What Is Money?

“We all know what money is, but do we really understand how it works? It’s not as easy as you might imagine, so this section will be challenging. But it’s essential that we understand that the manner in which money is created and issued concentrates wealth and generates poverty. In other words, poverty is not just a lack of money; it’s the result of the way money is created and issued. If we want to provide paid work for all, we must design a system for creating and issuing money in which work for all is the only possible output of the system. The current system cannot do so, for reasons that are intrinsic to the way it creates and issues money.

If we want to provide work for all to alleviate poverty, we must first design a system of money that makes this possible.

Let’s start our exploration of the causal links between money and poverty with a thought experiment. Let’s say we could all create money out of thin air with a conventional printer or copier.

If I wanted to buy a house that was for sale, I could print $100,000 and offer the seller this handsome sum. But another bidder might print $1 million. I could counter with a $1 billion offer, and he might counter with $1 trillion.

We can easily see the consequence of unlimited money being available to everyone: money quickly loses its purchasing power—what we commonly call inflation. When money loses its purchasing power very quickly, it’s called hyper-inflation.

Traditional societies maintained the value of money by choosing something scarce as money: in the far-from-the-sea Himalayas, seashells were used as money, as their relative scarcity made them valuable. In the South Pacific, sperm whale teeth were used as stores of value. Scarcity creates a store of value.

Money has two basic functions: it is a store of value (that is, it holds its purchasing power after you obtain it in trade for goods and services) and it is a means of exchange: there has to be enough of in circulation to grease the exchange of goods and services.

Though we are accustomed to one form of money playing both of these roles, there is no reason why each function can’t be served by separate kinds of money—that is, one for exchange and one as a store of value. This is precisely what we find in the historical record, where bills of exchange, letters of credit (in essence, credit money), paper chits from retailers and other ephemeral means of exchange greased trade, while gold and silver or other scarce materials served as stores of value.

The key feature of money used for exchange is that it always has an end buyer. The intrinsically worthless chit issued by a retailer can serve as money through hundreds of transactions because everyone trusts that the issuer—the retailer—will accept the chit as being worth an established amount of goods.

If this end buyer vanishes, so does the value of the money.

This is why many people have come to define money as whatever the state accepts in payment of taxes, as the state is the ultimate end buyer: whatever is accepted as payment of taxes is money. In historical examples, this has ranged from commodities such as bundles of grain to purely symbolic forms of money such as notched sticks.

Trust in an end buyer is the essential characteristic of money. When gold and silver were scarce in pre-Renaissance Europe, the great trading fairs relied on credit money—promissory notes, bills of of exchange and letters of credit, each of which could be used as money because the end buyer—the counterparty named in the credit instrument—was known and trusted.

As anthropologist David Graeber established in his book Debt: The First 5,000 Years, money arose not from barter—the usual assumption—but from the rise of credit-based exchange and debt recorded on clay tablets, notched sticks or parchment. Money simplifies the payment of debt, and thus anything with an end buyer can serve as money.

This understanding of the historical way money was created—by issuing credit—helps us understand how money is created and issued today. Though we tend to think money is created when governments stamp gold coins or print paper money and place them in circulation, this is not the entire story. As economist Steve Keen (among others) has described, money is created when banks lend money, i.e. create credit, the same way pre-Renaissance merchants created money when they issued bills of exchange. When the bill of exchange is paid and the bank loan repaid, that money disappears from the system.

This is confusing unless we separate the two functions of money: means of exchange and store of value. Accustomed as we are to gold coins and paper currency acting as both, we forget that the vast majority of our money is credit-money: the actual physical money in circulation in the U.S. is a $1.4 trillion dollars, while the economy’s gross domestic product is 17 trillion and the global GDP is $72 trillion. Total net worth of U.S. households exceeds $100 trillion.

In the Renaissance trading markets, money was created when a merchant sold ten tool boxes and accepted a bill of exchange from another merchant for the boxes. The most important feature of this transaction is the money was created to match an expansion of goods and services.

In other words, although the money was created out of thin air in the sense that a piece of paper, once signed by both parties, was transformed into money that could be used in transactions by many other merchants throughout the fair, it was actually created as a result of the ten tool boxes being produced and brought to market where their value could be established and traded. In other words, money expanded because production expanded.

Now compare this to the modern form of creating money. If a homebuilder constructs a new home, that produces value that did not exist before: a stack of lumber and other materials was transformed into practical shelter.

The home buyer usually needs to borrow the money to pay for the new home. The bank lends the home buyer the money by issuing a mortgage. The bank does not take cash from its deposits to fund the mortgage; if the bank has cash reserves of $10,000, it can issue a mortgage of $100,000 via fractional reserve lending. This $100,000 is newly created money.

Once again, we see that this creation of money aligns with the creation of goods and services—in this example, a new house.

