What is money?

I’m going to take a step back from writing about specific economic policies or investment ideas and ask the general question, what is money? I’ll try not to talk about it being a medium of account or a store of value for simplicity. It is those things, but on a more basic level, money is a tool.

If we were cave people, I might specialize in making bows while you might specialize in hunting. I would trade my bows for your kills. Voila! But as soon as our basic economy advances beyond this prehistoric state, that sort of barter arrangement becomes untenable. Right now I work in visual analysis. When I go to Safeway to buy some prime rib, it would be difficult for me to trade an hour of analytical time for the meat, right? Instead both Safeway and I choose to use the same tool to conduct business, the US dollar.

We know the US dollar is money, but what is it supposed to represent? Some people believe it should represent a claim on a commodity (gold or silver). In a way this is safe because, many times in the past and present, the sovereign has devalued our money in order to pay for wars or welfare or royal extravagance. Devaluing gold is harder than paper, though you can do it by mixing the coins with baser metals, chipping off their edges, etc.

But gold is a commodity with it’s own value separate from money. This is true because we all accept dollars and euros as money, yet gold fluctuates. We don’t exchange gold for goods and services even though we could. We use the socially acceptable IOU, our sovereign currency. Because money requires law, which requires enforcement, we’ve entrusted governments with handling our money.

That gets to the heart of the matter. Money is a tool of exchange, but we can also accumulate it. So it’s more like an IOU. When I go to Safeway and buy my prime rib for $40, I’m giving them an IOU. I owe them a claim on my labor worth $40. Because they don’t need my labor at the moment, I give them an IOU that can be valued and measured with everyone else’s IOU’s. Easy, right?

What happens when we throw credit into the mix? With small amounts of credit that we pay off in a month or two, this isn’t a problem. I promise $40 via my credit card, work for a month and pay off the balance at the end of the month. I’ve fulfilled my IOU by collecting my own IOU’s via my work. But this gets more complicated when you buy something huge on credit, like a house or a factory.

Let’s stick with a house. I promise 1/5 of the value of my current labor over the next 30 years to pay off the loan that lets me live in my house. There’s risk on both sides here because my labor may be worth a lot more (or a lot less) in 5 years’ time, or even in 6 months time. If it’s worth more, the seller of the house may have lost out. If less, I’m in deep trouble.

But because my parents talked about prices in the 70’s and my own observations of prices within my lifetime, I expect the value of my labor to increase by 2%-10% per year. If I accumulate skills and accolades, maybe a lot more. The bank and the seller of the house expect this too, and we’re all happy making the transaction based on our collective knowledge of the past, and our gut feeling about the future.

There’s a problem: my labor changes price even without it fundamentally changing, even without the economy changing. Let’s say there are no technological advances in the next 30 years that would make my skills obsolete, no outsourcing of my skills to India, no extra demand for visual analysis. And I don’t change jobs. I still expect the value of my labor to go up by the rate of nominal economic growth (or at least the rate of inflation). I think the economy will grow 5% a year, thus my skills in the same economy should be worth 5% more (assuming no population growth).

If those expectations change by say, dropping to 0% or -10%, then I have a big problem, and the bank may have a big problem. I’m at risk because the obligation I thought I could pay back will be bigger than my expected future income. The bank has a problem because there are a lot of people like me who find themselves in the same situation. Homeowners have a problem because the benefit you get from taking on debt to buy a home has just vanished (even turned sharply negative).

That’s why economists like Scott Sumner (or before him Milton Friedman) talk so much about expectations. What we expect to happen is how we make our credit and investment decisions today. If what we expect changes sharply, the entire economy suffers (or benefits).