Written in 2016. Updated early 2023 to remove references to Bitcoin as fiat money, since by about 2017, it had become obvious that, despite early intentions, Bitcoin had completely failed to become a form of money.

As I explored monetary theory, I discovered that there is a mainstream economics view, and a banker's view, and they differ. (There is also the crackpot/gold nut/conspiracist camp, but that can safely considered to be a distortion of the credible camps.) At length, I realised that different authors were using different definitions of money, and in different contexts. For example, Niall Ferguson in his excellent book The Ascent of Money talked about money as a medium of exchange, then later states that money is really a form of credit. (No criticism is intended - Niall is a brilliant writer and historian, and deep technical detail was beyond the scope of the book.)

There seemed to be an implicit assumption that all the different definitions of money are equivalent, or in some sense the differences don't matter. I now suspect that to be a dangerous assumption. I eventually figured out that the different characterizations of money can be systematically analysed in two dimensions, resulting in six distinguishable types of money. I find that the classification system clarifies the discussion very well, though I am not aware of it anywhere in economic theory. I present it forthwith.

Let us start with a definition.

Money:

Anything that can be exchanged for arbitrary goods and services.

This is a concrete, operational definition. If it can be used as money, it is money. This makes sense, because consumers contributing to aggregate spending do not know or care what type of money they are using. Economic activity is the production and exchange of goods; what the goods are exchanged for is immaterial.

Two Classes and Three Orders of Money

Two Classes Of Money

Money comes in two classes: commodity money and fiat money.

Commodity Money:

Money which is ultimately derived from a good that is inherently valuable, that is, the good is sometimes purchased to be used in its own right - not just as money.

Fiat Money:

Money which is money by decree. Some authority has defined something to be exchangeable for goods and services. The thing is not inherently valuable, nor purchased for direct use.

Examples of commodity money in use include cigarettes (and other drugs) in prisons, and cattle in Africa. It could be argued that money in the modern world ultimately derives from houses, but we shall explore that in another essay.

Fiat is Latin for 'by decree', which implies some authority to issue the decree that defines something as a unit of currency. Now, in principle, authority need not be formal and centralized; it is at least hypothetically possible that a social convention may arise that some particular thing with no inherent value can be traded for goods. Bitcoin is a recent example of an attempt at creating a decentralised fiat currency. However, by about 2017, it had become obvious that Bitcoin was in no sense money, merely an instrument for speculation. The crypto-collapse of 2022 rammed home the complete failure of the project as a currency.

In lay discussions of money (especially those of a psycho-ceramic nature), gold is usually contrasted with fiat money. The claim is that only gold is real money, while money in the bank, or bank notes, are just 'funny' money. In fact, gold is largely fiat money! The industrial demand for gold is only a fraction of total demand. In ancient Incan culture, gold was not used as money, and was not considered particularly scarce. The modern obsession with gold as money actually traces back to Ancient Rome, where Caesars had pictures of themselves engraved onto noble metal coins, and decreed that these coins could be used as payment.

Three Orders of Money

Given an underlying 'base' unit of money - whether a commodity or a fiat money - there are (at least) three orders of possesion of the money.

Zeroth Order Money

This is the base money unit itself, either the bag of rice or the bitcoin.

First Order Money

Money which is a direct claim on the base money. First order money is exchangeable on demand for zeroth order money.

Second Order Money

Money which is a future claim on the base money. Second order money is not always immediately exchangeable for zeroth (or first) order money.

To illustrate the orders, let us imagine a pre-industrial economy that is based largely in agriculture, for example Feudal Japan. Rice is the staple diet, so every body needs rice. Furthermore, rice is very durable, if stored carefully, and is easily divisible, right down to a single grain. Hence rice would usually be accepted in exchange for other goods and services. So in this society, rice is an ideal base money. (Obviously it is a commodity money.)

