Chapter 1: What is Money?
George Bailey: “Only one way you can help me. You don’t happen to have eight thousand bucks on you?”
Clarence (his guardian angel): “Oh, no, no. We don’t use money in Heaven.”
George Bailey: “Oh, that’s right, I keep forgetting. Comes in pretty handy down here, bub.”
– It’s a Wonderful Life (1946)
Down here, we need money. We need it to eat, to pay for a roof over our head, to buy clothing, medicines, concert tickets, and pretty much anything else we need or want. Once upon a time, we might have been able to barter, trade our stuff for other stuff, our services for those of others. These days, for most things we'll just take money, thank you.
But what exactly is money? The dollar bill in your pocket? Your checking account balance? What about an iTunes gift card? The IOU from your roommate? The weird Australian gold coin your uncle gave you on your first birthday?
For one, money is a unit of measurement—an agreed way of measuring prices, like Fahrenheit and Centigrade scales are agreed ways of measuring temperatures. Different countries use different units, or currencies. In the U.S., we’ve agreed to use the dollar as the accepted method. Much of Europe uses the euro, Mexico the peso, China the renminbi (also called the “yuan.”) McDonalds will sell you a Big Mac meal for $5.67 in the U.S., but in Mexico you will pay about 50 pesos. Meanwhile, in China the average price is 21.50 yuan. We can’t really compare these unless we convert them all into one currency, which is what The Economist magazine does when it calculates the cost of a Big Mac around the world converted into U.S. dollars.
Data source: The Economist, January 2020
But money is more than that. Once we’ve agreed how to measure prices, money is a medium of exchange. With money, I can be confident that I’ll be able to buy and sell anything rather than having to barter. Its value is known, and it is readily and widely accepted.
We also want to be able to buy and sell in the future at similar prices as today. In other words, we want money to be a good store of value. If I have to work fifteen minutes at my job to make $5.67 today to buy myself a Big Mac, I don’t want to go to McDonalds next week and find out that a Big Mac now costs $6.67. I don’t want to worry about the value of my money going down too much in the future.
Most of the time the value of money—measured in terms of what stuff costs—indeed goes down (meaning the prices of things go up.) This is inflation. Inflation recently has been pretty low in the United States: less than 2% a year. If you have a dollar and hang on to it, in a year it will only buy you what 98 cents buys you today. “Big deal,” you say, “I can live with that.”
It wasn’t ever thus. In 1980, inflation in the U.S. reached almost 15%. In one year, a dollar dropped in value to 87. Throughout history and around the world inflation has at times hit extremes, making money useless as a store of value. As of this writing in October 2019, for example, inflation in Argentina is 53%. People are standing in line at banks to change their pesos into U.S. dollars as quickly as possible because they are losing value so fast.
What assurances do we have that the dollar is a good store of value? Basically, we’ve put our faith in the government to make sure that inflation doesn’t get out of hand. Our central bank, the Federal Reserve (a.k.a “the Fed”) is charged with this job. They have been shooting to keep inflation right around 2% a year. Despite lots of huffing and puffing by politicians and armchair central bankers, they’ve been doing a pretty good job.
Here’s the thing, though. Over time even 2% inflation steadily erodes the value of money. In ten years, a dollar only buys 82 cents worth of stuff. In forty years, that’s down to 45 cents. This is why sticking your money under the mattress is a bad idea. You need to do something with it to make sure your savings at least keep up with inflation.
Should you really worry about forty years from now? Absolutely! Read on.