What Is Money, How It Works, and Why We Need It

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

In this article, we take a look at the nature of money, where it came from, how it works, why some people have it, and why others don’t.

Table of Content


What Is Money, How It Works, and Why We Need It

Pre-Origin Times

I like to think that the need for money is associated with the need for law.

Both of these human-made concepts appear once a society with only one person (uni-individual society) evolves into a society with several people.

Let’s take an example.

Imagine a hermit on an island. The hermit lives alone.

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

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 done to extract 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 authoritarianism because there is no one to confiscate freedom. By the same token, the inherent condition of our hermit is freedom, because there is no one to take it away from him.

There is no poverty because the hermit can’t afford to be poor. Poverty would mean death, as there is no one to save the hermit.

The hermit “lives”, and is accountable to himself for his own survival.

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 control 100% of what can be controlled.

This notion is important. It underlines how the massive system we created called “society” is a consequence of interactions between individuals.

If as little as one person joins our hermit, the whole society changes.


The Hermit Is No Longer…a Hermit

The addition of one person to the hermit’s island changes everything.

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 a new individual adds elements of randomness to society. The new person cannot be entirely controlled like a pet could, for example.

What was formerly under the direct control of the hermit (how he decorates his house) isn’t anymore. He has to share control with that new person.

In order to get along, these two will have to agree on some rules: the Law.


The Emergence of the “Law”

L’enfer, c’est les autres.

Now that the hermit is no longer alone, he can interact with someone else.

Since the hermit and the new individual are two different people, and that the possibilities of environmental control are limitless, they will first have to create an agreement on the ownership and percentage of control of the controllable variables.

What does that mean? It means we need a code of conduct to say who does what and how.

That’s basically the definition of the “law”.

Humans, when alone, exercise 100% of 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 as the new person adds elements of uncontrolled randomness into the environment and possibilities of control of that which was previously controlled by the initial individual.

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.

Whatever the hermit lost in control, he gained in productivity thanks to the appearance of a new principle: cooperation.

In the beginning, the hermit controls 100% of his island, dog, and house. Now that someone else arrives, he has to share the control with that person.


Cooperation

While “other people” decrease the amount of control you have over your life, they also give you the chance to cooperate.

When you do, you achieve work bigger than the sum of its part, a concept absent in the uni-individual society.

As a result, the share of control you give up on the island is 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 was impossible to be picked up, can now be picked up.

While the number of people on the island has been multiplied by two, the productive output has been multiplied by three.

While the hermit alone could only harvest one coconut per minute, two people can harvest three coconuts per minute.

As my dad used to say, “working in duo triples the output for equivalent time and efforts”.

He wasn’t wrong.

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

Let’s do some math:

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

2 people produce 3 units 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 keep in mind that while the hermit now produces more coconuts, he will also have to share them with the new person. However, they will both have more coconuts than when the hermit was alone.

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

Mathematically, yes. He gained more coconuts.

He is now more productive and can enjoy more wealth than before, provided the loss of control on his environment is estimated to “be worth less” than the new volume of coconuts he has. .

Will a newly added person always multiply the total produced coconuts by 300%?

Hell no.

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

However, more people will mean more coconuts, and more coconuts per person (output/person), until you reach the efficient societal size (roughly 150 people), where one added person would decrease the volume of coconut per person.

This relation is expressed as follow.

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 subsequently 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 fewer 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: cleaning, cooking, walking the dog.

Now that one person joined him, they got into an agreement that makes them both more productive.

The hermit now fishes for two while his wife gardens.

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 fish for two, and his wife won’t only eat the apples and pears from the garden.

The hermit will exchange fish for pears, and his wife 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.

In this case, the two people can’t barter.

This is where money gets into play.

What if they had 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 else?

In this way, if B had something that A didn’t want, this neutral value could be exchanged instead. This way, 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. It also embodies that value since it is exchanged against the good.

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). 

-> 5 euros is as valuable as 5 euros, and can be exchanged against anything worth 5 euros.


The Third Function of 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 anything else, which is the main reason for its attractiveness → money is an enabler (“simplificator”) of trade (third characteristic). 

As we explained above, money does not only represent value, but it is also a way for people to trade and produce a good or service for others.

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 be sold for much (unless it’s an NFT ;)).

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.

I make almost no money because I provide almost no value.

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

And avoiding traps.


Money 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 is in this case, the 100 pieces of bread you must produce during the day.

Whether you take 1 or 10 hours to make the bread is 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 hand, 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.

Unfortunately, most employee contracts don’t work this way. Employees get hired to work a certain amount of hours, not to deliver a certain amount of value.

Let’s take an example.

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.

-> 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.

A salary cannot be scaled.

To recap, the first trap, when it comes to money, consists of selling your time against money. This contract is a bad deal as it prevents you from scaling your work and multiplying the volume of your income.


