Recently, I explained how bankers create value by reducing transaction costs. In this article, Id like to explore how money itself reduces transaction costs. I wont get into the law and economics of money or the history of money per se; rather, Im going to explain how money makes the world go round by making it easier for people to exchange by reducing the transaction costs of triangulation, transfer, and trust.
Pretty much every economics textbook explains how money has four functions. It is first and foremost a medium of exchange, and it ultimately derives all of its other functions from its usefulness as a medium of exchange.
Barter, the exchange of goods for goods, is possible but difficult. You have to find people who want what you have and have what you want. Money reduces the transaction costs that would otherwise make it impossible for an apple grower to buy oranges from an orange grower who doesnt like apples. This is called the problem of the double coincidence of wants (or sometimes the mutual coincidence of wants), which economist Antony Davies explains in this video from LearnLiberty:
If you like oranges and none of the orange growers like apples, youre out of luck. The same is true if youre a cattle rancher and everyone who grows the wheat you want is a vegan. Triangulation, which is the cost of finding and coming to terms with trading partners, is very costly in a world without money, but life is a lot easier for the rancher if he can sell beef for money and then use that money to buy wheat from farmers. The widespread use of money makes it a lot easier for people to cooperate with others who do not share their preferences, beliefs, or moral commitments.
Money is also a unit of account that allows us to compare apples and oranges by measuring their value in terms of money. It makes complex economic calculation possible by providing a common index emerging from all transactions and telling entrepreneurs (through profits and losses) whether they are increasing or decreasing gains from trade in the markets they serve.
Moreover, the price of a good or service at any point in time measures everyone elses best estimate of the value of the best way the good or service could be used. If the asking price of a haircut is $40, for example, it tells me as a customer that a stylist expects to be able to get $40 from his next customer (and, therefore, would expect to incur a loss relative to this alternative by cutting my hair for $30).
Moneys usefulness as a medium of exchange also makes it useful as a store of value. Simply put, its a lot easier to store wealth in the form of money than it is to store it in other forms. If youve ever watched a TV show about extreme couponing, youve seen how people have hoards of paper towels and toothpaste and the like. Its interesting, and some people seem to enjoy it, but hoarding is a bulky way to store wealth that could be stored as more-easily-converted money.
Moreover, when we talk about something being a store of value, we have to keep in mind that value is subjective. Some people might not want that particular brand of toothpaste. Others may not need any more paper towels at current prices. They are more willing to accept money because it is easier to turn money into virtually anything else via exchange.
Finally, money is a standard of deferred payment. Its rare for people to want money as such. Theres simply not much you can do with it. Commodity money like gold and silver might have uses other than as money, but this is not the case with bank deposits, token coins, and currency. People accept money as a pledge.
The buyer might not be able to give the seller a specific good or service that the seller values. She can, however, give the seller money as a kind of IOU that implicitly says Whoever offers this back to me will get what I have to offer.
Money is not mysterious or mystical. Contrary to what a lot of people think, it embodies cooperation rather than exploitation. Specifically, it greases the wheels of commerce and makes it easier for people who might disagree fundamentally on important moral, religious, and social issues to cooperate to mutual advantage.