Monetary Mechanics: Part I - Why Money?

"But what is Bitcoin backed by?" This common inquistion is usually spurred on by one's natrual skepticism. But we should then at least apply this skepticism universally, and so we like to retort with another question; "What are US dollars backed by?" This question is the beginning of our journey into monetary mechanics. We are taking this approach so as to create a foundation of knowledge with which we will be ble too actually understand what money is, why money is, and how money is. This will be purposefully simplified; in order to more easily convey all the necessary concepts to fully understand the invention we call money, and how it relates to crypto and Bitcoin in particular. Money was created to serve a purpose, and although it may be in vogue to think of money as "evil", the reality is that the major problems we face with modern money are a consequence of improper implementation, corrupt institutions, and poor policy decisions. The origin of money and its early beginnings, were a massive improvement to civilization. Increasing trade and productivity, and following from that an evolution of society to higher levels of complexity and stability. So what exactly about money made this possible? Three ways in specific that money improved civilization. It exponentially increased and faciltated trade, served as a pricing mechanism for good/services of differing relative value, as well as allowed for humans to save the excess wealth they created through their labor. On that first point; early humans who settled in agricultural societies began to specialize in different skillsets, meaning they were creating different specialized goods/services from one another as well as creating ones that didnt exist before. Hunter gatherers were only interested in basic needs being met, but early agricultural societies developed new priorities since scarcity of necessities was becoming less and less important. Shepards kept sheep, and sold their wool. Fishermen would begin to start to sell their excess fish they could not consume. Builders created shelters/homes for others to reside in. As individuals began to differentiate from one another, bartering became a natural means of exchanging goods between two parties. But this system has many flaws. These flaws are what spurred the invention of money, which is old as civilization itself, directly because people realized the need for money almost immediately. So lets explore this idea a bit. Lets say a fisherman wants to trade with a blacksmith for a hammer; how would we ensure the value exchange was equivalent? What if the blacksmith doesn't want any fish? In order for the trade to be simple we must have what is known in economics as a coincidence of wants, meaning that two parties both want the goods that the other has to offer. This would be a rare occurrence and heavily limits trade. Without money we would need to find another third party with a good or service to offer that would satisfy all three participants. For example, the blacksmith does not want fish, but he does desire some quantity of wool. The fisherman would need to trade fish for wool first, then go back to the blacksmith and trade the wool for the hammer he wanted. This is incredibly inefficient means of trade, and also may result in an exchange simply not being possible. Now we decide to introduce money as an abstraction of value, that allows for trading value without needing to trade specific goods. This is a major improvement from the barter system, dramatically increases trade and productivity within the community. Now on the second point; pricing of relative values. Without money we run into another immediate issue. What is anything worth, and how does it compare to other goods/services? How do we create a fair way to determine value? Let's expand on our ealier example. Lets say the blacksmith and the fisherman both decide they want what the other has to offer. In this case, we then need to determine the proper quantities. How many fish is one hammer worth? The blacksmith thinks the hammer is worth at least 3 fish, but the fisherman thinks it's only worth 2 fish. Without the abstraction of money, these two individuals would be left to haggle with one another, and in the end the value exchange will likely be better for one then it would be for the other, creating a disparity, which discourges trade. Money allows for a solution to this issue. With money, all goods and services can be priced and then traded for currency, instead of bartering goods for goods. This creates a method for proper value exchange, and for that value to be "fungible" meaning the money is always interchangeable with itself, where goods are not fungible(think hammer and fish, everyone will accept money as payment but not necessarily any particular good for payment). Another defining principle of money is "divisibility" which is related to the pricing of relative values. What if the blacksmith and fisherman do agree to a trade, but they settle on 1 and 1/4 fish for a hammer. How would one exactly divide a fish into 4 equal parts? better yet, what about 1/8 or 1/32? With barter this divisibility is not possible, but with money, it now is. Money and it's ability to be divisible allows for transactions of any size or amount to be completed, even in the fractional case(1 and 1/4 is easy with money). Now let's address that third point; that money should also allow for individuals to save the excess wealth created through their works. For example if we used fish as our money, it wouldnt be able to be saved for long would it? If I were to produce a good or service that the community desired, I would generate wealth. If I were to consume less than what I produced, I would create an excess. If money was a commodity money(say tobacco, which served as payment in the Northeast USA in the place), it would not be easy to save that value I created. The tobacco eventually degrades or goes bad, as well as the fact that the supply of tobacco is affected by many different, unpredictable factors. There may be a particularly good harvest, or a new large produce joins the market. This may result in a larger quantity of tobacco to go around, and if tobacco were our only form of currency, we would experience price inflation. If there was a particularly bad season and tobacco became more scarce, we would experience price deflation as the value of the "money" would be higher due to a decrease in supply. In essence if the supply or value of our chosen currency isn't stable, then it will not allow for proper saving of wealth. In later articles we will explore why gold filled this void so well, but in essence, it fulfilled many of the most importanr principles of money, and was especially effective way to store our excess wealth. The 5 underlying principles of good money; being a proper medium of exchange(easier to trade paper money than hard goods), being a unit of account(meaning 1 dollar is always 1 dollar, where as no one fish is the same as any other fish), fungibility meaning it is interchangeable with itself and will be accepted as payment universally(where as fish would only be accepted by those that want fish), divisibility of the money(allowing for transactions of any and all amounts to be viable), and lastly as a store of value to save excess wealth generated through labor(meaning its supply and value should remain as stable as possible over time). In this article we examined the underlying principles that define good money, as well explained the fundamental and necessary reasons for WHY society developed money. This WHY was a natural extension of settled civilizations who needed a proper way to exchange value with one another. In Part II we will answer the question of HOW money is. From how it is created, to how it is destroyed, as well as the specific mechanics which control its supply, demand and utility.