What is Money?

I first became curious about money during the Great Recession of 2009. At the time, years of subprime lending in the residential real estate market created a debt bubble, runaway housing prices, and ultimately a deep recession when reality set in.  

During the heat of the crisis, in the days and weeks after Lehman Brothers collapsed, I observed the United States Treasury Secretary, Hank Paulson, and the Chairman of the Federal Reserve, Ben Bernanke, plead with Congress for fiscal support and passage of the Troubled Asset Relief Program. I watched as they anxiously explained that if actions were not taken immediately, the ATM’s in America would need to be shut down in a matter of days. An economic calamity was in the making and people's lives would be ruined. 

And then I watched the Federal Reserve print $3.7 trillion dollars to bail out our banking sector.

Where did this money come from? And how were we going to pay it back?

And then I watched this story repeat itself in March of 2020 when the United States government returned to the same playbook. Only this time they went right for the Hail Mary. To date, we have printed $5 trillion dollars in response to the pandemic and its economic toll.  

Below we can see the impact to the Fed's balance sheet from QE. An additional $2.2 trillion of fiscal spending went out in March which is not reflected below.

Source: Federal Reserve of St. Louis. Annotated by Michael Nadeau.

These actions are humane and necessary. We aren’t here to argue that point. 

But to really understand the potential unintended impact of all of this money printing, I had to ask myself a deep and profound question that I suspect many go through life never truly pondering.  

What is money?

My sense is that money is commonly believed to be a government creation. And if you ask the average person about money, they will likely respond with "it's what I use to buy things.” Or, "it's how I get paid.” While they are not wrong, there is just so much more to understand when it comes to money.

In this article we’ll explore the fundamentals of money.

• Who created money?
• Why does money exist?
• What were the origins and types of money used throughout history?
• How does money “fail?”
• Does money change over time?

Who Created Money?

I used to think that the government created money. After all, George Washington’s face is on the dollar. Abraham Lincoln is on the $5. Alexander Hamilton is on the $10. Andrew Jackson is on the $20. Ulysses Grant is on the $50. Benjamin Franklin is on the $100. These guys created the money, right? 

Not so fast. 

There is no evidence in history to suggest that governments created money. There is no evidence to suggest that political leaders chose gold, silver, or any other monetary asset. Governments simply affirm what the people have chosen. It is then in their best interest to tax the people's choice, which can benefit all members of society.

Money is ultimately the product of individuals who make decisions to buy and sell things. If individuals decide via consensus that they do not want to use what the state designates as money, then it isn’t money. And if the state refuses to adopt what the market has designated to be money, it cannot collect taxes or buy people's services and goods. 

Why does Money Exist?

Money is the most marketable commodity in any particular society. It serves people and is the medium through which we facilitate trade. Money broadens the number of people who will be willing to sell us what we want. The more people who want money, the more people you will be able to deal with. Without money, we can achieve only a primitive economy. This is because every transaction would become too difficult to calculate. How many cattle do you trade for sheep? How many bananas equal a loaf of bread? Imaging having to run these calculations every time you wanted something? Currencies help us save time when conducting commerce. 

If someone wants to increase their personal wealth by giving up less valuable items in order to buy more valuable items, they need trading partners. As people trade with each other, they voluntarily begin to search out universally desired items in order to “hold for a rainy day.” They sell their surplus goods or services for this universally sought after good. Why? Because they make the assumption that people will want this good tomorrow, next week, next month, next year, and next decade. 

Money increases the division of labor. It increases our options of buying and selling. It promotes growth, innovation, and the advancement of societies.  

Money is ultimately a social phenomenon. It comes into existence because individuals begin to recognize that certain common objects in society are universally sought after. And people will always want to own whatever it is that will provide them with income (goods and services) far into the future.  

Money offers people the widest number of options in the future, so they sell their goods, services, and labor to buy money in the present. Who doesn’t like to have options? 

Origins and Types of Money Throughout History

History shows us there are 5 essential traits of sustainable money:

1. Divisibility - because we need to be able to count things. Ounces, grams, # of zeroes, etc. 
2. Portability - because we need to be able to easily transport it to transact with it.
3. Durability - because it must have staying power. Anything with a shelf life would not work for money. Money cannot have an expiration date.  
4. Recognizability - because everyone must be able to easily verify that it is real. It must be easily recognized and trusted.
5. Scarcity - because for anything to hold value, it must have true scarcity. Anything abundant and plentiful cannot be money for this reason. If it isn’t scarce, it isn’t valuable.

There have been some odd items that have served as money throughout history: beads, sea shells, bear claws, cattle, grain, and cigarettes (in prisons). I find cigarettes in modern prisons to be an interesting case study on money. Cigarettes have value in prisons because they are divisible, portable, durable (to an extent), recognizable, and scarce - because the supply is continually smoked away. Commerce just finds a way to be conducted. Even in prisons.

Ultimately, Gold was chosen as the first universally accepted money in the world. Gold meets the 5 traits of money. It is also shiny and beautiful, creating additional value since it could be melted down and used to make jewelry. 

Gold was chosen as the single monetary asset via consensus of the people. I think it's sometimes hard for folks to believe that free markets operate rationally. Even though there was no committee of expert planners or politicians to tell the market what to use as money, the market found a form of money that has been used and retained value for over 3,500 years worldwide. 

As we moved into the more modern era, economies evolved and became more and more dynamic. Weakness in Gold’s divisibility and portability functions opened the door for paper money to be used and transacted for trade. The way this worked was that gold was held in reserve for each dollar in existence. It was a 1:1 relationship. Over time, this relationship was broken down through money and debt creation, until ultimately the world moved to a Fiat money system (no gold backing) in 1971. If interested, you can check out my article here to learn more about this progression and its impact on debt levels.

