“Money” is anything that can serve three jobs at once — medium of exchange, unit of account, and store of value. Currency is how we make that value tangible, and some items (gold, we’re looking at you) make for better currencies than others because they’re durable, portable, divisible, recognizable, and have a low stock-to-flow ratio (that’s scarcity in fancy clothing). By the end you’ll see how every currency falls into one of three buckets — commodity, commodity-backed, or backed by nothing at all.
By the end of this piece, you’ll have a sense of the relationship between money and currency, why gold rose to prominence as the de facto resource underpinning the global economic system, and the primary distinctions between commodity currency, commodity-backed currency, and fiat currency. That sets the stage for the next post, where we’ll get into how governments benefit from meddling with currencies, the emergence of central banking, and the economic impact of transitioning from the gold standard to a fiat system.
Let’s dive in.
Turn your imagination on real quick
Consider the following: I have an apple, but I want an orange. You have an orange, but you want an apple. If by wondrous coincidence, we cross paths while both of these conditions are true, that’d be very convenient, wouldn’t it?
In a barter system (nO MoNey!!!), this is an example of the “double coincidence of wants”, and it’s not particularly common. Coincidence, it turns out, is not a great foundation for a thriving economy. We need something to facilitate transactions independent of the goods and services we produce.
In other words, we need a “medium of exchange.”
This, my friends, is one of the three essential functions of money.
Value now, value later
Day-to-day transactions are just one part of the economic experience. We do our jobs, we get paid, we buy bagels and lox, but what about the times when I’m not eating bagels and lox? You know what I’m talking about… the future.
If we produce more than we consume, we want to be able to save and plan for the future. As well as having value now (helpful for serving as a medium of exchange), money should retain its value for later use. Thus, the second essential function of money is to be a “store of value”.
Sorry, it costs how much?
The market is pretty good at determining the value of a good or service (a function of supply and demand). But what the heck do we use for “price”?
How do we denominate the value of our bank account? It feels unnatural to think about value without mapping it to a dollar amount — we’ve been thoroughly trained to think this way.
My point is this: the third function of money is related to measurement — money must serve as a unit of value — it’s how we all get on the same page. You may also have heard the term “unit of account”.
So there you have it
“Money” is anything that can fulfill the three functions mentioned above: a medium of exchange, a store of value, and a unit of account. In prison, they use cigarettes as money. In my household, we also use cigarettes as money. The kids love it.
Currency and money aren’t the same
Not gonna lie, sometimes I have a hard time with this concept. The point is, a currency is usually just a representation of money.
Money symbolizes the intrinsic value of goods and services — a bit more intangible than something like a gold coin or paper dollar. Said differently, money is the measure of value, currency is just how we express it for the sake of transaction.
We live in a digital age
We transact digitally, save and invest digitally, some of us even go to the bathroom digitally (wait, no that can’t be right).
But before everything started happening over the internet, the physical nature of currency actually mattered. And as some unfortunate people would come to learn, certain items make for better currencies than others.
So what makes a good currency? Two things, generally speaking.
1. Salable across time and space
A currency should be durable and recognizable — the physical characteristics shouldn’t change much over time (edible arrangements would be a terrible currency because they decompose… I’ve seen it).
It also shouldn’t be too difficult to move around, and it’s especially convenient when it can be divided into smaller, equally usable pieces (this rules out large, fragile things… my ego would make a terrible currency).
2. Low stock-to-flow ratio
Think of “stock-to-flow” as a fancy term for scarcity. In order for a currency’s purchasing power to remain generally stable into the future (i.e. $5 will get me a loaf of bread now, as well as a loaf of bread in 3 years), it’s important that the amount of new currency entering circulation in a given year doesn’t increase disproportionately to the amount of currency already in existence.
If the amount of currency in circulation goes up drastically, but the velocity of the production of goods remains the same, the currency’s purchasing power is reduced. This is called inflation, and in certain circumstances, it can lead to $10,000 bread — more on this in the next post.
Technology matters
Between 9000 BCE and 1600 BCE, economies with minimal exposure to other cultures were generally successful when it came to using “stuff” as their local currency.
