In an economy, money is like the magician’s assistant. It’s easy on the eyes, and gets the attention while the real action is happening elsewhere. See, when a magician is performing his trick, the real result is the same whether the assistant is present or not. But nothing happens if the assistant is present without the magician. Similarly, an economy is capable of functioning whether money exists or not. But money in the absence of a functioning economy is literally worthless.
To understand the illusion, let’s take a very high-speed look at about ten millennia of economic history.
As agrarian society developed, people traded goods and services with each other directly. Perhaps I’d give you some of my grain to feed your cattle, and you’d give me some milk and beef in exchange. In small villages, this model worked pretty well. But as people began to trade outside their villages, particularly over long distances, markets developed. People would bring their goods and services to a single location, where they would trade them with each other. This would often lead to complex, multi-step transactions. For example, I have wool and want barley, but the barley vendor wants olive oil, so I go to the olive oil vendor and give him wool, and then take the oil to the barley vendor. Some goods were of value to broad swaths of society, and they had long shelf lives, so they tended to be the most-traded, and were the most-used as intermediate goods. Barley and olive oil were the most common of these, though for higher-value transactions precious metals (mostly silver) were used.
Carrying the lower-value intermediate goods around the market was a hassle, so vendors started issuing tokens. I could go to the olive oil vendor and, instead of getting a bottle of oil, I’d get a clay token redeemable for a bottle of oil. I could then take the token to the barley vendor, who would collect as many of those tokens as he needed over the course of the day and redeem them all at the close of the market.
With precious metals, the hassle was more around the ease of division and measurement. It was much easier if you knew precisely how much of the metal you were trading, and had appropriate denominations for the transactions, so reputable smiths would stamp specific quantities with markings noting the purity and quantity of the metal.
Over time, governments stepped in to manage the metal stamping, which was preferable to the markets because it didn’t depend on the reputations of particular smiths. Once this occurred, the need for the tokens diminished, and commerce clustered around precious metals as the universal exchange for goods and services. Since these metals were universally accepted, people wanted safe places to keep them, and banks arose to fill this need. Someone going to market would stop by the bank beforehand, withdraw metal, trade at the market, and then deposit the metal back in the bank afterward.
As standards of living rose, inflation rose along with it. Transactions required ever increasing quantities of precious metals, and carrying that much around was a hassle. Banks began to issue their own tokens, typically in the form of paper, which is much easier to carry around. Whoever presented the bank with its issued paper would receive metal in the quantity specified. This was the first paper money. Some of the more clever banks also issued special forms that could be used for arbitrary denominations, as written and sealed by the account holder. The redeemer could then receive that amount of money directly from the writer’s account, when presented at the bank. This was the beginning of checks.
I’ll stop there, but the story does evolve further, of course.
The point in all of this is that the evolutions at every step of the way were reductions of friction in the market. Reducing economic friction makes everything run more smoothly and quickly, and therefore improves the market, increasing economic activity. But the market exists both in the presence and absence of money. In fact, we leave money out of the picture entirely on a regular basis, such as when we get friends to help us move in exchange for beer and pizza. That’s an economic transaction, but no money changes hands among the friends. There was a pretty significant barter economy during the Great Depression, because money was in short supply, but the forces driving economic activity were still there.
In essence, money is to the economy what batteries (or, more accurately, capacitors) are to electronics. It’s a way of accumulating and storing economic potential. But, in the money space, real work happens when the money moves. And, since money is given to someone in exchange for goods and/or services, money moves in the opposite direction to real economic activity. So when people talk about following the money, they’re really talking about swimming up the economic stream.
So why all of the focus on money, instead of other economic activity? Because it’s easy. It’s a single, common language with which to examine the economy. And since more economic activity involves money than any other commodity, it becomes a good tool to use to view economic trends. But we spend so much time focusing on the magician’s assistant that we forget where the real action is.
This often leads people to wish for tax policy that isn’t necessarily in line with what’s best for the economy, or themselves. That will be a topic of a future article.
For now, I’ll leave you with a reminder to pay attention to the magician, because that’s where the real action is.