On Money, Part 1

This is the first post in a series on money.  These posts are going to be long, and might bore you.  But if you read them, you will know more about money and the current monetary system than anyone outside of the banking industry (and more than many of those inside the banking system as well).

Let’s start with the big question: what is money?  Most people think of money as those coins and green pieces of paper that you use to buy stuff with.  And aside from wanting more of it, that’s where their understanding of money stops.

It is important to understand that money is not necessary in a primitive society.  In such a society, where there is little specialization, the members of the society can just engage in barter.  That is, they can trade the goods that they have produced for the goods that they are unable to produce.  Such a direct exchange does not require the use of what economists call a medium of exchange.

Unfortunately, the use of barter does have some drawbacks:

  1. Exchange is limitedIn order to get what you want, you have to find someone who both has what you want and wants what you have.  If such a person cannot be found, you will have to find someone who wants what you have and has what the other person wants.  You trade with that person, and then take what he gives you and trade it with the person who now wants what the third person has given you.  This can easily become a very long and complicated search for individuals who are willing to trade.  There is actually a TV series called Barter Kings that illustrates this concept very well.
  2. Some goods lose their value when they are divided.  Let’s say I own some pieces of art, either the Mona Lisa and the Venus de Milo.  Both are very valuable items.  But if all I want is a Big Mac, then I am going to have to either trade one of them for something else that is less valuable, pay a lot for that Big Mac by trading one of my very valuable art pieces for one, or by dividing my art into smaller pieces.  You can see the problem: no one wants to own one of the toes of the Venus de Milo, or just the smile from the Mona Lisa.  Either way, I’m not getting my Big Mac.  Dammit!
  3. A system of barter lacks a way to report profits and losses in an easily understandable way.  If my neighbor and I are trading cows and chickens, how do we know if it is profitable to do so?

Since a barter system results in these problems, people came up with the idea of using certain items for indirect exchange.  Instead of trading the goods they had for the goods they wanted directly, they chose some other good that they knew that others would accept in trade.  They then traded their goods/services for that item, and then traded it for the good or service that they wanted.

These other goods are what we call a medium of exchange.  A medium of exchange is an instrument of indirect exchange that is acceptable to both parties to a transaction.  Aristotle was the first to note the properties that an ideal medium of exchange would possess.  These properties included:

  1. A high level of demand for the item.  A high level of demand means that the item will be accepted in exchange by almost anyone.
  2. Ease of dividing the item into smaller pieces to allow for both large and small purchases.  This avoids the problem of cutting up the Mona Lisa or hacking off parts of the Venus de Milo to get a Big Mac.  Yay!
  3. Portability of the medium of exchange.  It should be easy to carry the medium of exchange around so that they can buy something at the store without getting a hernia.
  4. A high value per unit of weight.  This requirement is an outgrowth of #2 and #3.  You want something that is small and very valuable, so you can still make purchases if the item is divided and you won’t get a hernia if you have to carry the item around.
  5. Durability.  A medium of exchange should last for a long time so we don’t have to keep obtaining more of it as the years pass.

In Western civilization, the two items that fit Aristotle’s requirements were silver and gold.

But not all societies used silver and gold, especially since they often weren’t available.  Some other items used were:

  • Wampum (used by the Indians in New England)
  • Tobacco (Virginia)
  • Rice (South Carolina)
  • Sugar (the West Indies)
  • Furs (the Northwest U.S.)
  • Very large stones (the island of Yap)
  • Salt (Africa and Rome)
  • Cattle (Rome)

Our current language reflects the prior use of both salt and cattle as mediums of exchange in Rome.  Roman legionnaires were paid in salt—salarium.  This is the Latin origin of the word “salary.”  And the term ‘pecuniary‘ is derived from the Roman word for cattle.

As mentioned above, the items that came to be used as media of exchange in the West were silver and gold.  This is reflected in the fact that our modern monetary units began as descriptions of different units of weight for gold and silver coins.  The British pound was once called the pound sterling, and originally referred to a pound of silver (i.e., one pound sterling was equal in value to a pound of silver).  The dollar began as the applied name of a weight of silver coined by a Count Schlick, who lived in Joachim’s Valley (Joachimsthal), and his coins were known as thalers.

In Part 2 tomorrow, I will discuss the origins and history of money in the United States and why we no longer have silver and gold coins in circulation today.


Categories: Banking, Credit, Debt, Money

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