Disclaimer: I am merely an amateur enthusiast, and not an economist nor a financial advisor. Your millage may vary.
Preamble
As a result of the Global Financial Crisis in 2007, I took a much more rigorous look into investing, (hence this blog/presentation), which naturally led to the topics of inflation vs deflation, and the nature of money. Many questions bugged me, such as: "Why to the RBA target 2-3 percent CPI, and why is that the sweet spot?", and "What does an economy 'running too hot' actually mean?". I now think that I have a solid enough understanding to be able to answer most of these types of questions. In this article, I hope to give you some of that understanding, although I don't intend to directly answer those questions!
What is money?
Let's start with a definition of money. The best definition that I have heard for money is formalized obligation. Obligations are simply IOUs.
So, where did money come from? Despite the popular belief that money arose out of the barter system to solve the double coincidence of wants, money, as formalized obligation, simply evolved from less formal obligation, ie, informal obligation.
Informal obligation is the sense in your mind that either you owe somebody something, or they owe you something, as in "Thanks mate - I owe you one". The formalization increases - but not quite to the point of money yet - once these obligations begin to be tracked over time, as in Brownie Points!
Let's consider brownie points between you and your significant other. You buy you SO a great birthday present - you gain some brownie points. You miss the mark with the birthday present and it isn't well received - you lose some brownie points. Neither you or you SO actually keep track of the points formally, but both of you keep a rough ledger of who owes whom.
In the receiver's head, an IOU pops into existence - eg, "Wow, I had better get her a birthday present just a good as this one", and simultaneously, in the giver's head, a UOI, for want of a better term, pops into existence - eg, "I'm gonna get some tonight". With some luck, later that night, the IOU/UOI pair might vanish from existence, as the debt is repaid.
Obviously, the lack of formalization can lead to disputes about exactly how much one person owes another. One form of this is commonly known as not pulling your weight. When a group decides that someone isn't pulling their weight they can raise this issue, however when the response is "Yes I am", the only way the issue can be resolved is to formalize the tracking of contributions and therefore obligations.
Another issue that can arise from the lack of formalisation of the IOU is the exact terms of the IOU. Is there an expiry date? Does the IOU bear interest? Is the IOU transferable?
Have you ever been in the situation involving three people, where somebody both owed, and was owed, the same amount of money, and that person tried to remove themselves from any further obligations by linking the other two - "Hey, if Adam owes me $20, and I owe Zac $20, can we all just agree that Adam owes Zac $20?", and in the nod of heads, a primitive payment was made.
So, payments, in there simplest form, are simply a mechanism to adjust two obligation ledgers - to extinguish the IOU and the UOI, which are simply the two sides of the same obligation between the giver/receiver, lender/borrower or creditor/debtor.
The process of obligation formalization can be contractualization, tokenization, digitization, or serialization of this mental construct - the IOU/UOI pair. The formalization into a contract can take various forms, from a Note, Bond, Cash Note or Coin, Casino Chip, or a digital record in database. Once the obligation is formalized, we have money!
It is often said that money must be a) a unit of account, b) a medium of exchange, c) a store of value, however while this is true for a monetary system, it does not need to be true for a particular form of money. That is, there is no need that the medium of exchange also be the medium to store value. In fact, the monetary system will be more stable if these roles are kept separate.
Here are some examples of ye olde money:
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Note the text: "We promise to pay the Bearer the Sum of One Pound Sterling" - unquestionably formalized obligation.
In Australia, before 1911 when the Bank Note Act was introduced, it was the private bank notes that circulated as currency. After the Act was introduced, it was the national currency that circulated. Importantly, the concept of bank IOUs as distinguished from government IOUs still exists in the world today, but as digital credits, it is much harder to distinguish between them. Indeed, you probably don't even know that you exchange bank credit for government credit every time you withdrawal cash from the ATM.
The above bank notes are also the simplest form of a derivative. None of these notes are a One Pound Stirling note. They are Australian Pty Ltd bank IOUs for British Government IOUs. Being derivatives, there are inherent risks involved. Will the bank stay in business? Will it honor it's promise to pay the bearer? If the bank does honor it's promise, will the British government honor it's promise to pay "One Pound Stirling"? One Pound Stirling of what? That promise was long defaulted on!
Another risk within these bank note derivatives was whether on not the note would be accepted at face value by the market. Given that the Bank of Paramatta only existed for FOUR years, would you hand over your goods for the face value of these notes?
The Monetary Plane
Here we draw a distinction between the physical plane, consisting of real tangible goods, and the monetary plane, consisting of financial products, including cash.
Using our original definition of money, we can see that everything in the monetary plane is an IOU, or debt based, whereas the physical plane consists of real assets. We also see that only way we know the worth of things in the monetary plane is by the magnitude of the number associated with it, whereas the items in the physical plane have a real value to the holder of the item.
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