If a government or central bank prints new money, and there is no corresponding increase in the production of goods and services, the expanding money supply is untethered from the real economy. Over time, increasing the supply of money in this fashion reduces the purchasing power of the money, as the amount of money that can buy goods and services outstrips the actual production of goods and services.

We call this loss of purchasing power inflation, but it is actually a devaluation of money. If money is only created to match the expansion of goods and services, inflation resulting from overproducing money cannot occur.

The old trade fairs’ dependence on credit money illustrates another important feature of money that helps us distinguish between means of exchange money and store of value money. A handful of bills of exchange and promissory notes could enable dozens of transactions between buyers and sellers without any need for a single gold coin or other form of store of value money. At the end of the fair, all the credit slips were tallied and settled, and the difference would be paid in silver or gold.

The credit money might well have enabled $1 million in sales/ exchanges, and the balance after all these many credit transactions were settled might be $1,000 in gold coins. So a very large amount of trade can be transacted without a single hard money silver or gold coin trading hands, and the final settlement of all these transactions from an entire fair could be settled with a mere handful of store of value money, that is, money that is not based on trust in an end buyer.

This example from history shows us that credit money has a very high utility value, i.e. it is extremely useful, and hard money is not as essential as many seem to believe. Another example from history reveals a key aspect of credit money and hard money. When the Spanish Empire conquered central and south America, it gained vast quantities of hard money—silver and gold. It seems obvious that this enormous windfall of new hard money greatly enriched the Empire, and indeed, the purchasing power of this hard money wealth was immense.

But the Empire found its aspirations exceeded this supply of hard money, and so it borrowed heavily from Dutch and other European bankers. Eventually the debts exceeded the Empire’s ability to pay the interest due, and the hard money flowed north to the owners of credit money. The point here is that possessing store of value money is no guarantee of solvency. Value flows to what is scarce and in demand. That could be land, labor or credit—whatever is in demand due to its utility value. Gold Rush miners in California placed a high value on fresh eggs, and money flowed to their scarcity and utility value. Value always flows to what is scarce and in demand, and it’s important to differentiate between demand for credit money (means of exchange) and store of value money.

Though scarcity creates value, store of value money has an intrinsically symbolic component. The Rai stones on the island of Yap provide a striking example of this characteristic of store of value money. The large round stones (as much as 3.6 meters/12 feet in diameter) do not physically move from owner to owner as they change hands; rather, the ownership is maintained in oral-history records. A Rai stone in the bottom of the lagoon serves its purpose as a store of value just as well as one propped up in front of the owners’ home. The utility value of a Rai stone is essentially zero—it serves no purpose other than as a marker of stored value, just as the utility value of a gold coin is low (what function does it serve? Perhaps it performs duty as a paperweight, but a valueless stone would serve this purpose just as well.)

This third attribute of money—its symbolic value above and beyond its utility value—is both mysterious and ambiguous. Money can be a marker of status, of esteem, of responsibility to the community and many other things. Though modern money is assumed to be entirely abstract, this is not an intrinsic feature of money; money can represent more than a store of purchasing power.

Money has a fourth attribute that we tend to take for granted: money is a commodity, and its value—in other forms of money, and in goods and services—is established by the supply and demand for that specific form of money. If we say that money has value, we have to ask: measured in what? Though we focus on the ability of money to retain its value, the ultimate value of any money is its exchange value for assets, goods and services with high utility value: assets that generate income and goods and services that are useful.

Let’s summarize what we have discovered about the two kinds of money.

1. The two functions of means of exchange and store of value do not have to be served by one form of money. Multiple kinds of money can serve both functions in a transparent market where the value of each currency is set by buyers and sellers.

2. Credit money functions as a means of exchange and store of value as long as there is trust in an end buyer of the money.

3. The value of traditional store of value money that has no real utility is a function of scarcity and symbolic value.

4. Scarcity only creates value if what is scarce is in demand.

What is demand? Markets of buyers and sellers—trading fairs, open exchanges—enable the expression of demand. In general, whatever has utility value and is scarce will be in demand, and money that can be used to buy what is scarce will also be in demand.

In some circumstances, gold is scarce and valued highly. In others, eggs are scarcer than gold.

Money is only valuable if it can be exchanged for goods and services. If there is no market of goods and services, gold is no longer money; its value is merely decorative. If a large market of goods and services exists but gold (or whale teeth, Rai stones, etc.) is scarce, then credit money serves as means of exchange because it has utility value and is in demand.

Value flows to what’s scarce and in demand, and as a result those who control what’s scarce control value creation and thus wealth.

So just who controls value creation? This question cuts to the core of the role money creation plays in poverty.

