What is Money?
From an economic and financial perspective understanding precisely what money is and how it influences the economy is crucial. Why? Because money is the most important tool we use in modern life. Money is at the heart of every financial transaction, including our calculations of output, profits, and every measurement of our financial health. Understanding how this tool works is central not only to understanding how the monetary system and the economy works but to understanding modern human life.
Why Do We Use Money?
Before we can say what money is, it’s helpful to understand first why money even exists. To answer that question, and really begin to understand money and the history of money, it might help to understand the most basic purpose that money serves. As highly socialized and intelligent animals, we humans have created various tools that improve our ability to trade and interact. A barter system is relatively primitive and insufficient because it forces you to be able to obtain something that someone else will want in exchange for the things you might need. Creating a universal medium of exchange is the bind that ties all goods and services together by making all goods and services exchangeable. At its core money is simply a social construct that allows for the exchange of
goods and services.
Money, within a modern human society, is highly evolved, formal, and even institutionalized. The true history of money is lost in time, but it’s likely that money started in the form of unspoken promises, evolved through a barter system of some type, and has expanded over time into formal promises and legal contracts. Today most money is defined and protected by laws. Modern money has evolved primarily into the electronic records of account.
We live in a highly advanced and sophisticated economic system that is predicated on the social interaction of trading goods and services for money. Said differently, money is the medium by which we gain access to the things we desire. You can’t always trade a back scratch for a back scratch, but humans have resolved that issue by creating something that facilitates the exchange of most goods and services. For instance, if I want a back scratch, but I don’t want to scratch your back, it’s not a problem. Instead you scratch my back in exchange for $10, thereby voiding my need to provide you with an equivalent back scratch, and you can go buy whatever you want.
At its most basic level money is just a tool that is created to facilitate exchanges among highly socialized animals—a social tool that acts as an intermediary in transactions. So now we can arrive at our first understanding of money:
1. Money is a social construct.
But this still doesn’t tell us why money exists. Why do you work such long hours to acquire pieces of paper or electronic credits in a bank account? Why do we stress and worry about money? It might help a bit to think of money as a theater ticket.1 If the economy (and our access to goods and services) is the theater, then we can think of money as the ticket that gains us entry to the show. In a modern monetary system a specifically designated form of money is little more than something that gains you entry to be able to transact within that economy. And we work because of and stress about our ability to obtain money because our access to the goods and services that we need ultimately relies on obtaining this tool. At times in human history money has been many things, including unspoken bonds, sticks, rocks, precious metals, pieces of paper, or records on the Internet. Technically, many things can and do meet the various properties of money. These things generally represent something of a certain value that can be easily measured. In other words we have developed a system of using items of particular value that represent the right to claim a certain amount of goods and services. It is, in essence, a way of recording a deferred promise. But we should be careful not to always think of money as a physical thing or something that has intrinsic value. Money represents a certain value, but the money thing itself (like a cash note) does not necessarily have intrinsic value.
Money in a modern society is largely made up of electronic records and numbers in computer systems. Your bank account exists primarily in a computer system as a record of account and not as a bar of gold in a vault. The electronic money system has come to dominate the way we transact and use this social tool. This brings us to our second crucial understanding about money:
2. Modern money is not necessarily a physical item or something with intrinsic value but is merely a medium of exchange and a record of account.
But what is the primary purpose of money? As I mentioned briefly earlier, the primary purpose of money is to provide us with a convenient medium of exchange for access to goods and services. That is, instead of toting around bars of gold to buy groceries at Walmart or relying on a barter system, we have created convenient ways to record our payments in order to obtain goods and services that we might desire. This gives us access to the ability to feed our families, send our children to school, maintain our health, enjoy ourselves, and so on.
Money, while important, should never be confused with true wealth. Remember, money is merely the medium of exchange. It is a tool like many other tools humans create, and it provides us with a means to an end. While the ticket gets you into the theater, what you want is not the ticket. The ticket simply gives you access to the show, which is the true end. Money is merely the means to that end. Although money is a necessary component of modern life, it is not a necessary component of acquiring true wealth.
