Practical Dad

So, Just What is Money?

It's been clear that we're involved globally in currency wars and the recent decision by the Swiss National Bank to cut its peg to the Euro is one more skirmish.  Yet at the same time on the family front, Middle is beginning a semester course in AP Economics so there are basic questions about economics to be discussed.  I've already written about what interest rates are as well as the definition of inflation with the notion that the kids will read them at some point.  But what's happening globally begs a very, very basic question: just what is money?  I'll be forwarding this to Middle for his light evening reading because I believe that the heart of the current global currency wars and economic dislocations centers on a basic disagreement of the operational function of money, particularly between the United States - holder of the global reserve currency - and the Chinese.  So, Middle, grab a soda and earbuds and settle down for a little while...

We're inundated with all manner of informational overload about Personal Finance.  We worry about what the kids are learning and how they'll cope in their future.  But for all of the ink, there's a simple question that's overlooked: what exactly is money?  What is it about that crumpled five dollar bill that I just pulled out of your jeans before they went into the wash (and it's now waiting for you on the dresser) or that 1 Euro coin that came back from last summer's long-awaited trip?  They are obviously different in all ways - shape and substance, language, etc. - but each serves an identical purpose for its respective nation(s).  It doesn't make much sense to go into marginal analysis and supply/demand curves or ascertaining the cost of interest if you don't at least have a handle on that most basic financial tool, money.  For all of the differences in currencies across the globe - dollar, euro, krona, yuan, yen - each has three operative characteristics in common that make them able to serve as money.  It's important to understand these three characteristics because I believe that the heart of the most basic issues involving the currency wars is because the rest of the world places a greater emphasis upon one characteristic than the US does and the difference has created fundamental problems for the world that can no longer be ignored.

The first characteristic of money is that it is fungible.  One unit of money within a particular issuing region is precisely interchangeable with any other unit of that money.  In other words, that crumpled five dollar bill on your dresser could be taken to the soda cave at the nearby convenience store and used to purchase a bottle of Stewart's Orange Cream Soda as well as the five dollar bill that I pulled from my wallet to give you for that same bottle of soda, assuming of course that I was willing to do that.  You could borrow a five dollar bill from your buddy for the soda and that would serve as well as the crisp new fiver that you got from the bank.  The point is that they are interchangeable for use - fungible - and the store clerk is legally required to take any fiver presented to pay for the soda.  The sole reasons for not taking the note would be that it was either somehow damaged beyond repair - sorry, but half of a note is unusable - or there's reason to believe that it's counterfeit.  This same premise holds true across the globe in any reasonably functioning nation in which the citizenry actually has a semblance of trust in its currency; any ten pound note could be used to purchase chips in an English pub and any renmimbi note could be used to purchase cigarettes in a Chinese market.  If the people of a particular country want to take some other currency instead of their own for daily life - think Zimbabwe or Argentina for instance - then they have much deeper issues both economically and politically since the two go together like crap and stink.

