What is money ? Money is what people think as money. Cryptic ?! Well, a student of Economics learns that ‘Money is a medium of exchange, unit of account and store of value’. These are three basic functions that need be fulfilled for something to be considered money. And what can do these three, has always kept changing. In this blog, I touch upon the different kinds of material that have been/are/will be used as money in the past, present and future.
The different materials used as money could be classified into three types:
- Materials with intrinsic value: These are materials used as money which had some value in and of itself. This was the first form of money and some examples of these are cattle, grains, precious metals etc. All these things have some use and value by itself other than its usefulness as money. I call these imperfect money as it couldn’t perform all the necessary functions of money very well. Cattle was not a good medium of exchange as the value of single units was very high and it couldn’t be divided for purchases. Imagine having one cow and you wanting to buy few clothes, few books and some food from different sellers. Nor was cattle or grain a good store of value as they both have a limited shelf life. Precious metals like gold and silver performed these functions much better, but it presented a different problem. Its use was constrained by how much gold or silver the world had as these cannot not be produced (unless you are an alchemist!).
- Materials with no intrinsic value, but promised a material with value: This is money which has no value of itself, but are claims to some material of value. Such money did take shape very early on in human history. One example is a system where grain was given to a granary and the granary gave out clay tablets with details of type and quantity of grain stored. These tablets became claims to those quantities of goods and were thus used for exchange instead of giving the grain in return for goods. This is different from the first case as the clay tablet has no value by itself. It derived value equivalent to the value of the material it was a claim to. This kind of money later took the form of leather pieces, promissory notes given by goldsmiths against deposit of gold etc. These forms of money performed the three functions of money well, but were still limited by the availability of underlying material. These were the precursor to paper currency as we see today, but are different from paper currency in one crucial aspect.
- Material with no intrinsic value and no promise to a material with value: This is similar to the earlier type in that the material used as money has no value in itself. Further, this money is not even a claim to any underlying material. This is known as fiat money. All the currencies we are familiar with in the world today are fiat money. Any currency note in India has the following statement written on it “I promise to pay the bearer the sum of ____ rupees”. It is a promise to pay a sum, and not any material. This is different from the statement one would find on a currency backed by gold. An example is the 1922 dollar bill in USA which reads, “This certifies that there have been deposited in the Treasury of the United States of America ____ Dollars in gold coin payable to the bearer on demand.” Modern dollar bills have no such promise and only say, “This note is legal tender for all debts, public and private. This last form of money performs all the functions of money and its use/production is not limited by the availability of a material to back it.
Earlier forms of currency backed by a material required the issuer (Central banks of nations) to hold the material with themselves so that the bearers of the currency may redeem the material on demand. With fiat currency, the central banks no longer needed to keep reserves in the form of gold/silver. The provision in law making the currency legal tender gave value to the currency. When a currency is legal tender, it is illegal to refuse payment in that currency making an effective medium of exchange. But, this didn’t mean that we had created a perfect money that could serve the three purposes mentioned above. A central bank had to be careful as to how much currency it should print as printing too much currency could lead to a fall in the value of the currency. This is known as inflation and you can read more about this in my earlier blog article.
Apart from the problem of inflation. there is another problem which is that there are many central banks in the world and as many different currencies. Additionally, people want to exchange goods and services across countries. An Indian rupee note that is legal tender in India doesnt hold much value for an Israeli selling olives and it is quite likely that you wouldn’t be able to buy olives in Israel in exchange for rupees. Thus, international movement of goods, people and money brings up another issue for central bankers. That of determining the value of each currency against each other and keeping these values at levels favourable to each country. We will explore all these (Gold Standard, Dollar Standard, Floating currency system etc.) in greater detail in another post later. For now, I will say that this puts some constraints on central banks requiring them to keep some reserves in the form of gold, foreign currency or foreign bonds.
Future of Money
Not a material and no promise to any material: With improvements in ICT, it is no longer required to have any material to serve as money. A lot of the money that circulates in the economy today is no longer in the form of paper. A safe digital record of money serves as money today. A lot of the dollars and rupees that are transferred today are paid/received digitally through credit/debit cards, online transfers etc. These can be called digital currency.
The latest development in digital currencies is cryptocurrency. Cryptocurrency like bitcoins overcomes a limitations that current fiat money and digital currency has. It is designed to have no inflation. The total number of such digital currency is fixed unlike national currencies whose supply is increased by central banks. So, it is argued to be a better store of value than national currencies. But, it currently doesn’t perform the first two functions as unit of account and medium of exchange very well. If there is increased adoption of digital currencies by more people, we could probably be in a future where digital currencies without borders might become the norm.
Thus, bitcoin will be money when people begin to think of it as money.
P.S. – The history of money is inextricably linked to the history of banking and credit. This article has sacrificed completeness for brevity. For a more detailed account of the history of money, credit and banking check out the book ‘The Ascent of Money: A Financial History of the World‘ by Niall Fergusson, a history professor at Harvard and Stanford.