Chapter 1
What is money anyway?
Trade, or commerce (the buying and selling of goods and services) is a fundamental part of economics. And money is at the heart of commerce. It is familiar to us all, yet we rarely pause to think about what it really represents.
Money is any token, physical or virtual, that can be used in trade. Whatever is used as money might have intrinsic value, such as a disc of gold, or it might have only symbolic value, like a printed slip of paper with a fancy design. It might have no physical existence at all, like the virtual currency bitcoin – a digital currency that operates independently of the main banking system. Of course, even the ‘intrinsic’ value of a gold coin is culturally determined. Gold is of limited use outside jewellery and commerce. It is now used in electronics, but that use emerged long after gold was first considered valuable. It’s easier to make crowns and jewellery from gold than other metals, as it’s soft and doesn’t corrode – but you could say the same of plastic. Crowns and jewellery, while nice, are not exactly essential to survival – they are not ‘needs’.
Bartering doesn’t go well
Try to imagine a world in which there is no form of money. If you want something you can’t find or make yourself, you need to persuade someone who has it to give it to you. They will probably be unwilling to give it for free, but might be willing to swap it for something you have. This is called bartering. If you have a mammoth skin but want some watermelons, it might take a long time to find someone with watermelons who wants a mammoth skin. If the person with watermelons wants a clay bowl, you might have to trade a mammoth skin for a clay bowl, and then trade that for watermelons – if you can even find someone with watermelons who wants a clay bowl. You can see how it quickly becomes a complex, time-consuming and often frustrating endeavour. This problem, called the coincidence of wants, or double coincidence of wants, makes bartering systems unwieldy and inefficient.
GOLDEN CHAINS
The 16th-century philosopher Sir Thomas More satirized humankind’s greed for gold in his book Utopia. The Utopians do not see value in gold, as it is virtually useless:
‘Their chamber-pots and close-stools are made of gold and silver. . . . Of the same metals they also make chains and fetters for their slaves; on some of whom, as a badge of infamy, they hang an ear-ring of gold, and make others wear a chain or a coronet of the same metal. And thus they take care, by all possible means, to render gold and silver of no esteem. Hence it is that, while other countries part with these metals as though one tore-out their bowels, the Utopians would look upon giving-in all they had of them, when occasion required, as parting only with a trifle, or as we should esteem the loss of a penny.
‘They find pearls on their coast, and diamonds and carbuncles on their rocks. They seek them not, but if they find them by chance, they polish them and give them to their children for ornaments, who delight in them during their childhood. But when they come to years of discretion, and see that none but children use such baubles, they lay them aside of their own accord; and would be as much ashamed to use them afterward, as grown children among us would be of their toys.’
Sir Thomas More, Utopia, Book 2 (1516)
Instead, most societies have developed some form of exchange mechanism. This works on the basis that everyone agrees that some token (cowrie shells, perhaps) represents value. The value can be transferred between people and exchanged for goods and services. Now it’s easy to trade a mammoth skin for cowrie shells and take the shells to someone who has watermelons. The watermelon farmer can use the cowrie shells to buy a chair or a boat or a chicken – whatever he or she needs. As everyone in the community accepts that cowrie shells have value, they become a means of exchange – or money.
‘Money’s a matter of functions four, A Medium, a Measure, a Standard, a Store.’
Mnemonic for the functions of money (1919)
The four functions of money
In 1875, the British economist William Jevons set out the four functions of money in his book Money and the Mechanism of Exchange. Money is, he said, a medium of exchange, a common measure of value, a standard of value and a store of value. Some economists have argued that being a store of value and a medium of exchange are mutually exclusive, as storing it means you can’t spend it (exchange), and spending it means you can’t save it (storing). This is a trifle pedantic, as it has the potential to be both at different times.
A modern approach often lists three functions for money:
•a medium of exchange
•a store of value
•a unit of account.
It is called a medium of exchange as it facilitates the exchange (swapping) of goods and services, acting as an intermediary between disparate items such as mammoth skins and watermelons.
