The Economist: What is money?

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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