Something about Money (and cake) – Francis Turner
Money is one of those human inventions that is about as fundamental as the taming of fire. Every civilized society and many (possibly all) savage tribes of humans have some form of money. Societies that have attempted to do away with it have generally ended up both failing to and in the process killing people. Yet not many people understand money properly and, as a result, much suffering is brought into the world.
So what is money?
The glib answer from an economist’s text book is something like this:- money is a medium of exchange and a unit of account. Which is fine except that it’s got lots of words or more that one syllable and some of them have various meanings. So lets go back to basics (as the politician said to the archbishop).
The root idea of money is to store IOUs so that we can have distributed barter efficiently.
Without money, if Alice wants Bob to build her a table then she needs to have something that Bob wants in exchange. It could be that she offers to cook him four cakes. Which is fine if Bob likes cake. Alice and Bob have agreed that one table is worth four cakes and both are happy. Alice has her table and Bob has his cake.
Except that Bob doesn’t like cake but does like beer. But maybe he knows that his mate Charlie the brewer needs cakes so Bob swaps those four cakes for a keg of beer from Charlie. Charlie in turn feeds two of the cakes to his three children and offers the other two to Daphne in exchange for her cutting his hair and the hair of his cake-stuffed offspring. Daphne now has enough cake that she can stuff herself while watching some mindless romantic drama on TV. Everybody is happy (well apart from Bob because he’s got a hangover but he was happy earlier), and Alice has her table.
That second chain is where money steps in. It was only because Charlie heard Bob moaning about being offered payment in cake and then offering the swap that things worked out. Otherwise Alice would have had to offer something else to Bob or would have to have found Charlie directly and offered to trade beer for cake. And even then Daphne might have been left out except that she heard Charlie’s children griping about how they hated cake, particularly when they had to ingest it through greasy hair.
In an isolated small village (or tribe) it is possible to do this kind of barter chain with some success. It may take a while for Alice, Bob, Charlie and Daphne to figure out the relative value of cake, beer, tables and haircuts and who will do what in exchange for what, but it could be done in an afternoon in the village square. It would have been much more efficient if everyone sold things for some known unit of money (say a spondoolick). Alice sells her cakes at one spondoolick each, Bob sells tables for four spondoolicks, Charlie sells beer kegs for four spondoolicks and Daphne cuts hair for half a spondoolick a head. Now Alice simply goes to Bob and offers him 4 spondoolicks for a table. Bob takes the spondoolicks and hands them to Charlie for the beer. Charlie pays two spondoolicks to Daphne so that she cuts his hair and his children’s hair and buys two cakes from Alice for another two spondoolicks. Finally Daphne also buys two cakes from Alice for a spondoolick each and is much happier because her scissors aren’t all cakey.
Spondoolicks as a medium of exchange make things much better. Not only can we now have chains of transactions that also involve Edwin, Fiona, Gerald, Henrietta and Ian, it is quite possible for Fiona to be in the village on the other side of the hill and for Henrietta, Gerald and Ian to be in the local market town. So long as the two villages and the market town agree (more or less) on the value of a spondoolick Alice can sell her cakes in the market town on the table Bob built to Fiona and everyone is happy.
Trade occurs when the two villages and the market town disagree on the relative value of things as priced in spondoolicks. The only reason Alice takes a day to go to the market town and sell her cake is because in town she can sell them for 2 spondoolicks each, especially to idiots like Fiona who have more spondoolicks than sense. On the other hand Charlie used to hate the town because Edwin, the brewer there, sells his beer at a discount, especially if you buy 10 kegs at a time. But then he realized he could buy 10 kegs for 6 spondoolicks and sell them back in the village for a spondoolick each and even with the spondoolicks he had to pay Bob for loan of his cart he can sell beer at a profit and have more time with his children because he doesn’t need to actually brew beer any more. And next week he suggests to Alice that rather than she struggling to market with all her cakes and that stupid table, why doesn’t she just sell them to him for one and a half spondoolicks each and let him deal with the table and dogooders like Gerald who try to tell Fiona that two spondoolicks a cake is a rip off.
And this is where we get to the concept of the merchant and the idea of money as a store of value. The merchant (i.e. Charlie) acts as the middle man between people in Aliceham who need something (e.g. beer) and people in Brewersville who have too much of it. The merchant buys the excess of beer from Brewerville at a price which is lower than he can sell it at Aliceham and then in reverse takes all the extra cake from Aliceham and sells it in Brewersville.