As a store of value, it’s important that whatever is chosen as the means of exchange does not readily deteriorate or decay. This is one reason for choosing gold – it doesn’t corrode, evaporate or change in any way over time, and it’s difficult to destroy as it doesn’t dissolve in most acids. It would not be sensible to choose, say, fresh fruit as a medium of exchange as it would soon rot.
WHEN MONEY GOES WRONG
When an economy fails, prices may rise beyond all sensible measure and each unit of currency will then buy less and less – its exchange value falls. In this case, money itself is no longer a good store of value. The classic example of this is the period in the 1920s when the German currency, the mark, became virtually worthless. Something that cost one mark in 1918 cost three billion marks in 1923. As a result, some people in Germany began to use other currencies or media of exchange in preference to the mark (see here).
Economists recognize two types of value: the utility (usefulness) of a particular good or service, and the power of a good or service when exchanged to acquire other goods and services. Anything used as money has exchange value. It can also have utility value, as we shall see.
The last function, a unit of account, means there must be a consistent way of measuring or counting money and that it provides the unit for pricing other items. This is served by currency: we count money in dollars, pounds, euro, yuan, yen, pesos and so on.
Commodity money
Physical items used as money are called commodity money. The item itself must have recognized intrinsic value. Examples of items that have been used as commodity money include:
•Buckskins and beaver pelts in North America. Hudson Bay had an official exchange rate for beaver pelts. One beaver pelt could be exchanged for two pairs of scissors, five pounds of sugar, 20 fish-hooks or a pair of shoes. Twelve beaver pelts would buy you a gun.
•Decorative items such as shells, mirrors, beads and decorated belts. Part of the payment that Dutch traders made to Native Americans when they bought Manhattan Island in 1626 was in beads, the total value of the goods traded being around 60 gilders ($1,000/£650).
•Axes. In 9th century Poland they were useful for cutting down trees and launching raids on neighbours.
•Bat and bird droppings (guano). The Incas used guano as a rich fertilizer.
•Food items which are slow to perish, such as salt, peppercorns, barley, rice, dried fish and cattle. Cattle are not divisible until dead, so rather inconvenient – a bit like an economy in which the only currency is $100 notes.
•Tobacco and cigarettes. Cigarettes have often been used by soldiers and prisoners as currency. A full economy based on cigarettes grew up in some prisoner-of-war camps in World War II. After smoking was banned in many US jails, foil pouches of mackerel fillets took over as the unit of currency.
Opportunity cost (see here) is clear with commodity money. The opportunity cost of paying for a stamp with a pouch of mackerel is the chance to eat the mackerel.
THE ISLAND OF STONE MONEY
On the Pacific island of Yap, wheel-shaped stones have been used as money for centuries. Some are small, but others very large – up to 3.6m (12 ft) across and weighing over 4,000kg (4 tons). Made of limestone mined and carved in Palau, they were moved by bamboo canoe to Yap.
The agreed value of a stone depends on its size, craftsmanship and history. The most valuable stones, paradoxically, are those that killed no one in transit and those that killed most people in transit. They are so large and heavy that they are rarely moved; trade consists only of recording a change of ownership. One stone even fell into the sea during transport to Yap and was still traded because access to it was not important. Everyone knew where it was and who owned it, so ownership of the stone could change without the stone being moved. Ownership of a stone that can’t be retrieved from the ocean is an early example of virtual money.
Modern money
For most of us, money is counted in units of a specific currency – dollars, pounds, euros, yen, yuan, lire, dinar and so on. This is called fiat money – the items exchanged have no intrinsic value, but they are agreed to have value for the sake of running the economy.
We are used to fiat money in the form of coins and notes, but increasingly also in virtual form. In the developed world today people are now less likely to be paid in cash. Their salary is more likely to be deposited in their bank as a figure that increases their balance, and is often spent by wielding a card that authorizes a business to reduce the balance, or by setting up a direct debit or standing order that lets them take away some of the balance on a regular basis. We might sometimes withdraw some cash – but for most of us today cash is not really the dominant form of money (see here – Is cash on the way out?)
