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Wednesday, October 14, 2009

What is Money?

I have been listening to a podcast on inflation / deflation, which I have not yet finished. This series has inspired me to build a set of financial concepts & definitions.

Most people don't really think truly what money is. To me, money is a tool, like a hammer or a shoe. It is crucial to understand what the true nature of money is, to better understand the risks we face today.

I will start with money in an IDEAL STATE.

Say we have a farmer and a shoemaker. The farmer can only produce food during spring/summer. While the shoemaker can make shoes year round. Neither can survive without the other. To survive each would be required to do all work themselves to be self sufficient.

The farmer may give 3 bushels of corn for one set of shoes for himself to the shoemaker. The farmer knows he may need shoes in winter, for his children, but may not be able to store food for such expenses. (Lets ignore that farmers turn food into "storable" food, such as smoking, jarring, etc.)

The farmer could give food to the shoemaker, and the shoemaker give back a DEBT NOTE worth X amount of shoes to the farmer. This works for both parties, the farmer has "stored wealth" in the form of a debt note from the shoemaker that allows the farmer to acquire shoes at any time. The shoemaker is given goods (WORK DONE), he has the output of work, with the promise of "someday" paying back the work.

Read the paragraph above, this is crucial to understand money. Without money, people would need to barter good/services and maintain debt notes with each other.

Say the farmer, needs a doctor in the winter, the doctor may accept the debt note for shoes from the shoemaker as payment, and 1 bushel of corn. The doctor performs a service (WORK), and receives payment (FUTURE WORK) from the farmer, payable by the shoemaker plus 1 debt note for 1 bushel of corn (FUTURE WORK) from the farmer.

If society ran on a barter system, you can clearly see how quickly this would become confusing. If payment in goods are not fully available at the time, debt notes would be needed. Even if payment is available, in the example above the doctor may not want a pair of shoes and 1 bushels of corn. The doctor would need to accept that payment and seek someone who wants these items to barter for what the doctor needs.

Any debt notes would be required to be paid by the issuer of the note. The doctor couldn't get shoes from any shoemaker, only from the shoemaker issuing the debt note.

Further, the doctor has no direct knowledge the shoemaker debt note is real, and not a forgery.

If all people in this example could use a standard for debt notes, aka money, each can assign proper value for work done to work owed.
Example:
3 bushels of corn = 1 pair of shoes
1 doctor visit = 1 pair of shoes + 1 bushel of corn
1 bushel of corn = 10 dollars.
Therefore:
shoes = 30 dollars
1 doctor visit = 40 dollars.

In an ideal world, you could take the example above, and the shoemaker would actually create 30 hand-written dollars to give to the farmer. The farmer would give the 30 dollars from the shoemaker, and hand write 10 more dollars to give a total of 40 to the doctor.

The people receiving the money created to "capture" the work done, could spend the money for any good/services they seem fit. The people who wrote the money would eventually pay back the work done in services when someone comes to them for services.

In an "honor system" people could just create money for services done PROVIDING they produce equal to or more than in work in their trade, therefore paying back the debt they generated.

There are obvious flaws to using money "created by anyone". The immediate obvious issue is people creating money but not doing any work to compensate for the work they received.
Also, the money itself would be not uniform, and impossible to account for any "fake money" generated. Also people would tend to over-value their work very differently from each other. There would not be uniformity of value for work done.

To overcome many of these problems, money is controlled by a central authority, one that creates money at a pace equal to the work being generated. Money is standardized in look, ensuring minimal fraud. Therefore money is a tightly (we hope) controlled TOOL, a way of standardizing work done to work owed. Once money is "in the system", it works uniformly across all work/services.

Summary
  1. Money is given for work done. The essence of money, it is an "IOU"
  2. Money retains value, based on it is a reliable universally exchangeable medium for future work. (Low fraud, everyone accepts for work)
  3. Money in its ideal state, is "created" for work done today, and is redeemed for "future work" as a payback by the person who originally received the work. (closed system, zero inflation)

In my next post, I'll cover Creating Money & Credit how this captures "work done".

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