Take out a dollar bill and hold it up. Examine it. Inspect it. Pick it over carefully. Surely, you say, this is money! An economist, however, would not entirely agree with you. In an economics textbook, you see, money is not defined as dollar bills. Instead, money is defined by the functions it fulfills. First, money is that which serves as a convenient way by which to trade labor for groceries (it's a "medium of exchange"). Second, money also must serve as a standard of comparison by which to compare the value of one thing to the value of another thing (an hour of work for a bag of groceries); thus, money is a "unit of account." And third, money must be a "store of value" as well, so that I can store the fruits of my labor and make purchases many days or even years later.

Take out a dollar bill and hold it up. Examine it. Inspect it. Pick it over carefully. Surely, you say, this is money! An economist, however, would not entirely agree with you.

Throughout history, many items have served these three functions with varying success. These items have included salt, cattle, furs, tobacco, shells, arrowheads, stones, and precious metals such as gold and silver. Because in these examples money is always a physical "thing," it is called commodity money. And there are additional requirements: (a) whatever is used as money must be widely accepted as money by all people in society; (b) it must be standardized so that one unit is the same as another unit; (c) it must be reasonably durable so that it does not spoil; (d) it should be valuable relative to its weight so that large amounts of value can be easily transferred; and (d) it should be divisible into small portions as well.

To use cattle as money, therefore, poses a problem because cattle is not easily divisible or, if it is, it is not durable since a cut-up bull rots and stinks to high heaven pretty fast. Shells and arrowheads are not sufficiently standardized, and salt, if you are not careful, will take on water and spoil, too. And the problem with gold and silver is that it is easy to shave off tiny flakes and pass the rest on as the real thing. Moreover, gold and silver are heavy and cumbersome to lug around. Imagine paying for your shiny, new $30,000 car in gold!

Over the eons, therefore, money evolved. The clincher came with the invention of paper money. At first, you'd deposit some "money," such as gold, with a trusted friend who, if trusted by many people, eventually became a "banker." He'd keep your gold and in exchange give you a piece of paper, a certificate, verifying that he had your gold in store and whoever got the paper could claim the gold. Later, you'd get several papers (small denominations) to claim fractional values of the deposited gold. These paper certificates eventually became accepted as money itself, fulfilling all the functions and requirements listed above. At one point, though, there were so many bankers, each with their own certificates, that it became difficult to trade across the entire United States. It seemed simpler, then, for a central government to step in and to decree that, henceforth, only certain government-approved pieces of paper would be money – "legal tender," as that dollar-bill of yours says. This is fiat money – money by government decree!

So far, so good. But there is a problem. Suppose that you have $10,000 deposited with your banker friend. You keep it there of course because it is convenient and, probably, safer than keeping it under your mattress. You keep it there in storage to claim it later when you really need it. Your banker friends knows that, on an average day, some of the deposited money gets withdrawn of course – but then other money gets newly deposited so that, really, most of the time most of the deposited money just sits around doing nothing. Well, why not take a cut and loan it out to someone who wishes to borrow, and make a little money – from the interest rate – on the side? Banks are private, profit-making corporations after all.

If you don't need your $10,000 why not have the banker loan it out? Why can that possibly be a problem? Alright, let the drama play itself out. Suppose that you are person A with the $10,000 in your checking account. To be on the safe side, Banker B keeps $1,000 in reserve but loans out the other $9,000 to me, Customer C, to buy a used car. I sign a statement promising to pay back the $9,000 sometime in the future. Meanwhile, I buy the car and give the $9,000 to the car dealer (D) who takes it to the bank to deposit it. Again, to be on the safe side, Banker B puts ten percent, $900, in reserve and hastens to loan out the other $8,100 to Ms. Elegant (E) who wishes to refurbish her home by buying fancy furnishings from furniture dealer (F) who takes the $8,100 to Banker B for deposit.

Let's look at Banker B's balance sheet.
 

ASSETS Reserves - for you, A                      $  1,000 - for Car Dealer, D           $     900 - for Furniture Dealer, F    $  8,100                                         $10,000 Loans - to Customer, C              $  9,000 - to Ms. Elegant, E           $  8,100                                         $17,100 Balance                          $27,100

LIABILITIES Deposits - from you, A                       $10,000 - from Car Dealer, D            $  9,000 - from Furniture Dealer, F     $  8,100                                             $27,100         Balance                               $27,100

By loaning out money, it mysteriously begins to multiply faster than rabbits in the Australian outback.

By loaning out A's money, it mysteriously begins to "multiplies" faster than rabbits in the Australian outback. And that's the problem: because if A, D, and F now go to the bank to claim "their" money – $27,100 – they will find that The Money Ain't There! All Banker B has in reserve is $10,000 (because F's money has not yet been loaned out; it's still in reserve). That's a  bit embarrassing. But, Banker B says, "not to worry, Customer C and Mrs Elegant E owe me $17,100 which, together with the $10,000 in reserve, is just enough to return the deposits to A, D, and F."

But of course Customer C and Ms Elegant E don't have the money either! If A, D, and F insist on withdrawing "their" money, Banker B goes bankrupt, and the entire monetary system collapses. 

The moral of the story? The money – "your" money – in your checking account isn't really there at all. "Your" money is a fiction! It's by far the greatest demonstrable social fiction I know of. It's such an incredible story that, when I first heard it, many years ago, I decided to study economics. Now I am a professional economist, and money still is a fiction. I only understand it better. And perhaps I shouldn't have shared the secret!

Stay tuned; more installments on money are coming up. Meanwhile, don't run to the bank to claim your money– like God, just simply believe that it's there when you need it.