Understanding Money, the World's Most Powerful Tool

 

Written by Olga Cooperman

​

Introduction

​

Money is omnipresent in every aspect of our lives, yet it is often taken for granted and rarely

questioned. Its true nature may come as a surprise to many, as it is not always what it appears

to be. As the old banker in Walt Disney’s Mary Poppins song explains, banks take people’s

deposits and invest them into the economy, creating loans that drive businesses and enable

them to grow. However, this simplified view does not reveal the full picture, as banks have the

power to create their own money without relying solely on deposits.

 

Historian Yuval Harari once proposed that the reason we desire money is because everyone

else wants it and believes in it. He posits that trust is the fundamental ingredient in crafting all

forms of money. Yet, the true explanation behind our willingness to exchange objects of value

for colorful paper is more intricate than that.

 

In recent years, there has been much debate about the merits of decentralized money, such as

cryptocurrencies, and gold-backed currencies. However, in order to engage in these

discussions effectively, it is essential to establish a good understanding of what money is and how it functions in a society.

 

Economic Theories of Money

​

The concept of money has long been a subject of debate among economists, with two

prominent theories seeking to explain its nature. The first, known as the commodity theory,

postulates that money serves as a convenient intermediary object that facilitates the exchange of goods. Its value is derived from the commodity it is made of or can be converted into, with the ability to store value being one of its defining characteristics. According to this perspective,

commodity money emerged as a solution to the challenges associated with the direct exchange

of goods, commonly referred to as barter.

 

On the other hand, the credit theory asserts that money is a token representing a credit relationship between a borrower and a lender. This token can be transferred to others and utilized for payments, provided that the issuer is deemed creditworthy. In theory, any individual or entity can create credit money if there is a willing recipient who accepts it as payment. Typically, the most creditworthy issuer is a state. The credit theory suggests that credit money was developed to address the issue of trust between strangers when exchanging goods or services. Determining the accuracy of these theories is essential in understanding the nature of money as either a store of value or a credit relationship. Let’s explore which of these two aspects is necessary for making money work.

 

Two Fables about the Nature of Money

 

Witch’s Money is a satirical story by John Collier. In the story, a traveling American painter stumbles upon a picturesque French village and decides to stay there and work. However, there is no rental market in the secluded village – in fact, not much of any market at all. The artist roams around until he finds a vacant property and offers to buy it for 30,000 francs. The owner accepts a check from the painter, although he’s never seen one before. It is not uncommon in the village to settle payments at a later date. At the end of the week, he comes back with the check and demands that the painter gives him 30,000 francs. Instead, the painter refers him to the bank, which is a daylong trip from the village. At the bank, a teller explains to the villager that he needs to open a checking account, wait for the check to clear, and come back in a week to withdraw money. The villager is frustrated but has no choice other than to wait. He comes back a week later and asks again for his 30,000 francs. Since he is taking all the money out, the teller closes the checking account and withholds a small fee for the service. The villager is now furious – after all his troubles, he does not get the nice round sum he anticipated. He returns to the village and vents to his friends about this gross injustice. They all agree that this is unacceptable. Moreover, they note that the painter has a full book of checks, each worth 30,000 francs – how can a person have so much money? The friends kill the painter and split the checks among themselves. Immediately, they feel rich and start trading with each other. Soon, they start trading with their neighbors. While in circulation, blank checks inspire all sorts of new services, business projects, arranged marriages and shady dealings. In fact, the sleepy village is soon transformed into a place bustling with commerce. The painter’s checks change many hands before making a full circle back to the perpetrators. The story ends with the friends, dressed up in their best clothes, laughing as they enter the bank to cash their checks.

 

The Rich Guest paradox depicts an impoverished town where residents are indebted to each other but don’t have the money to settle their debts.  A visitor arrives in the town and asks for a room in the local hotel. However, he wants to inspect the room before renting it. He leaves a large cash deposit at the front desk and proceeds to explore the hotel. The hotel owner takes the deposit and gives it to his chef as he hasn’t been able to pay his salary. The chef takes the money and repays his debt to the grocer. The grocer can finally pay his doctor. The doctor pays the nurse. The nurse owes money to the hotel where she stayed while looking for a place in the town. She brings the money to the front desk. The guest comes back and takes his deposit – after all, he will not be staying at this rundown hotel. Nothing really changed in the town, but residents are now debt-free.

 

These two stories reveal something important about the nature of money. Worthless checks in Collier‘s story worked as well as any real money - as long as the villagers believed that the bank would exchange them for 30,000 francs each. Circulating checks served the purpose of a transaction tracking system. The person holding a check has given something of value to others and is entitled to something in return. The role of the bank was to give legitimacy to the painter’s checkbook outside of the village.

