The 15-Minute Economist

Chapter 1

What is money anyway?

Trade, or commerce (the buying and selling of goods and services) is a fundamental part of economics. And money is at the heart of commerce. It is familiar to us all, yet we rarely pause to think about what it really represents.

Money is any token, physical or virtual, that can be used in trade. Whatever is used as money might have intrinsic value, such as a disc of gold, or it might have only symbolic value, like a printed slip of paper with a fancy design. It might have no physical existence at all, like the virtual currency bitcoin – a digital currency that operates independently of the main banking system. Of course, even the ‘intrinsic’ value of a gold coin is culturally determined. Gold is of limited use outside jewellery and commerce. It is now used in electronics, but that use emerged long after gold was first considered valuable. It’s easier to make crowns and jewellery from gold than other metals, as it’s soft and doesn’t corrode – but you could say the same of plastic. Crowns and jewellery, while nice, are not exactly essential to survival – they are not ‘needs’.

Bartering doesn’t go well

Try to imagine a world in which there is no form of money. If you want something you can’t find or make yourself, you need to persuade someone who has it to give it to you. They will probably be unwilling to give it for free, but might be willing to swap it for something you have. This is called bartering. If you have a mammoth skin but want some watermelons, it might take a long time to find someone with watermelons who wants a mammoth skin. If the person with watermelons wants a clay bowl, you might have to trade a mammoth skin for a clay bowl, and then trade that for watermelons – if you can even find someone with watermelons who wants a clay bowl. You can see how it quickly becomes a complex, time-consuming and often frustrating endeavour. This problem, called the coincidence of wants, or double coincidence of wants, makes bartering systems unwieldy and inefficient.

GOLDEN CHAINS

The 16th-century philosopher Sir Thomas More satirized humankind’s greed for gold in his book Utopia. The Utopians do not see value in gold, as it is virtually useless:

‘Their chamber-pots and close-stools are made of gold and silver. . . . Of the same metals they also make chains and fetters for their slaves; on some of whom, as a badge of infamy, they hang an ear-ring of gold, and make others wear a chain or a coronet of the same metal. And thus they take care, by all possible means, to render gold and silver of no esteem. Hence it is that, while other countries part with these metals as though one tore-out their bowels, the Utopians would look upon giving-in all they had of them, when occasion required, as parting only with a trifle, or as we should esteem the loss of a penny.

‘They find pearls on their coast, and diamonds and carbuncles on their rocks. They seek them not, but if they find them by chance, they polish them and give them to their children for ornaments, who delight in them during their childhood. But when they come to years of discretion, and see that none but children use such baubles, they lay them aside of their own accord; and would be as much ashamed to use them afterward, as grown children among us would be of their toys.’

Sir Thomas More, Utopia, Book 2 (1516)

Instead, most societies have developed some form of exchange mechanism. This works on the basis that everyone agrees that some token (cowrie shells, perhaps) represents value. The value can be transferred between people and exchanged for goods and services. Now it’s easy to trade a mammoth skin for cowrie shells and take the shells to someone who has watermelons. The watermelon farmer can use the cowrie shells to buy a chair or a boat or a chicken – whatever he or she needs. As everyone in the community accepts that cowrie shells have value, they become a means of exchange – or money.

‘Money’s a matter of functions four, A Medium, a Measure, a Standard, a Store.’

Mnemonic for the functions of money (1919)

The four functions of money

In 1875, the British economist William Jevons set out the four functions of money in his book Money and the Mechanism of Exchange. Money is, he said, a medium of exchange, a common measure of value, a standard of value and a store of value. Some economists have argued that being a store of value and a medium of exchange are mutually exclusive, as storing it means you can’t spend it (exchange), and spending it means you can’t save it (storing). This is a trifle pedantic, as it has the potential to be both at different times.

A modern approach often lists three functions for money:

•a medium of exchange

•a store of value

•a unit of account.

It is called a medium of exchange as it facilitates the exchange (swapping) of goods and services, acting as an intermediary between disparate items such as mammoth skins and watermelons.

As a store of value, it’s important that whatever is chosen as the means of exchange does not readily deteriorate or decay. This is one reason for choosing gold – it doesn’t corrode, evaporate or change in any way over time, and it’s difficult to destroy as it doesn’t dissolve in most acids. It would not be sensible to choose, say, fresh fruit as a medium of exchange as it would soon rot.

WHEN MONEY GOES WRONG

When an economy fails, prices may rise beyond all sensible measure and each unit of currency will then buy less and less – its exchange value falls. In this case, money itself is no longer a good store of value. The classic example of this is the period in the 1920s when the German currency, the mark, became virtually worthless. Something that cost one mark in 1918 cost three billion marks in 1923. As a result, some people in Germany began to use other currencies or media of exchange in preference to the mark (see here).

Economists recognize two types of value: the utility (usefulness) of a particular good or service, and the power of a good or service when exchanged to acquire other goods and services. Anything used as money has exchange value. It can also have utility value, as we shall see.

The last function, a unit of account, means there must be a consistent way of measuring or counting money and that it provides the unit for pricing other items. This is served by currency: we count money in dollars, pounds, euro, yuan, yen, pesos and so on.

Commodity money

Physical items used as money are called commodity money. The item itself must have recognized intrinsic value. Examples of items that have been used as commodity money include:

•Buckskins and beaver pelts in North America. Hudson Bay had an official exchange rate for beaver pelts. One beaver pelt could be exchanged for two pairs of scissors, five pounds of sugar, 20 fish-hooks or a pair of shoes. Twelve beaver pelts would buy you a gun.