The second characteristic of money is that it serves as a medium of exchange for any transactions that occur in an economy.  It that sense, money is a kind of tool that makes life easier.  The classic example would be in a simple farm and trade economy in which everybody has to barter what they have - chicken eggs for instance - for something else that they need.  If Farmer A has eggs but needs a plow fixed and the blacksmith doesn't need eggs but would rather have sheep wool, then Farmer A has to figure out exactly who both needs his eggs and has sheep wool; if no one else readily comes to mind, then the potential range of transactions becomes larger:  A trades his eggs to C for five bushels of excess grain and A in turn gives four of those bushels to F for the wool; A can then give the wool to the blacksmith for the plow repair and keep the grain as profit.  Over the course of centuries of this barter economy, people began to use various forms of money to make their lives easier and eliminate the need to navigate a massive web in order to get the plow repaired.  The biggest hurdle to overcoming barter and moving to money was the rise of a common belief that that form of currency would be good so that all parties could buy into that system and participate.  This was frequently based upon the belief that the political power was stable to enforce the laws and back that currency.  If you want a more up-to-date example of currency and the forms that it could take, think back to the night that we watched Stalag 17 on Turner Classic Movies.  William Holden played Sergeant JJ Sefton, a cynical anti-hero who was the resident scrounger and procurer of all good things within the German prison camp.  There's a scene in the first half in which he has his minion - because we all need our minions - inventory the contents of his usually locked footlocker.  He is loaded with cigarettes but also has a lesser quantity of chocolate bars, silk hosiery, men's cologne and even a camera.  In the closed society of the Stalag, the American dollar is worthless for everyday transactions because it is simply not accepted as a medium of exchange and God knows that the Germans wouldn't be giving the prisoners Deutschemarks.  But the cigarette is the commonly accepted medium of exchange for transactions between the prisoners and even the guards since the Germans produced lousy cigarettes and even they acknowledged that.  The cigarette is ideal because in that time and place, everybody smokes and accepts them; there is also a constant, but rationed supply coming into the Stalag via the Red Cross parcels that the prisoners periodically receive.  So if you want to bribe a guard or transact some business with another prisoner, the cigarette is the ideal form of money and the lesser quantity items would serve as the higher denominated forms of money.  A Red Cross parcel might contain two packs of 20 cigarettes each but only two chocolate bars, so in the purely theoretical world of currency exchange, a chocolate bar would be worth a pack of cigarettes and if it wasn't, then that would be due to purely local conditions.  The point is that everybody accepted them because all believed that American cigarettes were superior and that they were typically available.

Which leads to the third operative characteristic of money, a store of value.  People will use something as a form of money if it can reliably be found to hold it's value, particularly measured by an ability to purchase the same amount of something over time.  If that form can't maintain it's value, then the people will engage in economic behaviors to account for that until another form of money is found to replace it.  What might those behaviors be?  One might be to simply spend it as soon as possible instead of even bothering to save - the grasshopper side of Aesop's Ant and the Grasshopper - because there's no point to keeping it.  The person might also find something else to purchase that she believes will hold value better than the current form of money and in this regard, so-called hard assets such as gold, silver or even diamonds are prime examples.  No, you can't buy a Stewart's Orange Cream Soda with a gram of silver but you'll purchase the silver and simply set it aside and hold it as a form of savings since it can hold value.  When there's a reason to purchase the Stewart's, then you simply sell the silver and use the actual money as the medium of exchange with the clerk.  For the record, I can see absolutely no reason to sell silver in order to purchase Stewart's and if there is, you have more important items to purchase for survival than Stewart's.  Think back to the example we used from the movie Stalag 17.  The cigarettes are also a valid form of money because they do hold their value well.  There is a general equilibrium of value between the supply of cigarettes (periodic supply via the Red Cross parcels) and the demand for cigarettes since they are all smoked.  The conditions are set as well for their use since there's really nothing else of commonly-accepted value amongst the general population that could change.  On the one hand, the war might end as victorious Allied armies overrun the camps which means that the prisoners are released to the larger society in which they use dollars, and cigarettes become much more plentiful and hence less valuable.  On the other hand, the Allied Air Forces under the command of General Bernanke might decide to provide a mass cigarette drop on all known German Stalags as a morale boosting effort.  That would certainly make the prisoners happy, but it would utterly ruin Sefton's meticulously constructed business.

So what's the takeaway from this lesson?  That whatever serves as a viable form of money in an society must meet three basic criteria and that there should be a general balance between the three.  There can certainly be stresses to a currency dependent upon any number of factors whether they are social, economic or political, internal or external.  But to appreciate what's going on around you, you have to get your nose off of the screen and begin to pay attention, especially over the course of time; you have to start thinking beyond the now and try to view something as dynamic and within the context of a much longer timespan.  And finally, look for any number of ways to place what you're seeing within the context of the greater world.  You don't live in a vacuum and what occurs nationally or globally can have a significant local presence right in front of you.

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