Capital
It all begins with an idea.
What is Capital?
Capital is resources, assets, or wealth used to create value
In a free market system, that is, a system where everyone is free to do as they wish with their own property, each individual market participant is constantly deciding how to allocate their capital. Should spent your savings on car, or a down payment for a house, or should you buy stocks and bonds? Should a company spend its capital on a new factory or on research?
Here are some examples of capital allocation decisions:
a retail investor buying stock in a retirement account
a small business buying more inventory
a company building a new factory
a large corporation merging with another corporation
In these examples, a person or entity is deploying resources with the goal of generating more resources than they had before.
Money
It all begins with an idea.
There’s often a misconception that money is synonymous with wealth or capital, but let’s think about what it really is.
A medium of exchange: the primary function of money
The primary function of money is being a medium of exchange. If you sell books and I sell hats, I may need a book, but you may not need or want a new hat. By introducing a medium of exchange (money), I can sell my hat to someone that wants it, receive money, then and buy your book with that money. A system using money allows for specialization and division of labor. I can be skilled at making furniture and spend all my time doing that. I don’t have to worry about also growing food or hunting. I can sell my furniture and use proceeds to buy all the things I need such as food, materials for shelter, and more.
Store of value and unit of account: secondary functions of money
In addition to acting as a medium of exchange, money has other important functions.
As a store of value. I may be a very successful furniture maker, and everyone in my city may want my furniture. This is great news, but I cannot trade all my furniture for all the food in the city in one transaction - a surplus of food would spoil eventually and be a waste. Using money, I can sell all my furniture now and instead of direct exchange, I can receive money and store that value for later, buying food and other things as I need them in the future.
As a unit of account. Some of my furniture pieces are very large and considered very valuable. It may not make sense to exchange it directly for one unit of wheat. I have to figure out how much wheat I can get for my furniture. I also want to buy tools and shoes and textiles. I then have to figure out how much of each resource I can get for my furniture as well. Adding additional complexity, technological advancement means new things are being developed, which means I have to figure out their value. And the old things I still need like shoes and textiles are becoming cheaper over time as it becomes easier to make them. It is impossible to keep track of how many different things I can get for my furniture in an ever changing world. That is why money acts as a unit of account. I do not have to think about my furniture in terms of grain and shoes and other things, I can convert my furniture to a standard unit of account and see the value assigned to other resources when they are converted to a unit of account. Doing this, I can quickly see that my valuable piece of furniture may be worth the value of several different resources - I can see that I can obtain shoes, and textiles, and food, all for one piece of my craftsmanship.
Intrinsic value
Intrinsic value means that something has value “on its own” or “in itself”. If our money is made of metal coins, the metal has value on its own apart from being money. Depending on metal, it could be used as jewelry, in engineering, for weapons and tools, and more. This is what is meant when we say that a gold, silver, or copper coin has intrinsic value. Pre-modern societies often sought currency that had intrinsic value in large part due to the lack of societal stability. If a king issued gold coins, but the king’s reign ended, citizens and merchants would still have their pieces of gold which were seen as valuable.
Today, in countries like the US, our money has no intrinsic value, as it is simply a light piece of paper. Do not be confused, it still has immense value, but it is not intrinsic to the value of the paper it is printed on. Its value is not because of the paper - its value exists because everyone in society has agreed that it is the standard unit of exchange. It is known as fiat currency, as opposed to gold which is a commodity currency
Types of currencies
The most popular types of currencies throughout history are commodity, representative, and fiat
A commodity currency is one that has intrinsic value. Most commonly you might think of gold or silver coins. People value gold as a metal on its own, therefore it has intrinsic value. In some cultures we’ve observed things like grain being used as a currency.
A fiat currency is one that has no intrinsic value. Fiat means “by decree”. The US dollar is a fiat currency as its value derives from the notion that it has been decreed by the US government that this is the unit of trade, and we’ve all agreed to use it as such
A representative currency is a bit in between the other two types. A note, like a dollar bill, is backed by something with intrinsic value, usually a precious metal like gold or silver. This was the type of currency the US had until 1971. Prior to 1971, the US dollar was a “gold backed” currency. The dollar had the official backing of all the gold reserves of the US government, and you could even hand in your dollars and demand gold pieces from the government. In 1971 the US converted to a fiat currency, meaning dollars cannot be exchanged directly to the government for gold, and the dollar is no longer officially back by gold holdings of the government. Its only backing is the decree (“fiat”) that all debts public and private may be settled by the dollar.
A brief history of the emergence of money
Before the popularization of money, trading was more difficult. If I’m a farmer in ancient times, and you made tools, it would make sense for me to trade some of my food for new tools, and vice versa. How much grain should I part with, in order to obtain some of your tools, which would make my job easier and allow me to produce more gain? Likewise, you need food to survive, and I have plenty of it, so how much food should you demand in order to part with your high quality craftsmanship? There is no correct answer, and trade before money required every transaction to find agreement like this, which takes time and risks significant uncertainty.
We have evidence of tribes in ancient Mesopotamia establishing relatively robust trade, given the time period, as far back as 6000-5000 BC. These peoples produced things like ceramics, glass, grain, leather, fish, palm oil, reed baskets, and textiles. And they traded them to other peoples for things like copper, stones, and ivory from the Indus Valley; for precious metals like gold and silver from Egypt and Asia Minor; for wood from the Levant, and more. Figuring out how much palm oil to trade for ivory was a difficult endeavor, and any trader would want to ensure that they got a fair deal. Sometimes they were compared to units of precious metals or traded for metals outright, sometimes resources were bartered directly for each other. Even using metals at this time was difficult because of doubts about true weight, purity, and other potential imperfections at stake.
Though we have evidence of exchange for money-like things such as shells and feathers as far back as recorded history, the emergence of money at a civilization-level is often traced back to around 1000 BC in ancient China, where we believe metal coins first took hold to represent value. Prior to this, ancient China had a long history of using shells as a type of currency. Shortly thereafter in roughly 700-600 BC is the emergence of the first standard coinage in the ancient city of Lydia in present-day Turkey. The Lydians began stamping metal coins which became an assurance of the metals contents, weight, and purity. With this innovative standardization of money, transactions could happen more efficiently than ever, as people could quickly and confidently assign a value to their resources and make decisions accordingly. Money continued to evolve throughout history, but this is a good frame of reference for its invention and emergence.
The Lydian Stater, sometime around 600 BC