What is money and what have we made of it

Money is a medium of exchange, unit of account and means of saving. As a medium of exchange money serves to facilitate trade. As such it works if people accept it as something that represents a certain value. It is something artificial, something of which we tacitly assume as having and keeping that certain value.

Money as a medium of exchange and unit of account

In the absence of money goods and services have to be bartered: someone who has too much of a product, say sugar, and needs another product, say salt, must find someone who has salt and is interested in exchanging it for sugar. Money, in the form of coins, bills, or in some societies, shells or cattle, makes it possible for the person having sugar to sell it even if the buyer has no salt. The seller then looks for someone who wants to sell salt. This is a lot easier than finding a person with both properties: a need for sugar and salt to sell. Money is something so practical that through the centuries it was “invented” in all but the simplest societies. Because money ensures a much more flexible process of exchange it is the lubricant of the economy.

Added to the use of money as a unit of exchange is its function as a unit of account. Because of this feature, it is possible to compare the value of different products or services with each other.

Money as a means for accumulation or saving

A third function of money is that you can accumulate and hoard it, so as to use it at a later point in time. Money takes up very little space (except the cattle) and does not spoil. Accumulation leads to trade in money: those who need it but do not have it can borrow money from someone who has money to spare. The loan is paid back later, usually with interest: a premium that makes lending money attractive. Lending is also done by intermediaries: people taking savings from others and lending them to third parties. That’s how banking began.

The foundation of money: trust

The foundation on which the value of money is built is trust. For money to fulfil its role as a means of exchange and accumulation people must believe two things. The first is that it will be accepted widely as payment; the second, related one is that it will keep its value. If this confidence is lost money will lose its value as a medium of exchange, as a means of accumulation and as a unit of account.

WHAT HAVE WE MADE OF MONEY?

Money as magic

The principle of money is very simple. But especially during the past two centuries money has taken on an almost magical character. It is no longer seen as something created by man that, therefore, can be manipulated freely, but as something that conforms to its own laws that are beyond the control of mere humans. Therefore we barely dare intervene in the monetary system: we are afraid this will lead to uncontrollable events determined by timeless monetary laws, with terrible financial and economic consequences.

The greatest fear: (hyper) inflation

The greatest fear is for hyperinflation: money rapidly losing its value with fatal consequences for the monetary system and the economy as a whole. This fear is greatest in people with a lot of money, but ordinary people with some savings and employees whose salaries are not automatically adjusted to inflation also suffer heavily. Only those with large debts benefit: their debts are all but wiped out as the value of money approaches zero.

Money scarcity and economic theory

The science responsible for assigning magical properties to money is economics. Mainstream economic theory assumes that economic systems are in balance or are moving towards a balance, or with a fancy word, equilibrium. So too with money: economists assume that the money supply is balanced with supply and demand. Therefore, in line with general economic theory, the quantity theory of money teaches that pumping more money into the economy without a corresponding increase in the production of goods and services would inevitably cause inflation, meaning an increase in the overall price level. This theory has never been proven, it is – as we’ll see later – refuted by the facts. It is, in fact, little more than faith, based on a series of assumptions that have little to do with reality. But as a faith it is so dominant among economists and in their wake policy makers, politicians, the media, and almost anyone who thinks he or she knows something about economics that it’s at the basis of all financial policy.

Why governments don’t create money

The money supply theory explains why governments do not create money for their own use. It is fear: the fear of money creation by government causing uncontrollable inflation.[1] This fear of inflation is so strong that money creation by the government for use by the government has become a taboo. The only safe way to create money, so it’s assumed, is to subject it to market forces. This means money creation should be left to the private sector: to banks operating in a competitive market. Market forces will ensure that the quantity of money stays in balance with on the one hand, the quantity of goods and services and on the other, demand for those goods and services. Anything occurring outside the market, such as a government creating money (through the central bank) for its own use will, it is strongly believed, upset the balance established by the market and, in line with the quantity theory of money, cause inflation.

Money, economic theory and speculation

Over the years economists have developed all kinds of complex theories about money. Intricate mathematical models and equations have needlessly complicated the concept of money and especially, the way money works in our monetary and economic system. Since the 1990s such models have been used in financial markets for speculation: trying to make money by trading in money and financial products. Trillions of dollars are involved, as a result of which financial businesses hire the smartest economists and mathematicians in the hope their models will do the best job in predicting the market and thereby, maximising profits. The models and financial products they produce have become so complicated that they are only understood by the very best minds. Even the supervisory boards and boards of directors of the financial institutions employing these geniuses often do not understand the exact nature of the financial products involved and their effects on the economy.

Discussing our monetary system: experts only

The biggest problem with this complexity is that non-economists do not dare speak out about our monetary system. Only the experts have their say – and despite the mess caused by the 2008 crisis, foreseen by practically none[2], they continue venting their opinions with such aplomb that laymen will think twice about calling their expertise into question. Thus the thinking about what we would like our monetary system to be remains the exclusive reserve of a small group of insiders.

The comparison with nuclear energy

We should approach our monetary system as we do nuclear energy. We don’t have much of a clue of the workings of a nuclear power plant: that’s all enormously complicated technology – just as all those mathematical models depicting our economy are terribly complicated. But we do form an opinion on whether we want nuclear power or not. We are smart enough to weigh the pros and cons of nuclear energy when properly informed. And, after comparison with alternative forms of energy generation, we can express our opinion on whether we want such energy or not. Thus many people have formed an opinion about nuclear energy. Those who have not will usually say that they do not know enough of the pros, cons and alternatives.

