What is Money?
A short introduction to the concepts of money and credit.
A proper understanding of a monetary system starts with an understanding of money and credit. The two are not at all the same, although in today’s monetary system they are generally assumed to be synonymous. Similarly, money is not simply that which is most often accepted as a medium of exchange. This amounts to a definition by non-essentials, like defining a chair as any object which can be used as a seat.
I credit Keith Weiner of Monetary Metals for coming up with an analogy which aptly illustrates the confusion that arises when one confuses money with credit. Simply put, to confuse money with credit is akin to confusing a coat check with a coat. When one arrives at a restaurant, you can deposit your coat and receive a token. When you leave, you redeem the token for your coat. The token is not a coat, but rather a claim on a coat, in the same manner that credit is not a commodity, but rather a claim on a commodity.
Money needs to be a measurable, divisible, tangible object. It cannot be a collection of ones and zeros on a hard drive, nor can it be a paper note with an arbitrary value assigned it. Over time, the one commodity that evolved to fill this role was gold. It fulfilled that role because it is the most marketable commodity, with the greatest marginal utility which is capable of extinguishing debt. What are some of the characteristics which make it so marketable?
1. Gold does not deteriorate easily. Most of the gold ever mined still exists because of this characteristic.
2. Gold can be exchanged and stored more easily than other commodities because of its form as a solid. It can be divided into incredibly small units, even more so today given current technology. The lack of bulk makes for much cheaper storage and transportation costs as compared to other commodities.
3. Gold has an excellent stocks to flow ratio; a relatively small amount is produced each year compared to existing stocks. Gold is never converted into heat or food energy, so it avoids the substantial swings in supply versus demand which are characteristic of commodities like wheat and oil. Every ounce of gold mined is a positive addition to the total stock. Under a gold standard, it is simply not possible for the money stock to ever decline.
4. Unlike most commodities (or most other goods), there is no point at which someone would see no value in acquiring an additional unit of gold. It is for this reason that gold has the highest marginal utility of any commodity.
5. Possession of physical gold offers the option of not being a creditor. Thanks to its comparative lack of bulk, it is the most useful commodity for this purpose.
Money and Credit
To extend credit is to lend out one’s capital for investment purposes. To loan out gold is to lend the most marketable commodity, with principal and interest payable in that commodity, in order to finance a productive activity which will return a greater value than what is originally invested.
Under a gold standard, if the rate of return is less than the rate of interest, no gold would be lent out. The holder of gold would choose not to be a creditor as there would be a loss of at least some of the original capital.
A viable monetary system is one in which credit is extended only to those parties which have the means and intent to repay.
Gold allows for final payment of debt. Upon final payment, the lender has his capital (gold) returned to him. The borrower is relieved of any further payment obligations.
Gold allows for the stabilization of the rate of interest. If the rate of interest is too high, gold will flow into the credit system as holders of gold are incentivized to loan out their capital instead of hoarding it. Conversely, and more importantly for any monetary system, if the rate of interest is too low; i.e. the rate of return on investment is insufficient to compensate for potential loss of capital, holders of gold will refuse to take on the role of creditor. Gold will be removed from the credit system as a result.
Until the first decade of the 20th century, gold was money and functioned as such in the credit system in the manner described above. Since then, nearly all the principles outlined here were progressively distorted and abandoned until any and all connection between gold, money and credit was obliterated from the monetary system both legally and conceptually.