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Posted: December 01, 2010

The Economist: What is money?

Tucker Hart Adams

Since I wrote about stone money and the unimportance of gold last month, this month seems like a good time to examine what really is money. At the end of the year, faced with holiday gift giving and year-end taxes, it's a topic on everyone's mind.

More than 30 years ago I wrote my Ph.D. dissertation on the changing money demand function and the role of new financial products. At that time money was defined as cash and checking accounts, or M1. This was what the Federal Reserve was supposed to target to influence growth, inflation and employment.

But something strange was going on. Money was not behaving as theory predicted, complicating the Fed's job. New products and cash management techniques - savings accounts on which you could write a few checks each month, sweep accounts that enabled corporations to manage their cash more efficiently, the widespread use of credit cards, even exotic things like ATMs and debit cards - were becoming common. There was speculation that checks would disappear, than cash would disappear, that electronic money would become ubiquitous.

I used mind-numbing statistical analysis to support my hypothesis that the new products were changing the demand for cash and checks. For a while it looked like I was wrong; the volume of checks in the U.S. actually increased and huge amounts of cash remained in circulation.

But starting around 1995 the volume of check writing began to decline sharply. Debit and credit card transactions soared. Digital wallets appeared in the form of plastic cards that don't require signatures or pin numbers for small transactions. Today, mobile telephones can remit money around the globe between people who don't have bank accounts. In Japan, merchants offer discounts to customers who use electronic cash, and the volume is doubling annually.

Economists remind us that money serves three functions: a store of value, a unit of account and a transaction mechanism. As a store of value, money enables us to save for retirement or a large purchase or a rainy day. The unit of account function enables us to price all products and services using a common yardstick. I became very aware of the convenience that provides after traveling through six countries over three weeks that each used a different currency. I was never sure how much I was paying.

But its use to facilitate transactions is surely money's most important function. Can you imagine a barter economy where each day you have to find people with an excess of the product or service you want and a matching demand for the excess of the product or service you have to trade?

Only the simplest of societies can function this way. In fact, the first paper money was receipts for gold stored in the vaults of the goldsmiths back in Middle Ages. People quickly realized it was far more efficient to use these receipts to make a purchase than to go to the vault, get the gold and then take it to the merchant who immediately had to redeposit it in a vault, possibly of the same goldsmith.

It wasn't long before the goldsmiths figured out they could issue receipts for more gold than they held, since there was never a time when all of the gold was demanded at once. Thus the fractional reserve system developed. When the world went off the gold standard temporarily in World War I and permanently in 1971, we hardly noticed. As long as we believe the pieces of paper we trade are worth something, they are.

When my great-grandchildren (may there be an economist among them!) study economics, I doubt the three primary functions of money will have changed. We'll still need a store of value, a transaction mechanism and a unit of account.

But they may well consider ATMs and teller lines, with the idea of pieces of paper being traded between individuals and businesses to effect transactions, something to be studied in the same chapter with the medieval goldsmiths and the island of Yap.

Money to them will be digital, occurring with the wave of a cell phone or the latest Apple product.
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Tucker Hart Adams, president of the Adams Group, monitored and analyzed the Colorado economy for 30 years. She can be reached via her website, coloradoeconomy.com.

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Readers Respond

Hello - I my reply to your article last month, I had this to say: "Couple this with the public's perception that money is both a medium of exchange, and a store of wealth,..." ( http://www.cobizmag.com/articles/the-economist-why-gold/ ) I therefore read with some interest this month's article. You statement equating money with "a store of value, a unit of account and a transaction mechanism" sounds an awful lot lime my definition with an additional role added. I'm not a trained economist. Perhaps you can explain to me how 'unit of account' is anything other than a corollary of money's other two roles? But the salient point I want to make here is that, the US Dollar does NOT meet your definition of money. It fails miserably as a store of wealth. Since 1913, the dollar has lost anywhere between 95% and 98% (estimates vary) of its purchasing power. This is not to single out the FRN (Federal Reserve Note) - all other fiat currencies have been debased into a mere shadow of their former selves. And yes, 1913 was chosen for my example for a specific reason. So if the FRN does not meet your definition of money (miserable failure at its posited role of store of wealth), and neither do other world currencies, what is a concrete manifestation of money in today's world? Your example of electronic bookkeeping entries in a mobile phone? Absolutely not. Note that, when people use credit cards, or checks, or some digital cell phone transaction, these transactions are all backed with (denominated in) some governmental-issued currency. People *believe* they are employing dollars as money - not some blips on a wire. This is directly analogous to our currencies formerly being backed by commodity. Before there was an FRN, our currency was backed by gold or silver. Dollars actually used to have printed upon them an explicit reminder that the dollar note was not money, but was redeemable for a dollar's worth of hard currency (gold or silver) upon demand. Interestingly, gold meets all three of your stated criteria for money. It is an effective store of wealth recognized for millenia across the entire civilized world, it can be directly exchanged for goods and services, and even provides a standardized measurement of account. Indeed, it provides a better unit of account than does the FRN - a lesson I fear we will all be learning soon, as the world loses patience with us debasing the value of their FRN holdings. So if the FRN fails as money, as do electronic blips, than what would you recognize as money? By Nunya Bidnez on 2010 12 05

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