The purpose of money is to store our economic value (time, efforts, resources, etc.) Without money, a carpenter would have to find a chicken farmer that needed a new table if he or she ever wanted eggs. Because of monetary systems, the carpenter can produce a table, sell it to anyone, and use the money over time to buy groceries from various sources. Money greatly increase the efficiency of an economy.
Money comes in various forms. Commodity currency is money that has value in of itself. Salt has been used in Eastern Africa, tea bricks in Central Asia, Parmigiano cheese in Italy, cocoa bean in Central America, and pemmican in North America. Cattle, knives, and even potato mashers have been used as well. The most obvious example of commodity money is precious metal.
A lump of gold has substantial value no matter where or when you live. It is easily worked, carries a current, and is stunningly beautiful. To further ease transactions, the metal to be used as currency is often minted into coins or bars that are recognizable, standard in size, hard to counterfeit, and noticeable if shaved or clipped. This allows it to be exchanged without a scale and without fear of purity issues. The advantage of commodity currency is it will always be worth something. The disadvantage is that it is less portable and cannot be transported digitally.
Another type of money is representative currency. This is a certificate that can be redeemed for a commodity (something of value). Effectively, the object stays in place, but the title of ownership changes hands. The United States operated under this form of currency for nearly a hundred years. The United States’ paper money used to be exchangeable for actual silver at the Federal Reserve. An advantage to this method is the commodity doesn’t have to be continually packed by the owner and it doesn’t get worn or abused. A disadvantage is it masks the commodity and puts it in someone else’s control. If there is doubt that the certificate can be redeemed, the purchasing power of the certificate will plummet.
The final type of currency is what almost everyone carries today, fiat currency. This is currency that only has value because someone says it does. It is monopoly money when playing a game, tokens when at an arcade, stickers when paying the postage, fancy green paper with historical figures when paying in cash, and a blip on a computer screen when ordering online. In their own domain, they are each valid currency. If I were to pull out a checkbook while playing Monopoly, it would ruin the game and if I were to use Monopoly money at the grocery store, I wouldn’t have any eggs for dinner. If the rules within the domain are unchanging and fully backed, the system works. I’ve never had a hyperinflation problem while playing Monopoly, because I’ve never designated an official “game rule maker” who announced midgame that prices would double with each dice roll. The problem with the real world is there are “game rule makers”: the US government, the US Federal Reserve, and other law makers or currency regulators throughout the world. They constantly play with currency supply, interest rates, commodity prices, taxes, tariffs, and treaties to meet their objectives.
The US dollar is even one step more convoluted. They are not owned by the US government, but by the Federal Reserve System. When a dollar is printed, it is bought by the government and added to the government debt. That debt is then bought by other countries and investors in the form of US Government Debt Securities and will eventually need to be paid back with interest.
In 1944, 44 delegates from 44 Allied nations gathered together in New Hampshire to discus global finances in the WWII aftermath. At the time of the conference (Bretton Woods Conference), the United States was the leading exporter and creditor and the dollar was exchangeable for a fixed quantity of gold (representative currency). Because of the United States’ strong currency, the delegates selected it to be the international reserve currency. As the reserve currency, other nations would have to first trade their money for dollars before exchanging with other countries.
Imagine if you were a table manufacturer. To give you some economic buffer, you could produce and hold on to extra tables to keep you in business if you for some reason must pause production. You are protected if you hold on to cash. Then you have readily available assets to fix your factory and can get the factory into production sooner. It also creates a buffer from competition. If a high production table factory moves in and takes away your economic advantage, you have some reserves to buy time and equipment to adjust your niche and survive.
The same principles occur on a global scale with US dollars. Countries horde it for protection. They don’t want to have to scramble for dollars when needed. This hording creates an extra demand for dollars and gives the United States a huge advantage in power and prosperity. As the only legal producer of the US dollar, we also get a discount on transactions by avoiding exchanges. Much of the prosperity we experience today is directly dependent on reserve currency status.
In 1771, the United States released a series of economic measures known as the Nixon Shock. It was in these monetary policies that the US dollar lost its representative currency status and fell to a true fiat currency. This should have plummeted the value, but other countries weren’t willing to declare their holdings worthless.
Knowing the dollar had to be backed by something, even if indirectly, in 1973 the United States made a brilliant deal to protect Saudi Arabian oil fields (specifically from Israel) if they only sell oil in US dollars and place their excess profits in US government debt securities. By 1975, this deal was expanded to all OPEC nations, thus creating the US dollar into the petrodollar. These deals forced other nations to buy US goods to obtain US dollars despite the physical worthlessness of the paper money. The deals also gave artificial demand to US government debt securities, lowering the interest rates significantly. Basically, the US is able to print money to buy oil, then have the oil producers buy the debt used to print the money! It is this circular system that allows the US to print as much money as it wants. That is, until the system eventually backfires.
Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast. Anything I recommend should be personally analyzed and discussed with your financial adviser.