Money: recording entitlements and obligations
We regularly rely on informal forms of money. For example, someone does you a favour such as buying you a drink. Then you reciprocate with another favour which may be to buy them a drink.
In this example, the favour puts the recipient under an obligation and the giver holds an entitlement. We could make this deal a little more explicit. After you receive the favour, you write and "IOU" to the giver of the favour. When you honour the favour, you tear up the "IOU". The "IOU" records an entitlement of the holder and the obligation of the person who issued it.
In the South Pacific islands, people in the traditional economy continue to trade without the using informal forms of money. These people grow vegetables and fruit, produce mats and other crafts, breed chickens and pigs and catch fish. They trade by giving these products away. These are not acts of charity. They gave their produce to people from whom they would expect the receiver to reciprocate and provide gifts in return.
So, if a fisherman were to give a farmer fish, the farmer would be expected, at a later date, to give the fisherman some vegetables or something else that the fisherman may value.
If the farmer reciprocates with a “gift” of vegetables of equivalent value, the farmer would have settled his obligation. If the farmer wanted more fish and wanted to be given priority, he would give vegetables of greater value than the fish he received. In that way, the fisherman would be obliged to reciprocate and give him more fish.
These trades were not barter. They were a complex system of placing obligations on each other. When the fisherman gave the fish, he put the farmer under an obligation to reciprocate.
If the farmer did not reciprocate within a reasonable time, the fisherman would have been able to name whatever he wanted in return. For example, he may say, “I noticed you had a small bunch of bananas at the back of you land. Do you mind if I have it?” The farmer would have to grant the request, unless he could immediately come up with something that was more valuable to the fisherman. For example, if he has too many ripe bananas for his needs, he may say, “You don’t want those. They are green and diseased. I have a few hands of good ripe bananas here. Take these.” So the trade is completed. The fisherman would no longer have an entitlement from the farmer and the farmer would no longer feel obliged to the fisherman.
The fisherman would be entitled to the bananas only if the farmer felt obliged, following the gift of the fish. This concept of reciprocity, understood by the original giver as an entitlement and the original receiver as an obligation, is central to the trade without money. It is also central to the concept of money.
In the above example, the parties involved in the trade kept a mental record of their entitlements and obligations. Money is a system for recording our entitlements and obligations in a more secure and definitive manner.
Let us revisit the trade between the fisherman and the farmer. This time let us assume that the farmer writes an IOU for 5 kilo of potatoes in exchange for the fish. The fisherman now has a written statement of his entitlement. The farmer also has a written statement of his obligation.
The IOU allows the fisherman to transfer or negotiate his entitlement. For example, he may transfer his IOU in exchange for rope. The rope maker accepts the IOU knowing that the farmer will honour his obligation. If the rope maker did not trust the farmer to honour his IOU, he would not accept it. The IOU is valuable only if the farmer will honour his obligation. Without the obligation, the IOU is worthless.
Money is negotiable like this IOU. It grants entitlements like the IOU. It is valuable because it is linked to an obligation. If there is no obligation, then money is worthless (unless it has intrinsic value such as being made of gold or silver). Thus, if a banks loan's were to go bad, then the deposits, or money, with that bank could be worthless. The money is only as good as the asset backing it.
In other words, money is a recording system. The pieces of paper and the computer bytes used to record our entitlements and obligations are intrinsically worthless. Money is a record of a current entitlement and it has value only if there is a corresponding current obligation.
A problem with IOU's is that it is quickly returned to the issuer and vanishes. We need money for trade. If it disappears quickly, it is not going to be very useful.
It is for this reason that IOU's from foreign countries are often used as a base for money. These IOU's are often called foreign reserves. Money is created when exports are sold. The foreign money is put into the foreign reserves of the banking system and domestic money is issued in exchange. That domestic money or IOUs are used for transactions around the country. When that money is spent on imports, it is converted back to foreign currency. When it is converted back, the money disappears and the foreign reserves decline.
When banks create money by lending, that money can be spent on imports, also. When it is, that money depletes foreign reserves. However, there were no foreign reserves created when the money was created. Therefore, excessive bank lending can deplete foreign reserves.
Last update: 7 May 2012