What makes money, money?

Beaver pelts being stretched on a hoop

Before currency like the US dollar, Euro, and Yen were invented, people bartered goods to do business. A historical example of this is during the 1700s, when Hudson’s Bay Company, now a large retail chain in Canada and the oldest company in North America, used beaver pelts as currency to trade with the local indigenous population. The local tribes weren’t interested in traditional gold or silver money; they wanted guns, knives, and other supplies. On the other hand, Hudson’s Bay wanted furs, so they started bartering between the indigenous tribes and the company — say, guns for pelts.

The problem with bartering, however, is that it’s inefficient. Both parties need to have something that the other party wants for the barter system to work. For example, if you wanted to trade guns for deer skins, to be able to do business you needed to find someone that had guns and wanted deer skins, and finding the right business partner this way was an endeavor in itself.

Over time, a natural currency evolved that everyone could use: beaver pelts. By the late 1700s, items were mostly priced in beaver pelts and it quickly became a standard currency in the territories. For instance, one moose was worth 2 beaver pelts, while one deer was worth only a half beaver pelt. By this time, if you needed to trade deer skins for guns, you could do so by calculating the value of both in beaver pelts.

The reason this worked is everyone involved valued the beaver pelt. It was used as clothing by the Native Americans and to make hats by the European settlers. In addition to being valuable, the beaver pelt supply was fairly constant, and the pelts themselves were small, long-lasting, and its quality easily determined.

So if beaver pelts were currency — or money, really — why are they no longer used as such? What about new currency, like bitcoin? Is that money? For something to be suitable as currency or money, it needs to fulfill money’s three purposes — to store value over time, to facilitate exchange of goods and services, and to measure profits and set prices — and comprise of money’s five basic properties: divisibility, fungibility, portability, durability, and limited supply.

In this article, I explore what money is and what makes a type of currency “good” money. I also look at arguably the world’s most popular currency — the US dollar — and the world’s oldest functioning electronic money, bitcoin, and how they stack up to one another.

Functions of money

In order for something to be considered money, it needs to have the three main functions of valued currency:

Store of value over time.

Money as a “store of value” means the money you have now can be saved and used in the future and there is confidence that its value won’t diminish over time. Fresh food, for instance, while important and valuable would not be functionable as a “store of value” because food rots. Your stash of fruit needs to be consumed quickly or it will become worthless. Gold, by comparison, is something that has been proven a good “store of value” because it has been valued by people for thousands of years; people will want to buy gold in 10 or even 100 years from now. Artwork, like a Vincent Van Gogh painting, is another good example of a “store of value” because Van Gogh’s works have been considered of high-value for sometime and will likely continue to be valuable in the future.

Facilitate exchange of goods and services.

Money facilitates exchanges in goods and trade, or can also be described as a medium of exchange, which means you can exchange money with a broad group of people for a broad set of goods. Valuable artwork, while a good “store of value,” would not make a great medium of exchange. Why? Because it’s not practical to buy groceries with a famous painting. The artwork is likely worth much more than the groceries, the value is highly subjective, and you can’t make change if all you are exchanging is artwork.

US dollars are obviously a great medium of exchange. The currency is accepted everywhere in the US and even in some locations outside of the country. Its value is readily understood which makes trading goods and services for dollars easy. Oil and gold could also be used as a medium of exchange for large transactions. However, even if you found a store that accepts oil or gold, it would be hard to use these items to pay for small purchases because it would be difficult to measure out.

Measure profit and set prices.

The third purpose of money is to measure profits and prices, or a “unit of account.” This is a fancy term that refers to the way goods, services, prices, assets, debt, work, and more are denominated. Companies need to keep financial books, people working for a particular salary, goods offered for sales are also denominated in money — these are all things that need to be denominated in money.

This use of money may seem obvious, but its purpose is to highlight a particular distinction. For example, you work at a store for a rate of $10 dollars/hour and decide this week to be paid in product rather than money. Because you worked 20 hours, your earning should be $200, but instead of being paid cash you were able to be paid in two shirts and pants worth $200. In this example, the unit of account is the dollar/money, but the medium of exchange is the clothing.

