What is Money? (Part 1)

It’s impossible to be a great investor without a solid understanding of what money truly is, how it came into being in its current form, and how it works in today’s society.

Money vs. Currency

What is money? Most people assume it is whatever currency they are carrying in their wallets, whether US dollars or Japanese yen or the ill-fated euro. And it is true that “most people” generally refer to this as “money”.

Historically, though, this has not been considered true “money” (just ask anyone holding old Zimbabwean dollars or old German Reichsmarks how much that so-called “money” is worth today…zero!).

True “sound money” (real “money” in its historic sense) has intrinsic value, or value in and of itself (think gold, silver, cattle, wine).

“Currency”, on the other hand, is simply a medium of exchange with no intrinsic value (think paper…it has no value in and of itself, except perhaps for toilet paper or to mop up spills).

And to take this one step further, “fiat currency” is just currency with no intrinsic value of its own that derives its “face value” by arbitrary decree, order or pronouncement of a government that has absolute authority to enforce it.

All currencies in use today are fiat currencies, not true sound money. (Gold and silver still exist of course, but they are not recognized as “money” by most governments, although this is beginning to change…and they are beginning to be accepted as collateral by banks).

Barter and Gift

The earliest means of exchange from one person or group of people to another was via barter or gift.

Earliest Money: Wheat, Eggs, Barter

But wait, I don’t want eggs, I want shoes!

For example, if I had a pound of grain that you wanted and you had a dozen eggs that I needed, we could exchange these items in a transaction and be happy. However, this proved difficult at times, because how would we decide how many eggs a pound of grain was worth? And what if I wanted the whole chicken instead of the eggs, or something else entirely like a pair of shoes?

Did I first have to trade you for the eggs and then go to the cobbler to exchange the eggs for the shoes that I wanted? And what if the cobbler didn’t want eggs or grain? As you can see, barter worked well in basic transactions but was problematic as a regular means of exchange, so people quickly progressed to:

Commodity Money

Commodity Money

Cowry Shells, Base Metal Coins, Wampum Beads

(Cowry Shells –> Base Metal Coins –> Precious Metal Coins) 1000 B.C. – 120 B.C. Also “wampum” in North America in 1500 A.D and likely before

Commodity money rapidly became prevalent because it overcame the limitations of barter—people agreed on certain items that were universallyvaluable and storable (e.g. copper, whiskey, wine, etc.) and used these as an intermediary “money” in transactions.

Now, with this commodity money, you and I could simply agree on how much copper or wine, etc., our wheat and eggs were worth and I could “sell” you my wheat for a bottle of wine.

Then, I could store the bottle of wine and exchange that (or several bottles) for shoes from the cobbler. It quickly became clear that three commodities were especially good as a store of value and means of exchange:

Gold, silver, and copper.

First Round Coins (~1000 BC)

The first round coins are thought to have originated in China and were made out of base metals, often containing holes in the center (see picture above) so they could be put together like a chain.

Precious Metal Coins (~500 BC)

Outside of China, in Lydia (now Turkey), Greece, Persia, and Rome, people used precious metals (gold and silver) as coins and stamped them with the various emperors and heads of state to convey their authenticity. These precious metal coins had intrinsic value based on the amount of gold or silver the coin contained.

Ancient Roman Gold Coin

Ancient Roman Gold Coin

Receipt or “Representative” Money (118 B.C., banknotes in form of leather–> first “paper” money)

However, as people exchanged more gold, silver, and copper for other goods and services, it became difficult to store and keep these precious metals safe until they were needed for the next transaction.

Therefore, a new profession arose (the dawn of early banking…) where certain “trusted individuals” would store the precious metals of their clients and issue them “receipts” for their metals.

That way, if a person needed to travel to purchase an item, he could just bring his receipt with him to his destination rather than having to lug all of his heavy precious metals along that were needed to make his purchase. Upon arriving at his destination, he could simply hand the seller his receipt and the seller would deposit the receipt at his own “bank”.

The seller’s “bank” would talk to the purchaser’s “bank” and they would make the appropriate entries in their books to reconcile the transaction.

This “receipt money” was backed by the bank’s promise to exchange the receipt for the specified amount of gold or silver. This method of exchange lasted throughout most of the nineteenth and twentieth centuries through the use of the gold standard, which pegged the United States dollar and other currencies to a specified quantity of gold.

This worked fine as long as banks had enough gold and silver on hand to redeem the paper notes when needed by the customers.

However, it didn’t take these banks long to notice that they had a lot of gold and silver piling up in their vaults as more and more trade was conducted. They quickly realized that most people didn’t actually need to withdraw the metals very often, and decided that they could make more money by lending out these precious metals rather than by storing them.

Which brings us to…

Fractional Reserve Receipt Banking

Which I will cover tomorrow!

I hope you are having a great week, and let me know if you have any questions about money-money-money and fractional reserve banking!

To your financial success,

— Kung Fu Girl

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