In order to have a discussion of our modern monetary system, it is helpful to define what it is we are discussing in the first place. So, what really is it we are referring to when we talk about money? Money is simply a medium of exchange. The function of money is to act as a non-perishable store of real value. It is a promise agreed to by the majority of a society that allows members to freely exchange goods and services of varying value in an efficient manner. Civilizations throughout history have used all sorts of different material objects to represent this concept, from seashells to giant stones.
The actual object being used as currency is really just a symbol. In reality, you don’t actually need a physical object to represent value at all. There is an island in the Pacific named Yap, in which the inhabitants began to import large carved stones, some as large as a small car, from a neighboring island. The stones first became valued as art, but eventually came to be traded as currency for large transactions. Since it was not practical to keep moving these large stones around every time someone wanted to trade them, people just publicly started keeping track of who owned these stones at any given time. One day, a resident of the island was transporting a new stone onto the island by boat when a storm hit, and the stone was lost to the bottom of the sea. However, since the islander was trusted in the community, he was still able to trade the lost stone as if it had not been lost at all. The islanders continued to trade the stone at the bottom of the sea, and as long as everyone accepted it as payment, it was just as good as any other stone. At this point, it didn’t even matter if the stone was real; it only mattered that other people in the community would accept ownership of it as payment. This story illustrates that the real value of a currency is in the level of trust people have that they themselves will be able to exchange it for the same relative amount of value they exchanged away to obtain it. Of course, in general, people tend to trust money more if they can actually hold it in their hands.
So then, what sorts of qualities are desirable for something to be used as money? Well, first, you want something where the physical amount of it that is generally available allows it to carry a value that makes it practical to exchange in amounts easily handled by people. For example, you wouldn’t want to use gravel as money because you would need truckloads of it in order to buy anything. Second, you want a material which is chemically stable and that doesn’t deteriorate easily. The reason for this is obvious, you want to be able to store and save value without the medium itself being destroyed. Next, it is important that the material is easily testable and identifiable. The harder it is to counterfeit, the more useful it is as money. It turns out that out of all the materials available on Earth, gold fits all of these requirements better than pretty much any other substance. Gold is rare, but not too rare that everyone cannot own a reasonable amount of it. It is easily identifiable and very difficult to counterfeit, even with modern technology. A simple acid test will quickly and accurately verify a material as real gold. Gold is also extremely chemically stable and does not even tarnish. Lastly, given its relatively low melting point, gold is easily manipulated into a form, such as coins, that makes it very practical in everyday use. Thus, gold has been used as money by many civilizations, and is still valued as currency today. There is an important distinction here though; gold is only valuable because people have been convinced to accept it as a currency, not the other way around. In other words, “we use gold as money, therefore it has value”, NOT “gold has value, therefore we use it as money”. You may occasionally hear people or even politicians say something like, “We should use real money like gold and not some artificial money like paper dollars”. This is a straw man argument. People designate something as money or not, and therefore paper money that people trust is just as real as gold. There is a quote often attributed to Warren Buffett that goes something like “We dig gold out of the ground, melt it down, dig another hole, and put it back in the ground where we pay people to guard it. It has no utility. Anyone watching from Mars would be scratching their head”.
So, if gold does have qualities that make it ideal for use as currency, why don’t we still use it? Well, up until 1971, most currency around the world was still based on gold. This idea is generally referred to as “The Gold Standard”. The reason we left the gold standard is because gold does have one important drawback if you are looking to supply a large modern economy with currency: you cannot make any more of it. Now, the argument for going back to the gold standard is actually because of that very same fact. However, not being able to adjust the supply of a currency to meet demand has devastating consequences. I’ll explore why in the next post.