A PCT view of money

1. How is money created?

At first glance, it is obvious what money is. It's a unit of value that allows goods and services to be traded more easily than can be done by direct barter. On examination, that simple statement hides some important issues.

Let's consider the situation in an economy without money. If I want a haircut, I have to find Sam who not only can perform the job, but also wants something I can do or can give. If I don't have any such thing, and can not perform any service Sam wants, I don't get my haircut.

But suppose I find out that Sam would like a fancy set of buttons, which I don't have, but I know that Joe down the street has some, and Joe's lawn needs cutting. I say to Sam that I can get the buttons, but he will have to wait until I have mown Joe's lawn, which I can do, and I think Joe will trade the mowing job for buttons. Sam may trust me, that I will choose to mow Joe's lawn, and that Joe will trade the buttons for the mowing job, and that I will then give Sam the buttons. Sam and I can agree that this is OK, and Sam cuts my hair. Some time later, I arrange with Joe to cut his lawn, get the buttons and give them to Sam. All is now square.

Suppose now that Sam wants to get some steak from Bill the Butcher. Bill wants buttons. Sam says that's a fine trade, but he hasn't at the moment got buttons, but will be getting them from me. Bill trusts Sam, as Sam trusts me, and they make the trade, based on the fact that I owe Sam some buttons, and Bill perceives that debt as being good.

In this scenario, all that passes between me, Sam, and Bill is words in one direction (a promise of buttons to come), and goods or services in the other direction. The promise of buttons has performed the function of money. In fact, it is money, even though there are no physical coins or paper involved. I could have given Sam a piece of paper on which I had drawn the buttons I expected to get from Joe, and Sam could have given that paper to Bill. Bill may have known that Sam got it from me, in which case he could come to me for the buttons. Or he may not, in which case he might not know where the buttons would come from.

Whether Bill knows where the buttons are, and who wrote the paper, is immaterial, if Bill doesn't really want buttons. What Bill really wants may be cattle feed, but he knows a farmer who wants buttons. Provided the farmer trusts Bill not to give him a false debt, Bill can tell the farmer that he is owed buttons, or can pass on the piece of paper. So long as the person to whom the paper is passed can trust that it is worth buttons, it can be passed from hand to hand, permitting the trade of goods and services, even if I keep procrastinating and delay mowing Joe's lawn.

What happens when I do finally mow Joe's lawn? I get the buttons from Joe, and pay them to Sam--or try to do so. But Sam says that the debt is no longer owed to him. It is owed to Bill the Butcher. I go to Bill, but he has traded it to the farmer. Finally, I give the farmer the buttons and retrieve my debt (which may or may not be on a piece of paper). I tear up the piece of paper ,if there was one, since it now refers to a non-existent debt.

What happens now, if the farmer wants to acquire some fertilizer? He hasn't got a piece of debt-paper or a promise of buttons. He has to find something he has or can get that Fred the fertilizer producer wants. Suppose that Fred can't settle on anything he wants right at that moment. The farmer can still trade, if he promises to give the producer something of value equivalent to the fertilizer, later. He may write another piece of paper that has a picture of a bag of fertilizer on it. And Fred can use that just as Sam used my picture of buttons. It is new money, and can be used until the farmer pays off the debt.

Now suppose that before I pay off my debt of buttons, Fred wants something (not buttons) from Joe. In this case, the farmer has given Fred the paper with buttons drawn on it, not a new paper with a bage of fertilizer on it. What does Joe do? Does he accept the button paper, which he doesn't want as he already has buttons? Or does he ask Fred to give him something else for what Fred wants? If Fred offers something else that Fred doesn't have at the moment, but expects to be able to get, they have made new money. Fred can still trade his button promise for Ethel's milk, while Joe can trade Fred's new fertilizer promise for a haircut from Sam.

The point of all this is to show that money is debt that is not paid off, and that to pay off the debt is to reduce the possibilities of further trade. To repudiate a debt, as is done in bankruptcy proceedings, is also to reduce the possibility of further trade, and moreover, it reduces the trust of future traders in the value of the money. If one set of fancy buttons is worth one haircut, one promise of a future set of fancy buttons becomes of less value than one present haircut. If someone who is asked to hold that promise believes that the originator of the promise may just possibly not pay off, the chance of that failure has to be subtracted from the face value of the thing promised.

Trust is the important component of money--trust that at some future date the money will be as usable to acquire goods or services as it is now. How is trust developed? Normally it is by experience: that Sam has in the past kept his word, that other people have accepted my pieces of paper with buttons, fertilizer bags, and what-not as being acceptable substitutes for the real thing, even if they didn't really want the thing depicted. I could trust that they would accept the pieces of paper because they could trust that other people would accept them as well.

If Sam is going to wait a long time before using the promise of buttons that I say I will give him, the greater the chance that I will have repudiated the debt. If he is going to use it very soon, then he can take the promise almost at its face value, as being worth almost as much as a set of buttons in his hand. If he expects not to use it for some time, he should ask for more buttons in the set, or for something else of value in addition to the promise of buttons. This is inflation, and it is built into the very concept of money. An economy with zero inflation had better have some way to input value, or it will quickly grind down into a subsistence economy!