The Chinese say that fish are not aware of water. We talk about and use money so often that we seldom think to stop and ask: What is money? Why do we need it? What function does it serve?
I think money is a type of information technology that calculates, stores and transmits information about the quantity of one good one must exchange for a certain quantity of another good.
Money did not always exist. For millennia humans exchanged good for good between themselves in a system we call “barter.” Barter worked (and works) well if the number of goods and traders remains small enough that most traders in the network can calculate the relative quantities of any two goods needed to exchange one for one another. When the number of trade goods is small, individuals can track the optimum amount of good ‘A’ that should be traded for any other good ‘B-Z.’ However, when the number of goods soars the barter network collapses from information overload. With thousands or even millions of trade goods, no human can calculate the optimal trade amounts between any two goods. In modern terms, barter networks did not scale. They could only work efficiently with a small number of goods and traders.
Money evolved to solve this informational scaling problem in barter networks.
Money solves this problem by providing a universal trade good (UTG), a single good that anyone, anywhere will trade for any other good. With a UTG, traders need only know one trade quantity, the quantity of the UTG needed to exchange for any quantity of any other specific good. In effect, the UTG stores information about the quantity of the good that it itself was exchanged for. We label this quantity ‘the price’ of the good.
By storing and managing much more information, an exchange network that used a UTG could scale much larger than one based on barter. Networks with reliable and standardized UTGs, such as gold coins, grew much larger and faster than those without.
Using a UTG worked well up until the industrial age, when productivity began to increase rapidly. With no change in productivity, the amount of the UTG needed in exchange for any particular good remains fixed for long periods. Quantity ‘X’ of the UTG will consistently buy quantity ‘Y’ of trade good ‘A’. When productivity increases, Quantity ‘X’ of the UTG might buy quantity ‘2Y’ tomorrow. Knowing the amount of UTG one exchanged in the past ceases to predict the amount one will pay in the future. The UTG ‘forgets’ the ‘price.’ We call this effect ‘deflation’ and it dogged the economies of the 18th and 19th centuries.
Conversely, sudden increases in the supply of the UTG likewise destroyed the relationship between exchange quantities and erased the information they stored. We call this effect “inflation”. Gold rushes caused inflation in the 1800s.
By the early 1900s the the Gold Standard UTG had reached the limits of its scalability. To function as a UTG, the quantity of gold available had to grow and shrink in sync with the increase and decrease of productivity and that proved impossible.
Fiat money evolved to solve this problem. It solved the physical-availability problem by employing an Abstract Universal Trade Good (AUTG) to store information. Since the creator of the AUTG could adjust its physical availability at will, the quantities of AUTG could grow and shrink in sync with increases and decreases in productivity. The AUTG could calculate, store and transmit information about exchange quantities on a much larger scale and in a much faster-changing environment than could a physical UTG.
Making an AUTG function requires iron discipline to keep its quantities in sync with growth. Such discipline has not always existed, but on the whole using AUTG technology allowed us to grow a much larger and much more diverse economy than either barter or a physical UTG like the gold standard could support.
Some people like to think we could return to a physical UTG system using gold or other goods. We can’t. A physical UTG system just isn’t capable of doing the job of a fiat currency, anymore than barter can do the job of a gold standard.
The past is not the future.