Tuesday, November 26, 2013

What is Money?

I was going to write on redefining the financial institutions and the financial products they produce, but realised that you need to start with an understanding of money first.

So what is money?  The problem here is that the one word - money - is used for quite different things.
They are all real things, but they are not the same, and they all have different functions.

Economists talk of three functions - as a store of value;  as a standard or unit of exchange; and as a medium of exchange.

Money started as a gift between people. It could be a gold object, or a pig, or pottery, or shells, but each was a symbol of good will. Over time this changed. As societies grew, the pathway between the doer of, and the receiver of, any service or action got longer, and with new surpluses in agricultural products, these, like corn in Egypt, became the form of money - (this is called commodity money)

Farmers in Egypt could deposit their crops in government run warehouses, in exchange for receipts that showed the amount, quality and date. The farmers could then write a transfer for some of this grain to some-one else in exchange for goods or to pay rent. The various warehouses balanced these transfers and moved grain from one warehouse to another if needed. Other crops were also used in this way, like tobacco in the USA. These were efficient systems. The crops held their value, it was easy to understand and record, and the transfer dockets allowed small and large transfers to happen. It was also efficient in that the grains would deteriorate with time, and could be eaten, so there was an incentive to use it, to circulate the value through the society. Strangely this was like earlier times. Money was only useful as a "gift" to other people. If you did not spend it, it would disappear.

Things changed a bit with the invention of coins ( though the first coins were little metal toy tools, shells, and animals to mimic the exchange of the real things ). At first the coins were issued in parcels that made up the receipts as before, and the individual coins could be used for the smaller exchanges and transfers.

 As trade between kingdoms and peoples developed, these coins became useful as they extended the range of valid exchanges. They also helped cities manage the industrial revolution. As people specialised in the work they did, they also narrowed the range of goods they produced and so found direct barter harder to achieve. A neutral store of value was very handy.

The first coins were made and issued by the government of the region ( king, duke, war-lord ) They were usually made in gold, silver or bronze - metals both soft enough to mint, and relatively rare.
They were also issued in proportion to the underlying commodities. However, that soon changed.

Governments found that they could mint and issue a little more than what was supported by the commodities they held, so long as they were powerful enough to convince people the coins had value, though in part, the amount of gold and silver in the coins influenced this value ( because the coins could be melted and re-minted in the name of the receiving government ).

As the supply of coins increased, the problem of safely storing them arose. The government goldsmiths started to offer to store the coins, in exchange for letters of credit. This evolved into paper money, official documents that state that the person holding the letter, or note, has that amount of money. People had to trust that these notes had value - this is fiat money.

Now it got sneaky - the goldsmiths and the governments realised that the chance of all the people with letters of credit asking for their gold or grain at the same time was very slim. So they could issue many more paper money notes than they held reserves, and they could do this as loans to people without the reserves, and charge interest on those loans.

At the same time - merchants were using Bills Of Exchange or Promissory Notes - the merchant's promise to make payment for goods supplied at some specified future date. Provided that the merchant was reputable or the bill was endorsed by a credible guarantor, the supplier could then present the bill to a merchant banker and redeem it in money at a discounted value before it actually became due - an early form of credit – a medium of exchange and a medium for storage of value.

Kings and Dukes used similar bills to both record current taxes paid and taxes due to be paid. They then found that they could exchange these Bills, or Tallys, for gold or coin or services or supplies in advance of the actual tax collection, and then, of course, realised that they could create bills against assumed or estimated, future tax collections.

This acceptance of symbolic forms of money - coins, and paper money - meant money could represent something of value - a reserve -  that was available in physical storage somewhere else in space, such as grain in the warehouse. As a bill or promissory note it could also be used to represent something of value that would be available later in time, a document ordering someone to pay a certain sum of money to another on a specific date or when certain conditions have been fulfilled.

##[  http://en.wikipedia.org/wiki/History_of_money ]

This was the first divide between real money ( RM - money used as daily exchange and based on current real reserves ) and money that only became real in the future, and required trust that the future would be as described in the bill or note.

Essentially, both the paper money issued in excess of the actual reserves held, and the bills and promissory notes issued based on future creation of reserves meant that those people who accepted this form of money ( model money MM ) locked in their future to fit the model described by the issuer of that money. ## [ TD ]

For example, most of the money offered when you apply for a mortgage is model money - only a fraction is based on real money that matches cash reserves at the bank.  But the moment you sign the agreement, this model money becomes real money to be extracted from your future reserves - you sign your future over to the issuer of the loan.

This can be hard to see, but it means that your future becomes something that can be bought, sold and exchanged - this model money - now real money - becomes a commodity itself.

And as profits can be made trading commodities, what was earlier a bit of a fiddle issuing paper money and bills based on a near and likely future, has now become an industry as big as the real money world it overshadows. And why the financial industry can have such a large impact on ordinary lives and businesses.

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