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Classroom Economist: Money
An Economist's Perspectives Transcript

Part 1, What Is Money?

What is money?
So what is money? Well, first let's make sure we're talking about the same thing, because people use the term money to mean lots of different things. So you might hear somebody say, money is—I wish I made more money. And what they usually mean by that is, I wish I made more income. So money is synonymous with income sometimes. My dad used to say, if you marry for money, you're going to earn it. And in that case he's using money as wealth. So money can be synonymous with wealth. They asked the famous bank robber Willie Sutton once, why do you rob banks? And he said, well, that's where the money is. And if that's the case, the definition of money that I think we want to focus on today is that thing that you can use to buy goods and services.

What are the functions of money?
The definition of money that you'll get from a typical textbook will be about its functions. So the textbook will say, money is a store of value, which is to say that some element of money is wealth that you can use to spend in the future. Another function of money—they'll say money is a unit of account, which means that money is used to price all sorts of things. And the third function of money is usually [that] money is a medium of exchange—it's this thing that passes between us [that] is used to purchase goods and services and circulates in our economy.

The problem with defining money as a list of functions is that it leaves so many questions unanswered. So, for example, we know in some economies that one thing can be the unit of account and something else might circulate as a medium of exchange. In Israel, for example, almost all prices are denominated in terms of the new shekel, but many, many different types of other things, including the U.S. dollar, frequently circulate in many parts of Israel. Is money the shekel or is money the dollar?

Are any of these functions more important than the other? There are many things, for example, that are a store of value. This desk I'm sitting at has some wealth attached to it. Would I call it money, or does it need to have some element of all these other functions? When does something become money?

I think the essential problem that money solves is something known as a lack of a double coincidence of wants. A coincidence of wants is when two people meet and they both have what the other person wants. But let's say, for example, I want a loaf of bread and I go to a baker. I better go to a baker who wants to hear my lectures on what is money, otherwise I'm not going to have anything that he wants or she wants to trade.

And what money does is it provides a common medium that we all can agree on that has value. So I don't have to worry about whether my baker wants to listen to an economist's lecture on this subject or that—I only have to understand that we've agreed that this baker will accept money—in the case of the U.S. economy, [the baker] will accept this thing we call dollars in exchange.

What qualities does money have?
So what will satisfy this thing we call money? What qualities does it need to have? I see all sorts of lists, and all of them are good. I have my own list. There are four essential qualities that every good must have in order to be considered money. It must be divisible, so you ought to be able to buy big things and small things with it. It has to be durable, which means that it holds its value over time and it's not really expensive to maintain. It's got to be portable, which means you've got to be able to give it somehow to somebody else. And it's got to be recognizable—when you enter into an exchange, they have to be able to look at this money and understand what its value is.

As long as something has these four qualities, it's a good candidate to be money. Now of course goods that have these qualities in abundance are much more likely to be money than goods that are somehow lacking in one of these qualities.

Part 2, Early Forms of Money

What are examples of money in history?
So let's think about some very early monies, historical monies. Economists think that perhaps cows were one of the earliest forms of money as we recognize it as a medium of exchange. Well, what would make a cow a good money? Well, it's portable—they can go from place to place. And everybody pretty much knows what a cow is when you look at it, so it's recognizable. Cows are relatively durable, but they require some effort to feed and maintain over time. Perhaps the biggest drawback of a cow is that they're not very divisible, so generally people that exchange for livestock or cows tended to be only involved in relatively large transactions. This was not the sort of money that you can easily use for an everyday sort of purchase.

But over time, the things that we see people use as money have evolved. Certain things have demonstrated their ability to improve upon these basic characteristics of money in a way that was advantageous. So, for example, shells quite frequently circulated as money around the globe. In a place called the Maldive Islands, for example, came a little shell called a cowrie. Cowrie shells circulated across most of Asia, most of Africa, and far into Europe for many, many centuries, because people understood what these things were, they understood it had a certain value, and they were willing to trade for it.

In some civilizations, governments have stepped in to supply a money, much to their advantage. So, for example, the first coins emerged in a place that is now Turkey but at the time was called Lydia. Lydia was a kingdom that sat at a crossroads of trade. It was somewhere connecting Asia with Africa and Europe. Most people who had things that they wanted to exchange with other cultures had to pass through Lydia, and Lydia was an opportune trading place. What Lydia also had was an element called electrum, which is some parts silver, some parts gold that people understood had a certain value as far its beauty was concerned. The king of Lydia, Croesus, stumbled upon the idea that if he stamped pieces of electrum with his official seal in various denominations, that people would use them in exchange and would make Lydia a much more popular trading destination.

