Sunday, August 11, 2013

What Is Money?

Let me paraphrase Merriam-Webster here: money is something we, as a group, accept as a medium of exchange and a store of value. Or, in my own words: money is what we use so we don't have to barter.

Money can be anything. In the modern world, money is most often thought of as slips of paper, even though on the whole those slips of paper account for a tiny fraction of the world's money. Most modern money is entries on a ledger or, more accurately, digital information.

That makes some people uncomfortable, and I have to admit that I have my own concerns about digital counterfeiting. But, in truth, all money is and always has been nothing more than information. It was stored in certain goods, like grains or spices, or in coins or pieces of leather or clamshells. What made it money is that everyone agreed on it as a store of value.

Usually, the value is set by governments or banks. In the nineteenth and most of the twentieth centuries, most paper money was representative money, that is, it was a promise to pay the bearer a certain amount of gold or silver in exchange for the currency. Hardly anyone ever exchanged the money for actual gold or silver, though; they used the money in trade with each other.

Which is good, because it is unlikely that the governments or banks had anything close to the amount of gold or silver for which they issued currency. This is called "fractional reserve banking." And anyway, what are gold and silver useful for in everyday life? True, silver, in particular, has many industrial and even medical uses. But you can't eat gold and silver, or build houses or cars with them.

Which is why we've hardly noticed that our currency is no longer backed by anything. It is now what is called "fiat currency," backed only by the promises of the governments and the banks. Is that a good thing or a bad thing? Opinions vary, and it's part of what I am trying to work out for myself. But my instinct at this point is that it doesn't matter if money is backed by hard goods or not; what matters is who controls its value, and by that I mean who controls the quantity of money—and that includes coins, bills, and entries on an electronic ledger—in circulation.

Because trade has a way a determining the value of money on its own, based on how much of it there is relative to how much trade, in real goods and services, is going on in the economy. Creating more money creates inflation, an increase in overall prices, by decreasing the value of the money. Why does that happen? Because putting more money into an economy does not, in the long run, increase economic activity.

It's not as simple as a math problem, but you can kind of think of it as one. Total money in circulation divided by economic activity equals the current value of the monetary unit. Too much money, and the currency drops in value, which we call inflation. Too little money, and the currency rises in value, which we call deflation.

Which is worse, inflation or deflation? Whole books have been written about that, I'm sure, and we're not going to settle that issue in this blog.

But right now, in the economic environment we're living in, I do get the feeling that, for all the talk about inflation and deflation (and "stagflation," a lovely term from the 70s), that what really matters more is where all this money flows to and from.

And right now, it's flowing in the wrong direction. But that's a subject for another post.