What is Money?


December 1, 2011


(This item appeared in Forbes.com on December 1, 2011.)

http://www.forbes.com/sites/nathanlewis/2011/12/01/returning-to-the-basics-what-is-money/

What is money?

You would think this would be an easy question to answer – and it is, actually – but very few people seem to be able to, including most economists. This leads to all sorts of confusion, and the sort of disasters of incompetence that are now happening in Europe and elsewhere.

Ideally, today’s troubles will lead to a new monetary system, preferably a gold standard system. However, that would be difficult if nobody knows what money actually is.

As I argue in my book Gold: the Once and Future Money, money and credit are very different. Yes, I know there are many, many people who claim that “money is credit” and “credit is money.”

These people are confused. That is why, when you read what they write, you become confused also. Don’t you feel confused after you read this stuff?

The primary characteristic of money is that it is the item mutually acceptable as a means of payment.

Credit (a loan or a bond) is not generally acceptable as a means of payment. In effect, it would be a sort of barter.

Credit is a contract denominated in money. It is a legal agreement to deliver certain payments at certain times. For example, a 13-week U.S. Treasury Bill is not money. If I buy a bicycle, or some groceries, I can’t pay with a 13-week U.S. Treasury Bill. I can either wait for the bill to mature, or sell it, and receive money in return, which I can then use to make payments.

The same goes for a money market fund. A money market fund is an equity shareholding in a fund that owns things like 13-week Treasury Bills. I can redeem my holdings with the money market fund manager, and receive money in return. But, I can’t pay for groceries by saying: “Here is my holding of 174.334 shares in the RMT Bank Universal MMF.” The payee does not become the owner of a 174.334 share holding in the RMT Bank Universal MMF. I have to request RMT Bank to redeem my holdings in money, which I can then use for payments.

The same also applies to a basic bank deposit account, like a checking account. You can’t pay for groceries by saying: “Here is a deposit of $121.74 in RMT Bank.” The payee does not become the owner of a bank deposit in RMT Bank. They receive money.

There are two ways the payee can receive the money. One is that they can take the check to a branch of RMT Bank, and receive banknotes in return. More commonly, however, they receive the payment at their bank.

Let’s say the payee is a customer of ABC Bank, and the payer is a customer of XYZ Bank. The payer uses their debit card to transfer $121.74 to the payee’s bank account at ABC Bank. What actually happens here? XYZ Bank has to make a payment to ABC Bank. XYZ Bank makes this payment in money — either banknotes, as was the case in the past, or deposits held at the Reserve Bank (a central bank such as the Federal Reserve).

This is why bank reserves held at the central bank, although they are electronic book entries, are considered money — because they are acceptable as a means of payment. In the past, before there were centralized bank clearing houses in the form of central banks, commercial banks would actually make these transactions with paper money. ABC Bank receives the payment and credits the account of the payee accordingly. (In effect, ABC Bank automatically borrows the money from the payee, increasing their deposit account, which is a loan to ABC Bank callable on demand.)

Thus we see that even a debit card, wire transfer or check is actually a payment made by one bank to another, using base money, the acceptable means of payment.

Following from the above, money has certain characteristics. One is that there is no counterparty. There is no legal agreement. This is easy to see in the case of a commodity money like silver coins. However, the same is largely the case for U.S. dollar banknotes, managed by the Federal Reserve. It is more in the nature of a manufactured good, just as gold coins must be manufactured.

A banknote redeemable in bullion is a sort of legal agreement. However, since it serves as an acceptable means of payment, a redeemable banknote is, I would say, a form of money, not credit. Money generally does not pay interest (although Fed reserve deposits do for the time being), and credit generally does pay interest (although many forms of credit do not for the time being).

Gold bullion today generally does not serve as a means of payment. However, gold has the desirable characteristics that we all want the means of payment to have. Primarily, it is stable in monetary value. It has other desirable characteristics as well, such as being easy to store, infinitely divisable, a chemical element, compact and of high value, and so forth. This is why we say that “gold is money,” and it is why gold has so often been the foundation for successful monetary systems for the last five hundred years.

Perhaps this sort of theoretical discussion seems disconnected from today’s daily events. However, one of the reasons for the monetary chaos we endure today is that few people even know what they are talking about. How can you have a discussion about the best kind of money … if you don’t even know what money is? It turns out that money is actually very simple. When you can see how simple it is, then the process of making rational monetary systems also seems simple and achievable.