The Meaning of Money: Its Purposes and Functions

February 27, 2003

"When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to become ill done."(John Maynard Keynes)

Who amongst you has not been hurt financially as a result of the sharp decline of the world equity markets over the past three years? Has your pension fund been immune to this storm? How about your 401Ks? How about your RRSPs? The steep decline in major stock markets over the past several years can be traced to several causes, but one of the primary ones is the manipulation and decline of the U.S. dollar, the world's reserve currency. (Reserve currency is defined as a currency that is internationally acceptable and is used by central banks to meet their financial commitments abroad.)

The nature of money is very often overlooked and even taken for granted when, in fact, it is one of the most important concepts to be understood in the running of the world's financial system. It is its very linchpin. In order to gain a greater understanding of the concept of money, this article will examine its three principal purposes and functions. They are in order of familiarity a) medium of exchange and b) store of value {c} unit of account.

To begin with, money is the mechanism that enables parties to engage in an indirect exchange of goods and services. Every time you go into a supermarket to buy groceries or pull up at a gas station to buy gasoline for your automobile you are engaging in an indirect exchange of goods and services. The transaction is indirect in that it is not barter (goods and services for goods and services) but rather an exchange of goods for money. This concept is extremely important because it has enabled the economy to grow by leaps and bounds. It removes the necessity for the shopper to find a counterpart who needs the shopper's goods or services. The latter willingly accepts money as compensation and then applies it when and where he sees fit. Thus money functions as a medium of exchange. It serves, in effect, as an intermediary. It transmits value through space.

But what if the seller decides to wait before he applies his proceeds toward a good or service that he wants or needs? This brings us to another extremely important function of money. It acts as a store of value. It is thus important that money retains its purchasing power over time. Who doesn't remember his father saying that in his day, he could purchase a bottle of coca-cola for a nickel? A proper function of money, therefore, is to transmit value over time.

In order for money to ably function as a means of exchange it must facilitate -if need be- the transferring of large values between the parties involved in a transaction, and thus it must be easily portable. A paper currency backed only by the full faith and credit of the sovereign nation state fulfils this task. This type of paper currency is technically termed fiat currency. Fiat means "let it be" in Latin and fiat currency is currency or money that is sanctioned by the state as legal tender for all debts public and private. Furthermore, for our purposes, a paper or fiat currency will also mean one that is totally irredeemable, that is, not backed by anything of value. I stated above that a fiat or paper currency does a good job when it acts as a medium of exchange but it can and it inevitably fails to fulfill its role as a store of value.

All major fiat currencies in history have eventually lost all of their value. The main reason for this is the temptation of the institution that creates and distributes this currency to abuse this privilege. It does so by trying to get something (of value) for nothing (mere irredeemable currency). This temptation has always been irresistible. The U.S. dollar has been irredeemable (not backed by anything of value) and without links to gold or silver since August 1971 when President Richard Nixon closed the gold window because holders of U.S. dollars were exchanging too many of them for gold.

The "printer of money" in the U.S. and the administrator of short-term interest rates is the Federal Reserve Board. (Fed) This private organization has been in charge of the U.S. money supply since its inception in 1913. Since, as stated above, the U.S. dollar is the world's reserve currency today, it stands in a privileged position in relation to other currencies since there is a built-in demand for the currency in which virtually all key goods are priced, for example oil, to name just one.

As the American economy has deteriorated rapidly over the past thirty years with the precipitous drop in its manufacturing base, the Fed has been increasing the money supply and credit to enable the U.S. to acquire the goods it is no longer able to supply by itself. This abuse of privilege is now starting to manifest itself both in the balance of trade and domestic budgetary deficits of the U.S. This tremendous indebtedness has caused countries and institutions to become more reluctant to part with goods of real value in exchange for paper currency known technically as Federal Reserve Notes. The immediate result has been a decline in the foreign exchange value of the U.S. dollar and an accompanying loss of purchasing power both abroad and at home as the latest producer price index shows.

This decline in the store of value function of the U.S. dollar has only just begun. The ramifications are far reaching extending into the social fabric of countries wordwide. Look at the looming war in Iraq. Notice the curtailment of civil rights not only in the U.S. but also even in Canada as Canadian sovereignty is being threatened by tariff and border issues with the U.S. Briefly put, the imperial role of the U.S. dollar is now being supplemented, if not eventually replaced, by soldiers of the old fashioned kind.

Gold and silver, commodities with inherent value and with pedigrees as money going back thousands of years, are emerging as the choice for universal money. The ability of these precious metals to always act as a store of value makes them an unparalleled choice for such a job. Moreover a series of competitive currency devaluations is likely (known as a "beggar thy neighbour policy") as each country tries desperately to increase its exports at the expense of the other. Gold is now rising in value against all of the world's major currencies.

"Do not confuse the ticket with the show." (John Maynard Keynes) The third function of money and the most abstract but philosophically the most important is that of unit of account or numeraire. This refers to a standard of value, not so much in the sense of an unchanging measuring rod that is fixed forever, but more in the sense of an honest standard which is able to faithfully reflect a change in market demand and supply for a particular good or service. Most importantly this standard of value is not subject to manipulation and debasement by fiat and is able to keep the overall interest rate structure in the country stable thus enabling businesses to more easily meet their hurdle rates.

The reference in the quote refers to the difference between the object -gold in this instance- serving as the medium of exchange and the referent- gold once again- against which every item of value is measured. For example the ultimate recognition of this distinction will occur once people will cease calculating the price of gold in dollars and, should it be relevant, calculate that a dollar is worth so many grains, grams or ounces of gold. A hint of what I am getting at is found in the original meaning of the word dollar: a specific weight of silver. A rough analogy that may be helpful here is that of learning languages. One is considered truly proficient in a language if, and only if, one thinks and speaks in that language and does not have to go through the process of translating from one's mother tongue into that language.

Unless and until the money issue is at last resolved in favour of a standard of value that is not easily manipulated and debauched in favour of the few - instead of operating for the benefit of the common good - the stock markets will continue in a primary downtrend. Interest rates will begin to climb as creditworthiness becomes an increasingly important issue and, most importantly, social issues such as freedom, education and health will be dealt with in a manner most unbefitting a civilized people.

Naaman Helfield

27 February 2003
