For this Post in Product | Strategy | Innovation I will explore another spin on product. What is “money”? And what jobs are we hiring money to do of us? With supply chains, inflation and many other factors impacting our lives today, it is sometimes helpful to take a step a back to rethink a situation. In this case, first principles allow us to challenge our assumptions of what jobs we hire money to do.
To better understand these “jobs”, maybe we should first evaluate life without any form of money to better understand the jobs and value it provides to us. Without any form of money, you would have to produce goods like chickens and eggs or provide a service like hauling goods from point A to point B. These goods or services would have to provide value to you, but you would also have to barter directly with other people to exchange your goods or services and only those goods and services plus what else you can accumulate with barter to get what you need.
If any of these goods are perishable, urgency is also added to the bartering strategy. Your quality of life would be influenced by the limit to how much you can physically barter with goods and services to meet your needs. You would also need to sacrifice time to address more of your essential needs through your own efforts like building and maintaining shelter, gathering food and making clothes for protection from the weather. There are no brands. The objective is survival.
What are some of the available levers to improve your quality of life?
Find others to simplify bartering through community
Build a family to expand your capacity for the goods/services you can produce/provide for bartering
Organize within the community to conquer and take from other communities
Notice that these levers take us back in time before most of the innovations we use today. But even the Roman Empire used money to reduce the need to barter. These levers above take us back to early civilizations with the mechanical tools they created to improve efficiency to do different kinds of work. Commodities like cattle and salt were eventually used as intermediary stores of value for bartering.
To advance beyond the limits of bartering directly with other people for goods and services, we need an intermediary or medium of exchange. The first evidence of money dates back about 5,000 years ago to Egypt and Mesopotamia where gold bars were weighed to establish their value. Gold rings were added to provide small units of value. When we introduce money to enable the exchange of goods and services, the number of transactions increase and opportunities improve as a result. Money is more than an enabler. Money is a catalyst for change.
But to truly understand money, we have to understand some first principles. If money is a catalyst for a change, then money behaves like “energy”. And how to do we express energy? On simple terms:
Potential Energy (PE) represents stored energy with the ability to do “work” on a system.
The change in Kinetic Energy (KE) represents the work done on a system.
Energy is conserved, so PE(i) + KE(i) = PE(f) + KE(f) + heat where i = an initial condition and f = the final condition that includes heat.
So if money behaves like energy and energy is not a single concept, but the combination of potential energy and kinetic energy, then we must be hiring money to do different jobs. And we are.
1. Money as a Medium of Exchange
One primary job we hire money to do is to act like kinetic energy as a “medium of exchange”. We often call this form of money a currency like the U.S. Dollar or Japanese Yen. And currency comes with a number of unique features like a central bank to manage its supply and armed forces to defend its sovereignty.
Heat is a byproduct of changing from one condition to another in a mechanical system and is more related and somewhat proportional to the kinetic energy. Heat is lost by one system, but is gained by another system. But total energy is conserved not destroyed. This will be important later when we consider the rate of change.
Money used as a medium of exchange is created with 2 different procedures. 1. Legal tender, or narrow money reported as M0, is cash created by a central bank by minting coins and printing banknotes. 2. Bank money, or broad money reported as M1/M2, is the money created by private banks through the recording of loans as deposits of borrowing clients. Bank money is created as electronic money vs. the minting of coins and printing banknotes.
In most countries, the majority of money is mostly created as M1/M2 by commercial banks making loans. Contrary to some popular misconceptions, banks do not act simply as intermediaries, lending out deposits that savers place with them, and do not depend on central bank money (M0) to create new loans and deposits.
1b. Money as a Unit of Account
Another job we hire money to do is to provide a standard numerical monetary unit of measurement for the market value of goods, services and other transactions. Such a unit of account is a prerequisite for commercial agreements that involve debt, as denomination for trade and quoting prices.
A unit of account is also the basis for developing efficient accounting systems. These systems start with policies and procedures, but more recently these systems are realized with enterprise software from vendors like SAP, Oracle and Microsoft. Small to medium size businesses might use QuickBooks or other software systems.
1c. Money as a Standard of Deferred Payment
Another job we hire money to do is as an accepted way to settle a debt. This requires a unit in which debts are denominated and is legal tender in the jurisdiction where it is intended to discharge the debt.
2. Money as a Store of Value
Another primary job we hire money to do is to act somewhat like potential energy as a “store of value”. To do this job well, money should store value without loss or “leakage” in its value. That was an issue we mentioned for bartering with perishable goods that spoil. Urgency was added to the context of bartering.
Beyond these core jobs money is hired to perform, there are a number of properties we would like money to have. These are highlighted by Jeff Desjardins in this report.
Fungible: its individual units must be capable of mutual substitution (i.e. interchangeability).
Durable: able to withstand repeated use.
Divisible: divisible to small units.
Portable: easily carried and transported.
Acceptable: everyone must accept the money as payment.
Limited in supply: its supply in circulation must be scarce.
This is a short summer Post on a relevant topic. Part 1 provides some context to discuss more on money in two other parts.
Part 2 will go deeper into money as a Medium of Exchange.
Part 3 will go deeper into money as a Store of Value.
Money has enabled significant innovation to advance civilizations beyond direct bartering. But for money to do all the jobs we hire it to do, we likely need multiple products to do these jobs very well.
Best,
Stephen
Nothing in this post is intended to serve as financial advice. Do your own research.