Money, Currency and Wealth

The following is a guest post from Free Money Finance reader Rod Ferguson (see bio at end). It's a bit different than the normal fare here and quite a bit deeper (you all know that I write at a third-grade level), but I thought many of you would find it interesting, as I did, from a "history and understanding of money" perspective.

Most people view money, currency and wealth as essentially the same thing.  If you have a lot of dollars (money and/or currency), then you are wealthy.  Some of the wealthiest people in the world view their wealth in this way and for good reason – most everyone today only understands the “money” aspect of wealth.  But money, currency and wealth are three different things.  Merriam-Webster defines each as:

• money - something generally accepted as a medium of exchange, a measure of value, or a means of payment: as a: officially coined or stamped metal currency.

• currency - something (as coins, treasury notes, and banknotes) that is in circulation as a medium of exchange.

• wealth - all property that has a money value or an exchangeable value b: all material objects that have economic utility; especially : the stock of useful goods having economic value in existence at any one time.

Money and currency have practically the same definition with some small differences, while wealth isn’t necessarily determined by money.  Let’s take a look at the differences between the three.

The definition of money contains the phrase “a medium of exchange.”  Dollars are not the only money by this definition.  Checks, credit cards, gift certificates, etc, are all considered “money” as they can all be used as a medium of exchange.  The definition also contains the phrase “a measure of value”; before 1934, this meant “a measure of value against a set amount of gold” and today means “a measure of value set against the current account of the United States.”  Another way to define money would be to say that money “is anything that is generally accepted as such for the purpose of facilitating a trade.”

Currency diverges a bit from money.  Using the definition, a credit card is not currency nor is a check as neither is in circulation.  In the US, only Dollars and their fractions are considered “currency”; we do not issue treasury notes or banknotes – we issue Federal Reserve Notes that represent a unit of account (or debit) against the total net worth of the United States.  Another way to view currency would be that a Dollar represents a single share of the United States, Inc.

The definition of wealth starts with the phrase “all property that has a money value or an exchangeable value”; this measurement is the most commonly used, although most wealth is calculated in terms of dollars as we use dollars as “money.”  The next phrase is a little more interesting: “all material objects that have economic utility.”  In this context, “economic utility” essentially means, “worth having”; in the early 1900’s a horse had economic utility as transportation, whereas a horse has little economic utility now as automobiles have replaced horses for transportation. 

The next part of the phrase is the key part to understanding wealth: “the stock of useful goods having economic value in existence at any one time.”  Wealth is only determined when what you own has value at the time you wish to convert it to something else.  Your home, stock portfolio – even your bank account are only worth what you can buy with them at the time you wish to convert them to something else.

People currently living through the housing downturn are beginning to learn this lesson in a painful way.  They had what is called “book value” for a home that was used to extend credit, but when they attempt to sell they are discovering that “book value” isn’t reflective of the current (or “true”) value.  People who put money in a savings account in 2004 only to draw the funds today have discovered they have lost wealth as well; interest rates have been far below the rate of inflation, so the $100 saved in 2004 can today only purchase about $85 in goods, comparatively.  Another way to view wealth would be “purchasing power.”

Dollars

All three definitions tie into dollars.  To understand the dollar, we must look at its evolution; see where it came from and where it is going.  When the US was founded, a name needed to be decided upon for the national currency.  We chose to use the name of the most popular trade unit of the time – the Spanish  “dólar” which we changed to “dollar.”  Dollars used to be "symbolic money" – they represented wealth (i.e. - gold or silver) stored someplace, usually a bank.  Gold or Silver would be stored at a bank and banks would then issue dollars (bank notes) to represent the metals - similar to warehouse receipts for goods today. 

