The Independent Market Observer

11/12/13 – The Problem of Money, Part 1: What Is Money?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Nov 12, 2013 10:13:54 AM

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“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” — Mark Twain

What is money?

At first blush, the question either sounds pretty obvious or like a Zen koan. I think it’s worth asking, though, for the same reasons it was worth asking “What is a house worth?” in 2007. Although everyone thought they knew all about the real estate market, it turned out we didn’t. In the same vein, I think there’s a real benefit to taking a deeper look at exactly what money is, and has to be, to determine if what we think we know about it (and about current economic conditions) actually makes sense.

Let’s start with a common definition of money, as follows:

A good that acts as a medium of exchange in transactions. Classically, it is said that money serves as a unit of account, a store of value, and a medium of exchange. Most authors find that the first two are nonessential properties that follow from the third.

Well, I start to have a problem with this at word two—we’ll get into that in a bit. The part I do agree with is “medium of exchange,” which captures one of the two essential elements of money: that someone else is willing to accept it, or exchangeability.

The other fundamental characteristic underlies the use of money as a store of value, and that is scarcity. If leaves, for example, were considered to be money, anyone could become rich just by shaking a tree. Scarcity is a necessary precondition for something to act as money.

If we consider scarcity and exchangeability to be money’s fundamental characteristics, we can use that context to look at previous and future examples to see how well they fit.

Historically, gold is the most common example of “money”—the gold standard, if you will. That phrase alone tells you most of what you need to know about gold’s position in our consciousness. It fits the fundamental requirements exactly, being both proverbially scarce and eminently exchangeable. Even today, when it is no longer used as currency, most people still have some in the form of jewelry, precisely because it is perceived as having value of its own. If I get my wife some aluminum jewelry, for example, I will get a reaction, but it won’t be the same one as I get for gold.

The next stage in the development of money is paper currency. Paper currency usually starts as an intermediary step; it’s simply an easier way to carry and transport gold, as each unit of currency is, in theory, backed by actual metal and can be redeemed for such. This is how U.S. currency started. At some point, though, a government will break the connection between the paper currency and any backing good, making it purely notional—“fiat currency,” in the jargon.

With asset-backed paper currency, scarcity and exchangeability are the same as that of the asset itself—if you trust the issuer to actually redeem it. For fiat currency, though, there’s no backing, so all you have is the trust itself.

Looking at the two fundamentals, scarcity and exchangeability, with fiat currency, you replace the hard limits of gold with the much softer limits of trust in the issuer. There are advantages to this, which we’ll discuss tomorrow, but there are very real disadvantages as well. Exchangeability can be required by law—“This note is legal tender for all debts, public and private” is written on every U.S. bank note—but scarcity is a very real problem for fiat currency. Maintaining scarcity is a key task of a successful central bank, and it’s at the root of most of our current economic worries about inflation, asset prices, and currency collapse—all of which I will address in the next few days.

There is now a very visible separation between asset-backed currencies, like gold, and paper currencies. That divide is being eroded, however, by other forms of currency, which combine elements of both, the most prominent being bitcoins.

The bitcoin is a purely digital currency, with no central authority to force exchangeability, which is purely voluntary, but it does satisfy the scarcity criterion. According to the base construction of bitcoins, there are a limited number, which are increasingly difficult to “mine.” This enforced scarcity and perceived exchangeability have given rise to the first purely virtual consensual currency.

Again, note that what has driven the bitcoin’s emergence is the satisfaction of the two fundamental requirements, scarcity and exchangeability. In that sense, bitcoins are simply a new form of gold for the digital age, where mining is replaced by “mining,” and they can be understood as such. Unlike gold, however, bitcoins involve the element of trust in the issuer and verification system. No computers, no networks, no bitcoins.

Tomorrow, I’ll take the next step and talk about how we can understand our current monetary system, and its risks and opportunities, in the context of scarcity and exchangeability. And, in the next couple of days, we’ll look at what that means for our current environment and the future.

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