So, money is anything that can be used for these three functions. Some items, like art, are really good for one use but not for others. Let’s compare the function of the dollar to other valuables — art is a “store of value,” but clearly not a medium of exchange or a unit of account. Some items, like gold, could theoretically be used for all three purposes but aren’t commonly used for daily transactions anymore. Gold is a “store of value,” it is rarely used as a medium of exchange, and once was used as a unit of account when the dollar was backed by gold.

This conclusion raises the question: what makes “good” money? There must be a reason beaver pelts and gold were money at one time, but not guns and silver. There must also be a reason why they aren’t used as money anymore. The answer has to do with the underlying properties that enable money’s use; the stronger an item’s properties are relative to money, the stronger kind of money it is.

Properties of Money

There are certain properties related to what is considered “good” money. In addition to the three main functions of money, the currency must also be:

• Divisible — The money can be used to make both small and large purchases. Additionally, it shouldn’t be a challenge for the seller to provide “change” if needed.
• Fungible — The money is similar and interchangeable, meaning every unit is consistent and its origin doesn’t matter. For instance, a pound of gold is worth the same as any other pound of gold, whether that’s in its pure gold form or in the form of coins and ingots. This interchangeability reduces the cost of transactions and helps money scale.
• Portable — It can be easily transported (lightweight, not too heavy), it’s accepted by a large group of people, and it’s recognized as authentic. A person in one town could easily bring their money to another town and spend it without any issues.
• Durable — It doesn’t decay or easily wear out over time. If you own money today, you have confidence that it will stay the same amount in the future if left untouched.
• Limited supply — The amount of money available is limited or scarce. The supply of “good” money should be predictable and stable, this helps ensure that it remains valuable.

Using these benchmark values, food, art, and even gold do not have the functions and properties to be “good” money. Let’s break it down:

Food and art are definitely not money

Historically, non-perishable food items, like spices and grains, were regularly traded. But speaking generally, food would not make “good” money because it’s not durable or fungible. Food spoils and, as we know, apples and oranges are not interchangeable. Meanwhile, art is used by the rich as a “store of value,” it’s also very portable, durable, and scarce. But art doesn’t make “good” money because it’s not divisible or fungible — you can’t divide a famous painting to buy something inexpensive.

Gold could be money, but not good money

Gold is definitely a “store of value” and it’s been used as a medium of exchange and unit of account before, too. Gold can also be physically divided and it’s obviously fungible and durable. However, gold isn’t very portable in larger quantities. The German government repatriated $30 billion of gold it had stored in a vault in New York in case of a Soviet invasion. Moving the 4,400 bars of gold took years and cost over $10 million — that’s over $2,000 in transportation costs for each bar that is the size of a small water bottle.

Money properties explain why beaver pelts became money

If you look at the properties of “good money,” you can understand why beaver pelts was used as money in the late 1700s in the Hudson Bay.

• Divisible: While not readily divisible, beaver pelts were small enough units that the majority of goods were more expensive than a single pelt. (https://eh.net/encyclopedia/the-economic-history-of-the-fur-trade-1670-to-1870/)
• Fungible: The quality of beaver pelts could be easily measured and the quality pelts were interchangeable
• Durable: Pelts, like all furs and leathers, were long-lasting and could easily last for 20 or more years.
• Portable: Pelts weighed around a pound and a buyer’s horse could easily carry up to 200 pelts. At the time, that many pelts could cover the cost of over 40 ounces of gold, which would equal $50,000 today.
• Scarcity: The supply was limited — there were only so many beavers caught each year and their pelts were readily consumed (turned into hats). The short supply caused the number of available pelts to be limited.

As you can see beaver pelts were a valuable commodity that had all the properties of “good” money back in the 1700s. The pelts continued to be used as money for another 100 years, but it eventually fell out of fashion due to decreases in both the supply and demand, as well as the increased acceptance (i.e. portability) of money with superior properties — the US dollar.