And these were our first coins, and they had all the characteristics you would expect to see in a modern money. They were very divisible. They were easily portable. They were durable because they were essentially gold and silver. And most importantly, they were recognizable—people could see the symbol of the king, and they understood exactly what its value was.

The evolution away from commodity money
On the North American continent, I think we've seen the same evolution in the characteristics of money. So very early on in North America, trade between the native peoples and the Europeans was often conducted in something called wampum, which is a bead that is made from a quahog clam shell. Wampum was legal tender in many of the colonies. Also seen in the colonies circulating as money was tobacco. All of these monies—which I would call commodity monies—have an intrinsic value. And by intrinsic value, I mean they can be used for something other than exchange. Gold and silver is beautiful, so are shells, [but] tobacco you could smoke. So these provided a bedrock of value for your money. But it's also very expensive to maintain a commodity money. Shells have to be fashioned into some sort of jewelry, coins have to be stamped out, the gold has to be dug from the ground, that sort of thing. Over time we've seen economies as they continue to evolve, their monies continue to evolve—we get further and further away from some underlying intrinsic value, and our money just becomes money, something that we accept in exchange because we trust its value.

Part 3, Fiat Money

In almost all countries around the world today, what is money is fiat. Fiat is a money that [exists] by essentially government decree, but basically what it means is there is no other use for this thing. The money of modern economies is not necessarily beautiful. People don't want to wear it; they can't eat it. It can't do anything for them other than to be used as an exchange. So why do people take these pieces of paper? Why do people take this money in exchange? They do it because they know somebody else will agree to accept it, and therefore it has many of the same qualities as these commodity monies.

So, for example, our modern fiat currency is easily recognizable. You can go anywhere in the world [and] show people the dollar bill. And while they may not know of the George Washington that's on the front, they'll understand what its value is. Our money is very divisible. It is very portable—you can transfer electronic money anywhere in the world in just a moment. And, if central banks maintain the value of the money over time, it's durable. It should hold its value from year to year to year, so that as people accept the money, they know that when they go to exchange it sometime down the road, it will have as much value as when they accepted it.

Modern fiat money has no physical form. I can point to little green pieces of paper and say that these are U.S. dollars, and indeed they are. But much of what we call money today is just an electronic accounting on bank balances, and when you make a transactions, it is in fact electronic transfers of money from one bank to another, but nothing really physical ever changes hands. So, consequently, when you think about buying something, you can send electronic money across the globe in a fraction of a second.

So the great benefit of a fiat money is that it's very efficient at what it does, and it's virtually costless to produce. But therein lies some of the risk of a fiat money. Because it's costless to produce, you can imagine that the people who produce it have the incentive to overproduce it. And in fact, we see oftentimes that governments who are in financial difficulties will resort to the monetary printing press, so to speak, to solve all sorts of fiscal problems. In the American Revolution, the Continental Congress and all the individual states issued large quantities of paper money to pay for all sorts of fiscal stresses they were under, and ultimately that continental currency became virtually worthless.

You see time and time again, governments under extreme fiscal pressure resort to fiat money as a way to try to pay for all their debts, ultimately to the great expense of the economy, which finds that its money is no longer useful in exchange and the public has to scurry around to find something else to exchange goods and services with. For this reason, today, most central banks around the world are given certain independence from the government. While the government provides oversight of the central bank, oftentimes the central bank is expected to discharge its responsibilities with respect to certain goals, among them the stability of the purchasing policy of money independent of whatever fiscal pressure the government happens to be under—so that people can understand that even if there is a fiscal crisis in the country, the money that circulates among them will be relatively secure in value over time.

Some governments around the world gone to an extreme such that they require their central banks to hit certain inflation targets. This is another way for them to assure the public that the value of their money will be durable over time, and therefore it secures its place as an important resource for the economy.

So I guess, in the end, when you have a fiat money system, central banks really sell trust—trust that they will maintain the purchasing power of your money, so that when you go to spend it, somebody will accept it, and if you accept it, you are reasonably comfortable that it will secure its value over time.

