Money. You feel like you know exactly what it is, but when digging a bit deeper, it seems difficult to define. It is more than little green pieces of paper folded up in your pocket. It is more than the numbers that fill up the lines of your bank statement every month. To attempt to better understand what money is, I will take you through a journey through time to see what how money got to be what it is today.

Commodity Money

The first known form of money was commodity money, which has been used in countless civilizations throughout time. Commodity money has the property of being useful in and of itself as well as being used for money. Alcohol, gold, silver, candy, bronze, cigarettes, salt and barley have all been used as commodity money. Each of these has value beyond a mechanism for the transfer of value between two parties. Some of these commodities were more troubling than others as money due to storage or transportation concerns. Barley, for examples, was used between 3000 BC and 2500 BC in Mesopotamia. While barley certainly is intrinsically useful, transporting and storing it can be a problem for simple exchanges. Silver was also a dominant form of money because of its increased portability compared to barley. It is far easier to transport and store silver than barley. However silver is subject to fraud because impurities can be mixed in to alter the weights. The low cost of barley makes it less likely that counterfeit would happen with barley as commonly.

The inherent usefulness of commodity money meant that when people exchanged money for goods, they were essentially bartering one useful thing for another. Movies often show how prisoners create their own economy over time by using cigarettes, as a form of money and that may not be too far off from reality.

In Colonial America, when gold and silver (referred to as “specie”) were scarce, colonial Virginia and Maryland resorted to using tobacco as money. It is a commodity that has intrinsic value and is desirable for reasons other than its use as money. Payment in tobacco for goods and services was not uncommon because the recipient of the tobacco could either consume it himself or use it to further trade for some other good or service. So all of those prisoners using cigarettes as money may be replaying an important part of our American history. Almost all commodity money faces the same shortcomings of transport and storage. Throughout history, these shortcomings have been overcome with the use of “Representative Money.”

Representative Money

Commodities make for a fantastic medium of exchange because both parties in a deal get something of value that they want beyond just financial gain. Once a commodity is widely used and accepted as money in a society, it no longer becomes necessary to trade that actual commodity for every transaction. Robert A. Mundell of Columbia University gives an account of representative money:

In the ancient empires of Egypt, Babylon, India and China, the temples and palaces represented important centers of production and they quickly became the centers of storage of grains and the precious metals, typically under the control of palace administrators and the priesthood. When commodities were thus accepted in the centralized warehouses, it would have been natural for the stewards of the palaces to issue some kind of certificate of deposit that would certify the evidence of debt.

That certificate of deposit that was issued could then be used as money, which would be backed by the commodities. As an example, consider a merchant that stores his gold with the palace in ancient India and received a certificate stating a face value of 10 grams. When he chooses to purchase something, instead of redeeming the certificate then trading the gold, he can simply hand over the certificate so that the new bearer of the certificate can redeem the 10 grams of gold. Simply put, representative money is some form of currency that is backed by a commodity, where the representations are traded instead of the commodity itself. Historically, and logically, this is the next phase of money after a commodity economy.

During the Chinese Tang Dynasty in the 7th century, circular coins were used as money. These coins had a rectangular cutout, which would allow a string to pass through to carry many coins on a string, either as a necklace or simply to keep all of the coins together. Merchants that were wealthy would have several of these coins on a rope and carrying them became inconvenient at best, and unsafe at worst. To alleviate that problem, they deposited the coins with some trustworthy party that would issue a receipt indicating how much coin was deposited. These receipts, the earliest known form of representative money, were then used in commerce instead of having to carry the coins that might be too weighty. As long as there is the exact amount of commodity needed to back the receipts, the monetary system is strong and stable.

In the 10th century, the Song Dynasty took this representative money to new heights. The government issued the jiaozi (交子), which was the worlds first government issued banknote. By the year 1120, the central government gave itself a monopoly over issuing banknotes and was doing so at an unmaintainable rate. While these banknotes were, on the surface, redeemable for gold, silver or some other commodity, but in practice this was rarely allowed. The notes were redeemable after 3-year periods for the commodities that they supposedly represented, but instead new notes were issued with the same terms as before and it became evident to the government, that commodity backing may not be needed at all.

