What Is Money and How Does It Work?

What Is Money and How Does It Work?

August 4, 2020 0 By aure

Tl;dr: money has four functions within society: it is a value indicator; value itself; a facilitator of exchange; a wealth redistributor.

Peter Thiel, one of the most underrated thinkers of the 21st century, once declared that money could not be easily defined.

To begin to understand what money is, we take a look at its nature, how it works, why some people have it, and why others don’t.

Pre-Origin Times

I like to think that the need for money is triggered by a similar societal characteristic that triggers the need for law.

Both of these human-made concepts appear when a uni-individual society evolves into a multi-individual society.

Let’s take an example.

Imagine a hermit on an island. The hermit, by definition, lives alone.

He built his own house by himself, feeds himself by himself, dresses himself by himself, and entertains himself…by himself.

The hermit’s “society” is a system made out of one person that interacts with his environment.

Does money exist? Obviously not: there is no one to buy from or sell to.

The hermit finds the needed resources in his environment, which is “free” (minimum work must be undertaken to extract and convert resources.)

The hermit’s society is utopian: there is no crime because there is no law (and alternatively, no one to kill or steal from).

There is no poverty because there is no money. The hermit simply “lives”, and is accountable to himself for his own survival.

If the hermit does not look for food, the hermit dies. It’s nature in action.

Notice the amount of control the hermit exercises on his environment.

If he decorates his house in such a way, no one will come to change it. If he sorts out his clothes in such a way, no one will move them either.

Whatever the hermit controls in his environment is controlled by him and him alone.

The hermit owns 100% of control of what can be controlled.

This notion is important.

The whole structure of the system transforms when one person joins the hermit.

The Hermit Is No Longer…a Hermit

The addition of one person to the hermit’s society completely changes the societal equation and rewrites its rules.

Alone, the hermit had full control over his environment, as we said.

When a new person joins him, the hermit loses full ownership of control and must now share it with the new person.

Furthermore, the existence of the person adds elements of randomness into the societal equation, because that new person cannot be entirely controlled like a pet could, for example.

The total amount of controllable and uncontrollable variables in society increase, with a higher share of uncontrollable variables (the new person).

However, whatever the hermit loses in control ownership, he gains in productivity thanks to the appearance of a new principle: cooperation.

Before Cooperation: A Short Note on “People”

Another human being means a chance for the hermit to interact with someone else and the other way around.

Since the hermit and the new individual are two different human beings, and that the possibilities of environment control are limitless, the two inhabitants will first have to create an agreement on what is permitted to be controlled, when, how, by who, and in which context.

That’s basically the definition of “law”.

In French, there is a quote that says “l’enfer, c’est les autres”: “hell is others”.

Humans, when alone, exercise 100% control upon the controllable variables of their environment.

In the presence of other people, the control of what is controllable must be shared, which results in a loss of ownership, hence weaker control.

To sum it up, when society evolves from 1 individual to 2 individuals, the original individual’s control ownership decreases and environmental agency decreases and the new person adds elements of uncontrolled randomness into the environment.

From a control point of view, the hermit loses it all.

But from a “possibilities” point of view, the hermit makes substantial gains due to the possibility for cooperation.

Cooperation

While “other people” drastically impact the control you have over your own life, they also give you the chance to cooperate, a concept absent in the uni-individual society.

When “one person” evolved to “two people”, rules over the control of the shared environment must be established (law).

The share of control that is given up is however widely compensated by cooperation.

Why is cooperation important?

Because it enables the hermit to become more productive. Trees that used to be impossible to carry, can now be carried.

The coconut that used to be impossible to be picked up, can now be picked up.

As such, while the number of people on the island has been multiplied by two, the productive output has been multiplied by three, if not four.

As my dad used to say, “working in duo triples the speed compared to working alone”.

He wasn’t wrong.

The incremental added-value from 1 person to 2 people is extremely important.

Let’s do some math:

1 person produces 1 unity of output → 1 person = 1 unit

2 people produce 3 unities of output → 1 person = 1.5 unit

→ total productivity multiplier for one person added= 300% (from 1 unit to 3).

Of course, we need to remain aware that disregarding the number of units the hermit now produces, he will have to share them with the new person, but they will both have more than when the hermit was alone.

Did the hermit gain something by welcoming that other person on his island?

Mathematically, yes, because he is now more productive and can enjoy more wealth than before, provided the loss of control on his environment is estimated to “worth less” than the gain in productivity.

Will a new added person always multiply the total produced output by 300%?

Hell no.

The biggest incremental gains happen when a society transitions from 1 to 2 people.

However, more people will mean more output, and more output per person (output/person), until you reach the efficient societal size, where one added person would decrease the volume of output/person.

