A centipede was happy quite, until a toad in fun
Said, “Pray, which leg comes after which?”
This raised his doubts to such a pitch
He fell distracted in the ditch
Not knowing how to run.
“Anyone can create money, the problem is getting it accepted.”
– Hyman Minsky
Money. We all know what it is, right? Good. That’s that done with then.
The problem is, it’s not really that simple. Although the question of what money is might seem incredibly straightforward, when we really start to interrogate the question, it becomes quite difficult to answer. We all “know” what money is, but asking that question of the average person on the street would yield a plethora of answers. Money is paper and coins …but what about the money in the bank? …is that money even real? Money is what we buy things with …except when we trade for things other than money. What about gold? In which case, at what point does something else become money? Who decides whether something is money or not? Is money something we have, or just something we use? What is it, on a conceptual level? on a moral level? on a practical level? What types of money are there? Is fiat money bad? Should we go back to the gold standard? Do we need money at all?
According to Wikipedia, the definition of money is:
any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country.
Well then. That’s pretty broad. It’s a good place to start, nonetheless. Let’s break it down a little:
any object or record
So, that inherently includes coins and notes. It also includes commodities like gold and perhaps silver, or any other object that, in any given locality, is commonly accepted as money. Then there’s records. Records can simply record the fact that I have money — in a bank, for example. Then, on the other hand, there’s the fact that records themselves, such as a record of debt, can be traded. If I have a recorded promise to pay you money, that promise itself can be used as a form of payment with a third party, so long as that third party trusts my promise. That all sounds a little familiar, doesn’t it? “I promise to pay the bearer on demand” is, at least historically speaking, of that form. So, when we think about it, although bank notes are objects, in terms of their being money, they are actually records. They are records which happen to have lost their original meaning and purpose as records of a debt and now serve generally as money, through the common assumption that they are money.
generally accepted as payment for goods and services and repayment of debts
If someone walks into my shop, the law says that I have to accept British Pounds as payment for any goods the customer purchases. Yet, even if that law were not in place, I would still accept that money. That might seem obvious, but it’s not. Why would I accept a small, scrappy piece of paper with an old woman’s face on it, in exchange for a valuable and useful product? We have seen that bank notes are records of a theoretical debt, but in reality, I am not going to take my earnings to be redeemed at the Bank of England; nor would I be able to, since the end of the Gold Standard.
So what is the real reason that I accept money as payment for my useful goods? Simply that I know that I can then spend that money myself, and that someone else will in turn be willing to accept it as means of payment. Finally, we really come to understand what money is: it is anything that, in a given context, is generally accepted by the people as means of payment. Everybody is able to accept money because everybody else does. It is a social contract, built on a web of trust. If tomorrow, we all decided not to accept the ten pound note as a form of payment, it would cease to be money; its role as money is not inherent to its existence, but only a function of its social context. The same is true with the vastly larger amounts of money that are not in any physical form at all; we accept and use electronic payments, cheques and bank accounts because we trust the banking system to keep a fair tally of our credits and debts. When we make purchases, we trust that the lowering of a number related to our account and the raising of a number related to the seller’s account represents a transfer of value, even though it changes nothing in the physical world. In truth, what we think of here as money is not our money at all; we are creditors to the bank, who are transferring some of their obligations from us to someone else.
Money has exchange value because we believe it does. If, in a moment, every human being on this planet were to close their eyes and say, “I no longer take this coin, this note, this ledger, to have any value!” then all money would be instantaneously destroyed. The coins, notes and ledgers might remain, but these are mere physical ghosts, useless without their concept, without the belief in their value. That is the true value of money: the social contract whereby each and every person agrees to treat money as having value. Individually, we are powerless to destroy it on our own; each person not only holds themselves, but their peers, to the social contract of money. Credit is honoured because shopkeepers, traders and workers all accept coins or ledger credit as a placeholder for value. Debts are enforced because lender, magistrate, and bailiff all accept the existence of the debt, even if the debtor does not.
So what is money not? It is not eternal. Money has not been around forever. There are no laws of physics concerning money. Money is not a necessary substance for the chemistry or biology of life. In fact, as a species, we are unique in its use of it. I speak not only of paper currency and coin, but of tallied money, sums owed and accounted for. No other species quantifies its debts and assets in such a way and in fact, nor did early mankind.