Later, as the fame of Alice’s cakes spreads far and wide, Charlie and Ian from the land Faraway come to an agreement so that Ian buys most of the cakes from Charlie at a price of 20 spondoolicks per dozen and transports them to Faraway and sells them to would be gourmets at 10 bongoes a cake. He uses those bongoes to buy tools, spices and hops which he brings back to Brewersville market and sells to Charlie (who then resells the spices to Alice and the hammer to Bob) and Edwin the brewer and so on. As a result his initial outlay of 20 spondoolicks turns into 30 spondoolicks. Again he buys a dozen cakes but that leaves him with a profit of 10 spondoolicks which he leaves with Gerald so that next time he comes back to Brewersville he can buy two dozen cakes. Similarly when he gets back to Faraway he can save up his bongoes and buy even more spices, tools and so on.
Of course it isn’t totally clear what the exchange rate of bongoes to spondoolicks is. One way to look at it would be to use a cake-index and say that since Ian buys cakes for 1 ⅔ spondoolicks and sells them for 10 bongoes then the rate is 10 bongoes == 1 ⅔ spondoolicks (i.e. 1 spondoolick = 6 bongoes). But that ignores the fact that Ian makes a profit of 10 spondoolicks on his sale of Faraway goods in Brewersville. So perhaps a better way to get to the equal value thing would be to look at the price of hops (etc.) in Bongoes and Spondoolicks as well and then take the verage of the two. In fact probably 1 spondoolick is worth between 4 and 5 bongoes and taking a look at the retail price of cakes in both Brewersvile (2 spondoolicks each) and Faraway (10 bongoes each) 5 bongoes to 1 spondoolick sounds about right,
Of course when Daphne wants to travel to Faraway, Charlie, Ian or someone like them will charge her a commission on the trade so she only gets 4 bongoes per spondoolick and when Jessica comes to Brewersville from Faraway she finds that her bongoes are only worth 1/6 of a spondoolick when she tries to exchange them – unless of course she meets Daphne. And that of course is the point. A currency is worth what you are willing to exchange for it and the person on the other end of the deal has to agree.
We will note that in this example we haven’t yet said what a spondoolick is (or a bongo for that matter). It could be a lump of metal, seashells, leaves, pieces of paper with the words “! spondoolick” written on them or some electrons or magnets sitting in a computer somewhere. The critical thing is that we trust that a spondoolick today will be worth (more or less – famines and other major events excepted) the same tomorrow and next month. Related to that we have to be able to be sure that someone (e.g. Charlie) doesn’t produce a few extra spondoolicks now and again because his kids need a haircut and he doesn’t have any spare right now.
Historically lumps of gold and silver (and copper etc.) of known weight/purity have been a popular choice for what to make a currency from, but the temptation for someone to use slightly less precious metal than there should be (or even none at all) has also been popular. Similar issues have plagued every other way to keep track of currency though electrons (in the form of bitcoins) have generally proven to be less vulnerable although they have proven to be relatively easy to steal or lose. Either way one critical thing about money is that once we agree on what it is and what it is worth (more or less) a spondoolick from Alice is just as good to Daphne as one from Jessica, you can trust them equally and financially we don’t care about their past life (except for when it turns out the money is fake or substandard). Moreover paying with them is anonymous or can be. Apart from people seeing him sneak in the door, no one can tell that Charlie has a beer at Edwin’s place every market day. As long as he gets paid there’s no need for Edwin to care who it is he is serving and likewise no need for Charlie to care which pub he goes to in Brewersville because only one will accept his spondoolicks.
Something else we haven’t mentioned yet is “Government”. While, historically, governments have generally had a big say in money that is mostly because governments are what we trust to stop the Bobs of the world from getting away with counterfeiting money – both by setting standards for what money is and by punishing the fakers when caught. Although of course governments have also historically done an absolutely bang up job in debasing currencies themselves and a cynic might say that the reason why governments go after private counterfeiters and the like is that they hate competition. Governments are not required to do the whole thing for money to work. A number of countries (e.g. Hong Kong and Scotland) allow banks to print banknotes themselves and while this can cause problems when the bank gets in trouble or when someone tries to use, say, a Scottish banknote to buy a round of beers in London (though it probably works in Carlisle or Newcastle), it is generally not a major issue. Indeed when you consider the use of US dollars in countries like Iran or Zimbabwe, sometimes the fact that the local government has nothing to do with the currency is a major plus.
The key thing about money is that it only works when there is trust. When trading both parties to a transaction have to agree than the monetary object in question is genuine and worth an agreed amount of stuff. Similarly when storing money somewhere the person storing the money has to trust that the place he is storing it is safe and will give it back to him when he needs it. When we all stick our money in a bank and then, later, decide we don’t trust the bank that produces a bank run and it gets nasty when (as is often the case) the general lack of trust in the bank turns out to be well founded. Stopping bank runs from turning nasty is, actually, one of the things that we probably do need government for. The bank runs in the bitcoin world have been pretty catastrophic.
