What is Money?

dollarsThis is a long post – way more than the 1000 words recommended for a blog entry, but please take time to read all of the way through since I think it will be well worth the effort.  I’d also love to hear some comments, particularly from people who disagree.  If you have a way to make a living wage work, I’d love to hear it. – SI

From some of the ideas of how to help the economy, or how to help working people, it is clear that many people don’t understand the fundamentals of money.  When we were young, no doubt we admired the pretty pictures on paper currency and liked the shiny coins that stacked and clanked so nicely.  We were taught that money was something to obtain and guard and value, but what exactly is money?

Money is essentially an “IOU” for work.  You spend an hour doing something useful for someone like picking crops or building a house, and they give you an IOU that you can give to someone else in exchange for them fixing your car or cooking you lunch.  Ideally you should be able to work harder than you need to just meet your present needs when you are young and full of energy, saving up a few extra of these IOUs each year, and then spend them to have others provide for your needs when you are old and unable to work anymore (or just don’t want to work anymore).  If you die before you get all of your labor repaid, you can give the IOUs to your children so that they can receive an equivalent amount of labor as you contributed in the past.  Maybe this is why it is so sad when someone squanders an inheritance, since the person who gave you that inheritance worked so hard.  Read How to Invest a $100,000 Inheritance to learn how you can put that gift you’ve been given to more productive use.

Before money existed, we used barter.  You wanted a new wagon and were a farmer, so you found a wagon maker or someone who owned a wagon they were willing to sell who wanted a load of corn and traded them for it.  The trouble was finding someone who had what you wanted who wanted to trade for what you had.  You might need to trade several times with several different people to finally get what you wanted in the first place.

To make it easier for people to trade for what they wanted, trading posts were established.  There, you could trade whatever you had for the wide variety of things the trading post owner had.  (Note that the free enterprise system was working here – people saw a need for an easier bartering system, so they created trading posts.  They did this to become wealthier, but the way you do this in a free enterprise society is by taking care of the needs of others.  The more people you help, the wealthier you become.)  Owners would quickly learn what their customers needed regularly, so they would make sure to have regular deals with suppliers of those things.  The trading post owner would trade things that were a little less valuable than the things he received so that he could make a small profit to feed his family and provide for his needs since he was managing the trading post rather than out growing food or maintaining his property.  The value he created to his customers from creating and managing the trading post, however, more than made up for the differential in the value of the trade.  They knew they could get just what they needed from the trading post, rather than scouring the country for people who had what they wanted and would trade it for what they had.  The trading post owner created convenience and a time savings, which was valuable to the customers.  If it wasn’t worth the price they were paying, they would have not patronized the store and just traded directly with others.  People would also open other trading posts if they felt the existing ones were too expensive and they could take business away through slimmer margins.

At some point the trading posts probably found the need to issue IOUs rather than trade goods directly.  Maybe the farmers would trade their crops in the fall, but then wait until spring to pick up seed and tools.  Maybe regulars started keeping an account of credit at the stores so that they could come in when convenient and get goods rather than getting everything right when they traded their goods.  Maybe there were also things that were available only during certain times of the year, so people didn’t have things to trade for them when they came in.  People probably started swapping these IOUs with each other when there was something they wanted from someone directly.  That was likely an early form of money.  At some point people probably wanted an IOU that they could use at many stores, instead of just the trading post that issued a particular IOU.  At that point, they may have started using something like pretty shells or bits of gold.  It just had to be something that couldn’t be found everywhere that people knew would hold its value.  It also had to be something that people would work for to obtain even if they didn’t trade it for something else.

At some point precious metals became the standard.  These worked well because they were limited in availability and people wanted them for jewelery and adornment, so people knew they could always trade them.  Countries started shaping these metals into coins and standardizing the quantity of metal in each coin for convenience, but it was still the value of the metal in the coins that made them worth something.  If you wanted, you could always melt the coin down and recover the metal.  Gold was used for larger amounts, silver for medium amounts, and copper for small amounts.  (Note sometimes people would shave a little of the metal off of the coins before they spent them.  This was kind of like counterfeiting since now the coin you exchanged was not as valuable as its face value.)

