Why do we have money?
Money emerged because trade would be complicated without it. For example, if you are a hatter in need of legal advice, then without money, you have to find a lawyer who desires a hat. That is unlikely to happen. Maybe there is a fisherman dreaming of a hat, but he can’t give you legal advice. Maybe there is a lawyer in need of a hairdo instead of a hat. With money all these problems disappear like magic. You can buy the services of the lawyer so that she can go to the barber. After that the barber can buy fish and then the fisherman can buy a hat from you.
Despite these mind-blowing advantages, humans did not need money for a long time because they lived in small bands and villages where everyone depended on each other and everyone helped each other. This meant, for example, that when a fisherman needed a hat, you would give him the hat, in the expectation that if you needed anything, someone else would provide it to you. You did someone a favour so that he or she was obliged to do something back. In ancient times villages were self-sufficient. Trade with the outside world was limited and was done with barter instead of money.
Uses of money
People living in cities, kingdoms and empires didn’t know each other. It became difficult to track whether or not everyone was contributing. Favours and obligations did not suffice any more and had to be replaced by a formal system for making payments and keeping track of contributions and debts. Writing and money made it possible to specialise in professions and to administrate cities and kingdoms. Commerce as well as tax collection needed an administrative system as well as a unit of account.
You could get money by being useful to someone else. There was no need any more to keep track whether or not you were contributing. Money can be used (1) for buying and selling things, (2) to say how much something is worth and (3) for saving and borrowing. Money therefore is a medium of exchange, a unit of account and a store of value.
Money being a medium of exchange as well as a store of value is like your pet being a cat as well as a dog. The result is not really a success. The parts of the pet may often quarrel, for example because the dog part wants to play while cat part wants to sleep. If someone keeps money for a rainy day, and doesn’t spend it, others cannot use this money for buying stuff. And this really can be a big problem. A simple example can explain this.
Imagine that tomorrow everyone decides to save all his or her money. Nothing would be bought or sold any more. All businesses would go bankrupt and everybody would be unemployed. Without the businesses all the money that has been saved would buy nothing, simply because there isn’t anything to buy. This is a total economic collapse. In reality it doesn’t get that bad because people will always spend on basic necessities like mobile phones. When people only spend money on necessities there is an economic depression. Saving can make you poorer when there are too many savings already.
Money must remain in the economy. If you don’t need your money for buying stuff then it must be returned to the economy. You have to invest it or lend it to someone else who is going to use this money to buy stuff or to make an investment.
The value of money
Money has no value when there isn’t any stuff to buy or when there aren’t any other people to trade with. Imagine that you get the offer to be dropped alone on a remote island in the Pacific with 10 million euros. Probably you would decline the deal, even if you can keep your mobile phone. It is other people and stuff that give money value. But how? The answer is remarkably simple. The value of money is just a belief.
It comes from the fact that people are willing to work for money and sell their stuff for money. And because others do this, you do the same. For example, you may think that euro notes have an appalling design as well as an unpleasant odour, but nevertheless you probably desire to own them because other people want them too. The value of the euro is based on the belief that other people accept euros for payment.
This is just a belief and it is not very difficult to see. Suppose that you wake up one day to hear on the news that the European Union has been dissolved overnight. Then you may start to have second thoughts about your precious stockpile of foul smelling unstylishly decorated euro bank notes.
Suddenly you may ask yourself in distress whether or not your precious bank notes still have any value. What is the value of the euro without the European Union? Then you may find yourself hurrying to the nearest phone shop in an effort to exchange this pile of bank notes for the latest model mobile phone.
And to prove this point even further, suppose that the phone shop gladly accepts your euros. Suddenly they become desirable again and you may start to have second thoughts about that latest model you are about to buy. It may not remain hip for much longer, so you may change your mind again and prefer to keep your precious euros because there may be a newer model next month. So, because the shop wants your euros, you wants them too.
Types of money
Originally, money was an item that people needed or desired. Grain was one of the earliest forms of money. Everybody needed food so it was easy to make people believe that others accept grain for payment. In prison camps during World War II cigarettes became money because they were in high demand. Even non-smokers accepted them because they knew that other people desired them very badly. For that reason cocaine can be money too.
Wares like grain, cigarettes and cocaine have disadvantages. They degrade over time so they aren’t a very good store of value. This makes them a great medium of exchange because people won’t save them. An example can demonstrate this. Imagine that apples are money and you want to buy a house. A house costs 120,000 apples but your monthly salary is just 2,500 apples of which you can save 1,000. It takes 10 years of saving to buy a house. Soon you will discover that apples rot and that you will never be able to buy a houses. Then you will spend all your apples right away.
This is where gold and silver come in. Gold and silver have not much use, but humans have always been attracted to shiny stuff. Gold is rare so a small amount of gold can have a lot of value if people have a strong desire for it. Gold and silver coins can be made of different sizes and purity so that they are suitable for payment and can be used as a unit of account.
More importantly, gold and silver do not deteriorate in quality like apples, grain or cigarettes. They do not even rust after 1,000 years. This makes gold and silver an excellent store of value. But this should make us suspicious. A perfect cat makes a lousy dog so a perfect store of value can fail the test for being a good medium of exchange. People can store gold and silver so that there is less money available for buying and selling stuff. And this can cause an economic depression as we have seen.
Governments create money too, for example by printing “10 euro” on a piece of paper. Governments require by law that this money should be used for payments and taxes. This makes people believe that others accept this money too. Government money is called fiat currency or simply currency. The authority of a government is limited to the area it controls so in the past government currencies had little value outside the country itself unless this money consisted of coins containing gold or silver.
In fact, another reason why gold and silver are attractive as money, is that the value of gold and silver does not depend on the authority of a government. This made gold and silver internationally accepted as money. In the 19th century most government currencies could be exchanged for a fixed amount of gold. This is the gold standard. The gold standard boosted trade because gold was internationally accepted as money.
Most money is debt
Debts can have value and so debts can be money too. This may seem strange or even outrageous, but money is just a belief. For example, money is the belief that you can exchange a hat for money and then exchange this money for legal advice. Hence, if you believe that the debtor is going to pay, you can accept his or her promise to pay as payment. And if others believe this too, you can use this promise to pay someone else.
So if the fisherman promises you to pay next week for the hat you just made, you could say to the lawyer that you expect the fisherman to pay in a week, and ask her if you can pay in a week too. The lawyer could then ask the same of the barber and the barber could ask the same of the fisherman. If all debts cancel out then there is no need for cash. Most money we currently use is debt. But to make that happen, we need banks.
– Close up of coin hoard CC BY-SA 2.0. Portable Antiquities Scheme from London, England (2010). Wikimedia Commons. https://commons.wikimedia.org/w/index.php?curid=10842324