What Is Money?

8 min read

What Is Money?

Money is any object or tool that can be used as a unit of account, medium of exchange, and store of value. There are objective and identifiable characteristics that make something a good form of money. A specific type of money is known as currency, and the world has seen many currencies. Most of these are no longer in use, largely because they did not meet the necessary characteristics as well as their disruptors.

Currently, the world has many successful currencies existing simultaneously because there are many markets that have a need for money. The most common market is a country, and the most common currencies are fiat currencies controlled by the political leaders of a country. Most countries have their own currency which is limited by the geographic and political boundaries of the region.

Within a region, there is a market incentive to use the same currency so that transactions and informational exchange can proceed efficiently. This powerful network effect is only in equilibrium when everyone agrees on a currency, at least within a given market. Accordingly, a borderless currency that serves the entire world with sufficiently better characteristics than each dominant national currency would inevitably become a universal currency.

Characteristics of Money

There are objective characteristics that make an asset a good candidate for a currency. These characteristics are: fungibility, durability, portability, verifiability, divisibility, scarcity. Depending on the use case and the way a society operates, these qualities will vary in importance.

The U.S. dollar works well as a medium of exchange because it is sufficiently portable, divisible, fungible, and verifiable. It is not perfect in any of these categories, but it is good enough that the system can work.

The U.S. dollar is not scarce whatsoever because the government is constantly printing more dollars to pay bills, make room for tax breaks, or cut its citizens stimulus checks. This makes the U.S. dollar a terrible store of value. In an efficient modern economy, nobody interested in preserving their wealth would store their assets in U.S. dollars sitting in a bank account or under their mattress.

The amount of dollars in circulation can continue increasing forever, making it a non-scarce currency.
The amount of dollars in circulation can continue increasing forever, making it a non-scarce currency.

Gold, on the other hand, is sufficiently scarce and durable, giving it a strong use case as a store of value. Gold bars sitting in a bank vault could make sense for some investors depending on their goals and the state of the economy. However, gold is rarely adopted as a medium of exchange because it does not have the necessary characteristics. The logistics of carrying around a chunk of gold everywhere you go and chipping off the right amount to pay for a coffee make this currency completely infeasible as a medium of exchange. These two use cases are not inherently exclusive, but there are not many currencies that are good at both.

Network Effects of Money

The purpose of money is to simplify transactions by providing an easy-to-use and uniform system, regardless of the specific use case. This system works best when everyone participates.

If you had $10,000 and wanted to buy a sandwich at a shop that only accepted silver you would have a problem. You might be able to work out an exchange rate with the shopkeeper, but this extra step would be very inefficient and would detract from the utility that your currency provides.

The network value of being on a single system gives all currencies a very powerful network effect. The utility you get from a currency depends on how many other people use that currency. Accordingly, currency is a winner-take-all market that can only be in equilibrium when everyone in a market uses it or nobody does.

An incumbent currency that has been adopted by a market will have a strong lock-in advantage due to its established network value. Therefore, wide scale adoption of a disruptive currency is most difficult in the earliest stages. Every additional adopter creates a positive feedback loop that makes it more worthwhile for the next adopter to join.

Learn more about Bitcoin's adoption so far.

If the currency is adopted by a critical mass, where the network value gives the new currency more utility than the incumbent currency, then wide scale adoption will occur rapidly. The adopters prior to this critical mass would have to be motivated by other factors such as investment potential or transaction functionality.

Political Boundaries of Money

The properties of this network effect would lead us to believe that the entire world would use a single currency. However, the main currencies used today are fiat currencies and are controlled by groups with very specific interests: centralized governments. Each government desires the ability to control monetary policy within their country. This lets them enact policy that can prevent recessions, influence inflation, fund government projects, and nudge consumer habits. Through a series of nudges, each government ensures that their citizens subscribe to the local currency.

The Japanese yen and the U.S. dollar are both established currencies, but an American citizen deals exclusively in dollars and a Japanese citizen deals exclusively in yen. These political boundaries create segmented markets that can each have their own dominant currency. As a result, trade across these boundaries is difficult for everyone involved, but the governments have decided that autonomy over their monetary policy is worth the hassle imposed on their citizens.

Additionally, when interacting across borders, subscribing to a centralized government’s currency means following the government’s decisions and trusting their goals for the currency align with yours. Using the currency means using the government’s system. Your store of value and ability to purchase goods & services depend on the government’s survival. It is subject to every law, agency, and regulation the country puts forth.

Dominant Currency Replacement

The idea of replacing a currency may seem far-fetched, but it has happened many times before. The first currency used in ancient Mesopotamia was barley. It was used to pay for goods and services, and people hoarded stashes of barley much larger than they could ever consume.

Once standardized silver coins were introduced, barley was entirely replaced as a currency. The portability and consistency of the coins made it a better currency, and the network effect barley enjoyed was destroyed.

In the American colonies, colonists traded in commodity money such as tobacco and beaver skins when gold or silver wasn’t available.

These items lacked durability, among other issues, so they were quickly retired once the U.S. dollar was introduced. The dollar was once backed by gold or land, with a promise from the government that it could be exchanged at any time. During the Great Depression, the United States government nullified the gold standard and confiscated all privately held gold to enable the quantity of money printing that was needed to combat the crisis.

Learn more about what is backing Bitcoin?

At this point, the dollar had an established history from a trusted government, so it was able to retain its worth without backing from anything that held inherent value. Today, the most inherently valuable thing about the currency is the fabric it’s printed on, but people continue using it to buy food, houses, and cars. The value exists solely because everyone agrees that it has value and they agree to this because it is a convenient system to use.

Can We Replace Fiat Currency?

Any currency could hypothetically be replaced. A valid currency doesn’t need any inherent value in order to be widely accepted for its use cases. A disruptive currency would be a competitor for an incoming dominant currency if it were better than the incumbent based on established metrics of quality. Additionally, being immune to censorship and the constantly evolving policies of a government would add utility for some people. A currency that has the characteristics necessary for both storing value and for exchanging goods could serve both use cases simultaneously. This would further simplify the system, adding to the utility that the currency provides.

A currency with an advantage on all these fronts would then need to overcome the network value enjoyed by an incumbent currency. It is impossible to say how much better a rising currency must be to overcome this hurdle. What we do know is that every time the challenging currency gains a user, the difference in network values declines. Each additional adopter faces an easier adoption decision than the previous. If the currency gains sufficient adoption, it would pass a tipping point and rapidly establish itself as the incumbent within its market.

For a digital currency in the age of the internet this market would not be restricted by physical distance. If the currency were decentralized and independent of any government then it would not be restricted by political boundaries. If both scenarios were true the market of this currency would be any person who was connected to the internet network that the currency existed on. Pretty soon, that network will include the entire world. How much would a store of value and medium of exchange for the entire world be worth?

Key Takeaways

  • There are concrete characteristics that make something a good type of money.
  • Currencies with existing users benefit from a network effect.
  • Many different types of money have been used as currency in recent centuries.