Why Is Money?

By Annaly Capital Management

Back in June we wondered out loud, “What is a dollar?” That exercise—as well as the recent schizophrenic behavior of the currency market and the lamentations regarding the Fed’s “printing press”—has led us to wax philosophical on this Friday in August, and ask the question that is the title of our post today.

We tend to give the concept of money very little thought. For example, how many transactions does the average person engage in every day, and in how many forms? Our first transaction of the day is handing $1.25 in cash to a guy in a cart on 47th Street for our morning coffee. Throughout the day we buy lunch with a debit card, buy a book online with a credit card, transfer money to pay bills online and write a check to pay ConEd. In this parade of transactions, the relevant questions are “How much money do I have?” and “Do I have enough of it to pay for these things?” At no point during the typical day do we question the unit of exchange for all this activity, the US Dollar, or even wonder if it will be accepted as a form of payment (regardless of the form—cash, check, megabytes over an internet line).

The typical complaint about the dollar is that it is a fiat currency, one that is backed by nothing but the faith in America and its institutions. Some feel more comfortable knowing that their paper money can be exchanged at any time for a set amount of gold; it seems more grounded somehow, less faith-based. But a quick look at gold, despite it having a limited quantity (it can’t be printed at will), reveals that the major drawback of fiat money also applies to gold, meaning it only has value because we have always ascribed it value. Essentially, it is a malleable and ductile metal with a limited range of inherent utility. At the end of the day, you can’t eat it, or live in it (but you can wear it). As Willem Buiter, the chief economist at Citigroup and a gold bear, said, gold has benefitted from “the longest-lasting bubble in human history.”

So, with money, backed by gold or otherwise, what do we really have? Maybe we have something of a modified “greater fool” theory where we expect that it will have a value to somebody else in the future. If people start doubting the future value of money, then people will be less likely to take that money today. This is starting to sound like a very fragile system. It may or may not be, but nevertheless there is a natural tendency towards developing and using some form of money, like water flowing downhill. It makes things easier. A barter system is cumbersome, constrained by a double coincidence of wants requirement (i.e. for two people to trade, they both have to have exactly what the other person wants). That is why it is necessary for groups of people to form their own currencies. Think about cigarettes in US prisons (actually, now that smoking is banned in prisons, mackerel is the new currency). The natural first step is commodity money, where the form of currency typically has an actual use (cigarettes), but is different from barter because there is a fixed unit of measurement that goes along with it (i.e. 10 cigarettes for a sandwich). Commodity money makes transactions easier, but some forms aren’t very durable (like fish), and can be hard to transport and store. Gold (and dollars) as commodity money fixes the issue of transportability, storage and durability, but why would we have developed a system of money based on something that is inherently worthless when it comes to sustaining actual human life (unlike milk or codfish)? In short, because doing so is beneficial to us. The value of money/gold stems not from any specific utility but from the options that it presents to its holder.

Consider a haircut and a movie ticket in a world with no money. In this world, a barber will only get to see a movie every few weeks, or every time the movie theater owner needs a haircut. He has no other options. What he eats for dinner depends on what the farmer who needs a haircut that week grows or raises. But when the same haircut is purchased with money, the barber can then use that currency to purchase whatever he wants. He has options. He can go to a movie whenever he desires, he eats what he wants for dinner. The value of any currency derives from the options it affords its holder, and the flexibility and opportunity that come along with those options. “Wealth” really means that we have enough money to access many options. Whether people realize it or not, at its most atavistic level the propensity to accumulate large amounts of money stems entirely from a desire for choice. When we desire those extra bills in our pockets or the additional zeroes in our bank accounts, what we are really after is access to more options for ordinary and fundamental wants and needs: more clothes, educational options for our children, more living space, future financial stability, the ability to satisfy more philanthropic impulses, etc. We value money not for what it is, but for what we believe it can obtain in exchange.

Money, whether gold or fiat currency, is at its essence a belief system. And like anything based on beliefs, certain events over time can call those systems into question. The seeming capriciousness of cancer or Alzheimer’s can test some people’s faith in religion, and the events of the last three years certainly tested our belief in this system of money. Nevertheless, there is a natural tendency in human society towards the use of money. It makes things easier, greases the wheels of everyday life. In the essay "I, Pencil," Leonard Read describes the coordination of productive forces to create a simple item that we use every day:

“I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies—millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire…”

It is impossible to imagine this process without the use of money. The act of cutting down trees and trimming wood, mining graphite and zinc, the creation of machinery and the organizing of workers to run those machines, would simply be impossible without a readily acceptable currency to grease the wheels.

It may not be an exaggeration to extend this idea to the success of humans themselves as it relates to money as the ultimate form of cooperation and tolerance, allowing us to come down from the trees and populate the world. Thus, there should be a fairly strong tendency for a monetary system not to break down, similar to mutually assured destruction, but it does happen, and it can happen in different ways, such as a group of people choosing an alternative, like the euro for the dollar, or creating an alternative. This is happening today in different parts of the world, from California to Brixton and from Ithaca to Ireland, as well as that small kingdom known as Disney.

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As faith wavers in the current system of money and exchange, and as people contend with swings in the value of their local currency, it is worth remembering that the world needs money—the concept and the thing itself. Moreover, it needs a form of money that people will continue to have faith in, because we all want to know that the pile we have in our bank account today will be able to afford us the same options in the future. It isn’t a store of value that we need as much a store of faith and an instrument of cooperation. It can be the dollar, gold, or the yuan, or it can be Ithaca Hours or Disney Dollars.

Why is money? Because we’re humans.

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