Many people think of money as a creation of government, a system of managed value and legal tender for debts. An attempt to understand money by reading financial news will only serve to reinforce this view, portraying the idea of money as a lot of high-level decisions made by great planners, with a host of loathesome statistics to keep it out of the reach of the average person.

It is not difficult to understand money. In fact, it’s quite simple. Money is a good, just like cars, bread, and horses. Money is a creation of the free market, arising from the actions of individuals engaging in trade. Absent money, all trade is reduced to barter. If I am a shoe maker, certainly I do not wish to keep all of the shoes to myself; I have an interest in trading them for other things I need, like butter. If you are a farmer who produces butter, we may have an interest in trading with one another and we may arrive at a suitable trade agreement, say, one pair of shoes for five pounds of butter. But what if you have no need for a pair of shoes when I find myself in need of butter? Perhaps you are interested in trading your butter for a lantern. I may now seek out a lantern maker to see if he’s interested in a pair of shoes, and if I can complete a trade, I now possess a lantern that I may use to acquire butter.

It is clear that a barter system makes trade difficult compared to our modern experience with money. If you want a lantern, a pound of butter, or a pair of shoes you can easily find a seller and purchase the item with dollars. But how did the concept of money come about?

It is feasible to imagine that in one community, butter itself was recognized as money. People would hold butter not only for consumption, but as a medium of exchange that they know will be accepted by most other traders in their community. This allows them to sell their goods on the market in exchange for butter, and to then use that butter to buy whatever they needed for themselves. Butter still holds its value for cooking and other household uses, but it would also have a new value as a facilitator of trade.

If this example seems a bit of a stretch, it can be explained by noting that we’re not all on the “butter standard” today – over the centuries the market found the best solution, with gold emerging as the preferred medium of exchange, hence the term “gold standard.”

There are several key factors that make a commodity desirable as money:

Divisibility – It should be easy to trade in varying quantities. Both butter and gold meet this requirement. On a smaller scale, I may trade an ounce of gold or a pat of butter. On a larger scale, I may trade a gold nugget, or a wheelbarrow load of butter. But as the scale grows larger, we see value in…

Portability – It should have a relatively high value in proportion to its mass. Here, butter fails the test. Imagine trying to buy a car with butter; how much would it take, and how are you going to transport it to the car dealer? At today’s rate, you could buy a decent car with 20 ounces of gold.

Scarcity – If butter were money, anyone who became a dairy farmer could produce their own supply of wealth. Gold, on the other hand, is relatively scarce. Few of us have the means or desire to take up gold mining to amass our fortunes.

Durability – Butter doesn’t keep forever, so it would not be in your best interest to put 100 lbs of it under your bed as retirement savings. And if it’s too warm outside when you go to make a trade, it’ll melt in your pocket. Gold is very durable and highly resistant to corrosion.

Uniformity – It must be clear that one unit of money is similar to another. In the case of butter, it may vary in quality and ingredients to a large degree. Gold, especially when minted into coin or bullion stamped and assured of purity, meets this test.

Lastly, a commodity used as money must have some inherent value of its own, even if it were not money. Butter, of course, has value as food. Gold, on the other hand, is prized for its ornamental value in jewelry, as well as a conductor in electronics.

Butter did, in fact, serve as a medium of exchange in the barter system of Norway during World War II. However, reviewing the criteria for good money, we see that it falls short in the areas of portability, durability, scarcity, and uniformity. Try a few examples for yourself – pick any commodity, perhaps one that you remember has served as money in history, such as wampum shells. As you go through the list, you’ll find a test that it doesn’t satisfy as well as gold.

So why has the concept of money become so complicated and difficult to understand? Because throughout history, governments have sought to seize control of money from the marketplace, manipulating its value and monopolizing its production to finance government’s growth and war making power.

Next entry:Fiat Money