Bitcoin made simple - Part 3 - What is money?
Let’s talk about Money. What is money?
In simple terms - Money is a tool used for trading.
You want to buy an item - this is trading. You need money to complete this trade - you give money and get the item. The money you use has to be valid for use in the country you are in. It means the money has to be approved by the government of the country. Typically, you cannot use Euros or Rupees to buy an item in the US. You need to use US dollars. Of course, there can be exceptions if the seller is willing to accept Euros.
Money has been used by humans since times immemorial. What would happen if we had no concept of money? In that case, we would have to use the barter system. This was the case before humans invented money. In case of the barter system, a human would exchange their good say bananas for the good that the other party had such as chicken.
But a barter system is very inefficient. Some of these challenges are
The two parties have to have exactly the item that the other wants. If party A has bananas and wants chicken but party B has corn and wants bananas, then the barter cannot happen. They either have to find someone else who can bridge this gap, or they might have to use the concept of credit.
Many times, it might not be possible to divide the good used for barter. This can introduce challenges for the trade. For example, if I have a cow and want bananas in return, then I might be looking at a lot of bananas that I do not need.
And then we have the challenge of determining how many bananas can be exchanged for a cow.
Money was invented to address these challenges. Different type of goods have been used as money by humans over time. For example,
Salt bars were used as money in Ethiopia
Rai stones were used as money in Yap Islands
Cowrie shells were used in Nigeria
Beads (Wampum) strung together were used by Native American tribes
A major problem using these goods as money happened once foreigners came into contact with the society. The foreigners to the society figured out an easy way to produce more of these goods and they flooded the society with money. This debased the money. This resulted in the money dying out and no longer being used for trading.
Humans figured out that they need a good to use as money such that the good is not easy to produce. This is when humans started using silver or gold as money. Even silver was not a good candidate to be money since it could be produced much easier than gold. In that sense gold as money became the “gold standard”.
We have seen from history, that any good that is to be a good candidate as money has to satisfy the following requirements
The good has to maintain and increase its value over time.
The good has to be transportable to different geographies.
The good has to be divisible.
If you consider gold as money, its value does increase over time because of the scarcity associated with gold. The problem with gold though is that it is not portable. The divisibility of gold is also not great. Using gold coins for low value transactions was not feasible. Hence, silver coins were used to complement gold for low value transactions.
However, it was the lack of portability that was the biggest drawback for using gold as money. This resulted in the creation of paper money backed by gold. People could deposit their gold with goldsmiths, banks etc. In return they would be given paper notes which were then used as money.
The idea was that anyone could exchange the paper notes for gold stored at the goldsmiths or banks. And paper notes were easy to transport. But then the people storing gold found out that the gold exchange was needed very infrequently. So, they started producing lot more paper notes than the gold they had in order to make more money. In such a system, everything would be fine until all the holders of paper notes wanted to redeem them for gold at the same time - the bank run. And in that situation the banks would declare bankruptcy.
The governments then got involved possibly for two reasons
Since they wanted to have regulation to protect the citizens from bank runs.
And since they figured out that they could benefit by creating money (paper notes) out of thin air. They would do this by taking the responsibility for creating paper notes as money backed by gold. And then creating lot more paper money than the available gold.
So that gave rise to the gold standard - where we had paper money backed partially by gold. But in 1971 the gold backing was taken away by the US Government.
Thus, the money that we use today is called fiat money. That is because this money is legal by government decree. It’s not backed by anything other than the government decree. The central bank of every country is typically responsible for creating fiat money. While there are rules to be followed in order to create fiat money, these are manmade rules and hence can be modified by the powers that be.
Have you thought what would happen to the dollars or the loonies or the euros or the rupees if the government decides to make these illegal? We will look at these and other questions in the next article in this series next week.