The preceding statements may seem obvious, but they are important to take note of. The way money is talked about in modern times, our use of language surrounding it, is as if it were something more than a tally or token. We discuss money as it if were an immovable natural force. Money is a tool, but uniquely, it is a tool that restricts more often than it aids. Entire governments tell their citizens that certain goals are impossible, not because of any physical blockade, but for a lack of money. The monetary system is a conceptual tool, designed to solve resource issues in the physical world; now, the physical world is bent to solve imaginary issues in the monetary world. Yet, despite all this, money, along with its counterpart, debt, only have value because it is agreed that they have value. It is important to remember that money is merely a tool, and if we find a tool to be working improperly, we can ignore it or change it. Yet, because we have accepted the laws of money to be sacrosanct, we do not do so, as David Graeber describes in an example from his book, Debt: The First Five-Thousand Years:
The problem was, it took money to maintain the mosquito eradication program, since there had to be periodic tests to make sure mosquitoes weren’t starting to breed again and spraying campaigns if it was discovered that they were. Not a lot of money. But owing to the IMF-imposed austerity programs, the government had to cut the monitoring program. Ten thousand people died. I met young mothers grieving for lost children. One might think it would be hard to make a case that the loss of ten thousand human lives is really justified in order to ensure that Citibank wouldn’t have to cut its losses on one irresponsible loan that wasn’t particularly important to its balance sheet anyway. But here was a perfectly decent woman–one who worked for a charitable organisation, no less–who took it as self-evident that it was. After all, they owed the money, and surely one has to pay one’s debts.
The problem is mostly based on a simple assumption by Capitalists: the economy is make up of a series of transactions; each transaction is entered into voluntarily (which again, is questionable); therefore each transaction is fair; meaning that the economy composed of transactions must be fair. In other words, we are assuming that if each part is fair on its own, therefore the whole must be fair. I believe this to be a very dangerous and misguided assumption.
So what are the functions of money?
On a macroeconomic scale, the function is to control the production and distribution of goods and services, including labour. It is a tool of society. For most individuals, it allows them to receive something in exchange for their produce, which they may use in exchange for the things they need and desire. It eliminates the requirement for all commodities to be brought along for any potential trade, which is of significant advantage where distances are long and commodities are bulky. It also allows for increased flexibility; with no commonly accepted placeholder for value, it might otherwise take several trades to get from what one has to what one desires, depending on the possessions and desires of other traders. Instead, money provides an compact, universally accepted placeholder for value.
If money is a placeholder for value, what value does it represent? What is the value of ten British Pounds? Obviously, ten pounds is worth ten pounds, but this is somewhat tautological. In fact, it is simply that, just as other commodities have a value in money — what we call a “price” — therefore money has a value in other commodities.
So how is exchange value, or price, determined? Given a collection of items and money, how do we determine their relative values? Well, unfortunately for economists, it comes down to the old adage, “it’s worth what someone is willing to pay for it”. In straight trade, each trader knows the relative values they are prepared to pay: they might consider brick to be three times as valuable as wood, for example. Note that this is not always a constant: if I am thirsty, I might be willing to trade my donkey for a glass of water; after drinking a large glass, I might not, at that time, be willing to pay a penny more for another glass. Mostly what we consider, when making any purchase, is what we could get instead with the same money; what we’re giving up in order to have whatever we are buying. The higher the price, the more other things we will be required to give up within our finite budget — this is what economists refer to as the marginal rate of substitution. It’s important to remember that we all have difference means and preferences; individual sellers can try higher and lower prices to weight the change in profit margin against the change in demand. The seller’s own costs form a minimum price. The effect of competition can bring prices down where consumers have choice (and there isn’t a higher cost in the choice itself — for example, having to drive to a different shop).
On top of all these economically rational factors are human factors; the general whims of buyers and sellers. These can include errors of judgement, deliberate price fixing and cartels, and altruistic actions — for example, selling something at a lower price because you like the buyer — something that is consider “irrational” economically, but may be quite rational socially. Regardless, all of these factors weigh their part and prices are generally found.