At times it became difficult to carry around a lot of coins.  To remedy this situation, countries began issuing paper notes that would allow the holder to exchange the note for a specified amount of gold or silver.  This was called The Gold Standard and was very effective.  Because the amount of precious metals were limited, and because the amount of effort required to dig them up and refine them more than equalled the amount of labor the coins and notes represented, the value of money was relatively fixed.  In the US the value of the dollar stayed almost exactly the same from about 1800-1920.  This means that you could work an hour, save up a dollar note, and then trade it to someone 80 years later for the same amount of labor.  There was no inflation!

This all changed in the 1930s in the US when the country needed to repay its debts from WWI.  Rather than cutting government spending and raising taxes, and thereby raising the money legitimately, the government stopped guaranteeing the ability to trade notes for precious metals.  This allowed them to print money without needing to actually go through the effort to procure something of equal value to back it up.  They also confiscated most of the precious metals in the US so that people who held these metals wouldn’t suddenly realize a bonanza, since they knew that those metals would suddenly be worth a lot more dollars than they were in the past if the government started printing money that was not backed up by gold or silver.  When they spent these new greenbacks, there was now currency on the markets that had not been traded for an amount of work equal to its value, but that could be spent and traded for goods and services just like the legitimately earned dollars.  Because there were now more IOUs out there than there were goods being produced, the value of each dollar decreased and the value of gold in dollars increased.

This is called inflation.  To understand the effect of inflation, realize that the dollar that was worth exactly what it was a hundred years before in 1930 is worth one-tenth the amount it was worth in 1930 today.  If you worked ten hours to earn that dollar in 1930, you could now only trade it for one hour of equivalent labor today.  Inflation really is thievery by the government, or at least another tax levied on everyone who holds cash currency (or even money in savings and other bank accounts, since they don’t pay a high enough interest rate to overcome inflation), since it decreases the value of everyone’s money and they therefore lose part of the work they performed in the past.

And this is why the you can’t expect the government to just cover everyone’s needs, or even a few wealthy individuals.  The government could send out lots of checks, but without someone putting forth the labor to cover the value of those checks, the dollars they create decline in value to the point where thousands of dollars must be traded for a loaf of bread.  To put it another way, for every loaf of bread, house, or shirt that someone purchases with the money the government hands out, someone needs to put forth the effort to make that item.  In a functioning economy, you can either have most people working enough to cover their own needs with a few working extra to cover the needs of those who don’t provide for themselves, or you need to have a few people working really hard to cover then needs of a lot of people.  In the latter case, at some point those who are working really hard will just throw in the towel since they are getting nothing in return that comes anywhere close to the value of what they are producing.  They will just produce what they need for themselves.  As more and more people do this,  the amount of goods and services available declines.  You can then have a fist full of dollars, but it won’t buy you anything.

What about rich people?  Can’t they just cover everyone?  Well, people get rich by just getting a little more back than they provide from a lot of people.  They employ people and get a maybe $5 for every $100 worth of goods and services each employee produces.  They trade goods and services to others, and maybe get $2 for every $100 worth of good they sell.  The reason that they become wealthy is that they employ a lot of people and they sell a lot of items.  They become wealthy by providing a lot of jobs and meeting a lot of needs.  If a lot of the workers started receiving more than they produced, (through a minimum wage that was too high, for example,) and if a lot of the people started receiving the items for free, (because they receive dollars from the government to buy things but don’t provide the labor needed to earn those dollars), the wealth the rich person had would quickly disappear.  There would also be no one to take his place because there would be no incentive to put in the hours required and go through the hassle of opening a business and employing people.  You might as well just provide for yourself and do the minimum and enjoy your free time.

So, dollars are only worth something if people are doing something to earn them.  Remember that they are IOUs for goods and services you provided in the past and not some magic thing that governments can just produce at whim.  You also can’t produce $10 worth of goods per hour and recieve $15 per hour just because you need $15 per hour to pay for expenses.  Maybe a few people can, but on average everyone needs to be producing at least as much as they are paid, plus a little extra to cover the business owner and make it worth his time.  The government can produce the paper and the coins, but they can’t produce the loaf of bread or the house.  That takes an effort.

Contact me at vtsioriginal@yahoo.com, or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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