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Understanding Money

The information age has had a truly revolutionary effect on many aspects of our world. Perhaps most significantly, it has changed the way we communicate and interact with each other. Rapid, high speed, computerized interactions now afford us new opportunities to improve the way we organize ourselves in a civil society.

Certainly a revolution in energy production and distribution would have a profound effect on the world. And we understand how education is pivotal to the beliefs and perceptions of the rising generation. But perhaps there is even a more basic and fundamental stratum of the economy where revolutionary change is needed. This is the level where value is exchanged by individuals and corporations as they cooperate in the production of the goods and services we need to support and sustain ourselves. The medium of that exchange is money.

Hopefully we have discussed enough foundational topics to now explain what money actually is and how it often gets used to:

  • Foster our individual pursuits toward happiness and fulfillment, or to
  • Bind people down into obligations of servitude.

As it turns out, most of us don’t really understand money very well. Isn’t it interesting, we handle and use it every day, we plan our lives around it and we often choose our life’s work because of it. We budget it, we save it and we love to spend it. Sometimes we dream about getting more of it. Yet very few of us stop to figure out what it really is at its essence.

For example, if someone asks you: “how do you make money?” You might say something like “get a job” or “start a business.” True, we call that “making money” but is it really?

Or is that more about getting someone else to give you some of their money? When you get a job, is new money created (made)? Or do you just receive some of a fixed pool of already existing money?

When you start a successful business, are you making money? Does this imply money is somehow being created out of nothing? Or do you have to take the money away from someone else in order to get some for yourself?

Different people understand this concept very differently. In fact, the way we understand these questions may go deep to the root of which political faction you associate yourself with. You might view the economy as a zero-sum game, or a fixed size “pie.” In order for there to be a winner, there has to be a loser. If I get more pie, you get less.

Or you might think enterprise somehow grows the size of the pie so there is potentially more for everyone. Much of this may form a part of your Faith. Surely it affects the way you think about, and relate to other people in the economy.

In order to start answering these questions, let us do some experiments. Since we are not together in a laboratory, we will instead do the kind of experiments Einstein liked to do–thought experiments. To do one, we just make up a very simple scenario that is easy to understand and then use our intuition to determine what the results will likely be. Sometimes, we may exaggerate using extreme cases to be able to imagine the results more clearly.

Although such thought experiments are not likely to give us results as numbers or data like an accounting spreadsheet or a computer program might, still they do give us some kind of intuitive sense of how things work–particularly at the margins, or extremes. This makes it easier for us to imagine what is happening under normal, or less extreme conditions.

To get started, let us consider the difference between money and prosperity. Is there a difference? Previously we discussed how mankind has a number of inherent needs. Basic needs include food, water and shelter. Additionally, most people feel a desire for companionship and a sense of purpose, self-worth, or accomplishment.

For our discussion, let us define “prosperity” and “wealth,” which terms we may use more or less interchangeably, to mean people have most of the commodities necessary to satisfy their wants and needs. This might include an ongoing supply of food, a place to live in reasonable comfort, and a variety of possessions to use in work and leisure.

In contrast, the term “money” will apply strictly to cash and its direct equivalents. It is the stuff we usually give in exchange for the commodities we buy. And we usually receive it when we sell a possession or some of our labor, or time. It is an abstract representation of the value we place on these commodities. But we should not confuse it with the commodities themselves.

Later, we will go into more detail about different kinds of money. But for now, just think of dollars, euros, pesos, gold or silver coins and the like. Also, imagine whatever you think is in your bank account, whether you believe it is the same or not.

So if we say you are “rich,” we mean you have plenty of money. If we say you are “prosperous,” this means you have most of the other things you need in life to be happy.

So our first thought experiment goes like this: Imagine 5 people have found themselves on an isolated island in the middle of the ocean and have no contact, nor hope of contact, with any other people or civilization. As in the story of Adam and Eve, these 5 islanders have to work by the sweat of their face to obtain clean water and life-sustaining food. And they have to similarly do work to construct and maintain their shelters, clothing and so forth.

Now imagine, on the starting day of our experiment, we produce a balance sheet for each person. Remember, this will include any assets or liabilities owned by the person. In doing this, we find each person has claimed an equal share of some gold they jointly discovered in an abandoned pirate chest, but no one has yet produced any food, shelter or other necessities. Each person has a total of 1000 one-ounce gold coins which, in the outside world, could be worth well over a million dollars.

Now, use your intuition to answer the question: within the context of the island “economy,” are our 5 islanders rich or poor? Are they prosperous, or destitute?

Certainly in light of meeting their present and most urgent needs, they are destitute. While some may satisfy certain desires for a time by running their fingers through their newly found gold, before very long, they are bound to become hungry, thirsty and tired. At that point, they are going to need to do some things to make themselves more comfortable, and ultimately, to survive.

This is when the laws of economics begins to affect the ways they will relate to each other. We need to ask ourselves whether being rich is of any particular value at this point. And isn’t it interesting, the word “value” comes to mind very naturally as we try to evaluate the usefulness of the gold.

