Kinds of Money

The simplest kind of money is commodity money, which roughly means that we use a commodity to perform the role of money. Because commodity is one of those loaded terms in this field, its worthwhile attempting to define it, even if we can only do so superficially at this moment. Wikipedia states (emphasis ours):

Definition 2.3: […] [A] commodity is an economic good or service that has full or substantial fungibility²: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.

Examples of commodities that have been used as money are precious metals such as gold and silver, and others less so such as copper and zinc. Note that this property of fungibility — the ability to treat all instances of the commodity in the same way — is a core requirement. A second important aspect is that commodity money has a value in and of itself. There are two types of value we may ascribe to it: use value and intrinsic value, which Wikipedia defines as follows (emphasis ours):

Definition 2.4: Use value […] refers to the tangible features of a commodity (a tradeable object) which can satisfy some human requirement, want or need, or which serves a useful purpose.

Definition 2.5: Intrinsic value […] [can] be partially or entirely due to the desirable features of the object as a medium of exchange and a store of value. Examples of such features include divisibility; easily and securely storable and transportable; scarcity; and difficulty to counterfeit.

It is not difficult to find challenges with these definitions. Intrinsic value is believed to be intrinsic to the commodities in question because it is thought that they are naturally endowed of a set of features that make them suitable for their role as money. Now, an intrinsic property typically signifies something that exists independently of any observer, but in Computational Finance very few things have this robust characteristic. Similarly, my notion of use value may be quite distinct from your notion, and its hard to envisage how any type of value would exist were there to be no modern homo sapiens. The fact that gold and silver are considered special is as much a factor of social custom as is a consequence of their scarcity on our planet, ease of divisibility or transport; worse: in most cases, these are subjective judgements rather than objective³.

Nor could it be said that precious metals have had any relevance or special role for the majority of the existence of our species for, as far as we know, money is a relatively recent invention⁴. However, in a non-rigorous way, we can let ourselves be persuaded that a "large percentage of humans" would likely agree on the fact that certain commodities are "valuable", in and of itself, and that shall have to suffice for the purposes of this discussion.

A second, more modern approach to money is fiat money. Fiat is Latin for let it be done, but it is more generally understood as "an order, decree or resolution." Wikipedia informs us that (emphasis ours):

Definition 2.6: Fiat money is a currency without intrinsic value that has been established as money, often by government regulation. Fiat money does not have use value, and has value only because a government maintains its value, or because parties engaging in exchange agree on its value.

The key point about fiat is the fact that the illusive characteristics of use value and intrinsic value which were still present in commodity money, flimsy though they might have been, are now finally allowed to dissipate, as if by conjure. But fiat is no mere cheap parlour trick; it has proven itself an extremely successful approach, such that the vast majority of money systems in existence today are based on it.

Interestingly, its biggest advantage is also its biggest disadvantage. Since one can bring money into existence by decree, there is no need to wait for the discovery of raw materials, nor is the money system hostage to third parties who control their supply. However, if more money can be created at will, at very low cost to the producer (the government), why not simply create yet more money whenever required? Alas, excesses in supply can cause the fickle illusion to dissolve, causing a collapse of the money system. The downfall of fiat money tends to be closely associated with this phenomenon, even in present times⁵.

Fiat should be viewed as a "barer essence" of money: money when stripped of most of its historical baggage; thought-stuff, a purer creation of the mind. In this sense, commodity money was the scaffolding with which fiat money was built, but once the edifice is finished, the scaffolding becomes surplus to requirements and can be allowed to fall by the wayside⁶. Commodity money has its uses, of course, but it is no longer allowed to act the central part in the play. Fiat questions the dependency on rare physical materials, and swaps them for others that can be produced under control; but why stop there? One can continue to climb this abstraction ladder, and the next logical step is to question the need for a physical representation altogether.

However, commodity money is still closely anchored to the physical reality, placing natural limits to the expansion process. Due to its nature, fiat takes the idea of debasement to its logical conclusion: hyperinflation. This is a topic for a future instalment.