In this way, various commodities gain their value relative to one another. In the same way, the value placeholder of money gains its relative position by what people are willing to trade for it. It is an entirely cyclical arrangement; there is no “true” value, only relative values. The initial value of money can be set in a completely arbitrary fashion; other commodities, including products, services, labour and taxes, will find their value in money, and money will find its value in commodities and relative to its past self. What concerns us are these relative rates.
Finally, money also allows for deferred payment, the creation of credit lines. This is not dependent on currency, but is in itself, a form of money. In fact, debt is arguably the most basic and earliest form of money, even where it is not counted in formal units. Many economists follow the myth that humans all brought their goods to barter, until they invented currency. Conversely, it is more likely that people simply traded on credit, with currency coming along later, often as a tool of government, or at least organised society. As Graeber notes:
In fact, there is a good reason to believe that barter is not a particularly ancient phenomenon at all, but has only really become widespread in modern times. Certainly in most of the cases we know about, it makes place between people who are familiar with the use of money, but for one reason or another, don’t have a lot of it around. Elaborate barter systems often crop up in the wake of the collapse of national economies: most recently in Russia in the ’90s, and in Argentina around 2002, when rubles in the first case, and dollars in the second, effectively disappeared.
Graeber goes on to further destroy the barter myth through the rest of his book, which is very worthwhile reading on the history of money. That doesn’t mean that money doesn’t serve to eliminate the convenience of barter, of course, it just means that credit was doing this far before the creation of currency.
So what forms does money have?
The most simple form of currency is that of commodity money. This is a single commodity, or selection of commodities, which are socially accepted as the common medium for trade. Generally, this means the commodities which have the highest exchange value compared to their size. In order to maintain their value, their supply must be limited. They must also have some use value, even if that is only aesthetic, so there is initial demand for them. The commodities that happen to meet these criteria are precious metals; gold and silver. These have widely used historically and even today, are still used for some transactions between countries.
Commodity money, as something that has an initial demand, also has an initial value. Even if gold or silver are not treated as money, they still have value. Determining their initial value as money, then, is simple: it is the same as their value as a regular commodity. In fact, there is no absolute line at which a commonly-traded commodity becomes money; would it be when a plurality of transactions involve it? or a majority? or 90%?
It is important to note that this money does not actually need to circulate in order to be used as a standard for value. To quote David Graeber one final time:
Silver did not circulate very much. Most of it just sat around in Temple and Palace treasuries, some of which remained, carefully guarded, in the same place for literally thousands of years. It would have been easy enough to standardise the ingots, stamp them, create some kind of authoritative system to guarantee their purity. The technology existed. Yet no one saw any particular need to do so. One reason was that while debts were calculated in silver, they did not have to be paid in silver–in fact, they could be paid in more or less anything one had around. Peasants who owned money to the Temple or Palace, or to some Temple or Palace official, seem to have settled their debts mostly in barley, which is why fixing the ratio of silver to barley was so important. But it was perfectly acceptable to show up with goats, furniture, or lapis lazuli.
The money, commodity or otherwise, simply serves as the common benchmark for measuring value, even where no money actually changes hands. Certainly, the use of currency by the lower tiers of society has only become widespread in relatively modern times. Does this mean that the lower classes did not use money in earlier times? No, certainly not. In fact, their use of money shares more than we might think with modern times. While little silver currency crossed their palms, they still used money based on its value, in the form of virtual, ledger money, in the form of debts.
The debts themselves can even be traded: if x owes y money, y can trade that debt for produce with z; x will then owe z. We presume that this kind of debt trading is a modern concept, but it is not. It might form the basis of our complex derivatives and futures markets, but it’s really rooted in historical agriculture.
Still, currency did evolve, even if it was not used in all tiers of society. Trading tokens and precious metals come together in the form of coins, forged of precious metals and stamped with a value, approved by an authority figure. Notably, these coins had a function outside of trade, as bearers of propaganda. The downside to coins of this form is that they simultaneously carry two values: the value that is stamped on them and the value of their metal. If the former is greater, there is a risk that traders might refuse to accept that value; if the latter is greater, there is incentive to melt down the coin and sell the metal. This is far from an ancient problem, with many modern mints altering their alloys as metal prices increase.
