What Is Money? The Basics Your Teenager Needs to Know

Recently someone asked me to write an explanation of "money" for a teenager. Perhaps you have a youngster who could use such an explanation, so I am publishing it here.

* * * * * * * * *

The Evolution of Money

Once upon a time, people didn’t use money as we know it today. Instead, they exchanged favors for favors, work for work, or items for items, or some other combination.

For example, in the early settlement days of this country, pioneer traders would exchange jewelry, knives, and guns for beaver skins offered by American Indians. Or a baker could exchange ten loaves of bread for a case of apples. Or a friend could help you build your house, and you could help him sow his crops.

But this immediate type of barter exchange is not always convenient, since you may not want to acquire something right this minute. Sometimes you want to buy an item in a different town. Sometimes you may want to get a haircut next week, but not today. So people came up with the notion of “money” as a way to hold on to the compensation for your work, or for the items you sold, so that you could use it later.

Way back in history, this money could take the form of a valuable sea shell, or a cow. In later times it might be a silver coin or two, or a bar of gold. These objects had what's commonly called "intrinsic value," meaning that they were appreciated not just for their value in exchanges, but also for their own beauty and/or utility.

Eventually, the idea of writing a promise of value on a piece of paper became popular, especially in market situations. Because towns evolved to the point where most people didn't necessarily know each other, intermediaries became involved. For example, if you had a lot of coins, this intermediary was someone you could trust who could hold your coins and give you his paper in exchange. Everyone knew this person, so his paper promises were considered valid.

This transaction permitted you to go about your purchases without lugging your coins around or risking them being stolen. This kind of paper money was a kind of claim ticket, a kind of promise of future purchasing power, and the intermediary was actually the first banker.

Today, at some point in your life, what and how many dollars you have will probably depend upon how much your work is valued by the person who hires you. With the paper dollars you receive (or the digital dollars that arrive in your bank account), you can buy things and services. Or if you don’t want to buy anything right away, you can save the dollars so that you will have them for later use.

Three Facets of Money

So we have now described three basic facets of money:

1. Unit of account
2. Means of exchange
3. Store of value

You can easily understand that units of money are a handy way of comparing the prices of things, and that since money is expressed in terms of numbers of currency units (dollars in our case), it can therefore be counted. (No. 1) It can also be spent (No. 2), or it can be saved and invested (No. 3).

How Much of Our Money is Real?

The question arises whether or not paper or digital dollars are a good “store of value” over time. This question would lead us into a discussion of monetary inflating, about which I wrote a few months ago. It's rather complicated, but to make a long story short, the unfortunate truth is that paper or digital money is not always what it appears to be.

Just to give you an idea of what I mean, take a look at this chart of the diminishing value of a U.S. dollar since the beginning of the last century:

I have also prepared another chart and some photos that illustrate this phenomenon here.

It is very important that you realize that what I will call real money can only be those paper and digital claims that truly represent work done and that haven't yet been exchanged for other things or services. (This is an oversimplification, but I think it gets the important message across.) Anything above and beyond that should be called credit.

It used to be that banks were in control of the amount of real paper money and credit that were created. This worked pretty well since they were closer to the actual production of things. Bankers usually knew their clients well.

Unfortunately today, the amount of paper or digital money created in the US is now handled by a government-appointed bureaucracy (the Federal Reserve, or the Fed) that has no idea how much money should be printed to represent work done. In reality, for the past 100 years or so the amount of dollars printed or digitally created is way more than it should be.

Without going into too much detail right now, you do need to understand that any creating of money beyond the total value of work done by everyone represents credit, which is very different from our current definition of money, even though most people use the same name for it. Credit is really debt, and it must be repaid in dollars from future earnings. And credit involves risk. In fact the more credit, the more risk. We could say that credit represents tomorrow's work.

So far, all the real dollars and the credit/debt dollars created by the Fed have been absorbed by our economy and that of other nations. In fact, so much credit/debt exists today above and beyond real dollars that no one really knows how much our Nation has created, nor how much we can increase our debt load. The situation is precarious.

Throughout history this has happened in a number of societies, and it does not end well. Most recently, perhaps you lived through 2009-2010 and remember the hardships some people had to endure when things turned sour. That episode was the beginning of a tremendous crisis caused indirectly by excess credit. It was rescued in extremis by the Fed, at least temporarily, until the next episode.

You can also learn about what happens when things go badly by reading some of the stories of 1929, or of the Roman empire's decline.

If you have questions please don't hesitate to comment below. It will inspire more explanations. Another article is coming soon about handling your finances.

PS: My Dad (Edward C. Harwood, founder of the American Institute for Economic Research) stopped using the word "money" because its meaning has become very slippery, even among academics. He began using the phrase “purchasing media” instead of money, but that is a bit cumbersome for a teenager, so we’ll keep using “money” for now.