THREE HEADS FOR THAT DRAGON JAR
Some of the Penan people in Borneo used the severed heads of their enemies as tributes to the spirits that had power over rice. Heads were offered to make the rice grow, but also became an item of value in their own right, because of their efficacy as spirit-bribes. There was no physical trade in heads, though, as trading them was considered unlucky. Instead, a head was equivalent to a living slave or captive, which could be traded. Some items had a value as ‘virtual heads’. A dragon jar – a large receptacle with a green glaze and dragon motif, imported from China – was valued at three heads. If someone killed a person, requiring a tribute to the bereaved family of three heads, the debt could be discharged by the transfer of a dragon jar.
Two types of money
Increasingly, money has become dissociated from the real, physical world. I get paid for thinking and jiggling my fingers about over a keyboard. It’s about as unreal as you can get. The money I get for it is paid straight into my bank account and the bank takes out chunks for the mortgage, utilities and so on at regular intervals. The rest I spend by waving a bit of plastic or clicking on web pages. At any point, I could, in theory, go and take all my money out of the bank as cash. In practice, I would be challenged at every step: they would assume I was going to do something illegal with it, since people don’t usually withdraw all their money in this way. And it would be impossible to obtain my money if everyone else tried to draw theirs out at the same time. This is because money is now largely theoretical and there is nowhere near as much cash in existence as there is ‘money’ in the economic system. The money that is held only as electronic records is called bank money, for fairly obvious reasons.
Bank money is used to move money between financial institutions, governments, large corporations and so on. If you pay $20 to a bookshop using a debit card, there is no physical movement of actual money between your bank and the bookshop’s bank. The entire transaction, and all similar transactions, are carried out using bank money. In the UK, 97 per cent of money held by the public is in the form of bank deposits rather than as cash (2014 figure).
FROM COMMODITY TO FIAT AND BACK
Early Chinese coins had holes in them so that they could be strung on a thread or thong and were easy to keep. Since the coins had greater face value than the intrinsic value of the metal they were made from, they were an example of fiat money.
Chinese coins that came into the hands of tribespeople in parts of Malaysia were sometimes adopted as a local currency, but their value bore no relation to the face value of the coins. Instead, the holes made them useful as decorative items that could be fixed to other things, such as jewellery or head-dresses. The coins then became commodity money, based on their value as intrinsically useful items.
A run on the bank
In the film Mary Poppins, Michael, the young son of Mr Banks, is reluctant to deposit his money in a bank. When the bank manager snatches it, Michael demands back his tuppence (two old pennies, or 2d). The other customers, misunderstanding what is happening, assume the bank can’t honour a young customer’s demand for tuppence and a ‘run’ on the bank ensues – that is, everyone tries to withdraw their money at the same time. This is, in a nutshell, what causes a run on a bank: too many depositors want their money back all at once, and the bank can’t honour all the debts. A run generally starts because of a loss of confidence in the bank, and then becomes a self-fulfilling prophecy. In fact, if at any point all customers tried to take all their money out of the banks, the banks would not be able to honour the deposits. Usually only a minority of people want their money at any one time and everyone else believes they could get hold of it if they needed to, and so the illusion and the banking system are sustained.
Genuine bank runs are relatively rare. There was a run on the Montreal City and District Savings Bank in 1872 in Canada; there were bank runs in the USA during the Great Depression in the 1930s; and there were bank runs of a slightly different type on Northern Rock in the UK in 2007, Landsbanki in Iceland in 2008 and the Greek banks in 2015.
How much money is there?
To put it simply, bank money exists provided people believe in it. If we all stopped believing and wanted it in hard cash, the system would collapse because bank money isn’t really there (depending on your definition of ‘really’). There are different ways of talking about how much money there is and therefore about what constitutes ‘really’. In the USA, the two most important measures of the money supply are M0 and M1. Other countries use similar measures, sometimes with additional categories.
ECONOMICS-SPEAK: ASSETS AND LIABILITIES
An asset is anything that can be owned and which produces value (money). Assets include houses, money in the bank, a promise from someone to pay you money, or a machine for making something.