The strongest “good money”: the US dollar

How does the US dollar stack up when examined using the five main properties of “good money”? Let’s take a look below:

• Divisible: The dollar comes in units from 100 to 1/100, making it extremely divisible.
• Fungible: Paper dollars, while having unique serial numbers, are 100 percent interchangeable and completely fungible.
• Portability: The US dollar is a global reserve currency and is the most portable and accepted currency in the world. The only other currency that has really achieved that level of global acceptance is gold. While it could certainly be challenging to transport billions of dollars physically, these days it can be done almost completely electronically and at low cost.
• Limited Supply: The US dollar supply is controlled by the Federal Reserve and, as of date, they increase it by approximately 6 percent every year. For now, that consistent increase in supply is largely accepted by the market, but it’s always possible that the supply could continue to increase to the point that it could cause the value of the currency to decline through inflation. Inflation has already caused the purchasing power of the US dollar to decrease by 98 percent in the last century. This changing supply might be the only possible weakness of the US dollar.

It’s worth noting that these properties illustrate why counterfeiting is so bad for money — counterfeit money reduces the fungibility, acceptance, and supply of a currency. And because the US dollar is a popular currency, counterfeiting is a huge issue it is up against. In fact, black markets around the world use the US dollar for its “store of value,” medium of exchange, and unit of account purposes, so much so that the majority of the $100 bills that are printed are done overseas.

Could bitcoin beat out the strength of the US dollar?

Judging by the benchmark values I’ve iterated above, the US dollar is incomparably the strongest currency to be “good” money. Now, let’s compare it to bitcoin.

• Divisible: Bitcoin is extremely divisible because of its digital nature. It can be transacted in 1/100 millionth unit increments, which is approximately 0.006 cents, making it comparable to the divisibility of the US dollar.
• Fungible: Currently, Bitcoin has some fungibility issues. Blacklisted bitcoin, defined as any bitcoin marked by authorities for involvement in criminal activity, do not have the same value as regular bitcoin. This means that bitcoin is not 100 percent fungible. However, recent tech developments in bitcoin, such as the lightning network and privacy focused wallets, may improve its fungibility in the future.
• Portable: Bitcoin is electronic so it’s completely portable. It’s much easier to carry $1 million in bitcoin than in dollars. However, bitcoin isn’t as widely accepted yet and the maximum amount that can be moved around is limited by the value of the network. While the exact upper limit on transactions can’t be determined, we do see transactions up to $100 million worth of bitcoin every week or so.
• Limited supply: The amount of bitcoin that exists in the world is fixed at $21 million worth. $12.5 worth of bitcoin is created every 10 minutes, resulting in supply growing at approximately 3 percent. This will, however, eventually reduce to 0 once all $21 million worth of bitcoin have been issued. Additionally, lost bitcoin can never be recovered or replaced.

Bitcoin vs dollar — the final verdict

Today, the US dollar clearly has better money properties than bitcoin. It is widely accepted, it’s more portable in large amounts, and its cash is more fungible. On top of that, the US dollar already has the advantage of being “the standard” which won’t change easily.

That being said, there are areas where bitcoin is slightly superior to the US dollar. In terms of the supply properties, bitcoin’s supply is limited by its software that runs on thousands of machines. This is a critical feature of the program which would be impossible to change, unless literally thousands of people who own bitcoin and run its software agree to do so. And since increasing supply would decrease the value of the bitcoin they own, it’s unlikely that bitcoin industry players would agree to change the supply program.

This supply system is much more rigid than the US dollar, which currently has its supply grow by 6 percent every year thanks to the Federal Reserve. How does the decision to increase supply take effect from the Federal Reserve? It only needs a majority of its seven board members to decide so. The vulnerability of its supply system is one property where bitcoin arguably beats the US dollar. The supply of the dollar is susceptible to the whims of a small group of human beings and vulnerable to political pressure, while the supply of bitcoin is fixed and mostly predictable.

The portability and acceptability of bitcoin could also increase in the future, as more people become aware of this electronic currency. Bitcoin has some unique advantages that will likely drive this adoption. And last but not least, bitcoin’s current issues in fungibility is a software problem that will also likely be resolved over time.

So, if bitcoin maintains consistency in its supply system, and if it can improve its portability and fungibility properties, bitcoin could become a superior alternative to the US dollar and, to an extent, other global currencies. But the future of bitcoin remains to be seen, it is anyone’s guess what may happen.