As such, if we had to draw a graph where the number of people would be on the x axis, and the volume of output/person on the y axis, we would have a normal distribution.

In this graph, each person contributes to a more productive society producing more and more wealth, until point a, where added people for a short time does not increase productivity, and then where the subsequent added person consumes more than they produce, hence creating a loss of wealth for everyone in society.

Ideally, a society would stop adding people when it reaches point a.

I believe this graph explains why smaller societies have less social-economic inequalities than bigger societies.

The Specialization of Society

“So, what about money?” I’m getting there.

As society grows, it specializes. When the hermit lived alone, he’d do everything himself.

Now that one person joined him, they got into an agreement that makes them both more productive (as in “producing more”).

The hermit proposes to fish for two if the other person takes care of the garden meanwhile.

The incremental effort between fishing for one and fishing for two being minimal, this agreement helps our two inhabitants cooperate which makes them more productive.

Indeed, the hermit won’t eat the “fish for two”, and the other person won’t only eat the apples and pears from the garden.

The hermit will exchange fish for pears, and the other person will exchange pears for fish.

This system is called bartering, and it is believed to have taken place before the invention of money.

Bartering

Bartering is an exchange of value between two or more people.

To be fulfilled, bartering must meet four conditions: (a) agent A owns something that (b) agent B wants and (c) agent B owns something that (d) agent A wants.

Needless to say that four conditions are a lot of conditions.

What if agent A has something that B wants but A doesn’t want what agent B has? It wouldn’t work then.

It doesn’t work, does it.

The idea was then to use some sort of mediator in between goods owned by A and goods owned by B. Some sort of neutral value that could be exchanged against anything.

In this way, if B had something that A didn’t want, this neutral value could then be exchanged so that A wouldn’t have to get unwanted goods from B.

And that’s how money came to be.

So…what Is Money?

Here’s the best definition I could come up with.

Money eases the exchange of goods and services between agents by defining a value of the exchanged good or service that both parties agree on at instant t. 

However, money does not only define the value of the traded goods, but it embodies that value since against the good is exchanged the money.

We could say that money embodies both some sort of scale and the unit that makes up the scale, a bit like if “degree” and “thermometer” were the same thing.

Money is therefore both an assessor of value and the value itself (first and second characteristic). 

What to Do to Get Money

Let’s summarize: when a society is inhabited by several people, these people interact with each other by exchanging goods and services whose worth is measured by and exchanged against money.

Money being highly liquid (easily exchangeable), it can be traded against pretty much anything else, which is the main reason for its attractiveness → money is an enabler (“simplificator”) of trade/value/productivity/value production (third characteristic). 

We can therefore reasonably conclude that people will give you money if you can give them something of value in exchange.

A diamond will be sold for a lot of money because its value is very high.

A random rock will not likely be sold for much. As such, the basic original assumption is that:

Money = value at instant t

The surgeon makes a lot of money because she saves lives and lives…are valuable.

The legal tax evasion lawyer makes a lot of money because he helps save a lot of money.

Actors make a lot of money because they entertain millions of people. Million = a lot of total value = a lot of money.

Bill Gates made a lot of money because he enabled billions of people to use a computer, which is not nothing.

If you want to make a lot of money, you need to provide society with a lot of value.

And avoiding traps.

Avoiding Traps

First trap: Money = value = time. 

While it is true that money equals value, not everyone gets rewarded this way.

When an employer gets into a contract with an employee, the employee agrees to sell his time against money during which the employee will provide value.

And that is very tricky.

If you get a job in a bakery and sign a contract to produce 100 pieces of bread per day, you work within the concept of money = value, value being in this case the 100 pieces of bread.

Whether you take 1 or 10 hours to make the bread will be completely irrelevant to your employer as long as he can sell what you made.

You have been hired to provide value, so your job is to provide value.

Period.

The time you take to provide the value is your problem and can be changed at will.

If you buy a giant bread-making machine that makes 100 pieces of bread per hour, you will work 1 hour per day, which gives you enough time to get another one of these jobs to make more money.

If you make all the pieces of bread by hands, you may work 8 or 9 hours per day, and then you’re stuck with one job and little money.

Should you decide to become completely independent and sell bread to anyone for a living, the more bread you make in a given time, the more money you will make.

Now, if you sign a contract to work as a receptionist 8 hours per day, there is nothing much you can do besides…standing up 8 hours per day.

The nature of your task cannot be optimized with production hacks like bread making as you are forced to sell something that can’t be multiplied: time.

Selling your time is a bad idea because unlike bread, you can’t sell “more time” with a big machine.

