This post is intended as an add-on to the earlier post on money.

I wrote earlier that anything could be used as money so long as people generally accepted it as payment for goods and services. What I didn’t answer before is why some objects (such as gold and silver) have been used for centuries by many civilizations as money while others (such as leaves) have not. This is the question with which I will concern myself today.

There are three qualities which make a substance useful as money: value, fungibility, and liquidity.

[Value]

For something to be accepted as money, it must obviously be of some value to people, for money is a representation of wealth. This is why dog excrement has never been used as currency by any recorded civilization in human history. Value entails relative scarcity — this is why precious metals were used as money: in addition to being coveted by people for their physical beauty, they were sufficiently rare in supply that their value would remain stable over time. This ensures that they act as a good store of value over time and that they make for a good unit of account. Gold and silver are impossible to mass produce, unlike, say, Oreos, which would quickly lose value if used as money.

For fiat money — like paper money we use today — the government must be careful to maintain the currency’s value by cracking down on counterfeiters and by not engaging in government-sponsored counterfeiting (i.e, printing money).  The mass production of any type of money, fiat or commodity, causes rampant inflation which destroys the value of money.

This is why inflation is sometimes called the worst type of taxation; it is essentially a tax on information, a tax which destroys peoples’ ability to tell how much real wealth they have and how much goods and services really cost.

[Fungibility]

Fungibility is the second main criterion for a substance to be useful as money.

Fungibility: The quality of having interchangeable units.

Examples of fungible goods are corn, gold, and crude oil. A bushel of number 2 corn is the same as any other bushel of the same grade of corn; this is why farmers are able to deposit their grain into grain elevators without worrying about whether the individual pieces of corn or wheat that they put in are the same as the ones that are withdrawn at a later time. Similarly, a barrel of crude oil is the same as any other barrel of crude oil and ingots of 24 karat gold are interchangeable.

Why is fungibility important for money? Suppose that horses or diamonds are used as money in a certain economy. Clearly, both are very valuable, but they are not fungible because one horse or diamond does not have the same value as any other horse or diamond.

Each horse has its own individual draft power and endurance and each diamond has its own luster and size, among other characteristics. In trading, the buyer and seller must spend precious time and energy in bartering over how much each horse or diamond is “really worth”. This time represents an unnecessary transaction cost that could be eliminated by using fungible money.

Fungibility goes hand in hand with divisibility. Units of fungible goods can easily be divided into smaller units or combined into larger units without losing or gaining a disproportionate amount of value. For instance, two bushels of grain are worth twice as much as one bushel, and an ingot of gold can be split in half by a goldsmith to produce two pieces of gold, each of which is half as valuable as the original. By contrast, splitting a finished diamond in two or smashing two diamonds together would utterly destroy the diamonds’ value. Horses aren’t that divisible, either.

[Liquidity]

Liquidity (or more specifically, market liquidity as distinguished from accounting liquidity) is the final trait that any substance which is useful as money should possess.

Market liquidity: How easily and quickly an asset can be sold without losing value.

Cash is the most liquid asset in existence because its exchange does not affect its value at all. By contrast, houses and cars are very illiquid assets. When a car or house is first sold, for instance, it cannot be immediately resold except at a much, much lower price.

This is because the act of putting a car or house up for sale sends a clear message about its value: it tells other people that the asset in question is worth so little that the original buyer did not want to keep it for very long. That’s why used cars are much, much cheaper than new cars, even if the used car has few miles on it.

Because of this, cars and houses cannot be turned over and used as payment in the short run. In the long run, though, they may offer a stable store of wealth provided that there are no major upheavals in the housing and car markets.

[Conclusion]

I lied. Well, I kind of only told half the truth. Yes, anything could, I suppose, be used as money, but in practice, only liquid, fungible, and valuable objects are ever accepted as money in any economy.

I will advise my enemies to savor this moment, for from here on out, I solemnly swear to tell the truth, the whole truth, and nothing but the truth, so help me Adam Smith.