How does Money Fail?

Simply put, money has failed throughout history when people don’t see value in it anymore. The most common form of a currency failing is when the trait of scarcity is lost. This typically happens when governments print massive amounts of currency during a crisis. The printing of excess money can create inflation and sometimes hyperinflation - reducing and sometimes destroying the purchasing power of money. When people lose purchasing power, they are incentivized to hold another asset that may provide more value for them into the future. 

We’ve seen this play out recently in Venezuela, Argentina, Turkey, Lebanon, and Zimbabwe. We saw this play out in Hungary in the 40’s and the German Weimar Republic in the 1920’s. Every currency throughout history has ultimately failed for this reason. The Dollar and the British Pound are the only two currencies that have not yet failed. With that said, the British Pound did lose its reserve status and the currencies have lost 96% and 99% of their purchasing power over time.

Ever seen a one hundred trillion dollar bill? If you lived through the hyperinflation in Zimbabwe you have.

We saw an example of how the market reacts to inflation in the 1970’s in America when President Nixon broke our promise to deliver Gold in exchange for the dollar debts around the world. As such, America and the rest of the world came off of the Gold Standard. Money creation exploded. Inflation rose immediately, peaking at 13%. During this period in time, the price of Gold rose from $35/ounce in 1970 to $918/ounce in 1974, an increase of 2,600%. This was a period in time when it looked like the currency had the potential to hyperinflate. Market participants moved out of dollars and into Gold. Of course, the Chairman of the Federal Reserve at the time, Paul Volcker, ultimately broke the back of inflation by raising interest rates as high as 20%. This stifled money creation, reduced inflation, and ultimately got the currency back on track. However, a painful recession was necessary to achieve that. 

The United States printed $3.7 trillion dollars in response to the Great Recession. We have printed $5 trillion (and counting) since March of 2020 in response to Covid-19 and its economic toll. Will we see inflation similar to the 70’s? Time will tell. It's difficult to see it coming anytime soon because of the deflationary forces in the economy right now, but we should certainly remain vigilant in the coming years.  

Here is a quick view of the incredible amount of debt creation in America since we went off the Gold Standard. We have added $78 trillion in debt from a base of $2 trillion and $28 trillion in just the last 10 years.

Source: Federal Reserve of St. Louis

Can money change in the Future?

Because money is based on how market participants value it today and into the future, types of money can always change. History tells us that the most important trait of money, scarcity, is often corrupted via the printing of additional currency units which ultimately leads to debasement of the currency, and loss of purchasing power for the holders of that currency. When this happens, market participants must find an alternative to that currency, because it cannot retain value over time.  

The United States is currently working on the development of a digital currency backed by the Central Bank (CBDC). While this would not change the structure of the dollar in terms of its fiat monetary principles, it would change our payment structure, relationship with banks, and the government's ability to influence various sectors of the economy.  

Additionally, China, Sweden, Japan, Russia, Ecuador, Senegal, Singapore, Tunisia, Estonia, and Palestine are currently working on their own digital currencies.  

Something to watch for with this potential move to digital currencies is whether these countries will try to break their peg to the dollar as the world’s reserve currency.

It is also worth noting that while our money has not changed in America over the last 100 years, our monetary system has. We started on a true 1:1 gold standard. Over time, less gold was held in reserves (40%) than paper dollars in circulation. And finally, we broke away from any gold backing in 1971 and have operated in a fiat system since. 

While we have not seen hyperinflation in America, we should not assume that it cannot happen. History tells us that countries that come off of the gold standard ultimately grew their debt to unsustainable levels. If you’re interested in learning about America's current debt levels, you can check out my article inspired by Ray Dalio and long term debt cycles here. Huge debts force governments to print massive amounts of money when the economy enters a recession. Otherwise, the mountain of debt would unwind itself through a painful deleveraging and solvency crisis. This would manifest into a depression. We avoid this by printing money and creating more debt. The unintended consequence of this money printing is the risk that the currency loses purchasing power and value via inflation. Can we solve a debt problem with more debt? We'll have to wait and see.

Conclusion

Money was not created by governments. It was created by the people. Governments then have the power to tax the currency for the benefit of society. Throughout history, Gold has been chosen as the currency of choice because it met the 5 traits of money: divisibility, portability, recognizability, durability, and scarcity.  

We can also learn from history that countries typically begin their monetary structure on a gold standard. Because of debt creation, over time, the gold backing has been removed when there are too many paper units or too much debt in circulation. This happened in America in 1971 when Nixon took us off the Gold Standard. Worldwide debts have exploded since. 

Money typically fails when it is no longer scarce. When this happens, prices for goods and services rise, and purchasing power drops. Again, history tells us that this happens when governments print too much of the currency. Market participants then need to determine if the currency will act as a store of value in the future. If they deem that it will not, they move out of the currency and into other stores of value. 

We are currently at an important time in history. Debts in America and worldwide are at levels we have never seen before. Interest rates are negative on over $10 trillion of debt worldwide. Central Banks have almost zero ability to stimulate economies through monetary policy with interest rates at these levels. As a result, governments worldwide are printing money. Will we see any unintended consequences? Only time will tell. 

This is all quite the backdrop for the world’s first digital currency, Bitcoin to emerge as a store of value. Bitcoin has seen an increase of 174% in 2020 alone and has outperformed every other major asset class.

My next post will explore Bitcoin and its potential to be a store of value and a widely used currency. Could Bitcoin be money? Stay tuned. 

Thanks for reading. Leave your thoughts, disagreements, or suggestions in the comments.

The contents of this article are presented for discussion and informational purposes only and should not be taken as investment advice.