Petros Koumantaros is the Managing Director & CEO of Spectrum Pension Consultants and a Financial Consultant with intellicents.
A fundamental question has recently been on my mind: What is money? While this might seem straightforward, especially to those in traditional finance, unpacking it reveals deeper questions about money’s role in society, our financial system, money’s creation and destruction and why private ownership of sound money is fundamental to humanity.
You are likely familiar with the three functions of money:
• Medium of exchange: It is used for buying and selling.
• Store of value: It retains its worth over time.
• Unit of account: It is a standard numerical unit of measurement.
Many have also delved into the core theories of money: commodity theory of money, credit theory of money and state theory of money. There is no need to rehash these theories here, as ample content about them exists in the public domain.
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So, why is money necessary in a free society?
The Desire To Thrive
Humans are driven by a desire not only to survive, as do other species, but also to thrive. Consciousness, logic and reason enable humans to recognize that our quality of life can be enhanced through prudent actions.
This second need, the need to thrive, uniquely differentiates humans from other species. It also fuels our desire for goods and services that transcend basic physiological needs. People want more: better homes, enhanced life experiences, superior cars, finer clothes, increased leisure time, more recreation, extensive travel, etc. In financial planning, we often distinguish between needs and wants when helping clients develop household budgets.
The desire for more has pushed humans to allocate capital and resources toward specialized productive endeavors. Specialization has made us dependent on others to survive and to thrive. Today, few construct their own homes, manufacture their own clothing, purify their own drinking water and grow or hunt their own food. Even those opting for off-grid living typically purchase tools from others to build their homes, grow their crops and hunt their food.
Money facilitates commercial transactions, enabling people to obtain the resources to survive and to thrive from others. Money functions as a medium of exchange to support these spot commercial transactions between buyers and sellers. The medium could be tangible, such as cash or coins, or intangible, such as credit, where buyers promise future repayment.
The Need To Save For The Future
However, humans must cater to both their immediate and future needs and wants. The need to save for the future is as fundamental to our survival as the air we breathe. Why? Because the future is unknown and uncertain. Illnesses, natural disasters, pandemics, political upheavals, wars and other unforeseen events can disrupt our lives.
If someone knew exactly when they would die, then financial planning would become easier. However, humans must plan for risks that are both known and unknown.
Insurance policies help people deal with known risks, but what about unknown risks? Or, what about tail events—low probability, but very high impact risks? Saving and storing value mitigates these risks. Accordingly, surviving and thriving in the future requires humans to save until the savings are later needed. Just as energy can be stored in a battery for future use, value saved can finance future needs and wants. In this context, money, when saved, functions as a store of value.
The preservation of value is a necessary condition for money to finance future consumption. The form of money that best retains value over time is the soundest form of money for savings. Analogous to a battery that rapidly depletes its stored energy, when money’s value quickly diminishes due to inflation, people seek other stores of value. In our modern financial world, many turn to assets such as stocks, real estate or gold when state-issued currencies debase.
When assets assume characteristics of money as a store of value, they command a monetary premium. This phenomenon helps to explain why real estate values have increased faster than consumer prices and price-to-earnings multiples on the S&P 500 have expanded over the past several decades.
Inflation And Currency Debasem*nt
Money loses purchasing power when more money chases fewer goods and services. Today’s financial system is a fiat-based elastic monetary system, powered by fractional reserve banking. Banks originate loans to credit-worthy borrowers seeking capital. Bank loans are denominated in monetary units of account, such as dollars, euros, yen, etc. Borrowers repay bank loans with interest over time.
Under fractional reserve banking, the supply of money expands when commercial banks originate loans. This creates money. The supply of money contracts when borrowers repay principal or default on commercial bank loans. This destroys money. Over the history of the modern financial system in the U.S., which I consider beginning in 1913 with the Federal Reserve Act, the supply of money has rarely contracted.
As new money is created, productivity must keep pace or money will be debased. Ironically, in a fiat-based, elastic monetary system where substantial government debts are monetized, governments benefit from currency debasem*nt. In fact, the U.S. Federal Reserve acknowledges it targets 2% annual inflation. The alternative, deflation, poses significant challenges for those burdened with debt, governments included.
High inflation and erosion of purchasing power lead rational humans to sounder money that is not as quickly debased. We see this in emerging markets where local people will gladly purchase U.S. dollars as one alternative to the more rapidly debasing domestic currency. Sound money, whatever its form, will command a monetary premium.
A Tool To Improve Lives
At its core, money serves as a tool to facilitate our aspirations, both immediate and future. Money satisfies the human need to spend and to save, as necessary conditions to survive and to thrive. Money is a manifestation of our collective efforts to better our lives.
As the world changes, so will our understanding and use of money, but its foundational role in human progress will remain steadfast. Traditional finance professionals, and indeed all of us, would do well to continually reassess and understand this dynamic tool that so profoundly impacts our lives and aspirations.
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