One solution to this problem is the use of representative currency. Instead of a valuable metal being used for the coin, the valuable metal is retained by a central bank, which issues stamped coins of cheap metal. The cheap value of the cheap coin is prescribed in law and in the promise of the bank to swap the coin for its value in the precious metal, even as that value deviates. Importantly, it is only the theoretical ability to swap the coin for gold that matters; so long as that promise is there then the coin is “as good as gold”. Where coins and notes are fully-backed by gold, this is the “gold standard” we will discuss ahead.
The next step in the evolution of currency is that of fiat currency. This is what was created for most of the Western world when the gold standard was abandoned. We have already examined this form in some extend when discussing the definition of modern currency. The only difference from representative money is that the underlying precious metal is removed. When the gold standard was abandoned, many asked how money would retain any value. Again, simply, money falls back on the social contract; it has value because we all believe it to have value. Despite this, there are still some people calling for the restoration of the gold standard. I will explain shortly why I believe they are misguided.
Banks and Banknotes
Bank notes have come into use at several points historically, but their current form stems from the Goldsmith bankers of England. They issued deposit notes in exchange for precious metals and artifacts left in their keeping. Initially, these notes could only be redeemed by the depositor, but transfers were allowed and notes became payable to the bearer on demand. The deposit notes themselves, backed by the value of the deposit, were themselves traded, as a form of money.
One thing the Goldsmiths were aware of was that, while as time went by, some gold was deposited and other gold withdrawn, there was never a time when everybody withdrew their gold at the same time. In fact, since the goldsmiths were so trusted to always produce the gold if it were asked for, and since the deposit notes could be used far more conveniently as money, there was always a great amount of gold in their possession. So long as they did not announce the fact, they could quite happily remove three-quarters of the gold they had and it would not make any difference; just as long as there was not, what we would now call, “a run on the bank” where every customer simultaneously tried to withdraw their money. In fact, not only could they lend out the gold if they so wished, but they could create deposit notes for gold, beyond what had been deposited.
The ideas just described form the basis of the fractional reserve system, something that lies at the very core of our economy, yet is completely unheard of to the average citizen. It is the mechanism by which the vast majority of money is created, not through the printing of currency, but through debt. When multiple notes were created, backed by the same gold, money was created. The same value became present in three places at once: the gold, the original deposit and the lent deposit. All three can be used in trade as having the same exchange value. In fact, theoretically, an infinite amount of vitual money can be created by re-lending one deposit. This is money multiplication.
While early banknotes were issued by individual banks, eventually most governments intervened to create banknotes centrally. In 1884 the Bank Charter Act gave the Bank of England sole rights to issue bank notes in England, although with the exception that existing banks kept that right, the last being taken over in the 1930s. In the USA, private banks were permitted to issued notes until 1935, although only a few large banks did so in the end. The effect of this was to transfer the ultimate liability for redeeming banknotes to the central bank itself. The central banks also became the lender of last resort if other banks needed to borrow, while normal borrowing occurs between commercial banks – effectively, banks with excess reserves hiring out these reserves to other banks through the form of loans.
With the monopoly over note issue came the requirement for other banks to obtain notes issued by the central banks. Commercial banks were given accounts with the central bank through which they could purchase bank notes, currency, to distribute to customers withdrawing funds from an account. Governments used this opportunity in some cases to implement 100% central gold reserves, the “gold standard”. This meant that the value of bank notes issued by it at any one time could not exceed the amount of good it possessed. This was the case with the Bank of England in 1884. This meant that if the central bank had already issued the value of its gold reserves in notes, it could not issue more bank notes unless they were purchased directly in gold.
It would be a fallacy however, to believe this fixed all money to gold, as we must remember that even at this point, the majority of money is now held on the books of banks, not as currency. The effect however, is like declaring that “the buck stops at bank notes”. In other words, just as the Goldsmiths had to cough up a real quantity of gold when a deposit was withdrawn, so the commercial banks had the liability of coughing up a certain amount of central bank notes (or gold), whenever an account withdrawal was made. Since banknotes were fixed to gold, this left the commercial banks in effectively the same situation, by proxy: if every account holder were to attempt a withdrawal of bank notes at the same time, they would be bankrupt, since they have a finite amount of central bank notes (and/or gold, if they have it). If however, as is likely, customers do not all withdraw their account funds into banknotes at the same them, then it is still perfectly possible for the banks to perform the same trick of money multiplication, by simply modifying their account book to create a credit and a corresponding debt. They are able to create money in the account of a customer, by “lending out” money in the account of another customer, even though these both become debts for the bank, payable in notes when either or both makes an account withdrawal. At the same time, the borrower also has a debt to the bank. Thus, if I borrow a thousand pounds and put it into a new bank account, that account simply records the fact that the bank owes me a thousand pounds, that it hasn’t yet actually given me, yet I also owe the bank a thousand pounds.