A liability is the opposite of an asset. A liability is something that entails a cost or obligation to pay for something in money or by some other means. Liabilities include an outstanding mortgage on a house, or a promise to buy a present for someone or deliver a lecture for free.
Assets and liabilities are always equally matched: your mortgage liability is equivalent to the bank’s asset – a claim on part of the value of your house. If you owe $200,000 (a liability), the bank has an asset of $200,000 of value in the house.
•M0 is the total stock of cash – coins and notes – held by individuals and in banks and bank reserves. There is about $5 trillion (£3.25 trillion) of M0 in the world.
•M1 includes M0 and assets that are easily converted into cash (such as bank deposits in 24-hour access accounts). M1 comes to around $25 trillion (£16.25 trillion).
•M2, includes M0 and M1, and also longer-term, less liquid assets such as money tied up in savings accounts. It comes to around $60 trillion (£39 trillion).
Chapter 2
What goes into making things?
Long ago, there were no manufactured goods. Now, almost everything is processed in some way.
Our distant ancestors wandered the plains picking berries and roots and hunting animals that moved slowly enough to be killed easily.
At some point, they realized that sharpened stones and sticks could make catching animals easier, and making a fire to cook them made them tastier. The individual who invested time in sharpening a stone and making a spear was making an early form of economic decision: at the cost of time and labour (his or her own) and using a free resource (a stone and a stick), he or she made a manufactured good. The opportunity cost in making the spear was the time that could have been spent doing something else.
The utility of the spear (the benefit of the spear to the individual) was greater than the utility of the stone, stick and labour to make it, as it would secure food more easily and save time in the future. So making the spear added value; that is the defining feature of manufacturing industry.
Starting in business
An individual adept at making spears might also make them for other members of the group, perhaps in exchange for some skins to wear or some food to eat. A spear can have both utility value and exchange value.
In this example of early entrepreneurship, we can identify some of the basic elements of economic activity:
•the use of commodities: stones and sticks
•employing labour: the spear-maker’s effort
•making manufactured goods: spears
•representing capital: spears
•increasing utility: the benefit of a spear
•providing revenue: meat and skins
•facilitating exchange: spears for skins or meat.
Factors of production
Economists talk of the factors of production, which go into producing any manufactured goods. Neoclassical economics considers there to be three factors of production: land, capital and labour.
Land not only covers the land itself but also anything on it, above it or drawn from within it. This means that natural resources such as trees growing on the land and oil underground also count as land. For the spear-maker, sticks and stones come from land.
Capital is everything that can be used in the production of goods to gain more goods. Capital goods are not used up in the manufacture of more items (though they might eventually wear out). In the modern world, capital includes large items, such as factory premises, machinery and vehicles (lorries and tractors, say), and small items, such as a gardener’s tools and an artist’s paintbrushes. For our early ancestor, the completed spear is a capital good, as it is used to secure food.
Labour is the work that people put in to make something. If you make something for yourself, your own effort is the labour involved. Often, people work for an employer – they sell their labour in exchange for wages. (Economists refer to ‘wages’ even when pay is a monthly salary or a one-off fee.) The early spear-maker uses his or her own labour.
NEOCLASSICAL ECONOMICS
Neoclassical economics is the dominant school of economic thought. It puts supply and demand and the individual’s desire to maximize their profit or utility at the heart of economic activity. It uses mathematics and graphs extensively and bases its models on the belief that people will always act rationally. It has been criticized for this assumption, as people actually act in response to complex stimuli and biases and do not always (or even often) act with complete rationality. Neoclassical economics has been blamed for causing social inequality and poverty as it proposes that, given time, market forces will provide adequate workers’ rights, and so on. Alternative approaches tend to be grouped together under the umbrella term heterodox economics.
Capital this and that
The traditional, narrow definition of capital – objects that are not used up in the production of goods – has been superseded in more recent economic thinking. Intangible forms of capital are now included, such as the skills of an individual trained to carry out a particular job, or the goodwill built up by a company through its dealings with customers and suppliers:
•Financial capital is money in the form of financial assets, including money in bank accounts, money loaned by investors and obligations by others to pay money.