As such, you can’t increase the value you are giving against money which will considerably limit your chances to earn more.

Whatever you do, make sure the value you produce is scalable and can always be achieved with less time through an increase in productivity.

In the beginning, we said that when one other person joined the hermit, the total productivity tripled.

As such, make sure that other people can join you in providing value so that they provide value for/with you, which is the definition of an employee.

An employee provides value for his company against which he earns a salary.

The second trap consists of not spending all of your salary.

Second trap: spending more than you make and other distinctions on your intrinsic value 

Despite what many people may say, you are not worth your salary. You are in fact worth much more.

Reading the book about entrepreneurship “Start from Zero”, I discovered that employees make between 3 to 5 times what they are paid.

Call me stupid, but I didn’t know that.

I expected ratios to be the likes of 1.5-1.9 after taxes.

Let’s take an example.

My friend, who works in a computer science consulting company, told me recently that he had discovered he made his employer 700€/day before taxes.

In a 28-day month, that would be about 14 000€/month. Take off the 25% corporate taxes and you are left with 10 500€.

The company pays my friend a full salary of 2 900€/month (before taxes) and my friend receives 1 900€ on his account (after taxes).

10 500€ – 2 900€ = 7 600€ of profits left for the company.

7 600€/1 900€=4. My friend’s company makes 4 times what my friend makes by doing, well…almost nothing.

As such, my friend’s net total value is 7 600€ (after-taxes company profits) + 1 900€ (after-taxes salary of my friend) = 9500€.

Since my friend doesn’t have any other types of income, his net intrinsic value is 9 500€.

But what does it mean?

It means that it is implied (because the performances of my friend don’t impact his salary) that my friend produces value worth the equivalent of 9 or 10 iPhone-last-edition each month.

Or, as I’m writing this, the equivalent of 180.5 grams of gold.

Except that my friend’s worth is not measured in gold or iPhones, but in money: €.

That being said, my friend mustn’t spend more than he makes, as that would mean that he would consume more value than he is allowed to by his employer. 

Indeed, while my friend is worth 9 500€/month, he is only allowed to consume a monthly volume of output worth a maximum of 1 900€: his salary (20% of his intrinsic value).

A salary is to some extent an arbitrary measurement of the total volume of goods and services created by society that you are allowed to consume (we’ll get back to that).

He who consumes more than he makes never becomes rich, disregarding the amount of money that they have.

To summarize: money is earned when value is provided. The money can whether be exchanged against the value of the work provided directly, or against a period of time during which value must be provided.

The money is earned under the form of a salary or/and other streams of income, and its total amount depends (in)directly on the total worth of the value provided to society.

A salary represents the portion of the total wealth created in society that the earner is allowed to consume: money is a wealth redistributor (the fourth characteristic, further explained below).

This leads us to discover that the bigger the volume of societal output is, the more output there will be for members of society to consume.

Why Productivity Is the Real Driver Behind the Poverty and Wealth of Nations

Let’s imagine a village of 4 people made out of a baker, a butcher, a politician, and a tailor.

The baker makes 3 pieces of bread per day, the butcher makes 3 rib-eyes per day, and the tailor, 3 suits every 6 months. When the politician goes buy his daily bread, there are usually only two pieces remaining because the baker kept one for himself.

As such, everyone is fighting for bread, and the bread is very expensive.

The politician tried to print more money and give it to people, but the bread got more expensive instantlythere is just not enough bread for everyone.

The normal consumption of the village should be at least 4 pieces of bread/day, 4 rib-eyes/day, and 4 suits/6 months. But since it is not the case, people are poor and hungry and don’t have much money compared to the prices.

The baker would like to have more money, but selling the pieces of bread more expensively would mean nobody would buy them, and then the baker wouldn’t be able to buy half of a rib-eye and half of a suit at all.

A bit further stands the same village with the same people: a politician, a baker, a butcher, and a tailor. The minimum needs of the village are similar: 4 pieces of bread/day, 4 suits/6 months, and 4 ribeyes/day.

The production though is different. The baker produces 8 pieces of bread/day, eats one of them, and sells 6 of them, with one remaining daily.

The butcher produces 8 rib-eyes/day and also sells 6 of them, keeping one for himself and leaving one out.

The tailor produces 8 suits every 6 months, sells 6 of them too, keeps one for himself, etc.

The amount of money that the butcher, baker, and tailor make each allows them to buy more than they need in terms of bread, rib-eye, and suits.

People are wealthy and have plenty to eat and dress, they can pay their taxes, and the politician is also quite well-off.

Since there is a surplus in production, the baker, butcher, and tailor decide to decrease their prices to sell the remaining piece of bread, rib-eye, and suit.