Many of us have visited tropical islands, so you might have already imagined there are lots of bananas, mangoes and other good things growing all around. Perhaps every little while a wild boar may saunter past which could easily be grabbed and roasted over an open fire. But then our island would be too much like the Garden of Eden to suit the purposes of this thought experiment.

To make it more interesting, let us say, while there is a reasonable amount of useful plant and animal life around, it is hard enough to come by that it takes a significant amount of work to find and procure it. On average, it may take someone 4 or 5 hours of hard work just to collect enough food to feed themselves for one day. If our islanders want to eat, their gold is not going to do them much good right now. Someone is going to have to get to work, and quickly.

Now imagine only one of our castaways has really figured out what needs to be done in order to survive. While the others were still enamored with their gold, he went into the jungle and worked from dawn to dusk. For 16 hours, he gathered food and water and ate while he worked. Because of the economies of his work being accomplished all in one long, concentrated stretch, he was able to be a little more efficient. In addition to feeding himself all day, he was able to gather enough extra food to feed all 4 of the other people for a day or two. He also learned a fair amount about where to find the various kinds of trees and he remembered where he had already stripped off what fruit was most easily found.

As he showed up back in camp with all the food, let’s say he was willing to sell some of that food for the right amount of gold. How would the price of the food be established and just how “expensive” might it be?

Although it is difficult to predict exactly how much our islander might charge, we can guess that in terms of outside-world dollar pricing, it could get pretty expensive. In this isolated economy, it might not seem unreasonable to ask for 1 gold coin each from his customers. In terms of the outside world, that would be over $1000 just for one day’s food. But even so, hungry people probably wouldn’t mind giving up only one of their 1000 coins for a good meal. After all, they would still have a lot more left over. And eating a good meal before bed time would probably seem very important in their current state of affairs.

For a more extreme example, imagine several days had gone by and everyone was desperately hungry, nearing starvation. There was no more naturally occurring food to be found. But fortuitously, one islander just managed to find an old cache of army rations in a nearby shipwreck. If he wanted to trade the food for gold, what is the most he could charge?

You can easily imagine that facing starvation, the others would be willing to give up all their gold if it meant getting the food they needed to survive. But is it really possible one case of food could be worth $5,000,000 in gold?

You can see how our experiment is helping us understand the economic laws of supply and demand. In a very real way, the value of the food is highly dependent upon how much of it there is to go around. It has its own intrinsic value that has everything to do with how hungry people are (the demand) and how hard it is to come up with more food (the supply).

The value of the food has less to do with how much gold there is around to be traded. And it has virtually nothing to do with what a dollar is or what it can buy somewhere else in the world. So our first observation might be: commodities like food, clothing and other things we need or want in order to make us more comfortable, have intrinsic value. And that value is related to how plentiful or scarce they are, and how much people want or need them.

The next concept we should learn from this experiment is: the food itself was not the only thing changing value. The gold itself is also a commodity. And its intrinsic value can also change based on supply and demand.

To understand this better, it might help to “step outside” of how we measure value. If we are measuring the value of the food in terms of gold coins, then only the food changes value. But the truth is, the food would be valuable even if there were no gold at all on the island. How would the islanders measure its value then?

Perhaps they could measure it in terms of the number of days it would keep a person alive. For example, a particular container might be worth 10 man-days, keeping one person alive for 10 days, or 10 people alive for 1 day. In this example, the value of the food would be pretty constant. But if we were measuring the value of gold in terms of man-days of food, its value could fluctuate dramatically.

On the first day, the gold would probably be at its highest value, whatever that might be. But as people learned to value food more than gold, the gold would get less and less important to them. Ultimately when someone discovered the much needed crate of food, he could easily obtain all the gold in trade if he wanted it.

In a very real sense, the gold would be worth exactly the same amount as the food because it could be exchanged for the food. The gold, or money, would have derived its value from the food because the food is what was really wanted and needed most.

This is a critical concept to grasp in economics because sometimes, we make the mistake of thinking, if only there were more money around, everyone would be more prosperous. Some might think certain mean people in charge somewhere, who could just make more money if they wanted to, instead limit the amount of money so the rest of us can’t get enough.

But the value of our economy should not be measured by how much money we have, but rather by the wealth of commodities we have available to satisfy our wants and needs. Money is merely a temporary placeholder–a proxy for commodities which are the real things of value. The money, or the medium of exchange will derive its value from the value of the commodities it represents.

And so the value attributable to each unit of money, such as a dollar, will be a function of how many dollars there are available to trade, in comparison to the amount of commodities available to buy. This is the basic mechanism behind inflation and deflation. As more money comes into circulation compared to actual prosperity, the value of each dollar will tend to decrease. As less money becomes available, the value of each dollar increases.

So does that really happen? Is there sometimes more money and other times less? If so, how does new money come into existence? And can existing money somehow disappear from an economy?

In our island example, the gold coins are not likely to disappear unless they are lost or destroyed. And new gold is not likely to appear unless they happen to find another treasure chest or discover how to mine more gold from the earth.

But in modern economies, most money is not of the same kind as gold or silver coins–something we might call “commodity money.” Rather, most of our modern money is something we will call “credit money.”

This kind of money can easily be created and destroyed. So the amount in circulation can, and does, change from day to day and month to month.

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