What is Money?
By Richard Halverson

Money.  To economists it’s a medium of exchange.  To accountants it’s a unit of value.  To children it’s a penny.  To politicians it’s a campaign promise.  To government planners it’s a tool of management.  To bankers it’s the commodity they sell.  To workers it’s what they sweat their life’s blood for.  To a husband and wife it’s something to argue about.  To ministers the love of it is the “root of all evil.”

To the average person, money is what he or she never has enough of.

Everybody knows what money is, or at least they should.  But in reality very few people know everything about money.  For example, very few people realize that the invention of money is one of those innovations that rank with the invention of the wheel or the discovery of fire in its importance. 

As with wheels and fires, our world simply could not run without money.  Imagine the chaos if money were suddenly eliminated and society reverted to the old barter system.  Consider the plight of the brain surgeon trying to trade services for ten gallons of unleaded gasoline. (The gas may soon be worth about the same amount as brain surgery if it keeps going up.)  But how many service station attendants need brain surgery anyway? 

Imagine the computer programmer trying to work an arrangement to get a toupee styled.  Or a steelworker attempting to buy a can of hair spray at a discount store.  Without money, these transactions would not take place.  In fact, money has become the common denominator of nearly all our dealings.  Everybody understands how much various items are worth when they are valued in money.  This is because everyone knows what a dollar is worth ― even if it does seem to be worth less all the time.

The Value of Money

The reason money is worth anything at all is because of faith.  People have faith that the money they accept for work or selling something will in turn be accepted by someone they need to purchase goods or services from. 

The value in money is not in the material the money is made of, but in the fact that everyone accepts it.  The paper in a $10 bill is worth less than a penny.  But you can buy a thousand pennies for $10 bill.  (An odd problem facing the government at the moment, due to the recent rise in the price of copper, is that suddenly it costs more than a penny for the government to make a penny.  They will need to figure out how to make them cheaper but a penny will still be worth a penny.)

Sometimes even a valuable material such as gold isn’t worth much if people have no faith that they can exchange it for what they want.  I once heard a man tell of a dream he had.  He dreamed he was in a war-ravaged area.  All government, law, and society had broken down.  He dreamed he was holding a cat, for which he was offered a bag of gold.  Without hesitation, he refused the offer.  It was a logical decision under the conditions.  He had no faith that he could use the gold to buy things he needed, such as food.  But he could eat the cat if he needed to, and thus he could stay alive. 

After all, what good was a bag full of gold pieces if he died of starvation while counting them?

This little dream illustrates another point about money:  Money is valuable because it is scarce.  In the dream cats and other good things to eat were apparently more scarce than gold. 

The average person will quickly agree that money is scarce.  But it must be scarce, or it will have no value.  If the supply of money were to suddenly be doubled and passed out to everyone, inflation would occur.  Inflation in prices is the same thing as a decline in the value of money.  In this example, the value would decline about 50 percent ― meaning the price of everything would double.  Everyone would have double the money but everything would cost twice as much so everyone would wind up right where they started.

Inflation would occur because the large increase in money would not create an equally large increase in things to buy.  For example, a doubling of the amount of gold will not result in a doubling in the number of cats available.  Similarly, turning out an extra batch of dollars on the nation’s monetary printing presses will not solve family money problems.

Money isn't Cash

Increasing the nation’s money supply by turning on the printing presses not only would fail to solve family money problems but the phrase itself is misleading.  It implies that the federal government increases the money supply by printing more money.  That is not true. 

This mistaken idea starts with the popular misconception that money is cash.  Of course, cash is money, but most of the money in the country is not cash.  In fact, it is a challenge to define exactly what money is.  Currency plus checking accounts?  These plus saving accounts?  These plus investments?  The Federal Reserve (FED) uses several definitions of money.  One thing is sure cash is the smallest portion. 