Our monetary system as a given

What applies to nuclear power should also apply to our monetary system. At present almost everyone assumes that the system is a given, that there are no alternatives, and that therefore we have no choice but to continue with it – perhaps with some of the minor adjustments proposed by experts. This attitude must change. We can and, in our own interest and that of future generations, should form an opinion on the current system, look at the advantages and disadvantages, and explore alternatives. And we must take action to get a better alternative introduced. As in the case of nuclear power we should not be discouraged by the fact that we do not exactly or even approximately understand how the current system works. Important are the actual and likely outcomes of the current system, and those of alternative systems.

Money as a scarce resource

In analysing the current monetary system and its alternatives we should let go of ingrained ideas, especially the assumption that money is scarce. This assumption has taken hold under the influence of mainstream economics. Economists and other financial experts believe the amount of money is limited, and that society will have to live with the limitations imposed by that scarcity.

If indeed there is scarcity, a lack of money, it is self-imposed since as mentioned, in principle money can be created at will. The problem is that current attitudes and outlook make this idea difficult to accept. The idea that money can be made out of nothing runs against our deepest beliefs. Something for nothing, a free lunch, impossible – money has to be earned! The idea that we could just make money to, for example, repay a portion of the national debt or invest in renewable energy generation, energy conservation and better roads is hard to acknowledge. There must be a snag somewhere, a fly in the ointment. And yet it can be done: as mentioned, we do not even have to produce the money physically, in the form of banknotes or coins. As most money is electronic a few keystrokes on the right keyboard would suffice.

Something for nothing?

What we have to remember when we talk about money and the “there is no such thing as a free lunch” argument comes up is that actually, money is nothing. As said, most of it does not even exist physically, and even if it does, in the form of coins or paper money, it has almost no intrinsic value. You can’t do anything useful with coins or banknotes: you can’t eat, sleep, live, or move in them. Money, then, is nothing more than a symbol. Symbols you can create freely, especially if they are electronic. And because symbols are nothing you get, if you create money, not something for nothing, but nothing for nothing.

That does not mean there are no restrictions on money creation. The limitation, however, is not in the money itself, but in the products you buy for it: a meal or the ingredients for it, a bed, a house, a bicycle. Of these there are limited quantities. Therefore, the fact that in principle we can make unlimited amounts of money does not mean we should. We should not create so much money that producers can ask much higher prices because their products are bought anyway, or that workers can demand much higher wages because they will be paid anyway. That would lead to an increase in the overall price level: the very definition of inflation. A low level of inflation is considered acceptable and, in the eyes of most economists, even desirable[3]. In most countries, therefore, central banks aim for inflation rates of about two percent, as this is considered to contribute to stimulate the economy and thereby, economic growth. But higher inflation is rightly seen as harmful to the economy, especially for those with savings and for employees. And it can, if it gets out of hand, lead to hyperinflation and a financial and economic crisis.

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[1]    Inflation of one or two percent is generally considered acceptable and even preferable. If inflation rises above 4% it’s seen as a (serious) problem.

[2] Some experts did foresee the crisis – some economists and more often, non-economists who observed the facts and used logical reasoning to predict that pre-crisis events would lead to a financial melt-down. No model and therefore, no economists basing themselves on their models foresaw the impending disaster.

[3] The reasoning is that a little inflation will encourage people and companies to consume and invest rather than save, because in the longer run the money will be worth less. Investment and consumption are good for the economy: money should be spent, not hoarded. Conversely economists argue that deflation, the lowering of the price level and thereby, increase of the value of money, will stimulate businesses and people to hoard their money because they assume it will further increase in value. This is bad for the economy: money not spent will reduce economic activity and thereby economic growth. It has never been proven that these arguments apply in reality, i.e., that people will actually postpone expenditure because they think money will be worth more in the future, but the belief in such “rational economic behaviour” is so strong that it has become established wisdom.

This was the 2nd and 3rd chapter of the booklet “Our Money” by Frans Doorman, author of the books Crisis, Economics and the Emperor’s Clothes, Global Development: Problems, Solutions, Strategy – A Proposal for Socially Just, Ecologically Sustainable Growth and The Common Sense Manifesto.

This booklet explains, in plain English, what money is and how our current monetary system came about. It discusses the problems inherent to the present system and proposes an alternative.

It also explains how the current monetary system restrains us in addressing our economic, social and environmental problems, and even worsens them. It discusses the transition to a system that would work better, the main traits of that system, and the reasons why such a better alternative is hardly considered at present.

This booklet is intended for a broad audience: anyone with an interest in the solution of society’s social, environmental and economic challenges. People who are concerned about the continuing impact of the economic crisis that started in 2008 and about its aftermath: growing economic insecurity, inequality, and poverty. And people who are distressed about the environmental problems our global society is facing: the degradation of ecosystems and the environment in general, the depletion of natural resources, climate change, loss of agricultural land, and looming fresh water shortages. People who, even though they do not expect to be affected by these problems directly themselves are concerned about the future of their children and in general, of future generations.

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