But lugging bags of rice to the market place is inconvenient. Now suppose the local warlord (this is Feudal Japan) is an amateur philosopher who appreciates the power of commerce as well as the power of the sword. He builds a warehouse that is warm and dry, and kept free of rats and thieves. Farmers store their sacks of rice in the warehouse, giving a few percent of their rice every year as payment. The warehouse officials weigh the rice carefully, and keep accurate records of everything. And here's the important bit: they issue receipts for rice deposited in the warehouse.

Farmers now wander to the market place not lugging sacks of rice, but instead with elegantly-calligraphed rice receipts tucked in their pockets. When they wish to buy something, they produce the receipts and offer them as payment. Sellers know that the rice is sitting safely in a guarded warehouse, so they accept the receipts as being virtually as good as the rice itself. In fact, since keeping the rice safe and dry is already taken care of, they may find the receipts preferable to the real thing. After the farmer takes away his goods happily, the seller is left with the rice receipts. He knows he can trade them for whatever he wants in the market, because all the other traders will make the same judgements of trust and convenience that he has, and will accept them as payment. Thus, paper money is born.

This warehouse receipt paper money is first order money. The receipts can be taken to the warehouse, and the warehouse officials will redeem them for the specified weight of rice. The claim on the base money is direct. Notwithstanding the opening hours of the warehouse, the paper money is exchangeable on demand with a commodity.

Now consider the situation where somebody needs a large quantity of rice that they don't have. Suppose the warlord wants to build a fort quickly, and needs to feed and pay his workers and soldiers. His own rice paddies are ample, but harvest is a few months away, and he doesn't want to wait, so he decides to borrow the rice. A diligent and parsimonious farmer has enough spare rice to lend, so a deal is struck. The farmer delivers 25 sacks of rice to the warlord, and in the presence of a shaven-headed Shinto priest, they sign a contract wherein the warlord promises to repay 30 sacks of rice to the farmer at the end of harvest time.

All good so far. The farmer trusts the warlord will have enough rice to repay the debt, and the good character to do so. The warlord gets on with his construction project, and the farmer enjoys contemplating his future small increase in wealth.

Now suppose an opportunity expectedly arises for the diligent and parsimonious farmer to buy some land. Perhaps a small plot of land that he has had his eye on suddenly comes up for sale. The asking price is slightly more than the amount of rice that he lent to the warlord. Unfortunately, he no longer has that rice in his possession, so he cannot buy the land. Or can he? After much contemplation, he approaches the land seller and says "Ah so, I cannot give you the rice for the land, but look, I have a promise from our most eminent warlord that he will repay 30 sacks of rice at the end of harvest time. Take this contract, plus 5 sacks of rice, and you will have the full amount that you wish to be paid." The land seller contemplates a while and replies "Ah so, you are right. I have no immediate need for the 35 sacks of rice; that is merely the value of the land. I will accept the contract as payment, and in due course take possession of the rice." And they both lived happily ever after.

What just happened? Second order money was created. If the seller trusts that the contract will be fulfilled, and he will get his rice at the promised date, then he accepts the contract as payment. Notice that something new is required for second-order money: trust. Accepting credit as a form of money requires much more trust than for first-order money. In fact, the word 'credit' derives from Latin credo, meaning 'I trust'.

Because of the greater need for trust, the willingness to accept second-order money may sometimes be less than for first-order money. Another point is that if the trader wants the rice right now, and has no use for a promise of future rice, then he may refuse to accept a loan contract as payment. However, that may be mitigated by the fact that he may in turn be able to trade the loan contract for a quantity of real rice. This hinges again on the trustworthiness of the debtor. If trust is high, then the loan contract can circulate as money.

The last example raises an important issue that we will briefly touch on. If I have a contract to receive 30 sacks of rice in four month's time, how much rice will you give me now in return for the contract? Probably less than 30 sacks. The difference is known as the discount rate, and in medieval Europe, these kinds of transactions were routine. One sees that profits could be made by patient individuals with deep pockets. In fact, this is how modern banking began in Renaissance Italy, aided in no small part by the Church's ban on charging interest, which led to elaborate deals in loan contracts to properly reward lenders. Further exploration of this fascinating history, and the concept of interest rates, is beyond the scope of this article

We are now ready to summarize our classes and orders of money into a six part table.

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