Why we need money: my mental model
January 16, 2022 - Money
We are rapidly approaching an inflection point in the history of money. With the rapid increase in the number of U.S. dollars in circulation, the meteoric rise of cryptocurrencies in the public consciousness, and the waning of the American cultural and economic empire, now is the most important time in U.S. history to understand how money works. There are three important questions we need to answer about our current economic state:
- How much is my money worth right now?
- Will it still be worth something in the future?
- Where is the best place to store my wealth?
To answer these three questions, we first need to understand the following four questions:
- Why do we need money?
- How much money is worth?
- Why do we need banks?
- How is our money made today?
In this post, I will tackle the first question by presenting a somewhat allegorical history of money to demonstrate where we came from, and how we got here.
Let’s explore why we need money by going back to the early agricultural era, say 10,000 B.C. (before the invention of money and currency). Suppose there was a cow herder, named Tevye, with two cows producing two churns of milk a day. One day Tevye’s cows produce four churns as usual. He goes out into the market, and makes the following trades:
- Half a churn of milk for hay to feed the cattle.
- A full churn of milk for a sack of vegetables.
- A half churn of milk for a hat.
In addition, he keeps a churn for his own family. But, he still has one churn left over, and the cows will produce four more churns tomorrow. There’s nothing Tevye needs to trade for right now, but he also cannot keep the milk until he needs something, because it will spoil.
There are certainly people who will take the surplus milk in the village, but he can’t just give them the milk for free. Here we see the issue with the barter system. In early societies, we already see division of labor that leads to specialization. Using only the barter system means that the value of Tevye’s labor and capital (milk produced by his cows) is perishable. There is a lot of value being lost with just the passage of time. But, let’s see if we can come up with a way to fix this problem. Suppose he goes to the carpenter and gives him a churn of milk. In exchange, Tevye receives a contract that says the carpenter will fix an item of furniture some time in the future. He drafts similar contracts for the remaining surplus of milk in his possession. In theory, we’ve fixed the problem of loss of value.
IOU an explanation
However, now we have several new problems. Let’s say a few months down the line Tevye’s cows come down with an illness, and haven’t been producing milk for a while. This is the exact situation that he created all of those contracts for. But, when he tries to trade those contracts for food and supplies, he finds that:
- Some contracts are now worthless, because the guarantors have retired and no longer practice their trade.
- People are refusing to accept certain contracts, because they don’t want the good or service that the contract guarantees.
- People do not trust certain guarantors of the contracts.
- It is difficult for Tevye and those he is trading with to come up with fair trades, because they are unsure what these contracts are worth.
Essentially these contracts are not generic and measurable stores of value. For many, they are worth zero or very little. If nobody is willing to give you anything for a contract, they are essentially worthless. We need a medium of exchange that allows you to store your labor and capital with something that is easily measurable, and everyone agrees has value. Money is that thing that is measurable and everyone (or at least a lot of people) agree has value.
Eventually, Tevye finds someone to take a few of those contracts off his hands in exchange for food. But, he doesn’t ever want to be in this situation again. He decides that there must be a better way to store the value of surplus milk. A way that has the following properties:
- everyone (or most of the village) wants it
We will leave Tevye for a little while to allow him to ponder a solution to his dilemma. We will come back next time to see what Tevye comes up with, and answer the question, how much money is worth?
- Pratt, W. H. “Shell Money and Other Primitive Currencies.” Proceedings of the Davenport Academy of Natural Sciences, Volume II, 1876, pp. 38–46., https://archive.org/details/proceedingsofdav02dave/. Accessed 16 Jan. 2022.