Wikipedia offers the following definition of “money”:
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value.
To illustrate why all advanced societies use money, let us consider a village which operates on a barter system. (Many primitive cultures probably operated on a basis of mutual gifting rather than strict barter, but that does not affect the point at hand). Suppose the baker has produced two loaves of bread that will go stale in a day, so they would be best sold today. The baker would like a pair of sandals from the cobbler. They agree this is a fair trade, but the cobbler is backed up and will not be able to make the sandals for a couple of days. Thus, they cannot immediately make a swap. For this mutually advantageous transaction to proceed, the cobbler must agree to the obligation to deliver something (namely, a pair of sandals) in the future, in return for the loaves of bread today. The baker must believe that the cobbler will deliver on his promise.
Here we see the importance of credit and debt, which depend on mutual trust, to enable transactions where there is a time lag between the actions of the two parties. The cobbler’s promise may just be a verbal agreement, but now suppose the cobbler writes down on a piece of paper, “The holder of this certificate is entitled to one pair of sandals from me, the village cobbler,” and gives this to the baker. Now this piece of paper is nearly the equivalent of a pair of sandals in value. It has become a store of value. If the baker later decided that he would rather have some candles instead of the sandals, he might be able to exchange this certificate for the candles. Thus, this piece of paper, which started as a statement of a debt between two individuals, would serve the function of money. (In fact, such “bills of exchange” issued by merchants were an important form of money in late medieval Europe).
It would be even cleaner if the baker could simply sell the bread to the cobbler for something that functioned in that village as “money”, such as silver coins. The baker could then use some of the coins to either buy shoes or buy something else, either now or later. In this case, the coins operate as a convenient medium of exchange and also as a store of value. Both functions enormously aid financial transactions, which is a reason that money is so ubiquitous. Money also facilitates taxation by central governments, so governments have an incentive to put a monetary system in place.
In Money We Trust
For this system of money to work, the key players all have to believe in the value of the silver coins. Thus, money is a mainly social construct, an article of mutual faith.
With the rise of banking in the Renaissance, banks issued paper certificates which were exchangeable for gold. For daily transactions, the public found it more convenient to handle these bank notes than the gold pieces themselves, and so these notes were used as money. People generally trusted that the banks actually did have the gold in their vaults; if people lost confidence in the bank notes, they would all come at once to demand their gold in a “run” on the bank, which usually did not end well.
In the late nineteenth and early twentieth centuries, leading paper currencies like the British pound and the U.S. dollar were theoretically backed by gold; one could turn in a dollar and convert it to the precious metal. Most countries dropped the convertibility to gold during the Great Depression of the 1930’s, so their currencies became entirely “fiat” money, not tied to any physical commodity. For the U.S. dollar, there was limited convertibility to gold after World War II as part of the Bretton Woods system of international currencies, but even that convertibility ended in 1971.
Many older Americans and Europeans have a gut feeling that gold is “real” money. Its main advantage over fiat currencies is that there is only a limited world-wide amount of it, so it cannot be multiplied at the whim of some government or market force. However, even gold is just a shiny yellow metal whose value is whatever people believe it to be.
Money and Social Order
There are “preppers” who hoard gold coins, expecting that in the apocalypse they will be able to purchase goods with gold. But who knows how many gold coins it would take, in such a scenario, to buy a can of beans? Or if you show up in town flaunting gold coins, how long before the local warlord’s gang comes calling at your doomstead? I suspect in such a scenario society would revert back to using “commodity money”, using items with real alternative value, such as AA batteries, food items, or ammo. In the 1700’s frontier, beaver pelts, which had intrinsic value, were used as a common denominator for pricing and exchange.
If people lose faith in the value of some form of non-commodity money, it will in fact become valueless. For instance, during the American Civil War of 1861-1865 both the North and the South issued paper currency to fund their military efforts, since neither side had enough gold to pay their soldiers and suppliers of military goods. These were both fiat currencies, not at the time redeemable in gold. The North retained its government and a strong economy, and only a portion of its money stock was paper, so it experienced only moderate inflation. However, towards the end of the war, with excessive printing and with defeat of the Southern Confederacy in sight, the Confederate dollar lost nearly all its value. People no longer wanted to accept Confederate dollars in exchange for real goods, since they (rightly) feared that they would be unable to exchange the “greybacks” for the same amount of real goods in the future.
As long as a given government remains in power and does not issue crazy amounts of money (as in post WWI Germany or recent Zimbabwe), or some catastrophe does not strike, fiat currencies tend to remain in use. The value of fiat money derives in part from a government declaring that it must be accepted as a form of payment (“legal tender”) within that country, for “all debts, public and private”. The government typically requires that its citizens come up with some amount of its currency to pay their taxes, so that automatically creates some level of domestic demand for the currency.
Today, most “money” is not even tangible printed bills, but is in the form of digital entries in accounts “somewhere”. Nearly all of my life savings exists in the form of investments in stocks or bonds of corporate entities, which are held in accounts that I only ever access from my computer. I rely on on-going functional, reasonably honest government to enforce rules on the stewardship of those funds at multiple levels. So I am betting everything on the supposition that law and order prevail.
Economist Writing Every Day 