subscribe: Posts | Comments

What is money?

2 comments

It sounds like a daft question, doesn’t it? Money is the notes and coins in your pocket, the numbers on your bank statement, the limit on your credit card. You use it to buy things. Simple as that.

However, as with many seemingly daft questions, this one is worth scrutinising more carefully. For instance, why are those particular notes and coins ‘worth’ something? Why can’t we make our own? Why do we need money in the first place? How do the electronic numbers in bank accounts become the ‘real’ notes and coins in our hands? All of these questions and more spring up when we ask what money is.

Not all the questions can be answered in one short article, but we can lay the groundwork here. We’ll start with a basic premise and work upwards. Here goes: money is a medium of exchange.

That sounds simple enough, doesn’t it? Money is a method by which people can exchange goods and services. You might be tempted to ask “Why do we need a medium of exchange in the first place – why not simply exchange the goods and services directly?”

Here’s an answer. If, a few thousand years ago, someone had wanted to buy a chicken but only had a pig to exchange, they wouldn’t have been able to make the deal. Arguably – and I’m not in possession of the relative values of livestock in the ancient past – a pig would have been worth rather more than a chicken. In fact, a chicken would probably equate to one leg of a pig. Our chicken shopper is unlikely to have wanted to carve off the leg of their still-living pig in order to buy a chicken.

Enter money, the medium of exchange. Maybe the going rate for a pig would have been twenty coins, while the going rate for a chicken was four coins. Our chicken shopper could (assuming he had some money already) simply pay for the chicken outright, without having to take an axe to his pig’s leg. Lovely.

But what if our chicken shopper didn’t have any money? In that case he’d have had to earn it from someone else. Maybe he could sell a whole pig now, in which case he could buy the chicken and have money left over for other purchases.

Alternatively, maybe he could borrow the money from a friend, family member or money lender (i.e. a bank). In this case he can still buy the chicken – and depending on how much he was lent he may also have money left over for other purchases – but at some point in the future he is going to have to repay the loan, probably by selling a pig.

It’s time for another basic premise: money is a promise to pay.

Fast-forward back to the future. This premise is so basic that it’s even written on the notes we pay. Open your wallet or purse and have a look: “I promise to pay the bearer on demand the sum of…”

So when we use money to pay for something, what we’re actually doing is passing around an IOU. When I hold a ten pound note, the Bank of England is promising to pay me ten pounds. In the past this meant ten pounds in weight of silver, but now that we have what’s known as a ‘fiat currency’ (a topic for a future article) it means that your ten pound note may be exchanged for other legal currency, whether paper, metal or electronic.

That’s one reason why not just anyone can print money. The IOU must be backed by the strongest of banks, because everybody needs to know that the IOU will never be defaulted upon, that the Bank of England isn’t going to leg it to South America and not repay what it owes. Having a central bank helps maintain confidence in the IOUs, although this system is not without disadvantages. Again, though, that’s a topic for a future article.

When I use the ten pound note to pay for something, I’m giving my IOU from the Bank of England to the person whose product or service I am buying. I am, in other words, passing on the Bank of England’s debt to the seller. Now the Bank of England is promising to pay him or her, instead of me.

This leads us to yet another basic premise, similar to the previous one: money is debt.

That seems counter-intuitive, but with a few exceptions it’s true. The money you hold isn’t your debt, of course; it’s someone else’s. On the face of it it’s the Bank of England’s debt, but that’s not entirely true because the Bank of England is merely managing money on behalf of everyone in the economy. The money you have is actually debt owed by someone who borrowed money from the bank in which you deposited yours.

Another example is useful here. Let’s say you deposit £1,000 in your bank. Let’s say someone else borrows £1,000 from the same bank. At a simple level, your £1,000 is the other person’s debt (a note for the knowledgeable here; fractional reserve banking, interest and other complications have been deliberately left out to simplify matters).

Which brings us to the final premise of this article: money is a promise of future work.

The person who took out the £1,000 loan is going to have to pay it back to the bank at some point. He probably isn’t going to do so by selling a pig, unless he’s a farmer, but whatever he does, it is likely to involve work: that £1,000 is going to be paid back from the borrower’s salary.

We’ve come a long way from the millennia-old chicken and pig, but today money is still a medium of exchange, still a promise to pay, still debt and still a promise of future work.

This article has hopefully made you think a little about how money works. I’ll fill in more of the details in future articles, but for now there’s one important thing to remember. When you’re next considering taking out a loan for a new TV or holiday, it may seem like easy money, but in fact you are exchanging that plasma screen or trip to Egypt for a promise of future work. And your bank will be charging you handsomely for the privilege.

  1. economonkey » The trouble with bankers says:

    […] Eventually, though, the limit was reached, in the UK as well as the US. Debt, as discussed in a previous feature, is a promise of future work, and there’s a limit to how much work any one person can promise […]

  2. economonkey » The UK economy part 1: The Bank of England says:

    […] other can be quite elusive. We’ve covered some aspects of money on this site in the past (here, for example), but there’s more to the economy than money itself. In fact, arguably more important than […]