In the 1800’s, some banks were fraudulently issuing notes for metal they did not actually have while most would only redeem notes at face value from those banks they had agreements with.  This naturally created problems with exchanges – banks had some influence over where you could spend your money and to whom you spent it with.  Bank runs ensued and banknotes fell out of favor; people would rather hold their gold and silver instead of notes, so less gold and silver were being deposited into banks.  This put the banks in a quandary – they needed more money.  So, many began to issue debt (mortgages, business loans, lines of credit) to encourage deposits back into the banking system; by issuing debt, the banks would either ensure a stream of notes or metals flowing back into the vault.  This started as an extension of something called the Real Bills Doctrine, a means for banks to lend to each other before the establishment of the Federal Reserve.  It was expanded from bank to bank to include bank to consumer.  Eventually, debt began to function as "wealth" - a mortgage was counted alongside gold and silver as "reserves" for note printing purposes.  Since not all notes could be redeemable in metal, the fractional reserve banking system was formed (only X percent of metal in vaults for currency in circulation.)  A half-century later, all redeemable money was removed and only debt money remained.

Today a dollar isn’t “money” in the classical sense as there is nothing tangible backing it.  It is a Federal Reserve Note, or FRN.  It does carry a promise to pay, but the “payment” is the US government’s debt; the Federal Reserve creates “money” by printing dollars to buy government bonds (hence the “full faith and credit of the United States” backing given to the dollar via bonds by dollar holders at home and abroad).  As a side note for those of you who’ve just verified the FRN by looking at a dollar: Legal Tender means "cannot be refused," so a dollar cannot be refused for debts - but it can be refused for purchases (you can't use dollars to get a replacement Social Security card, for example, only checks, money orders or credit cards – and it’s perfectly legal for the SSA to refuse dollars as payment).

What does this mean?

Today, wealth is created through credit or debt expansion at some level.  Either someone borrows money to generate wealth through business investment or someone saves money from performing services and the US government generates the debt.  Dollars denote debt  - not wealth.  Debt isn’t necessarily bad, but if it’s overused –and it will be overused if allowed – it can be dangerous for both people and governments.  Understanding that money (what you use to buy things with), currency (US mandated money) and wealth (things that have value) are three different things is essential to manage your financial status and future.

My opinion

It doesn’t matter what my views on sound money, the Federal Reserve or US debt are.  But, the whole idea of a currency being used as money to measure a person’s wealth only being backed by debt seems ludicrous to me; all of your wealth is just debt, and debt can be eliminated by decree leaving you with some pretty pieces of paper that have no value.  It’s a wise idea to diversify your portfolio – not just your stocks, but also your whole wealth base.  Get some land, some foreign currencies, some stocks and some metals; nobody can predict the future and the current system may continue well past your lifespan, but hedging is not a bad idea.  You never know what tomorrow might hold.

Rod Ferguson was born in 1969 in Iowa City, Iowa.  His family moved around the country quite a bit so he became very used to change.  After graduating high school, he joined the Navy and married his beautiful wife Anne.  Choosing technology as his profession, he rode the dot-com boom up and slid right down with the market at the turn of the 21st century.  After this rather frustrating ride, he decided that by learning about finance, and then economics, he might avoid this ride in the future.  His studies began with the stock market, branched to global currencies and foreign economies, then delved into the history of the US economy and histories of foreign economies.  The more he read and researched, the more he realized that economics was one of the major driving forces in our history – that the rise and fall of nations has depended much more on the management of economies than on the management of armies.  Armed with this knowledge, changed his approach to managing his personal finances and began teaching others what he knew and how to apply it to their lives.  This is his first foray into publication and he hopes you enjoy and can gain value from his works.

Comments

[Trent Hamm]

There's also the factor of increased productivity. If a person can do more work today than they used to be able to do, thanks to technology improvements or efficiency concepts, then they're producing more value and thus more wealth.

[Mixer]

I understand what you are saying, Trent, and in a way you are correct - since the dollar is based on total net worth of the US, more productivity equals more wealth. But in real terms, more productivity just means more stuff and will only be more wealth if you happen to be able to convert it to something else at some point. See the recent wave of retail bankruptcies; they have lots of stuff, but not much wealth, so they have to file for reorganization until they can turn their stuff into wealth to pay their creditors (i.e. - get people to buy their stuff so they can pay the bank.)