Mention of banks leads us to the concept of loans and interest. Again this isn’t anything complex. Alice cooks Katherine a cake today because she happens to have all the ingredients and a week from now Katherine cooks one for Alice. Effectively Alice loaned a cake to Katherine for a week. Assuming the cakes were the same then there was no interest on the deal. If Katherine’s cake was bigger than Alice’s then difference in size is interest on the loan (if it was smaller then the interest was negative and Alice makes a note to never bake a cake for Katherine ever again). Interest is a way of measuring the different value of money over time. Katherine really needed a cake today but didn’t have any flour. Next Sunday she’ll have loads of flour so she can bake a bigger cake for Alice than the one Alice cooked for her.
We can extend the example further – say Alice cooks a big cake for Katherine and in return Katherine gives Alice a sticky bun every day for a week. If 6 sticky buns used the same ingredients as a cake then that 7th sticky bun is Alice’s interest and the profit on the deal. If Alice did this a lot then (apart from becoming overweight and sick of sticky buns) she’d get called a loan shark or worse because 1 cake in 6 is 16.7% and 16.7% interest for a week works out at something like 6000% on an annual basis. Of course if she got paid one bun a month it would still be steep but much more reasonable (~30% annual rate).
Now lets assume lots of people deposit excess cakes with Alice and agree that they’ll take back either sticky buns or cakes when they feel a touch peckish. If Alice now had 30 cakes which she loaned out to Katherine and 29 other people, she’d get just a single sticky bun every day but in 7 months she’d have a 5 extra cakes (or cake equivalents – remember 1 cake = 6 buns and 30 loans of a cake for 7 buns gives you 30 extra buns). Nice work if you can get it especially if the other cakeowners who gave Alice their cake only ever want a sticky bun at a time and no more than one of them wants a bun each day. It goes a bit wrong however if one of the other cakeowners (Louise) shows up with no warning on Saturday a month down the road and demands her entire cake back now because it’s her child’s birthday party. Unless Alice has a spare cake (or can make one quickly) she can’t pay Louise back as she promised which will make her very unhappy – and of course she’ll tell the mothers of the other 5 kids who were invited to her birthday party and they’ll start wondering what happened to their cakes and on Monday Alice will have demands for 5 more cakes which she won’t have either and that news will spread and so on. That is what we call a bank run and it probably results Alice getting a load of sticky buns in places she won’t enjoy.
Now Alice could avoid this situation by not loaning out all the cakes she got (perhaps she gets 40 cakes but only loans out 30) or by writing a contract that says that you can’t get your cake for 6 months or that you have to wait 6 days after you request a cake for it to be provided to you or some combination. For example Alice might say that if you want your cake back now you get nothing, but if you leave it with her for a year you get a cake and a sticky bun. In other words Alice is paying you interest for leaving the cake with her for a fixed period of time and she might make a rule that you can only withdraw one bun a day unless you give prior notice. With these sorts of rules and with 10 spare cakes sitting in her freezer Alice can be confident that Louise will be satisfied when she wants her cake back. Alice will get a decent surplus of sticky buns even assuming that some people decide that they’d rather have a cake and a sticky bun next year than just a cake today.
But it also assumes that all the 30 people Alice loans cakes to give her a bun a month. If Maria doesn’t pay after 3 months and Nina doesn’t pay at all then Alice is out a cake and a half. If that’s all it’s not too serious. The other 28 people will pay their full amounts so instead of ending up with a surplus of 30 sticky buns Alice ends up with 19 (7 lost from Nina + 4 from Maria). But if she gets it wrong and another three are like Nina then that 19 bun profit will turn into a loss of 2 buns.
Of course Alice could solve this by paying Bob a couple of sticky buns to go around to Maria and Nina and stand over them menacingly while they cook their buns (a 2 bun loss is far less bad than an 11 bun loss) and if Bob does it right to Nina when she hasn’t paid for 2 months then maybe Maria hears about how nasty it all was and manages to pay off her loan even though she really wanted those sticky buns herself. Either way Nina and, possibly, Maria now have a terrible credit rating – no one will lend them a cake again unless they show they really have turned over a new leaf and they probably have to pay 8 sticky buns back instead of 7 to cover the risk that they don’t pay back any sticky buns unless (or even if) Bob goes around and (threatens to) beat them up..
Right now we know what money is, how it works, how loans and interest work and things like that. This is all a basis for what we need in a possible new currency. Our new currency needs to be trusted, consistent in value, storable and able to be used anonymously. Sounds easy….
Notes: Richard Tol in http://www.the-american-interest.com/2014/12/10/hot-stuff-cold-logic/
In a barter economy, one needs to know the price of everything relative to everything else. How many eggs for a liter of milk? How many slices of bread for a liter of beer? How many iPads for a yacht? In a monetary economy, however, one needs to know the price of everything in money only. In a barter economy, there are n2-2n prices (with n being the number of goods and services for sale). In a monetary economy, there are only n prices. That is why, at some time in the deep past, many human civilizations of diverse origins independently invented money.