Ask anyone on the street this question, “What is the difference between currency and money?” I bet you’ll discover that most people think they are the same thing. This is not true. They are different. I think the confusion comes from the fact that the subject is so out of the mainstream. Nevertheless, knowing the definition of these terms and developing a clear understanding of their differences has potential to dramatically impact your behavior and investments. Thus I have chosen to devote an entire post to the subject.
What gives money power?
Question: Is that twenty dollar bill in your pocket really worth $20? Look at it; it’s just a piece of paper with some ink on it. Now, if I offered you to trade me any old piece of paper for 20 loaves of bread or 10 bags of potatoes, you’d probably refuse. These goods have much greater value than some random piece of paper. And yet, those items are easily bought and sold for that $20 bill in your wallet every single day. So I ask you, why in the world should that particular piece of paper be worth $20? What gives it power?
“Those you trust the most can steal the most.” – Lawrence Lief
Money value and buying power
In order to really understand this issue, we have to define two terms, namely value and buying power. Value comes in two varieties, absolute (intrinsic) and relative. Here is a simple example of this distinction. A pound of sugar relative to the measurement of weight is one pound. A pound is an absolute unit of value relative to weight; it is exact and it does not change. A pound is a pound and will always be a pound.
Relative value of money
However, a pound of sugar relative to a measurement of cost varies. You may be able to go into three different stores and buy a pound of sugar for three different prices in each. Furthermore, as you likely remember, a pound of sugar fifteen years ago did not cost nearly as much as it does today. This is because a dollar represents relative value, not absolute. This relative value is commonly referred to as buying power.
Absolute and intrinsic value of money
Absolute, or intrinsic, value is set through the market forces of supply and demand. Within the world of money and finance good examples of absolute value are gold and silver. If I were to hand you a shiny bar of gold, wouldn’t you instinctively know that you are holding something of value? Of course you would. That precious metal stores intrinsic value in itself and you know this intuitively. Exactly how much value this bar of gold holds at any given time is established by the market place. In other words, it’s worth whatever someone will pay you for it.
Buying power is relative
Buying power, which is relative, can be transferred onto an object by means other than the free markets. For instance, the only reason that $20 in your wallet is good for anything is because the government says so, and we the citizens agree to it. Therefore, while the little piece of paper with a picture of a dead president on it isn’t worth anything close to $20 in terms of absolute value, it represents the buying power of $20 because of something called a government fiat, which is a government regulation or mandate. This twenty dollar bill in your wallet is actually called fiat currency because it derives all of its’ buying power from a government mandate, but it might as well be monopoly money. It has no value except for that which our government says it should have. It truly is just a piece of paper with some ink on it.
The difference between money and currency
Such is the basic difference between money and currency. While money stores intrinsic value within itself, fiat currency possesses buying power bestowed upon it by the government. But this was not always the case. At its’ inception the dollar was backed by gold and silver, which meant that every unit of currency in circulation was redeemable in gold and silver. In America, a person could walk into a bank, hand the teller his $100 bill, and have it cashed in gold or silver coins. Thus, at this stage currency was nothing more than a receipt redeemable in gold or silver for its face value. And even though the paper currency did not possess intrinsic value, under the gold standard it represented the buying power of gold and silver, which is set by the free markets. So, the absolute value of the precious metals transferred to the paper.
But what do you think happens if for some reason the currency is no longer “backed” by gold and silver? If the currency is supposed to represent the intrinsic value of gold and silver, then if you take the metals out of the equation, what value exactly does the paper represent? I’ll tell you what – the value of the power of a government mandate, whatever it is.
In America this finally happened in 1971, when President Richard Nixon announced that the U.S. currency was no longer redeemable in gold. The dollar had become completely a fiat currency for the fist time in history. The government gained an ability to print as much paper currency as was needed to cover its’ obligations since it was no longer necessary to collateralize it with anything other than the U.S. government’s promise to pay. Unfortunately, all this monetizing, or printing of currency, comes at a price. It inevitably leads to a terrible thing called inflation, which is just another form of taxation since it destroys the buying power of the currency. Let me explain.
Inflation and currency
Inflation is the act of inflating or expanding something. In terms of currency, inflation occurs when through the government’s monetary policy, additional currency is added into circulation – this is called monetary inflation. When people talk about the government printing money, this is what they mean.
In simple terms, our economy can be explained as units of currency chasing units of goods and services. What do you think happens if, all of a sudden, the number of units of currency in circulation increases (monetary inflation) while the amount of goods and services available for purchase stays the same? All of the goods and services become more expensive, causing what is known as price inflation. Thus, monetary inflation always leads to price inflation, which is the reason why currency is a metric of relative value. It is why that pound of sugar cost so much less fifteen years ago than it does today.
Here is another illustration of this reality. I remember a time not so long ago when a typical loaf of bread cost under $1. Today, the same loaf costs roughly twice as much. Why is this? Here are your choices: (a) The loaf of bread is more valuable, (b) The loaf of bread is twice as nutritious, or (c) The loaf of bread has become tastier. Of course, the answer is none of the above. The bread simply costs more today because the currency which is being used to pay for it has lost half of its buying power. Therefore, it now takes twice as many units of currency to buy the bread. The buying power of each dollar has lessened so it takes more dollars to pay for everything!
Buying power vs inflation
So what does all this mean relative to the $20,000 you stuck underneath your mattress, thinking your money was safe and secure? Well, it is not safe from the erosion of its buying power due to inflation, nor is it secure because there may come a point in our society when currency becomes so abundant due to government printing that people lose faith in it altogether. In this case, when you pull that money out from underneath your mattress ten or fifteen years from now, you may be surprised at how little it buys. Imagine saving $20,000, and discovering that instead of buying a new car, all you get is a pair of shoes.
Sound unbelievable? This very thing has already happened multiple times throughout history, most notably in the World War I era Weimar Republic in Germany. In his book entitled Guide to Investing in Gold and Silver, Protect Your Financial Future, Michael Maloney eloquently describes the dire realities of hyper-‐‑inflation. In simple terms, in order to pay for the expense of war, the German government decoupled its’ currency from gold and began to print obscene amount of marks. According to Maloney, by 1923, a loaf of bread went from half a mark to 200 million marks. The currency had become virtually worthless due to hyper‑inflation.
Buying power’s effect on saving for retirement
Now, this is an extreme example of inflation which is unlikely to happen in America in my opinion. However, I would rather err on the side of caution. As such, I do not think that trying to save-up for retirement is a viable plan since it does not address the loss of buying power of the currency that is being saved.
Should you store your wealth in currency?
Understanding that fiat currency is inherently unstable and does not hold any intrinsic value leads me to conclude that currency should not be used as a medium within which to store your wealth – which is definition of saving. Rather, currency should be traded for something that possesses intrinsic value which can not be eroded by inflation - which is the domain of investing. In fact, investing should be thought of as simply a trade of dollars (or another currency) for assets, with three main objectives: to generate passive income, to protect buying power of wealth from erosion due to inflation, and to grow wealth by generating investment returns outpacing the inflation.
I have barely scratched the surface of the subjects of money, currency, and inflation in this post. I encourage you to do further research on the subject and pay attention when you hear it being discussed. Governments are not about to stop printing fiat currency any time soon. Therefore, it pays to be educated as to the matters of inflation so that you are better equipped to formulate a strategy which will allow you to benefit from it!
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