In the old trade fairs, two merchants who exchanged a promissory note created credit money that could be used by other merchants in the fair as a means of exchange for other trades. The note’s value was based on the trust that the merchant would make good on his promise to pay the note at the end of the fair. In effect, the merchant promised to be the end buyer of the credit money.

Note that no central state or bank issued this credit money. It was decentralized and market-based; its value was based on knowledge of the merchants who created the credit money. Their reputation accredited the paper as money. This illustrates the critical role in accreditation and trust in creating credit money.

Now consider the way that modern money creation is limited to central and private banks. All the profits from creating credit money—the transaction fees and interest—flow to banks. Those with access to low-cost money issued by the central bank can lend this money at higher interest, or use it to buy income-producing assets. No one saving cash from an earned income can possibly compete with someone with access to low-cost credit money.

If we follow this logic, we must conclude that the monopoly on creating and issuing money necessarily creates vast wealth inequality, as those with access to newly issued money can always outbid those without this power to buy the engines of wealth creation.

Control of money issuance is power, and so is access to low-cost credit. Those with access to low-cost credit have a monopoly as valuable as the one to create the credit money. This reality has led many to see the solution as the eradication of credit money in favor of gold-backed money, so-called hard money that cannot be created out of thin air. But as I have shown, credit money has two essential characteristics not shared by gold-backed money:

1. The ability to create credit money can be decentralized; it does not need to be centralized.

2. Means of exchange money can be created in tandem with the expansion of goods and services. This gives it a much higher utility value than intrinsically scarce gold or silver store of value money. The problem with credit money is not its nature (based on trust in an end buyer) but its current centralized issuance by a monopoly.

The key to the success of the credit money issued in the trading fair was it was created only when the supply of goods and services expanded. The supply of credit money was never infinite in the old trade fairs; rather, it was strictly limited by the quantity of goods and services being exchanged.

Since value flows to what’s scarce and in demand, gold will flow to the wealthy who control value creation in the economy. In a credit money system, wealth will flow to those who create the credit money and those with access to low-cost credit money, as they can outbid cash buyers for income-producing assets, i.e. the engines of value creation.

We now understand why the current system of creating and distributing credit money generates poverty as its only possible output, as those closest to the money spigot can buy control of value creation. This cannot be reformed away by more regulations; it is intrinsic to the centralized creation and distribution of credit money.

For money creation to not generate vast wealth inequality, the ability to create money must be decentralized, and the new money must be distributed to everyone producing goods and services.

We can now see that for credit money to serve both functions of money (means of exchange and store of value) it must expand only with the expansion of goods and services.

This leads to the question: who are the natural end buyers in a credit money economy? In practical terms, permanent demand replaces the end buyer, and relative scarcity (i.e. the supply of money does not exceed the expansion of goods and services) drives permanent demand.

There are several pools of permanent demand:

1. Debtors who need money to pay off their debts.

2. Those with surplus goods or services they want to exchange for money.

3. Those seeking to borrow money to buy assets.

4. Those seeking the symbolic attributes of money: status, esteem, etc.

According to Graeber, the anthropological record suggests money arose to facilitate the payment of debt, so we can assume that debtors constitute one source of demand.

Though lenders may well prefer gold, Rai stones, etc., if the choice is to receive credit money or nothing, lenders will accept credit money.

Those with surplus labor, services and goods must exchange the surplus for money in order to realize the value of their surplus. Once again, those with surplus goods, services and time may prefer gold, whale teeth, etc., but if the choice is between credit money or nothing, they will accept credit money.

The magic of credit is that by borrowing from future income, a productive asset can be purchased today that will generate the income needed to pay the debt off in the coming years. For this reason alone, there will always be a demand for borrowed money.

Assets that increase productivity are typically manufactured, and as a result they are surplus goods to producers. If I fabricate vegetable-oil presses, and do so efficiently, I will have a surplus of presses I need to exchange for money. If a buyer does not have the cash but can borrow the money, his need to borrow and my need to exchange my surplus goods for money both create demand.

Human beings, being primates, construct elaborate pecking orders of status and power. As a result, some people will seek to acquire more money than they need for mere well-being. In many cases, status is earned by sharing the money with supporters or the community at large. Unlike the model of hoarding precious metals as unused wealth, establishing status and power requires not just acquiring money, but spending it in ways that benefit the group.

Scarcity and demand create value. If there is a large market for my surplus goods and services, and permanent demand for the money I receive for my surplus, scarcity is localized: a relative abundance of credit money will cause that money to flow to whatever goods, services and credit are scarce. Whatever goods and services are abundant will attract credit money from locales where these goods and services are scarce. The key requirements of this system are: open exchanges for ideas, knowledge, goods, services and decentralized money that is only issued when new goods and services are created.”

A Radically Beneficial World: Automation, Technology and Creating Jobs for All: The Future Belongs to Work That Is Meaningful, pp. 142-152, Charles Hugh Smith