Cattle, shells, big ‘ol stones mined from special quarries — these items served their populations sufficiently because everybody was equipped with similar (and limited) means for creating more of said currency. You can only breed cattle so fast.
This gets thrown out of whack when these local economies come face to face with more technologically advanced cultures. Technology can create the means to rapidly increase the amount of local currency in circulation (cue the Europeans). It’s still hard to breed cattle faster than nature will allow, but gathering seashells or mining big rocks? Technology can handle that.
There are a bunch of examples of various European characters coming into contact with Asian and African civilizations, figuring out how to manufacture or expedite the creation of their local currency, and aggressively leeching their natural resources. Colonizers were not nice. I won’t dwell on it here.
Given what you now know about the criteria for a “good” currency…
Is there any physical material or resource that comes to mind as being particularly well-suited to the task? If you said “James’s Giant Peach”, I would reach through the internet and smack you.
The answer is gold. I guess “precious metals” would’ve worked — silver and others played their roles throughout history, but gold takes the cake.
Gold is scarce, it has a low stock-to-flow ratio despite all of our technological advances, and it’s practically indestructible. On top of that, it’s divisible, lightweight (sort of), and recognizable (although fool’s gold is a thing). It’s also shiny, which I like.
“But besides those qualities, does gold have any intrinsic value?”
It’s a fair question. A currency doesn’t need to have intrinsic value, because a currency is just a representation of the value of money. In this sense, a currency just needs to be really good at being a currency.
Gold’s natural characteristics fit the bill (the shiny thing is important too — from Europe to South America, gold’s allure was ubiquitous). It’s not surprising that the first gold coins made their debut over 2,500 years ago in what is now Turkey, and continued to play a major role in the story of currency up until 1971.
I’m not gonna dodge the question entirely
The truth is, gold has value because we say it does.
Yes, it’s technically a commodity, but it’s not particularly useful outside of a few niche industry cases. Ultimately, we say it has value because it has had value historically (thanks to its role as a currency and in certain cultural settings) and we all agree that it will continue to have value (most likely due to its scarcity — again, this is tied to its previous role as a currency, and probably also its beauty).
Oh, there is one other teeny tiny thing about gold: it can’t be created out of thin air.
The three categories of currency
And then you’re free to go think about how someone might breed cattle faster (this is a trillion-dollar idea!!!!).
1. Commodity currency
Conceptually, this one is very easy. The currency is the commodity. The most common example is probably antique coins. Gold ones, silver ones, copper ones — their value came from the material of which they are composed.
2. Commodity-backed currency
While jangling around with a big sack of gold coins certainly sounds fun, sometimes it’s easier to just stash all the gold somewhere and use paper “receipts” to represent it. Paper money — technically cloth — has been around for a long time. Paper “IOUs” appeared in China during the Tang dynasty (around 800 AD), serving as a convenient alternative to lugging around precious metals.
Paper money is efficient for transactions both large and small; you can have a $5 bill next to a $10,000 bill, both fitting comfortably in your wallet. But what does the paper money actually represent? Well, if your currency is commodity-backed, it represents the commodity.
During the years when the United States was on the gold standard, paper dollars were just receipts for a corresponding amount of gold. You could take your paper money to the government and say, “please exchange this for gold,” and they would do that. How nice of them.
3. Fiat currency
In a fiat system, there is no commodity for which you can exchange the paper. But that’s not to say the money isn’t “backed” by anything. The legal tender is backed by the government — the laws that make it legal tender, the fact that you have to pay your taxes in it, and (ultimately) the coercive force standing behind all of that.
They say it’s worth something (in Latin, fiat means “let it be done”), so it is — and we all kinda accept that because we don’t want to go to jail.
If that smells a teeny bit fishy, well, the backstory isn’t going to make it any less so. That’s the subject of the next post, where we’ll turn to the role of governments, central banks, and the economic effects of fiat money.
The end.
Nothing in this essay is investment, legal, or tax advice. It’s a general discussion of concepts I find useful in my work and shouldn’t be relied on as a recommendation for your specific situation. Talk to a qualified advisor (ideally one who knows you) before acting on anything here.