Fiat Money

The Yuan Dynasty took the representative money concept to the extreme and printed money freely without the formality of having to back it up. In August 1260, the founder of the Yuan Dynasty, Kublai Khan, issued paper currency known as Chao (鈔) that was originally limited in its duration and backed by a commodity such as gold or silver. However, the needs of the kingdom were too great for the amount of currency in circulation. As a short-term measure to finance his empire, he issued paper currency that was backed by nothing. This was the genesis of fiat money — currency that is redeemable for nothing of value. The Venetian traveler Marco Polo wrote about the miracles he witnessed in China and the concept of fiat money was transferred to Europe. In his book titled “The Travels of Marco Polo,” he dedicated an entire chapter to this discovery that he witnessed. The chapter [SS1] titled, “How the Great Kaan Causeth the Bark of Trees, Made Into Something Like Paper, to Pass for Money All Over his Country,” read:

All these pieces of paper are, issued with as much solemnity and authority as if they were of pure gold or silver… with these pieces of paper, made as I have described, Kublai Khan causes all payments on his own account to be made; and he makes them to pass current universally over all his kingdoms and provinces and territories, and whithersoever his power and sovereignty extends… and indeed everybody takes them readily, for wheresoever a person may go throughout the Great Kaan’s dominions he shall find these pieces of paper current, and shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold.

The birth of fiat money was a boon to rulers of governments that were now free from the financial restrictions of having to have value to their currency. This very act, more than all others, caused the downfall of the Yuan Dynasty. Fiat money is backed by nothing at all — its value is derived either by the central bank manipulating, or the free market determining, prices of goods and services.

Money Supply

Money has evolved to become far more than commodities and/or pieces of paper. In our modern financial system, we have fancy labels for concepts to subvert and hide exactly how much money is in existence. The monetary system in the United States of America is a fiat system, in which the currency is not actually backed by anything other than the “Full Faith and Credit of the United States,” which is a mirror of what Kublai Khan’s Chao was backed by. Abandon all notions that our money is backed by gold, which many Americans still believe. All of our money falls under what is known as M0, which is defined as the total amount of Federal Reserve Notes, US Notes and coins held in banks and circulating in the economy. That is the simplest measure of money supply and one that the Federal Reserve does not actively track and is conspicuously missing from statistics and reports that the Fed released. The next level of measure is known as M1, which includes M0 and demand deposits made at depository institutions. If you are the only person in the economy and have $100 cash, that would constitute the M0 money supply. Once you deposit that $100 in a bank, you’ve transferred it to count in the M1 money supply. Once the bank loans it out, it is cash again, in someone else’s hand, and now the total amount of money in the M1 money supply is $200. We’ll explain how this trick of alchemy works in later posts, for now we simply need to concern ourselves with the definition of M1. This is what the Federal Reserve tracks as the base unit of measure with regard to the money supply. In 1959, there was $138 billion of M1 but due to unrestrained fiscal policy, it has grown by more than 1,900% in 2013 to $2.63 trillion.

A broader measure of money supply is known as M2. If this is starting to seem absurd, you’re not wrong. The list of things considered money grows and grows, with each level including broader things to encompass money. M2 includes M1 and money market funds, and CD’s under $10,000. Yes — you are correct in asking why so many different definitions of money supply are needed. I wish I had an answer for you, but alas, I don’t. No one does. The more simple the question, the more complicated the answer you are likely to receive from the Federal Reserve and other government officials. If only it ended with an M2 definition, but we cannot hope to be so lucky. The next level is MZM or “Money Zero Maturity,” which is M2 without time deposits (CD’s and the like) with money market funds. All of these highly specific and ever more complicated definitions of money help mask the fact that your money is under attack. There are also other definitions such as MB, M3, M4-, M4 and L. We won’t get into the definitions of all of these definitions, but they simple include more and more concept of money such as the Eurodollar, commercial paper, repurchase agreements and United States Treasury Bills.

As of October 2013, the total money supply of the United States was $12 trillion, which is an absurdly large number to consider. If we assume that we had 12 trillion $1 bills, the stack would be 814,000 miles — enough to go to the moon and back… twice! The US National Debt, as of October 2013, is $17 trillion — so even if we had a full $12 trillion it existence, it wouldn’t be enough to pay down our national debt. Of course, we don't actually have $12 trillion — the number is made up of mathematical wizardry and is subject to growth at any time with the simple stroke of a pen or computer keyboard.

So what is money?

The government and the Federal Reserve (yes, they are two distinct entities — not part of the same) have perverted the definition of something that seems so simple to be so very complex, which makes it, understandably, difficult for the average person to understand what money is. As stated earlier, it is far more than the $20 bill in your pocket. Whatever money may be, ultimately, it is supposed to act as a store of value for your labor, ingenuity and good fortune. When you earn a salary or even start a business, the money that you earn is supposed to be a representation of the value that your effort provided to society as a whole. Ayn Rand’s classic “Atlas Shrugged,” is a work of fiction that touches greatly on the concept of money. One of her central characters, the hardworking aristocrat, Francisco d’Anconia gives a moving speech about the value of money and in it, sums up perfectly what money should be. He defines it simply: “Money is the barometer of a society’s virtue.”

About the author: Shamoon Siddiqui is a serial entrepreneur, software developer, investor and public speaker in the NYC area. To get more awesome content like this, just sign up for my mailing list.