What is money and what are its uses? From gold to paper money to electronic money

Adam Smith in 'The Wealth of Nations'[1] shows us that the fundamental, true measure of the value of an object is labor-objects which need more labor to make, in general, are worth more than objects which need less labor to make. Allowance must be made for different skills and training involved: an object (or service) of labor of a few hours is sometimes worth more than the object of labor of many days, due to the higher skill and training required in the former.

However, it is inconvenient to talk about objects in terms of their labor content or units of labor they save the buyer; and since most objects are exchanged with one another rather than with labor itself, money becomes a more convenient measure of value.  This is the reason goods (and services) are quoted in money prices; but we must not forget that the true value of goods is measured in labor. You exchange the produce of your labor with the produce of others' labor. You get paid for your labor in money, and you exchange that money with the goods produced by other people's labor, is the real exchange going on in the world. Labor is the true price of all objects; money is their nominal price only.

When considered as a measure of value of goods and services (the most common use of money), money may be thought of as similar to the unit of mass, the kilogram (kg) or the unit of length, the meter (m), which from the Système Internationale (SI) units conventions, are standardized units of measuring mass and length. An open source cryptocurrency based on a this idea, Smith Money, here.

From gold and silver to paper money, and now to electronic money

Many things have been used as currencies in the past-salt, cattle, sea  shells, dried fish, etc. Paper money started becoming popular in the times of Adam Smith (around 1760).  However, banks were still required to hold reserves in gold and silver, and the paper currency was backed by gold. This would later be formalized in 1944 by the Bretton Woods agreement, where all currencies were required to be backed by reserves in gold, and someone could exchange their currency for gold by going to a bank at any time.

The Bretton Woods system came to an abrupt end in 1971, when the US, the main original creator of the Bretton Woods agreement, opted out of the convertibility of the US dollar to gold. This was credited to President Nixon, and many economists and finance types predicted the end of the world and run away inflation after this was instituted.

None of the crazy things predicted by the economists happened after 1971. The US continued to become a richer country, and floating currencies (currencies with no gold backing) became the norm after that time.

How could this be? How could a country (US) or the world, transition to a completely paper based currency system, and still have no major catastrophes? A paper currency bill guarantees nothing except that you can exchange it with another one of the same denomination at the bank, now that the gold backing was removed.

The faith in the dollar bill is a faith in the US government, because all collections of taxes are in US dollars, and the US government runs all its operations in that currency - pays the government workers in dollars,  makes payments in dollars for purchases made from private companies, etc. This is why the people could accept a freely floating currency- they realized that as long as the US government collects taxes and runs its operations in dollars (it may help to think of the  US government as a the largest non-profit corporation in the US, which employs about 10% to 20% of the population, directly or indirectly. If the biggest employer in a country runs their operations in US dollars, all smaller entities are fine using the same instrument), their money will always have good value, for the government would not manipulate an instrument it uses itself for its operations (this lesson unfortunately is not understood or followed everywhere, which is why Venezuela's currency has no value). With the removal of the gold backing, the banking system became less relevant.

This successful transition to floating currencies also happened because prices are a time series, and people work hard at an individual level to provide price stability, and in reality exert a constant downward pressure on prices (the inflation data and story is a big lie). When millions of Americans (and the same thing happens in other countries) go out to buy stuff in the grocery store today, they use the prices of yesterday (or whenever they went to the grocery store last) as an anchor, because their wages have not jumped up suddenly in 24 hours. They naturally try to get the most amount of goods for the X dollars they want to spend in the grocery store today. If prices of a product jumps up suddenly, they will buy a much smaller volume of that product, or in many cases will not buy that product at all. This behavior, coupled with the thousands of products which they can spend their money on, forces the prices of goods to fall constantly. This in effect means that dollars saved are worth more tomorrow than today, because they will buy more goods tomorrow that today, even if you just hold the dollar bills and get no interest.

This general stability of money value is also the reason that in most developed countries, people will buy a house on a 20 or 30 year mortgage. They know that prices of goods are generally stable, and so are their jobs. If they were not sure of the general stability (or downward movement) of the prices of goods or their wages (if they lose their job, they can find another job in a few months) they would never enter into such an onerous contract as buying a house on mortgage. They also have some liquid savings in paper dollars (or the country's currency), which can cover the monthly mortgage payment in case they can't earn anything for some months. All this shows an inherent stability in the system-and there was no need for them to rush to a bank to turn their dollars into gold. This happened BEFORE the gold standard was removed; the banks were rarely being called for converting their dollars into gold in the US before 1971. The paper currency took a value of its own, and with a stable government and a reasonably responsible banking system backed by a central bank (which doesn't give money out to people for free) which in turn is backed by the US government, the system in the US and all countries successfully transitioned to freely floating currencies without any backing of gold.

Together with this there was an important development-the invention and acceptance of checkbooks (checks are an extension of paperless bank-to-bank transfers, where previously you had to go to a bank to transfer money from your account to another account. You could now do it much more easily by issuing checks). Checkbooks are a predecessor to credit and debit cards and electronic money-they removed the necessity of carrying around wallets and suitcases (if you buy expensive objects) full of dollar bills. Once checkbooks became an acceptable form of payment, the banks needed to print even less dollar bills, because many payments, especially the larger ones (e.g. buying a car, a house, or company-company payments), could be made via checks.

Credit and debit cards took out checkbooks from the equation. As I write this (in 2017) a large amount of purchases are done by credit and debit cards. We can safely say that in many countries, and this includes not just the wealthy and developed countries, but even developing countries like India and Chile, that most transactions in money are electronic; via bank-to-bank transfers, checks, debit cards and credit cards. I would guess that more than 95% of the total value of the transactions in any developing or developed country are non-cash, i .e. electronic (Sweden reports that only 2% of the country's transactions are using paper money). Most transactions are electronic because most of the total wealth held in money by individuals or companies in any developed or most developing countries is held in electronic form in banks as deposits, with only a fraction, maybe less than 5%, held in actual paper currency. We don't carry around large amounts of paper currencies in most countries; and it is safe to say that we have now moved from paper money to electronic money in the 21st century. The advent of the Internet which simplifies bank-to-bank transfers, worldwide credit card companies like Visa and Mastercard, and payment wallets like Paypal and Venmo are all aiding in a complete elimination of paper currencies, and I surmise that in a couple of decades they will cease to exist altogether, with all money being completely electronic. Sweden already has committed to a completely electronic money system from 2020 onwards.

Every individual or company keeps a small part of their wealth in money (the only exception is the financial sector). Most individual assets are in real estate, household objects and furniture, cars, jewelry and gold; and stocks, which represent ownership of assets via a stock exchange. Companies hold assets which are saleable and do not want to hold money...they would rather own objects which they can sell for a profit than money. Companies hold some money only for liquidity purposes, to assist in the buying and selling of the goods or services they trade in. Most money being already electronic in most developed and developing countries, it follows from this than even a smaller portion is held in paper money (dollar bills, other currency bills) and coins.

When a country like India implemented demonetization to target this small wealth of people which they hold in paper money, they wasted everyone's time rather than rooting out corruption or tax-evasion, because they did not realize that most wealth of individuals is not held in paper money.

Role of the banks and financial system

I have come across a lot of confusion in investment and financial circles on the meaning of money and the role of the banking and financial system. More on the role of banks here.

For an updated version of this article download my Economics book on Amazon Kindle here

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