Now, true wealth has different meanings to different people, but in most cases it involves the addition of companionship, good friends, good family, good health, access to food, access to water, security, et cetera. More money might make it more convenient to achieve certain things, but money and true wealth should not always be thought of as the same thing. Confusing money with true wealth is like confusing the theater ticket with the performance. Although we need some amount of tickets to enter the theater, the quality of that show is not necessarily dependent on the number of tickets we obtain throughout our lives. While money can certainly make it easier to obtain material goods, and perhaps even some level of happiness, it is always a means to some other end and
should not be confused with the end.
This brings us to what might be the most important lesson we can learn about money:
3. Money is not necessarily true wealth.
Almost anything can serve as money. You could take toilet paper to the local pawnshop and trade it for something of equal value, assuming the pawn shop will find it valuable. More commonly we tend to see people view precious metals like gold as money. This is not incorrect. Anything can serve as a medium of exchange. It’s just that gold is a rather inconvenient form of money. It’s heavy, hard to value in real time, and not widely accepted as a medium of exchange. So it’s a fairly inconvenient means of purchasing goods and services.
Most of the money in a modern monetary system is what’s called fiat money. Fiat money is money that has no intrinsic value but is used as a medium of exchange because a specific government deems it so. In Latin fiat means “let it be.” Today’s monetary systems are designed as social systems that institutionalize and organize money under specific laws within specific societies. Governments regulate these monetary systems and identify the entities that may issue specific types of money. The US government regulates the US monetary system, which is designed around the private banking system. You can think of the private banking system as the playing field upon which the US payments system works. The government is the referee (regulator), and we are the players trying to obtain balls (money) to score goals (consume and produce). But if you want to play on the field designated and regulated by the US government, then you must use the ball that it deems to be acceptable, and that means engaging the playing field that is the US banking system.
In the United States the dollar is the unit of account in which all money is denominated. Unit of account is the measuring stick we use for money. Much like the metric scale, money is measured according to its unit of account. So one dollar can buy you X number of sandwiches or whatever goods or services you desire. The unit of account is different in different countries, but the concept is always the same—a government has designated a specifically denominated money as the unit of account (for instance, the yen in Japan, euros in Europe, or pesos in Mexico), and the government regulates the playing field upon which that unit of
account is used. If you want to participate in the US economy, you must generally obtain money that is denominated in US dollars, which is the standard form of payment accepted for goods and services. In most cases that means participation in the US banking system using bank deposits denominated in dollars.
This brings us to the next important understanding about money:
4. Modern money is a specifically defined unit of account.
For the purposes of this book I will focus primarily on the economic purpose of money. At its most basic purpose, money is simply a medium of exchange, the tool that gains us access to goods and services. Today’s primary tool of exchange is bank deposits. The modern monetary playing field exists primarily within the banking system, which processes trillions of dollars in payments every single day. When you buy a sandwich with your debit card, your bank is processing a payment on your behalf. You are transferring bank deposits from your bank account to that of the seller. When you take money out of the ATM to make a purchase, you are drawing down a bank account in order to transact with physical money more conveniently. All these transactions are centered around the banking system and the deposit system. Today’s monetary system exists primarily on spreadsheets as numbers in computers recorded by banks as bank deposits. Bank deposits are created when banks make loans; then these deposits are used as the primary means of transacting business at the point of sale. Modern money is both someone’s asset and someone else’s liability, existing primarily in computer systems as records of this basic accounting. For instance, when a bank creates a loan, the loan generates four specific accounting entries. The loan is an asset for the bank; when the recipient of the loan deposits the money, the deposit creates a liability for the bank. For the borrower the loan is a liability and the deposit is an asset.
Understanding that most modern money is based on the electronic deposit system controlled by the banking system, and that this money is created as credit through the loan creation process, is crucial. This sophisticated banking system allows us to conveniently and efficiently exchange goods and services by establishing a money supply that is elastic. This means the money supply can expand and contract according to the needs of its users. This brings us to an essential understanding of modern money:
5. Most modern money is credit.
In today’s electronic money system most money exists as a record of account on spreadsheets as a result of the accounting relationship that created the money through the loan creation process.
- Where Does Money Come From?
- Understanding the Modern Monetary System
- Understanding Moneyness
- Understanding Inside Money and Outside Money
- Credit IS Money
- Where Does “Cash” Come From?
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.