 

All debts in the Rich Guest Paradox ultimately added up to zero. This is true for any closed system: one person’s obligation is another person’s claim. The residents of the impoverished town could not extinguish their equal and opposite mutual indebtedness because their personal debts were not equally trustworthy. The rich guest’s deposit helped to bridge the trust gap and net down all their debts to zero. Technically, you are debt-free if you owe $100 to a neighbor, and simultaneously you are owed $100 by a different neighbor. You still need to collect money from one neighbor (if you are lucky) and deliver it to the other neighbor to extinguish your debt.  However, if you were to owe money and be owed an equal amount by the same person, you would just mutually agree to erase your debts to each other. This idea of introducing a trusted “central counterparty” that stands between each borrower and lender is widely used in the financial world. This arrangement allows canceling out any equal and opposite obligations between individuals separated by and facing off to the central counterparty. In both stories, the role of a universally trusted guarantor is essential for making money work, while the intrinsic value of the object used as money is not important at all. These fictional but insightful examples suggest that the credit theory of money may be more correct than the commodity theory.

 

The Birth of Money

 

The canonical story of money begins with the concept of barter.  At the dawn of civilization, a fisherman would offer excess fish to a butcher in exchange for some meat. If there was no “coincidence of wants” between the fisherman and the butcher, the fisherman would need to exchange his fish for something that the butcher wanted to get meat. It must have been cumbersome and time consuming to fulfill one’s basic needs in a barter society! Thankfully, money emerged as a medium of exchange and a standard measure of value. Precious metals were a particularly convenient material for this purpose as they could be made into standard bullions and coins and stored indefinitely. Eventually, debt and credit developed to support growing economies.

​

This convincing story was theorized by Adam Smith in the Wealth of Nations and became the textbook explanation of how money came to be. The trouble is that anthropologists never identified any ancient society that worked on barter as the original and primary mode of trade. Money-based societies had occasionally resorted to barter during extraordinary events (e.g., hyperinflation), but the antecedence of barter was never supported by evidence. According to anthropologist and writer David Graeber, debt was the oldest means of trade; money appeared later, and barter arrived last. Before cash and barter, a fisherman and a butcher would extend to each other social credit. This informal trust-based transaction did not require a coincidence of wants or a precise way of measuring the value of one item in terms of another item. In fact, giving back the exact value received would suggest the end of trading relations. There was no expectation of immediate and direct compensation, but taking advantage of the system would adversely impact one’s ability to do business within the community. 

 

The idea of money - a universally acceptable form of payment that could be used by total strangers - was born out of imperial conquests. Imperial rulers needed to solve a challenging problem: how to effectively feed and supply a professional army. The solution was ingenious: mint coins and give them to contract soldiers and simultaneously decree that taxes are payable in the same kind of coin. The objective of collecting taxes was to create demand for coins and by doing so facilitate the flow of goods to the army. From the very start, money was invented for dealing with strangers and its legitimacy was based on faith in a central authority. Taxes were the magic wand that could turn metal or any other object into money. 

 

How Money Works Today

 

Money has been around a very long time and we may never know with certainty how it first came to be. However, if humanity were to start over in a brand-new world, how would we begin creating money from scratch and integrating it into the economy? Fortunately, we don’t need gold or any other precious commodity to bootstrap a financial system. Commodity money would only hinder the economic development. If the supply of money cannot grow dynamically with the level of production, the prices will fall and discourage commercial activity. All we really need to jumpstart an economy are two things:

1. banks to make loans

2. willing borrowers who would use capital to build new products and businesses.

 

A modern monetary system is a network of commercial banks connected via a central bank. In this system, there are two main types of money: central bank money or “money base” and commercial bank money. Money base is created by the central bank and placed into “reserve” accounts that belong to commercial banks in exchange for debt (loans) originated by these banks. Commercial bank money are deposits held by the public at commercial banks.  Commercial bank money is created when a bank loans money to a client and simultaneously deposits the same money into that client’s bank account. This operation is initially a zero-sum game for the bank: the client owes borrowed money to the bank and the bank owes deposit money to the client. Commercial banks must maintain a certain ratio of central bank reserves to customer deposits; therefore, banks continuously borrow reserves from each other to maintain the ratio. Banks first lend money and then cover their reserve requirements at the central bank.  Here are the basic steps in the money creation process:

 

1. Bank A makes a loan to a customer and simultaneously deposits this newly created “bank money” in the customer’s account.

​

2. Bank A has the requirement to hold a certain percentage of customer deposits as reserves at the central bank. Bank A can achieve this in 2 ways:

 

• Bank A sells the customer debt to the central bank in exchange for newly created reserves

• Bank A borrows reserves from another bank

 

3. The borrower uses the money to make purchases or investments. The recipients of the money deposit it in their bank accounts at a bank B.

 

4. Bank B requests reserves to be transferred from the Bank’s A reserve account to its own reserve account at the central bank.

 

 

Example 1 illustrates the process of money creation by a central bank and commercial banks.

 

 

 

Example 1: Day Zero of a brand-new economy without any pre-existing money

 

Bank A lends Jane $1,000 “out of thin air” and immediately deposits it into her bank account. In order to satisfy the reserve requirement, the bank transfers Jane’s debt to the central bank in exchange for newly created central bank money. (In reality, Bank A only needs a small fraction of deposits to be held in reserves).  The economy now has $1,000 of central bank money and $1,000 of commercial bank money.

​