It should be noted at this point that no other business is allowed to operate on such terms. Effectively, banks are allowed to create money. In fact, it is not just an allowance: it is the foundation of the current financial system. One thing that banks are prevented from doing is lending out the same money twice… at least directly. If a bank has a total of 1 million GBP from depositors it can lend out that 1 million in a loan. It cannot then lend out that same 1 million belonging to the initial depositors again. If however, the funds from that loan are deposited into an account, there is nothing to stop that money being loaned out, since it is a new deposit; money has no inbuilt knowledge of from whence it came. Therefore, money, can be made from money, can be made from money. In practice, money received from loans is often deposited in other commercial banks, creating a web of debts and credits. Ultimately though, it is all a stack of cards, built on trust in the banks.
There is one other thing I feel it is important to mention at this point. There is a commonly held idea that, “the government cannot just print money, as this would lead to inflation”. So, unable to do so, the government must borrow money from banks. Banks are allowed to create money through fractional reserve. Unless this money is paid back almost immediately, the exact same amount of inflation is created. Yet, a debt is also created for the government. In fact, once that inflation has taken effect, paying back the debt would cause a contraction of the money supply: deflation. So let me repeat: the government is not allowed to create money, so it borrows money from someone else who creates it, with interest charged to the taxpayer and the same level of inflation, and potentially destabilising deflation when it is paid off. I will return to this later, but just consider the absurdity.
One effort to control the rate (and therefore risk) at which banks could create money was through the regulation of fractional reserve. This meant that if a bank received a deposit of 1 GBP, it could only lend out 0.90 GBP – or whatever the amount was specified by law. For example, the USA enforces a liquidity ratio of 10% for large banks. That means that of a 100 USD deposit, 90 USD can be lent out. The bank of England on the other hand has zero mandatory reserve rate. This means that banks can theoretically create infinite amounts of money (although their own risk increases as they do). In practice, the rate in the UK is currently around 3%.
The current phase of fiat currency came into being when the USA terminated the Bretton-Woods system. The Bretton-Woods system was a gold standard established after the second world war, where the US dollar was pinned to the gold standard and each other currency in the agreement was then tied to the dollar. In 1971, President Nixon, under the fiscal strain of the Vietnam war, ended the tied of the US dollar to gold. The gold standard was no more. Many falsely predicted that this would end the safety provided by the gold standard; in reality, as the majority of money already existed as virtual debt, no such safety ever existed.
Nothing about fiat currency compels a nation to print excess money – it simply enables it. Fiat currency also frees a nation from the requirement to keep large quantities of potentially useful gold, buried underground and guarded, at no use to anybody. Finally, we should consider that gold itself now has an inflated value. Its current values are only held so by the common belief of people in its value. This is no different to fiat currency. Fractional reserve (or zero reserve) — the dependence on debt to create money — is far more the source of our problems than fiat currency, and the two are by no means inherent partners.
The last physical changes in the form of money have been in the form of money on computers and credit cards. Although these are a jump forward in the physical medium of commerce, they are essentially still a form of money on account; that is, money that only exists as a number written down. Money on a modern supercomputer is in its nature, little different to the money of old ledgers. The main difference is simply the pace of trade this has allowed. We have always had debt, now we have faster debt.
So in conclusion then, what is money? It is a tool of society. It functions however we as a people choose it to do. Under capitalism, it is used almost universally though production, labour, distribution and investment mechanisms. Yet, it is possible to envision and economy where it performs none, or only some of those roles. It is a placeholder for value in exchange, and for the measurement and payment of debts. It is created by a cloning process, where existing money is used in more than one place at once. The value of money is not inherent; it is only relative to the value of other commodities, which have values relative to each other, and to the value of itself in the past.
With this in place, we can start to examine the role of money under capitalism.