[JACK]

First off, fractional reserve banking goes back a lot further than 19th century american history. I agree it is problematic. But it is only problematic in the sense that it is applied to accounts that are marketed as "on demand" accounts. There's nothing wrong with fractional reserve banking if it's known upfront that you are unable to retrieve your deposit because the funds are elsewhere.

Second, his analysis is a bit off. I think it's great to get thinking about "what is money?" and his defintions are not bad, but I worry it's a bit too influenced by the "paper collapses" mentality amongst some. I'm as much of a complainer of present day monetary policy as anyone, but I think too many "sound money" folks get wrapped around the axle on this. Our wealth is not "just debt". Our monetary unit is simply not as stable as many would think. And we no doubt have debt issues that need to be fixed as it is hurting the dollar and the economy. But the value of the gold standard wasn't that gold was "real money" and paper isn't, but that gold was something valued by people and not as susceptible to manipulation. It's value (seeing as paper could be redeemed for the gold that backed it) was as a check on governmental action. Precious metals have some obvious advantages over other things that could be used as a check. But the power came through the ability to convert. I think it's an open question as to how much of our "wealth" is really monetary inflation (which would be risked by a collapse of the dollar) versus real productivity and wealth gains that would be translated to whatever became the currency of the day. Simple example: I own a car. The dollar collapses. I still own the car. Someone wishing to buy it could verify that there's something real there; the value I associated with the car previously wasn't just monetary inflation talking. We'd have to arrive on another unit of exchange, but no one would deny that my car still has value. That's partly why many have pushed for a change in tax laws that would lift tax burdens from transactions conducted in alternative currencies (particularly metals): to provide a level playing field for the establishment of alternative units of exchange. Essentially, to allow the marketplace to establish the currencies.

[getagrip]

Talking about the "value" of a dollar always makes me think of collectors or people who hoard "stuff". You ask them how much some of their stuff is worth and you'll usually hear the price they paid for it, rather than the price someone else would be willing to pay for it now. Same goes for the listing of a price of a coin from one of those coin collectors books. Sure, it says you should be able to get X dollars, but you have to be able to find someone willing to pay that much for it. Sometimes they're lots of folks willing to pay that much or more, and other times, no one will pay anything like the listed price. While oversimplified, even gold is only worth what someone is willing to trade for it.

[rwh]

from the post: "Another way to view currency would be that a Dollar represents a single share of the United States, Inc."

So I guess the dollar is the original index fund!

[Steve]

Interesting ideas. Tying money to gold may be only one solution, but most people look at wealth as if it were something real... it should have inherent stability. The idea that it rises and falls, at the whim or so many influences is disturbing. Diversify? I just want to put it in the bank and know everything will be fine.

[tara]

"The whole idea of a currency being used as money to measure a person’s wealth only being backed by debt seems ludicrous."

This seems like a philosophical metaphor somehow - an illustration of the idea that we create our own reality; Value, currency, money, wealth - all these have no intrinsic existence (gold or no). Yes, they *do* exist, but as social constructs - their substance formed by shared beliefs among large numbers of people. (uh, this is why I go to work every day?)

[144mph]

Let me start off by stating that you have a responsibility when making a blog post to get your facts straight.

"Legal Tender means "cannot be refused," so a dollar cannot be refused for debts - but it can be refused for purchases (you can't use dollars to get a replacement Social Security card, for example, only checks, money orders or credit cards – and it’s perfectly legal for the SSA to refuse dollars as payment)."

Are you suggesting that checks, money orders, and credit card payments to the SSA are made in some other form than dollars? Are they paid in Ameros or Pesos?

Are you trying to get people fearful that they won't be able to purchase groceries with dollars, so they should deposit all their cash onto a debit card? How exactly would that help?

