Monday, September 27, 2010

Economics: What is currency?

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This may seem just a little *too* simple to start with, but roll with me for a moment. Understanding currency is absolutely VITAL to understanding economics, because generally speaking, currency is half of every single transaction. You buy stuff with money, you sell stuff for money. Shouldn't we understand what money is and where it gets its value?
Shouldn't we understand what money is and where it gets its value?
Entire books are written on that simple question and I've listened to more than a couple lectures about it, so I'll make this as brief as my loquaciousness allows. Currency started as a means to barter between people. In a community, some people grew produce, others were craftsmen, some of your neighbors wanted your service and some didn't, so how did you trade with the ones who didn't?

This is essentially how currencies developed. A community needed to be able to trade with one another with confidence that what they received in return for their offered goods would hold value once they try to use it with another community member. Therefore, early currencies had intrinsic values to their cultures. For instance, some Aztecs used beans as a bartering tool, and even as recently as the 17th and 18th century beaver pelts were used as currency in Canada and parts of North America.

There's many important features to a good currency, but at the top of the list is that it must retain its value. I'm sure at some point beaver pelts were no longer the cool thing to barter with and someone was the last one to know, maybe they ended up with a gang of pelts stinking up the patio. More likely they were able to sell their pelts for dollars once dollars were being widely circulated as a common trading currency. One thing we know for certain: beaver pelts are no longer an acceptable bartering medium. This tells us a very important lesson, there is no guarantee that what we use to trade with today will be the same thing we use tomorrow.

So, what are the characteristics of a "good" currency? This unequivocally depends on who you're asking. If you ask a government official, they'll always want (and historically have always found a way to get) a currency that is easy to make, so that they can make more of it (governments like spending and need money to do so). That's the reality of fiat currency, aka "paper money", you can print as much as you want as long as you have paper to print it on. And now in our digital age, you don't even need paper, it's just numbers on a computer screen. Of course, printing everything you want is a bad thing for currency, which brings us to our first characteristic:

A good currency has a limited supply. It's a very common law in any market that the more there is of something, the less value it has. The law of supply & demand. I realized that early in childhood through collecting baseball cards, "rare" equated to "high value". Why should money be any different? Of course if it's too rare, like a diamond for instance, then there is not enough supply to be usable, and besides, a diamond would be bad for our second characteristic.

It must be divisible. Being able to break up the currency helps in bartering. Think about it, when dealing with someone and all you have is a $20, but you only want to pay $15, how do you get around that? You have to hope they have change. However, a good currency would allow you to simply chip off a piece to keep, give the rest. Likewise, if it's easily separable then it should be easy to put together. Maybe something like copper? Copper works in this rule as well as with the next characteristic.

It must have intrinsic value. As noted above, this is a subjective evaluation. At one time beaver pelts held value for people in the north, but the dollar holds no intrinsic value, because if people ceased trading in dollars then it's worth would be ZERO, there is no inherent value to it. Whereas even a beaver pelt has some durable value: it can keep you warm, decorate your pad, or (God forbid) clothe you. Paper does none of that, and is not considered to be of any value without the US *using threat of legal prosecution to force its use*. Copper on the other hand has an intrinsic value, it's useful in and of itself, but it's value is so low that it would violate our next rule.

It must be portable. When it comes to metals, there's far more valuable options that follow all of these rules but keep enough inherent value that you can carry it on your person without needing a pack-mule. Gold and Silver are good options, currently a single ounce of gold is worth $1,300, that's pretty easy to carry on your person. So, precious metals are fantastic options because it follows all these previous characteristics, as well as the last.

It must be durable. Not just a physical durability, but something you can look back at through history and have certainty that it's use isn't a fair-weather option, but that it's been used for ages and stands the test of time. Of course, physical durability is important too, something that doesn't tear or disintegrate through usage is vital to future trade, so as not to devalue your wallet.

Obviously, paper money scores on like 1 of these 5. It isn't durable, has no intrinsic value, it's not divisible, and it has an unlimited supply. However, it is portable, but in the instance of our dollar it's portability works against us since you can make as much as you wish (to the detriment of its value) without worry of difficulty transporting it. If you look throughout history fiat currencies have a staggering rate of failure, and I suspect that its failure rate will end up at 100%, because it violates the very heart of "good" currency. The thought of using gold and silver will bring up some questions like, "What about banks?" or "I don't want to carry around a brick of gold!", do not fear, these questions will be addressed in a future post, but before I do I want to reveal in as many ways as possible why fiat currency is bad. Next: inflation.
A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

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