Most money is nothing more than bookkeeping entries at a bank and notations in your checkbook.  For example, very few people pay bills with cash.  Most people write a check to the credit card company that they used for all their purchases.  Most people do not keep their money around the house; they keep it in banks.  And what is true for ordinary people is even truer for the nation’s business enterprises.  Nearly all of their operating money is on deposit at the bank.  Bank deposits represent most of the money as defined by the FED’s M1 definition.

The money on deposit at the banks is mostly in the form of bookkeeping entries.  Very little is cash.  Of course, banks do keep some cash in their vaults for cashing checks and supplying retailers with cash register money, but the great bulk of their deposits are not held in cash.  Most of the deposits are invest in loans, government securities, and other investments.  Customer deposits themselves are just numbers on the bank’s computer ledgers.

Numbers on pages of books and bytes in computers representing nearly all the money might strike some people as funny.  It doesn’t seem to fit with the idea that money must be scarce to be valuable.  Obviously, there is an endless supply of numbers in the world.  Numbers certainly aren’t like gold or silver, which eventually will all be dug out of the ground. 

The Laws of Money

What keeps these special numbers scarce are the laws that govern them.  Take the numbers in your checkbook.  It takes no effort at all for you to write down $1,000,000 in your checkbook.  But if you try to write a check for $1,000,000 and the bank doesn’t have corresponding numbers on your records, you will go to jail.  That’s pretty good incentive to keep you from writing numbers you don’t have.

Here’s how it works:  Assume there is just one bank in the country.  There is only one entity that can actually put new numbers into the bank, and that is the FED.  Legally, the FED is charged with controlling the money supply of the country.  Assume the FED creates $10,000 in new deposits in that bank.  Now, having $10,000 of nice new numbers on the books is great, but the bank is in business to make loans.  So they will loan the new money out.  However, they will not loan out all of the new money.  They must keep a portion of their deposits in reserve.

Assume the required reserve is 10 percent.  With a 10 percent reserve, the bank can loan out 90% ― or $9,000. 

Let’s assume that the first customer through the bank’s door is the owner of the corner drugstore.  Let’s say he needs $9,000 to buy an inventory of bubble gum for the coming gum-chewing season.  The bank makes the loan.  However, the druggist doesn’t cart the money out in cash.  Instead, the bank deposits $9,000 worth of numbers in the druggist’s account. 

Notice, at this point, the bank has a new deposit for $10,000 from the FED and a new deposit of $9,000 from the druggist.  Already the new money created is $19,000.  But it won’t stop there.  Now the bank can loan out 90% of the new deposit by the druggist ― or $8,100. 

The next person through the door may be a homeowner needing a loan of $8,100 to remodel her closet.  The loan is made.  Another new deposit, this time for $8,100 is created.  This process goes on and on until the original $10,000 deposited by the FED has expanded into $100,000 worth of new deposits.  The total amount of the new deposits depends on the reserve requirement and how rapidly the banks can create loans.

Shuffling Numbers

What happens to the money supply when all the people that took out new loans write checks against them?  For instance, when the druggist pays for his bubble gum?  Not much.  The bubble gum company will take the numbers it receives from the druggist and deposit those numbers in their account.  The bank still has the same amount of numbers just in different accounts.  Only the FED can put new numbers in or take numbers out.

Naturally, this example is very simplistic.  In reality, the problem of money creation is very complex.  But this is the general mechanism by which it occurs.  Note that no new greenbacks were printed in the money creation process.  All that was created was a lot more numbers in the bank’s computers.

Does all this matter to the average person?  Yes, indeed.  But we take the money creation process, like most things that work pretty well, for granted.  What really matters to us is the numbers in our own checkbooks, and the cash in our own wallets, and the loans at our own banks.  Money matters to us all right, but the same way it matters to the FED.  The FED is worried about the nation’s money supply.  If they create too many numbers there will be inflation.  If they create too few numbers there will be recession and deflation.  I cannot think of a tougher job.

The average person, however, is only worried about his or her own money supply.  The average person is concerned with day-to-day money matters, such as budgets, bills, and bankbooks: college, retirement, and financial security: and stocks, real estate and savings accounts.  That’s what money means to the average person, and that is why money matters.