Part 4, The Curious Case of Yap Stones

Let's talk about a very curious money. It comes from an island of Yap, which is in the Western Pacific. Actually, Yap is a closely clustered group of about four islands, with a bunch of outer islands. There are about 6,000 people who live on the four main islands. And the people of Yap for centuries have used a very strange money: these giant stone wheels called rai. The rai stones as money are supposed to evoke curiosity from you. You're supposed to look at it and say, what a strange money this is.

But when you think about what it is that money does—the problem that it solves—I think the stone money of Yap is very fascinating, and it can teach us a lot about our own money. And it's not so strange after all.

Here are a few things that I understand about this stone money. First of all, there is no stone on the island of Yap. The Yapese have to travel about 150 nautical miles to a place called Palau. It's another island that has limestone. And and they carve out of the mountains of Palau these big stone wheels and put them in the canoes and bring them all the way back to Yap.

The second thing to understand about Yap stones is that the Yapese don't have any particular need for these stones. So, for example, they don't consider the stones especially beautiful; they don't have any religious significance. So as near as I can tell, they have very little what I call intrinsic value. They can't really do anything except be money.

Another curious feature about the stone money of Yap is that while some of the stones can be gigantic—12 feet across, weighing almost as much as a car—the biggest stones are not necessarily the most valuable stones. The Yapese value their stones on the basis not of their size necessarily, but on how difficult it was to achieve the stone. So, for example, if one of the stones was brought over from Palau at great cost to the people who went to get it, that would be a very valuable stone. But some of the very biggest stones on the island didn't come by way of canoe, they came by way of western ships. So of course, because these were very easy to get to the island, they tended to trade at a much lesser value among the islanders.

Now if you think about what are the qualities of our money, what are the characteristics of our money, let's think about the Yap stones. For one thing, it has to be recognizable. Well, with Yapese, because they have chosen to use these giant wheels as money, [they] can recognize pretty easily what it is that they're dealing with. And because it's a relatively small island, people understand what the value is that has been attached to these various stones. The second thing is durability. These are big stones, so in a physical sense, they're not going anywhere anytime soon. You might worry a little bit about the value of the stones actually deteriorating, but that wasn't the case, and the reason it wasn't the case is because the amount of stones coming in was naturally regulated. Palau was a long way from Yap. Moreover, how much effort you used to bring the stone over determined its value. There was no free lunch here. This was not fiat in the sense that you could just easily produce more of these stones. You were going to work for the stone if you went to get one.

One of the common problems that people say Yap stones had is they weren't very portable and so consequently they probably were somewhat of an inefficient money. I think that's not right. I think it's not right because in practice these stones rarely got physically moved from place to place. Once put in place in front of a meeting house or along a road, the stone had a tendency to stay there. It would change owners from time to time, but it would not change location. So the only thing that needed to change was everybody's understanding of who the new owner of the stone was, and that was virtually costless. Where the stones might have had a problem was divisibility. These stones tended to be relatively valuable things, and because of that, you generally only saw Yap stones exchanged for something pretty valuable. Everyday exchanges probably would not have occurred with these stones.

So were these giant stones money? That's a complicated question. It really depends upon what we think the problem is that money was solving. So, for example, one of the reasons you might not think this is money is that these stones did not circulate from person to person to person to person. Oftentimes, what happens is that a Yap stone changes ownership temporarily and then goes back to the original owner. So it's a marker, a marker of a debt. Some people would call this a gift economy, where you give some of your work to your neighbors with the expectation that they will do the same for you in kind.  There are some economists who think that's a pretty good definition of money.

Economist Narayana Kocherlakota, for example, has said that he thinks money is a memory. And so you can think of money in this way, as a giant spreadsheet, where everybody makes contributions to society, which get added up and give them a claim to the contributions of the rest of society, like giant gifts. So while the stones may not necessarily fit everybody's definition of money, if your concept of money is money as memory, then I think the Yap stones are a pretty good example.

I think we can learn a lot from Yap stones as a lesson in money. It's much more than just, isn't this a curious thing that these people on Yap do? I think it teaches us something about our own money and what's important. What's important is that it maintains its value over time, that you can trade it with somebody else, that it keeps a careful record of what your contributions are and therefore what your claims are on the contributions of others. It kind of reminds us of the very essence of money. And even though it comes from a very curious and faraway place, I think these are valuable lessons.


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