•Natural capital is naturally occurring in the environment and is an enriching asset for everyone. Examples are trees, water and oil.
•Human capital covers all aspects of value in human talent, knowledge and social interactions. It includes some subcategories, such as: social capital, characterized by human interactions that have value, such as brand loyalty and goodwill; instructional capital, or intellectual capital, is teaching or knowledge transfer – it can’t be inherent in a single expert individual, but must be transferable; individual capital is the valuable skills, abilities and knowledge inherent in individuals – it is closely related to labour, and some economic approaches don’t distinguish between the two.
The pioneering Scottish political economist Adam Smith distinguished between fixed capital – items not used up in production, such as tools and factories – and circulating capital, by which he meant items that are used up, such as raw materials.
The capital of a whole nation includes many goods from which everyone benefits, such as the infrastructure of roads and railways, amenities such as electricity and water supply, and publicly owned schools and hospitals.
‘That part of a man’s stock which he expects to afford him revenue is called his capital.’
Adam Smith, The Wealth of Nations (1776)
Putting people at the centre: labour
Neoclassical economics does not make the people who provide labour (do the work) a particularly important part of the equation. It puts capital at the heart of economic activity. Workers are treated, in general, as a resource that can easily be replaced or renewed, with one working unit exchangeable for another.
The German political philosopher Karl Marx (1818–83), the author of The Communist Manifesto, saw production much more in terms of the use of labour than the use of capital. He defined the factors of production as labour, subjects of labour, and instruments of labour. Labour, again, is the individuals who do the work. The subjects of labour are the goods acted upon to make something (raw materials). In a coffee-processing plant, the coffee beans are the subjects of labour. The instruments of labour are the tools, buildings and machinery used to carry out the work (capital assets). In processing coffee beans, the roasters and other machines used are the instruments of labour. Marx put the value added by labour at the heart of the value of goods and services in an economy (see here). He considered all commodities to represent ‘congealed labour’.
Sticks, stones and managers
The spear-maker who makes a spear for himself uses only freely available natural resources from the land and his own labour. If he collects a stock of suitable sticks and stones ready to make into spears, this collection would represent circulating capital, according to Adam Smith’s definition.
Suppose now that an enterprising individual saw that the spear-maker was very good at making spears, but could only devote a short period of time to the task each day because of the need to do other things, such as catch and cook food, collect water and guard children from predators. This enterprising intermediary, or ‘entrepreneur’, might offer to take on one of these activities herself, in exchange for a share in the extra spears the spear-maker will now be able to produce. In fact, the ‘entrepreneur’ doesn’t plan to guard the children herself. Instead she deposits them in the care of someone who is already occupied in minding children. It’s no harder to keep predators away from four children than two – the cost to the ‘childminder’ in terms of additional effort is very low. The ‘entrepreneur’ gives away one spear to the ‘childminder’ to secure this service. Now the ‘entrepreneur’ has no tasks to perform, but has made a profit in terms of spears by acting as an intermediary between the manufacturer (spear-maker) and the service provider (childminder). This is something that modern economists call entrepreneurial capital. It is the management of an organization to make the ‘best use’ of its production.
Something for nothing?
In practice, although it looks as if the ‘entrepreneur’ does nothing, it’s not quite nothing. She:
•sees an opportunity (or problem)
•thinks of a way of exploiting (or solving) it
•sources the different parties who can work together
•vets (we hope) the childminder
•handles the payment to the childminder
•oversees to ensure that the childminder does the work competently
•supervises the quality of the spears and rate of production.
While the spear-maker exploits natural capital (sticks and stones), the manager exploits human capital (spear-maker and childminder).
The entrepreneur might act as an agent, taking a percentage of the spears produced, or might act as an employer, perhaps even providing the sticks and stones and allowing the spear-maker to keep a certain number of the spears as a wage. In the last scenario, the entrepreneur has become a capitalist – someone who owns the means of production and puts it to use to make a profit, paying for labour in the process.
For all we know, there might have been enterprising managers or entrepreneurs long ago, but it is generally thought that this type of economic activity developed over time as western societies adopted more sophisticated forms of commerce (see here – How did we get here?)