Second Trap: The Salary Trap 

We outlined above how getting a job prevented you from growing your salary. Getting a job is a trap. We will now go further by looking at how unfair salaries are.

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

Reading the book Start from Zero (cringe book, don’t read it), I discovered that employees make between 3 to 5 times what they are paid.

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

It’s not.

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…almost nothing.

As such, my friend’s net 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 type of income, his net 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 €9500 per month.

Does my friend receive €9500 on his account?

No.

He gets 1900€. This amount of money corresponds to the value that my friend is allowed to consume per month.

To put it simply, my friend produced 5 apples, but he can only eat 1.

Is it fair?

No.

In a fair society, productive agents should be able to consume an equal sum of what they produce. Practically though, this is never the case for employees.

Their company pays them less than what they are worth in order to make a profit.

When you are an employee, it is your company that decides the amount of value you are allowed to consume because they decide your salary.

A salary is an arbitrary measurement of the total volume of goods and services created by society that one is allowed to consume.

We’ll come back to that.

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 in the form of a salary or/and other streams of income, and its total amount depends (in)directly on 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).

To consume a lot, you should produce a lot.

The more everyone produces, the more everyone will consume.


The Wealth of Nations

Let’s imagine a village of 4 people: 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 to 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 printed more money and gave it to people thinking it would arrange things, but the bread got more expensive instantly: there 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 of things.

The supply of goods is low, and the demand is high, making prices high.

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

It’s a dilemma he doesn’t know how to solve.

A bit further down the road stands the same village with the same people: a politician, a baker, a butcher, and a tailor.

The needs of the village are similar: 4 pieces of bread/day, 4 suits/6 months, and 4 ribeyes/day.

Life here 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, and keeps one for himself, etc.

The amount of money that the butcher, baker, and tailor make 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 it away.

Life is good.

This story illustrates the differences in terms of productivity which matters greatly to understand poverty (and prices, hence inflation).

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

It comes from insufficient production of output.


The Fourth Function of Money

Money is unlimited because it is printed out of thin air.

Goods and services aren’t unlimited.

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, expensive.

In the second village, everyone produces too much, so, everyone has too much.

-> the wealth of a society is equal to the sum of the production of everyone in society.

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

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

Money, in this story, encourages people to produce as the more they produce, the more money they will make, the more they will be able to consume.

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

The amount of money within society is completely estranged from the production volume, and doesn’t change the abundance or scarcity of output in society. 

If people produce a lot, everyone will have a lot. If they produce little, everyone will have little.

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.

What does this mean?

The total amount of money in society must be equal or lower to the total value of output in society. There should be enough money to allow the baker, butcher, tailor, and politician to purchase for themselves a part of what is jointly produced by everyone, and no more.

If you pay people too much, they will consume more, which will increase inflation.

I think this is why salaries don’t catch up. Society has no interest in paying people too much, as this would increase consumption, and hence inflation.

A society can survive as long as it has food and electricity. If everyone starts consuming like crazy, society will collapse.

Inflation has little to do with money itself. Inflation arises when a society consumes more than it produces.This happens when we give money to people that didn’t earn it.

We also see how dangerous it is to give money to people that don’t anything.

Society survive as long as it produces at least as much as it consumes.

This is why you are not able to consume more than you produce.

In theory.

In practice, it’s not the case. Unemployed people and everyone else that doesn’t do anything live at the expanse of the few people that produce.

The reason why my friend earns €1900 and not €9500 is because a huge chunk of his money is redistributed to people that don’t do anything.

This is called solidarity, and this why most people that pay taxes don’t want to pay them.

It’s not fair.

While economics considers that inflation arises when people consume more than they produce, the case could be made that people just don’t produce enough.

The employment-to-population ratio measures the population in age of working, and that actually works.

In Belgium, it’s 50%.

Yes.

Let’s say you have 100 000 people in age of working. Well, 50% of them actually work.

Those 50% carry the entire country forward.

Why do you think taxes are so high?

There are a lot of people that don’t do anything.


Why Capitalist Societies Are Richer Than Communist Societies

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

-> capitalism encourages production and makes society rich.

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.

So, nobody works.

They have no reason to since it won’t impact their salary.

If nobody works, nothing is produced.

If nothing is produced, everybody dies of cold and hunger.

That’s what happened in China in the 1950s and in the Soviet Union in the 1930s.

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

Kharkiv, Ukraine, 1933. A female child died of hunger. Source: Holodomor.ca.

The Bottom Line

So, what is money? 

Money is energy. You earn money by making efforts, and spend money on stuff someone else spent energy on. 

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 people incentives to produce more to maximize their own wealth, hence maximizing society’s wealth.

Money is further redistributed to workers through salaries to make sure they consume less than they produced, 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 (the rest going to the pocket of their company, or government).

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: does the employee status hurt out total production?

For more articles, head to auresnotes.com.

Photo credits: Photo by Micheile Henderson on Unsplash

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  • Post category:Articles
  • Post last modified:May 2, 2022