If any of the following confuses you, please read, or re-read, Private Enterprise Money until the following makes sense to you.
Early in the story, I Want The Earth Plus 5%, we find the following paragraph:
"The gold which I fashion into ornaments and jewelry is an excellent metal. It does not tarnish or rust, and will last a long time. I will make some gold into coins and we shall call each coin a dollar." He explained how values would work, and that "money" would be really a medium for exchange - a much better system than bartering.
Money is, or should be, an abstract accounting concept that represents a claim on the general wealth of the trading community. In other words, the traders in the community have each agreed to exchange their goods, products, and services for money. Which items are to be so exchanged and in exchange for how much money is determined during each trade negotiation and is the essence of the free market. Money does not necessarily represent a claim on any particular item of wealth but rather represents a claim on a portion of the total wealth in the trading community. It should be noted that currency is validatable evidence of your ownership of a certain amount of money but is not itself money. Money should also not have any intrinsic value (or at least a miniscule value not related to the amount of money evidenced).
In our story, gold is already being used to fashion ornaments and jewelry so gold apparently already has intrinsic value. If we now attempt to use gold as money, or as evidence of money, we have created a problem. We now have a single object, the gold coin, which is gold, and thus has intrinsic value, and is also evidence of money so the gold coin is now essentially a claim on itself. As an example of the problem, imagine that you want to buy some gold coins. You ask the coin dealer how much he is charging for a one-dollar gold coin and the obvious answer is "a one-dollar gold coin". Why would anyone want to make such an exchange since after the exchange each trader still has the same thing, a one-dollar gold coin. Perhaps the coin dealer wants to charge one-dollar and fifty-cents for a one-dollar gold coin. Why would anyone want to make this exchange? So it appears that if we use gold coins as money, then no one will be able to buy gold coins. What's the problem here, anyway?
The problem is that we are attempting to make a single object serve two functions, i.e., an object of intrinsic value (or wealth) and a claim on that self-same object. This cannot be done in a logical manner since it leads to the conumdrum described above. An object cannot be both the item and the claim on the item. Therefore, if currency is to represent the abstract accounting concept of money, it must be intrinsically worth much much less than the amount of money it represents.Gold coins cannot fulfill this function since they have significant intrinsic value.
But gold has been successfully used as a medium of exchange for thousands of years. How can we say that gold cannot be money? When you use gold as "money", you are actually completing a barter with the other trader. You and the trader have agreed that the gold is worth the same as the object being traded for. When you give the trader your gold and the trader gives you the object being traded for, you have completed a barter transaction. Everyone is satisfied and nothing remains to be done. The transaction is complete. Money is a claim on wealth and no one has a claim on either item of wealth since both items are now in the physical possession of their respective owners. Since no one ended up with any additional claim on wealth, no money was created by the transaction. (Keep in mind that there is a difference between a medium of exchange, which can be any item of value, and money, which is an abstract accounting concept.)
If, in the exchange above, you happen to have with you some currency notes, i.e., evidence of money, then you could have offered the trader the currency instead of a gold coin. If the trader had accepted your offer, then you would have completed a money transaction but the exchange of value has not yet been completed. You now have possession of the item of value that the trader exchanged the currency for but the trader only has evidence of money (currency) and, worse, has less wealth in his possession than he had before. What can the trader do with the currency? He cannot eat it. He cannot use if for clothing. The only thing the trader can do with the currency is exchange it for other items of value. In order for the exchange of value to be completed, the trader has to exchange his currency, evidence of money, for something else of value, probably for several different items with several different traders, all of whom are part of the trading community and have agreed to honor, or back, the money by exchanging items of value for the currency. This process is called a split barter transaction and is the only way that real money can be created. A money system implementing this concept is usually called a Mutual Credit System.
As an interesting side note, Federal Reserve Notes (FRNs) actually fulfill some of the requirements of currency. They have very little intrinsic value, most traders in the US community will exchange wealth for the FRNs, and they are evidence of a claim on a portion of the total wealth of the trading community. The only problem with FRNs as currency is that they are issued incorrectly. (This is discussed as part of another mistake.)
So the first mistake the people in the story made was agreeing to use gold coins as money.
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