Previously, we mentioned that verifiable records are an important candidate for money. The significance of this idea can hopefully be made apparent by means of a small thought experiment. Picture the distribution of money across a country, at any given time point \(t\), as a kind of a gigantic ledger⁷ which emerged as a result of the activity between economic agents; and think of the transfers of money between agents as changes to the "records", as the clock ticks. In such a world, it would be very difficult to distinguish between money as a physical thing and money as merely the records of the activity that has taken place, provided that all the agents trust the record. Further: given these premises, it follows that it should therefore be theoretically possible to tally up all the "records" (i.e. the money), at any time point \(t\), and see exactly who owns what.

Whilst there are practical difficulties in doing this for an entire country — stopping time being chief amongst them — there are indeed those who make a business model out of a slightly less ambitious version of these ideas. They go by the name of Banks, and the techniques employed to discretise time should already be familiar from the world of relational databases; they are used to ensure the correctness of their records⁸. The records they keep are known as Bank Money, defined thusly by Wikipedia (emphasis ours):

Definition 2.7: Bank money, or broad money (M1/M2) is the money created by private banks through the recording of loans as deposits of borrowing clients, with partial support indicated by the cash ratio. Currently, bank money is created as electronic money. […] Bank money, which consists only of records (mostly computerized in modern banking), forms by far the largest part of broad money in developed countries.

A great deal could be said about bank money, but to keep us from straying too much we shall focus on only two key points that emerge from this definition. First, it is important to understand that when you deposit your money in a bank, you are effectively selling the government supplied representation of money and exchanging it for a bank-supplied representation of money — i.e. a receipt acknowledging the deposit is a proof that the bank now has you on their records and, therefore, that you own bank money. The fact that these appear to be one and the same to a layperson is not incidental, but a crucial property of the process, for it hides the true complexity of the exchange taking place. Similarly, as you transfer money from one bank to another you are exchanging one form of bank money for a different one.

Secondly, as the definition states, most money in a modern economy is bank money. Counter-intuitively, what a layperson tends to associate with "money" — e.g., notes and coins — is only a tiny sliver of the total money supply; it typically does not exceed 3% of the overall amount. Thus, the process of creation of bank money is really the only relevant factor in the expansion of the money supply in most economies. McLeay et al. explain it in great detail on a Bank of England publication (McLeay, Radia, and Thomas 2014), but, for our purposes, the key points are fairly straightforward:

• money is created by banks when they lend out money to customers. The loan results on a deposit into the customer's account;
• money is destroyed when customers repay their loans to the bank.

Alas, as you can imagine, loans — or better still, credit — is a world of complexity in its own right, and now is not the time for us to properly immerse ourselves in these dark deep waters; but if we keep our focus solely on the money creation part of the process, even this brief explanation should have already have given you a hint of the somewhat magical nature of the process. Varoufarkis (Varoufakis 2017) brings it to life by means of an imaginary bank customer called Miriam, who has been given a loan to setup a new business (emphasis ours):

[…] [It] is hard to believe that value can be born from nothing. […] In a sense, the banker arranged for the present Miriam — an entrepreneur with a plan to sell bicycles — to sit in front of the time membrane and reach through it to the Miriam who will exist five years from now — a wealthy businesswoman with a successful bicycle company — and snatch half a million pounds from her, bringing it to the present, invest it in the bicycle business and thus allow the future Miriam to become that successful businesswoman.

Predictably, this ability to reach out to future value can be misused:

Since they are not constrained to lend existing exchange value, bankers have every reason to keep conjuring up loans in the same manner — by a few strokes on their keyboards — for the more people they lend to and the more money they create for the economy, the greater the profits their retain for themselves.

Alas, as with fiat, so with credit: nothing good ever comes from excesses in the monetary supply — or, to misquote Varoufakis, "by messing around with the timeline". Of course, there are constraints on how much money a given bank can create: some of the constraining factors are the due diligence processes, which means that only customers who are able to repay their loans are expected to be given a loan; there are also regulatory bodies who try to ensure banks keep a "balanced" balance sheet — i.e., the cash ratio Definition 2.6 alludes to. But these and other measures are not always sufficient. As you can imagine, this opens the door to all kinds of exciting questions, but we best move on before we get too bogged down in this very muddy trail.