Money is something we take for granted and we usually don't think too much into what it actually is. As a result, when it comes up as a discussion topic, one may easily discover that nearly everyone has a personal twist on the understanding of what exactly is "money", and how this notion should be interpreted. At least that is the case within the circle of people, who are far from economics; and computer science people most often are. Last week this fact got itself another confirmation, when Swen came up with some fiscal policy-related problem, which didn't seem like a problem to me at all. After a long round of discussion we found out that when we said "money" we meant different things. So I thought I'd put down my understanding of this notion in words, so that next time I could point here and say: look, that's what I mean.
Of course, I don't pretend to be even a bit authoritative. After all, I don't know anything about economics (although I did take the elementary course, as any computer science student should). But I do find my understanding quite consistent with observation and common knowledge.
The Ideal Case
It's easy to start by imagining a country, call it "Veggieland", where people are completely inactive. They don't eat, work or play. Don't shop, produce or consume. Just lie around like vegetables, enjoy the sun and somehow manage to stay alive nonetheless. It is clear, that in this world, no money is needed: there is simply nothing to do with it.
Next, imagine that suddenly one veggielander Adam started longing for a glass of water, but he had no idea where to get it. At the same time another veggielander Betty saw Adam's problem and said: "Hey Adam, I can give you a glass of water, but you have to scratch my back for that", because Betty really liked when someone scratched her back. They exchanged services and were happy. Still no money was needed in Veggieland.
After that day Adam discovered that he was really good at scratching Betty's back, and he even liked it. So next time he came to Betty and proposed to scratch her back even though he didn't want water. What he asked in return was a promise that she would get him a glass of water next time he would ask. After a month or so of scratching Betty's back he collected 100 water glass promises, each written with Betty's hand on a nice pink piece of paper, and he found out that this was much more water than he would need until the end of his life. But he had to do something with these promises, because he couldn't "unscratch" Betty's back, right? So he went to that other guy Carl and said: "Hey, Betty has promised me a glass of water, and I can pass this promise to you, if you give me that shiny glass bead that you have, because I adore glass beads". Carl always trusted Betty's promises so he agreed. Now Adam had a bead and 99 water promises, Carl had one water promise. Carl then went to Betty, showed her the pink piece of paper, Betty exchanged it for a glass of water and burned it. Now there were just 99 promises left in circulation in Veggieland.
A month has passed and veggielanders understood that they could actually pass Betty's promises around, and give out their own promises in exchange for services. They wrote promises on pink pieces of paper and picked the "water glass promise" as a universal measure: now Daffy was providing floozies in exchange for 2 water glass promises, and Ewan was selling tiddlybums at a price 3 water glasses per portion. The system worked, because it satisfied two simple conditions:
- Firstly, at any given moment the number of undone work was equal the number of these pink paper promises in circulation.
- Secondly, the number of promised work was always feasible.
These conditions were easy to satisfy in Veggieland, because veggielanders were all honest and friendly people. They decided that any time someone fulfills his own promise, she should destroy one pink paper, and any time someone gives a promise, she should write a new pink paper, but no one should give a promise he can't hold.
As a result the people of Veggieland ended up with a perfect monetary system, driving its economics, and allowing citizens to trade services and goods. The analogy of this system with the real monetary systems around is straightforward, yet it is much easier to understand its properties, and thus the properties of the real-world money. The following are the important observations:
- Money itself is just an abstract promise, it has no form or inherent value. As long conditions 1 and 2 are satisfied, there is really no difference whether the function of money is performed using pink papers, glass beads, or even word-of-mouth promises. Money is not a resource, don't be misled by the idea of the gold standard times, that money equals gold. The point of the gold standard was just that, at the time, gold could somewhy satisfy properties 1 and 2 better than printed money and checks. Otherwise, you don't really need to "support" money with goods for no purpose, but to provide an illusion to people that money is indeed worth it's promise.
- The amount of money in circulation does not equal the amount of natural resources of the land. It is equal to the amount of economic activity, i.e., the number of unfulfilled promises. If someone discovers a gold mine, or simply brings in a lot of gold into the country, this will begin having impact only when people start actually demanding this resource and giving out promises in exchange.
- Who makes money? Well, ideally, each person that gives a reasonable promise in exchange for a real service increases the amount of money in circulation, and the person that fulfills a promise - decreases. Of course, real people are not honest and therefore real monetary systems are a crude approximation, with banks being in response of this dynamic money emission process.
- The choice of currency does make a difference. If someone comes to Veggieland with a bunch of euros (which are, in a sense, promises given by the europeans), the veggielanders won't be inclined to exchange them for their own promises, because although the newcomer can easily make use of the veggielanders' services, the contrary is not true: Veggielanders just never leave their country! A corollary of this observation is that the larger is the geographical span of a particular currency, the further away from the ideal trade unit it will be.
The Real Life
Now let's look at how monetary system is implemented in real countries. There are two main aspects to this implementation.
First issue is the choice and social support for the base monetary unit. Each country typically figures out its favourite name and denomination for the unit and calls it its "currency". A social contract is then made among the citizens, that all promises in the country are to be measured in this unit, and everyone should accept this unit in return for services. Note that this social contract guarantees the absolute liquidity of the currency and puts it strictly aside from anything else you might imagine to be a "close analogue" for money - be it gold, government bonds or securities. The latter are just not liquid enough to work as a general promise-container.
Secondly, the process of emission and subtraction of money from circulation. This certainly cannot be trusted to people, like it was in Veggieland. A banking system serves the purpose. The idea is that a single central trusted party is chosen, which emits and discards money. A person comes to the bank asking for a loan, the bank confirms that the person is trustworthy enough to keep his promises and gives him some money: money has just been emitted into circulation. Note that in our digital world most money is emitted in digital form, no paper money needs to be printed for that. In other words, the number you see on your account is actually larger than the number of paper money stored "behind" it. This is very natural, because otherwise the bank would have to keep paper-money-printing and destroying machines in it, which would be dangerous.
Most real monetary systems are just a bit more complicated, having a two-level banking system. The central bank crudely regulates money supply by emitting paper money, giving loans to commercial banks and instructing them to as to how much "more" money they may emit via the reserve requirements. The commercial banks then provide actual banking services to the people. With this distributed system people have a choice of several banks to trust their finances to, not just one. And if it turns out that one bank emits too much (i.e. gives too many loans), so that the emitted promises cannot be met, only the people trusting this bank (i.e. holding "this bank's" money) will suffer.
Final Questions
Despite the fact that the above theory seems consistent to me, it is not without complications. As I believe you've already tired of reading this post, I'll avoid spilling too much further thought upon you and just list the three points I find most confusing briefly.
- Despite being an abstract trade unit, money actually has value: it can bring interests. How do these interests "earned from nowhere" correspond to money emission? Why should owing lots of abstract promises necessarily generate more abstract promises?
- Internet banks take a fee for transfers, which makes digital money somewhat less liquid than paper money. I find it incorrect. Why should I pay to pay? I understand that banks need resources to support their services, but the amount of resources should not be proportional to the number of operations performed.
- If all the customers of a bank one day come to claim their savings in cash, the bank won't have enough cash and it will be perceived as a collapse for the bank. Considering the fact that digital money is, in fact, still real money, I see this as a certain drawback of the current two-level banking system. Or is it a necessary condition to distribute trust among the commercial banks?
If you think I'm completely wrong with all that, you are welcome to state your opinion in the comments.
