be created outside the direct control of national mints. Credit is a promise and the "value" of the promise is based upon expectations that the loan will be paid in a timely fashion.

Those who see the evil in "fractional banking" and "fiat money" have confused a specific mechanism for the creation of credit with the idea that money is based upon trust, regardless of how this is defined. So proposals to limit banks to lending only what they have in reserve, for example, just put the entire creation of the money supply in the hands of the government. If they fail to put enough money into circulation (either in the form of paper or bonds) then trade becomes constrained just as it was with a limited amount of coinage in circulation.

Proposals to substitute something for credit all are variations on going back to the old system. Should we base wealth on land or a basket of commodities? If so then how do you determine the "value" of these things. We have seen recently that land and oil can change value just as rapidly as anything else. There are no physical commodities which have a value independent of what people assign to them.

One could argue that the use of credit has worked well since it became the norm in the 20th Century, but this isn't true. There have been dozens of revaluations of money and a successions of international mechanisms set up to deal with problems. Going off the gold stand, Bretton Woods, the creation of the IMF and World Bank have all been attempts to systematize a process which is fundamentally based only on trust. We are now going through the latest international convulsion over money and will probably see some new ad hoc mechanisms put in place to restore confidence.

As I said, I don't have any ideas, but it seems to me that we will be stuck with trust-based credit for the foreseeable future.
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