Today we are going to take a look at the concept of money. What it is, what it isn't, how it works and where does it come from. Let's start from the beginning.
We have explained in previous lessons how people value some things over others and how when opposite valuations meet we have voluntary exchanges which facilitate the fulfilment of our needs. Kim wants gadget A but he only has gadget B (he values A higher than B). Floriana on the other hand has gadget A and she wants gadget B (she values B more than A). They meet and exchange A for B. In this manner Kim's and Floriana's needs have been fulfilled.
This is what it is called Direct Exchange or barter. Bartering was how markets first developed. As both parties in the deal had to be present at the same time and location for the exchange to take place, regular meeting places for exchange evolved. Hence, the term market place. Barter was a large step forward for humanity but eventually its limitations became problematic. These are some of the problems:
The objects to be bartered must be present at the same time (would you trust a stranger to give you their part of the deal at a later date?).
Some of the objects to be bartered had a shelf life. It is obviously not possible to store a cow or a barrel of apples for years.
In many cases it was not possible to deal in fractions of objects. If you have a live pig to exchange and you need a sword, you can't give half live pig.
Exchangers must actually want what each other has to offer. If Kim needs a sword and has barrel of apples to pay with and Ulrich wishes to sell his sword but he dislikes apples there will be no barter.
As you can see, barter works but only at a basic level. Passing this level, barter becomes a hindrance because although you own wealth, you cannot use this wealth to acquire the things you need or want. These problems are called "indivisibility" and lack of "coincidence of wants".
There is a clunky solution to barter problems, and this solution is to find an intermediate good or service. Let's take our previous problem. Kim wants a sword but he only has apples. Ulrich has a sword but he wants two chickens for it. And so Kim exchanges his apples for two chickens with Amanda and then he exchanges those two chickens for Ulrich's sword.
The problem with this process is that although it will facilitate and solve some of bartering problems, we are still stuck with the fact that we are still dealing with goods and services with a fixed shelf life.
A better Intermediary
So far we have considered the situation where two people (Kim and Ulrich) have different things to offer in exchange for what they want. But what happens if they both have the same thing? What this means is that they now both have something that both consider to have value. Let's say that this something is salt. They both know that they will both accept salt as payment. They also know that they can store salt indefinitively and that they can fraction salt and that it is very likely that other people may also accept salt in exchange for other goods and services. But, more importantly, they also know that they can use salt to cook. Salt is what is considered a commodity. Something that has value because it fulfils a need. And so Kim gives salt to Ulrich for a sword and the barter takes place.
But Ulrich is now able to take his salt to the next market and exchange it for something else because he know that salt will be needed in most markets. What this means is that this intermediary is exchanged for and accumulated not because it will fulfill a need or want but because it will make trades easier. But as more people realize that they can do this, this intermediary becomes more "marketable", this is, capable of being exchanged for something else in a market. Is this increased property of "marketability" that makes an intermediary valuable beyond what its original use may have been.
Indirect Exchange and Money
Now consider the situation where instead of using salt, we use something else with the same purpose. For example silver. Silver metal is used in jewellery and as such it is a commodity that has real use in the real world. We know that silver will be accepted everywhere because everybody knows that they can exchange silver for anything else because it is in short supply to make jewellery. Silver is valuable and as such it is valued and accepted. Once this happens, once a commodity is accepted by the majority of market participants in exchange for goods and services, it becomes something else. It becomes money and as such it is the intermediary in any exchange. Such exchanges (or barters) are called Indirect Exchanges. Over time and as the use of such commodity becomes widely accepted, it mostly stops having value as a commodity and acquires value as the means of exchange. In other words, silver as money has value precisely because everybody else is willing to accept is as a means of payment and not because it can be converted into jewellery. This is how money is born; the market decides which commodity will be used as money. If you look at different civilizations, you will notice that salt, gold, silver, sea shells, wood, copper and many other commodities were used as money. Gold and silver were the most widely used money in the past, but this does not mean that they are somehow "special". They are only "special" insofar market participants consider them to be money. Money is first and foremost a medium of exchange. How much "value" money has beyond it being a medium of exchange it depends of the characteristics of each money. For example, gold and silver can be used in jewellery and that's their "other" value.
Gold and silver floated to the top in terms of being selected by the markets as money not only because they have "other" value, but because they can be stored, divided, carried and cannot be counterfeited and they are scarce. Basically, the market selected a commodity that will prevent market participants from cheating in terms of money! How about that. Not only this, but markets did it without the need of a central authority!
Anything can be considered to be money, but only insofar it is fully accepted by the market. It is for this very reason that cryptocurrencies are becoming money, because they are beginning to be accepted by markets. This is a very unusual event and you are a witness. Cryptocurrencies are the first currencies in the world that are becoming market money in the last 100+ years.
Fiat money is also money because it acts as a means of exchange, but there is a crucial difference. Fiat money was first imposed on the market through brute force and its quantity is fully controlled by governments. This makes fiat money awful money indeed!
But what is critical to understand is that real market money maintains its value because people determines its value in the market place. The value of fiat money, on the other hand, is determined by the government through the manipulation of its quantity. As such, there is a group of people that can and do cheat in the market all the time: governments.
Furthermore, the value of fiat money beyond it being a medium of exchange is almost zero. What can you do with paper money if nobody accepts is as money? Toilet paper? Decoration? Collection item? Sure, but it is obvious that even these values are pretty low. It is for this reason that Austrian Economists state that the ultimate value of all fiat currencies is ZERO.
Praxeology doesn't really care what kind of money is in use, it only cares about what happens with this money and how is it being used. Because praxeology is money-neutral, it can afford to study the different types of money in terms of the effects they have on markets. It is for this reason that praxeology can obtain valuable insights because it does not bundle all money in the same bag and it does not take sides. It only points out the effects should one type of money be used instead of the other.
This is the last point of this lesson but it is very important:
Money is a means of exchange and not the objects of exchange themselves.
This is important to understand because in the end the sole purpose of a monetary system is to facilitate the exchange of real goods and services. Anything else that hijacks this purpose is artificial. It is for this reason that government manipulation of fiat money is so destructive, because money is being altered to suit other purposes for which markets never required (and as so never developed) a solution. If markets would have required a means to "stimulate" jobs, markets would have evolved an independent mechanism. But from a marketplace perspective, this is not necessary because normal market activities keep jobs in balance with market needs.
Note: please see the Glossary if you are unfamiliar with certain words.