What is money? Part 1 - Functions and history of money
Oct 28, 2022
Disclaimer: Economics is not an empirical science. This contribution is based on the intellectual framework of the Austrian school of economics, as well as a personal opinion. There are various monetary and economic theories that encompass different views, this paper represents one of them.
In order to understand what Bitcoin is and why it is the way it is, one must first understand what money is and what makes a sound money.
Money is a medium of exchange. It is normally the most traded and thus the easiest commodity to sell. Almost everyone accepts it in exchange for goods and services because everyone can rely on its acceptance and stability.
In a modern economy with advanced division of labor & specialization, it is not possible to produce goods by oneself. Each individual is mostly specialized in one subject area, which creates extreme efficiency in the whole society. However, it is extremely difficult to find suitable exchange partners if one wants to exchange directly into goods.
This is called the coincidence of desires, and in essence describes the problem that it is very unlikely that person A and person B will have the desired good ready for exchange in exactly the desired quantity at exactly the same time. If I want to buy a cow, and I only have apples, it is unlikely that anyone will take tons of apples from me, which will then rot quickly. In such societies, based on the division of labor, a commodity had always emerged, which could be used for any kind of exchange. It usually retains a relatively stable value, is accepted by almost everyone and is popularly called money.
The three main primary functions of a money are as follows:
Money must have a constant value so that one can make time-delayed transactions without having to fear that the value will decay. Long-term savings must therefore be possible in order to build up reserves and plan for the future. Money thus establishes itself in such a way, precisely because one can build up assets without great speculation and not have to keep up with investment professionals on the financial market.
The value and usefulness of a currency are strongly linked to its characteristics and circulation. Often, this function is seen as the foundation for expanding the other two functions. Only a commodity in which one can store its value with constant or even increased purchasing power can even be considered for payments or to be used as a unit of account.
Money is used to make payments. It is used to pay for goods and services. Acceptance plays an important role here. If not enough individuals accept the same money, its use is limited. The more marketable (i.e. easier to buy/sell) a good is, the more suitable it is to become a means of payment.
Goods and services are most easily expressed in monetary units, as this is the most traded of all goods. Money is thus a general reference to measure prices for goods and services and, above all, to observe their price changes. Without prices, we cannot do economic accounting and it would be more difficult to calculate opportunity costs of different courses of action. In a complex society, therefore, a common unit of account is absolutely essential.
In the history of mankind, there have already been many different types of money. At a certain level of division of labor, barter simply became impractical. Therefore, the market sought something that would make a perfect object of exchange. However, the road there was a rocky one.
One of the first types of money used is called commodity money. These were, for example, snail shells, shells, salt, skins or stones. Mostly they were goods that could have a certain exchange value and degree of rarity. In the Yap Islands, huge round stones were used at times. They were located in the middle of the village and were very difficult to create and get on the island.
The owners of a stone announced to everyone when the owner changed, which of course only worked in a limited society. However, this created a consensus in the community and this protected against theft, since everyone knew who owned which stone. So to be solid money it was important that the money was rarely metal money and therefore limited, it had a value, could be stored for a long time and was accepted by all.
Over thousands of years, metal money thus emerged as a suitable candidate for money and displaced other commodity money. These were gold, silver or bronze, which could be freely traded. The minting of coins helped to be able to quickly recognize whether it was real gold, for example. It was not until later that it became established that coins were only issued by state-owned, central institutions.
Metals had the advantage of being scarce and therefore valuable, durable and relatively easy to divide. In the beginning, coins were almost 100% gold or silver. Over time, however, the temptation for centrally controlling institutions to create more money grew, so they lowered the purity of the money. They collected coins, reduced the gold content without publicizing it, and created more coins from the same amount. These were the first forms of inflationary expropriation by rulers and governments. Thus, even then, a naturally emerging money was manipulated over time by governments, for example, to finance wars.
The first forms of paper money existed in China, according to historians. Paper was very cheap and widely available, and bills in paper form were much easier to transport. The value of this money came from the decree and promise of the emperor. The emperor's power and promise of value were enforced by force in case of emergency. In the course of time, non-state paper money also appeared in the European Middle Ages. That paper was a so-called bill of exchange, which is nothing more than a contract and says that you can exchange that paper for gold or silver. Now you no longer had to carry your gold in large quantities, if necessary, but could simply exchange these bills of exchange.
The better portability optimized trade enormously and ensured steady growth in prosperity. One drawback here is the trust that is required. You have to trust that the bill of exchange is genuine, and that the issuing office is not issuing more bills of exchange than it has actual gold reserves. Today, it's quite similar. Just about every country in the world operates on a fiat money standard. This means the money is not backed by gold reserves or the like, but only by the economic and enforcement power of the state, which creates a demand for the money through taxes and laws.
State-issued, unbacked paper money (as in China) was never able to establish itself permanently in Europe in the past because the value and use were not freely established on the market but were enforced. The commercial value is then derived from the credibility and assertiveness of the state, which prescribes its currency as the money to be used. There were periods when much of the currency was actually backed by gold, and there was the ability to demand it.
Private banks issued notes that were redeemable for quantities of gold or silver. Central banks, as they were eventually called, issued numerous banknotes based on that principle. In history, there were several phases in which money was backed by gold. The most important are the gold standard until 1933, which was followed by a ban on private gold ownership in the U.S., and the Bretton Woods system (1944-1973), which finally ended in 1973 but already in 1971 removed the peg of gold to the U.S. dollar.
Today, this form of money is the most widespread. It has no physical component and exists only digitally in the account books of commercial banks. This giro money can be easily recreated by banks according to certain criteria by granting loans. The generally perceived value of that money is based purely on trust in the banks and the state. Because of the governments' great fear of a loss of trust by the citizens, states often rescue large and important banks in times of crisis so that the system does not topple.
However, such costly bailouts are carried out with money newly created by central banks, which means that this is done at the expense of the general public. This is because it dramatically reduces the value of money. The price of a so-called bail-out is therefore paid by the population.
Bitcoin is a new form of money. It is a decentralized money where no states, institutions, or individuals can decide to change it. Although the Bitcoin price is very volatile in the short term, Bitcoin has proven to be a great store of value over long periods of time since its inception.
Just as a money depends on functioning and being used in society's network, with Bitcoin you can see directly from the price increase that more and more people are using and holding it. If the number of Bitcoin users continues to grow like this, it is quite possible that it will also be able to perform the other two money functions more and more and thus become the accepted medium of exchange and the commonly used unit of account. The incentives are good here because Bitcoin, unlike our current money, is in limited supply, so there is an incentive to hold it for the long term rather than get rid of it as quickly as possible.
In the second part of this blog series, we will take a closer look at the properties of money, monetary policy and the phenomenon of inflation.
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