They now sell more, while making the same amount of money, which allows everyone to have even more bread, rib-eyes, and suits than before.

100% of what is produced is consumed (understand: bought). People live in abundance, they now have too much bread, rib-eyes, and suits that they have to throw away.

Life is good.

This story illustrates the differences in terms of productivity which matters greatly to understand poverty.

Indeed, poverty does not come from a lack of money, as often outlined.

It comes from insufficient production of output.

Money Is Unlimited

Money is unlimited because it is printed out of thin air. Goods and services aren’t.

What money can buy represents the total amount of value that is produced in society.

The first village is poor because its inhabitants don’t produce enough so that everyone has enough to live comfortably.

3 pieces of bread, rib-eyes, and suits are not enough, and people fight over the resources that are scarce and hence very expensive.

In the second village, everyone produces too much, which allows everyone to have, well…too much.

As such, the wealth of a society is equal to the sum of the production of each agent within society.

If no one produces anything, everyone will have…nothing.

If everyone produces too much, everyone will have too much.

Money, in this story, is an enabler of value production by giving people incentives to produce so that they can consume too. 

If the tailor doesn’t eat bread and rib-eye, he won’t have enough strength to make suits and the baker, butcher, and politician will die because of the cold.

If both the baker and butcher produce enough food, the tailor will be able to make a lot of suits for them.

The amount of money within society doesn’t change the abundance or scarcity of output in society. 

On top of being an enabler of productivity, money is as we said, also an allocator of resources (also called “total produced-value redistributor”, fourth characteristic) through the distribution of a salary.

The total amount of money in society must be equal to the total value of output in society as the money only allows the baker, butcher, tailor, and politician to purchase for themselves a part of what is jointly produced by everyone in society in society.

Should you have “more money” than “output”, this will lead to inflation, hence balancing the amount of money compared to the volume of output in society.

This principle is drastically important if one wishes to understand what made China rich in just 30 years.

In the 80s, China was poor because China wasn’t producing anything. After they built factories and trained workers, China became rich because they produced much more.

And while production is key, one more requirement needs to be added.

Let’s imagine the baker from our village would not sell his bread, neither the butcher his ribeyes, nor the tailor his suits: nobody would survive then, and all of them would have to become hermits.

It is therefore not only the fact that they produced a lot of output that made them rich, but that they traded this output, allowing them to produce more.

How did they trade?

By exchanging this output against money, then later on exchanging money against something else.

We recognize here the second characteristic of money as an assessor of value and as an enabler of trade, supported by produced output subsequently exchanged.

The conclusion of this part is the following: if one wishes to take people from poverty to wealth, one needs to put tools into people’s hands so that they can start producing as much as they can.

The bigger the total production is, the bigger the portion of the total production that will be allocated to each person will be (in an equal society).

Why Capitalist Societies Are Richer Than Communist Societies

This principle we just saw explains why capitalist societies are richer than communist societies.

In capitalism, people tend to maximize profits for themselves. To do so, they must produce as much as they can.

When everyone within society produces a great volume of output, everyone can enjoy this output and people are wealthy.

Communism doesn’t work this way.

Communism proposes that the production does not belong to anyone in particular, but to everyone, and promises that everyone will enjoy the production of everyone.

Since individuals count on “everyone” to produce, they are not as encouraged to maximize their own productivity as they would in a capitalist society.

Indeed, they won’t see the fruits of their labor since what they will produce will go to someone else.

As such, production in communist societies does not reach maximum output.

In fact, it barely reaches the minimum. Sometimes, the production reaches even less than the minimum required, and people go hungry and die.

That’s what happened in China in the 1950s.

The food production was really low, a problem that no amount of money could fix.

The Bottom Line

Money has four roles within society.

When a society is constituted by several agents and when these agents produce output and cooperate (exchange), money intervenes as an assessor of value to estimate the worth of goods, value itself as money is exchanged directly against the good and as a facilitator of trade (productivity) by allowing people to choose what to exchange their production against.

These give agents within society incentives to produce more to maximize their own wealth.

This increase of production increases the total wealth produced within society which thanks to money, can be redistributed through salaries, highlighting the role of money as a redistributor of the total produced output (allocator of resources).

The money people make is equal to the total value they add to society.

The money people earn is equal to the amount of total produced output they are allowed to consume.

A wealthy society is a society where people produce on average at least as much as they want to consume. 

To increase one’s income, one should increase the value one provides without being bonded to an agreement exchanging time for money, as time is not scalable and can’t increase productivity.

This spurs a new question: do employee contracts based on time spent at work hurt total output production? 

Photo credits: Photo by Micheile Henderson on Unsplash