"Eventually, debt began to function as "wealth" - a mortgage was counted alongside gold and silver as "reserves" for note printing purposes. Since not all notes could be redeemable in metal, the fractional reserve banking system was formed (only X percent of metal in vaults for currency in circulation.) A half-century later, all redeemable money was removed and only debt money remained."

Why not go into a detailed explanation of the M1, M2 and so forth or even the fractional reserve system and how the FDIC suspposedly works or the Fed controls the money supply? That would be far more useful than what I'm reading here, which seems like something that my junior-high aged sibling would prepare if he cobbled together something on the bus for an impending assignment.

You're either very bad at explaining things, or deeply misunderstanding how the system fully works. I've had college level micro and macroeconomics and this whole post is nonsensical and very difficult to follow. I pity the people who read it in the hope of learning something useful.

For those who desire clarity, just do a wiki-search and avoid wasting your time trying to decifer this potpourri of finance jargon.

[Rod Ferguson]

@144mph:

My, what vitriol. Okay, lets start with your first accusation:

"Are you suggesting that checks, money orders, and credit card payments to the SSA are made in some other form than dollars? Are they paid in Ameros or Pesos?"

I never said that dollars aren't eventually traded in this transaction; I am trying to explain that our perception of dollars is driven by a cultural reinforcment of this idea that dollars can be used for any purchase. Legally speaking, they are not; practically speaking, they are - but that may change, and has with at least one department of the government. Several communities across the country have created and are using local currencies independent of the dollar (although convertable to the dollar). Those who are aware of the possiblity of change can prepare better for that change when it occurs.

"Are you trying to get people fearful that they won't be able to purchase groceries with dollars, so they should deposit all their cash onto a debit card? How exactly would that help?"

I'm not even coming close to stating this and I'm having difficulty understanding how you could come to this conclusion. Please explain further, if you will.

"Why not go into a detailed explanation of the M1, M2 and so forth or even the fractional reserve system and how the FDIC suspposedly works or the Fed controls the money supply? That would be far more useful than what I'm reading here, which seems like something that my junior-high aged sibling would prepare if he cobbled together something on the bus for an impending assignment."

I could, as well as how the TICS data influences the USDX and inflation.. but that audience doesn't visit this blog. I am trying to explain a complex idea in easy to understand terms; for that sort of analysis, I recommend you visit Nouriel Roubini's blog.

"You're either very bad at explaining things, or deeply misunderstanding how the system fully works. I've had college level micro and macroeconomics and this whole post is nonsensical and very difficult to follow. I pity the people who read it in the hope of learning something useful."

I think you may be misunderstanding the purpose of this article. This piece was meant to describe the differences between money, currency and wealth, not to go into the intricacies of the US financial system. If you are interested in researching the differences between them further, I can recommend a book by Andrew White called "Fiat Money Inflation in France"; it covers the transition of wealth into currency being used as money and how it affected the nation overall in the late 1700's. I believe it's an eBook now, so it should be easy to find and download.

"For those who desire clarity, just do a wiki-search and avoid wasting your time trying to decifer this potpourri of finance jargon."

People should do their own research and discover for themselves what their wealth means (in terms I think you'll understand - "people should do their own due diligence"). Wiki is a good start, but going to the source - the Federal Reserve, for example - is better.

[55mph]

Personally, I enjoyed the article. A perfect primer for the topic that takes as long to read as my break between projects. Being of the age where I have to worry about whether I'm making strong decisions with my money so I may someday retire (with wealth) AND put my kids through college, it's good to learn about differing views and plans of others. Thanks!

144mph, congratulations on taking college level classes. That must make you s-m-r-t. Thing is, which you may realize long after your sibling is old enough to drink, college will not teach you everything you need to know to thrive in the modern and ever-changing world. Especially freshman level Econ classes. There's more to know. Go get it. Re-read the article first.

[Saravanan]

This is a really good article which describes clearly the concept of money..

Cheers