•Decorative items such as shells, mirrors, beads and decorated belts. Part of the payment that Dutch traders made to Native Americans when they bought Manhattan Island in 1626 was in beads, the total value of the goods traded being around 60 gilders ($1,000/£650).

•Axes. In 9th century Poland they were useful for cutting down trees and launching raids on neighbours.

•Bat and bird droppings (guano). The Incas used guano as a rich fertilizer.

•Food items which are slow to perish, such as salt, peppercorns, barley, rice, dried fish and cattle. Cattle are not divisible until dead, so rather inconvenient – a bit like an economy in which the only currency is $100 notes.

•Tobacco and cigarettes. Cigarettes have often been used by soldiers and prisoners as currency. A full economy based on cigarettes grew up in some prisoner-of-war camps in World War II. After smoking was banned in many US jails, foil pouches of mackerel fillets took over as the unit of currency.

Opportunity cost (see here) is clear with commodity money. The opportunity cost of paying for a stamp with a pouch of mackerel is the chance to eat the mackerel.

THE ISLAND OF STONE MONEY

On the Pacific island of Yap, wheel-shaped stones have been used as money for centuries. Some are small, but others very large – up to 3.6m (12 ft) across and weighing over 4,000kg (4 tons). Made of limestone mined and carved in Palau, they were moved by bamboo canoe to Yap.

The agreed value of a stone depends on its size, craftsmanship and history. The most valuable stones, paradoxically, are those that killed no one in transit and those that killed most people in transit. They are so large and heavy that they are rarely moved; trade consists only of recording a change of ownership. One stone even fell into the sea during transport to Yap and was still traded because access to it was not important. Everyone knew where it was and who owned it, so ownership of the stone could change without the stone being moved. Ownership of a stone that can’t be retrieved from the ocean is an early example of virtual money.

Modern money

For most of us, money is counted in units of a specific currency – dollars, pounds, euros, yen, yuan, lire, dinar and so on. This is called fiat money – the items exchanged have no intrinsic value, but they are agreed to have value for the sake of running the economy.

We are used to fiat money in the form of coins and notes, but increasingly also in virtual form. In the developed world today people are now less likely to be paid in cash. Their salary is more likely to be deposited in their bank as a figure that increases their balance, and is often spent by wielding a card that authorizes a business to reduce the balance, or by setting up a direct debit or standing order that lets them take away some of the balance on a regular basis. We might sometimes withdraw some cash – but for most of us today cash is not really the dominant form of money (see here – Is cash on the way out?)

THREE HEADS FOR THAT DRAGON JAR

Some of the Penan people in Borneo used the severed heads of their enemies as tributes to the spirits that had power over rice. Heads were offered to make the rice grow, but also became an item of value in their own right, because of their efficacy as spirit-bribes. There was no physical trade in heads, though, as trading them was considered unlucky. Instead, a head was equivalent to a living slave or captive, which could be traded. Some items had a value as ‘virtual heads’. A dragon jar – a large receptacle with a green glaze and dragon motif, imported from China – was valued at three heads. If someone killed a person, requiring a tribute to the bereaved family of three heads, the debt could be discharged by the transfer of a dragon jar.

Two types of money

Increasingly, money has become dissociated from the real, physical world. I get paid for thinking and jiggling my fingers about over a keyboard. It’s about as unreal as you can get. The money I get for it is paid straight into my bank account and the bank takes out chunks for the mortgage, utilities and so on at regular intervals. The rest I spend by waving a bit of plastic or clicking on web pages. At any point, I could, in theory, go and take all my money out of the bank as cash. In practice, I would be challenged at every step: they would assume I was going to do something illegal with it, since people don’t usually withdraw all their money in this way. And it would be impossible to obtain my money if everyone else tried to draw theirs out at the same time. This is because money is now largely theoretical and there is nowhere near as much cash in existence as there is ‘money’ in the economic system. The money that is held only as electronic records is called bank money, for fairly obvious reasons.

Bank money is used to move money between financial institutions, governments, large corporations and so on. If you pay $20 to a bookshop using a debit card, there is no physical movement of actual money between your bank and the bookshop’s bank. The entire transaction, and all similar transactions, are carried out using bank money. In the UK, 97 per cent of money held by the public is in the form of bank deposits rather than as cash (2014 figure).

FROM COMMODITY TO FIAT AND BACK

Early Chinese coins had holes in them so that they could be strung on a thread or thong and were easy to keep. Since the coins had greater face value than the intrinsic value of the metal they were made from, they were an example of fiat money.

Chinese coins that came into the hands of tribespeople in parts of Malaysia were sometimes adopted as a local currency, but their value bore no relation to the face value of the coins. Instead, the holes made them useful as decorative items that could be fixed to other things, such as jewellery or head-dresses. The coins then became commodity money, based on their value as intrinsically useful items.

A run on the bank

In the film Mary Poppins, Michael, the young son of Mr Banks, is reluctant to deposit his money in a bank. When the bank manager snatches it, Michael demands back his tuppence (two old pennies, or 2d). The other customers, misunderstanding what is happening, assume the bank can’t honour a young customer’s demand for tuppence and a ‘run’ on the bank ensues – that is, everyone tries to withdraw their money at the same time. This is, in a nutshell, what causes a run on a bank: too many depositors want their money back all at once, and the bank can’t honour all the debts. A run generally starts because of a loss of confidence in the bank, and then becomes a self-fulfilling prophecy. In fact, if at any point all customers tried to take all their money out of the banks, the banks would not be able to honour the deposits. Usually only a minority of people want their money at any one time and everyone else believes they could get hold of it if they needed to, and so the illusion and the banking system are