What makes good money?
Money is often described as a collective illusion. While there's truth to this, distant and recent history clearly shows that not all illusions are equally sustainable and have different consequences.
In 2020, I was travelling in Colombia for some weeks. I saw many homeless Venezuelan refugees on the streets as the political and economical situation was very bad in Venezuela at that time. I was impressed by the Venezuelan people that they never just begged for donations but always tried to offer at least anything symbolic in return like sweets for example. Most impressive to me was people selling handcrafted goods like bags and wallets purely made of Venezuelan currency, the Venezuelan bolivar, that hyperinflated back then. The currency was more valuable as craft material for art than as money.
It was mindblowing to me to witness how these banknotes, once represented significant value, became worthless paper. Examples like this highlight why it is fundamental to understand what society is using as money and what properties actually make for good money, as failing to do so may end up in a situation like those poor Venezuelans ended up in. Luckily, there are alternatives and possibilities to protect yourself from such incidents. It all starts with understanding the problem to be able to judge alternative solutions. In my opinion, basic monetary education is the most effective protection against that. That's one of my motivation to help spreading this message as many people just don't know these fundamentals and are thus impacted the worst by inflation.
Throughout history, humans have used everything from massive stone discs on Yap Island to cowrie shells, cattle, and precious metals as money. Some forms succeeded for centuries, while others collapsed rapidly. These varied experiments reveal that while money requires collective agreement about its value, not all forms of money are equally effective at fulfilling its purpose.
The massive stone discs used on Yap Island, called Rai stones, could weigh up to 4 tons and were so large they rarely moved—ownership was simply transferred through social consensus. While these stones worked for the isolated Yap community, they clearly wouldn't scale to global commerce. This extreme example shows how different forms of money succeed in specific contexts but may fail when circumstances change.
According to Carl Menger's analysis, good money must be able to transport value across two dimensions:
- Time dimension - Can this money transport value reliably into the future?
- Space dimension - Can this money easily transfer value across space, i.e. can it be easily transported and exchanged in different locations potentially far away?
But which properties actually determine how well a form of money can hold up to those dimensions?
Properties That Enable Value Transport Through Time
Durability
The ability to be resistant against physical damage and neither rot nor deteriorate. Extreme examples are fish vs. gold. Obviously gold is more durable than fish that would rot almost instantly.
Scarcity
The most important property of money determining its ability to hold its value reliably into the future is scarcity and thus the ability to resist supply inflation. In other words, how hard is it to create new units of that money. Lyn Alden states that scarcity was oftentimes the key differentiator in case of two competing forms of money. On the other hand, extreme scarcity can also be a problem since there might just not be enough units for the good to be widely used as money, e.g. an art collection consisting only of a few pieces. This in turn relates again to the divisibility property as we'll discuss below.
The most important concept to understand here is the stock-to-flow (S2F) ratio. The total existing supply of a good is called stock. While all newly produced units per year are called the flow. S2F = Stock / Flow. In other words, it measures how many years it takes with the current flow to newly produce the amount of the existing stock.
The Utility Value is the worth a good has because of its properties to be consumed or used. For example, Gold can be used in electronics because it is a great conductor that doesn't corrode e.g. as used in Smartphones. The worth of the utility Gold plays in this scenario is called the utility value.
If a good like Gold is used as Money for example the demand increases and thus its value increases beyond its utility value. This added value is called a monetary premium. As soon as a good's market value is higher than its utility value, i.e. it has a monetary premium, there is an even stronger incentive for people to try produce more of it. Thus, it is essential for good money to still be able to maintain a low flow to not inflate in such situations.
Historically Gold has always had the best S2F ratio maintained over centuries. Why is that? Gold has to be mined from the earth in a costly process and its supply has consistently increased between 1%-2% even when having a monetary premium. It has a natural scarcity enforced by nature. The current S2F ratio of gold is ~60 which means it would take 60 years to mine the same amount of Gold as is estimated to have been mined in total ever. In other words, it takes 60 years to double the current supply (stock) of Gold.
Another simplified example of a low S2F ratio would be a swimming pool that is half filled with water. If you start filling the pool with water from a garden hose, it would likely take only some hours until the pool is filled and thus doubled its stock. Thus the S2F ratio would be far below 1.
Fungibility
The same unit of that money must be interchangeable with another instance of the same unit, e.g. you don't really care which Dollar coin you hold as they are interchangeable and perceived to have the same value. A counter example would be rare collectibles like art images that naturally would end up having different perceived values and thus not being interchangeable.
Now that we've examined properties that help money maintain value over time, let's look at those that make it practical to use in daily transactions.
Properties That Enable Value Transport Through Space
Portability
The ability to easily transport amounts of money for varying types of transaction sizes. For example, Rai stones were very large and immobile whereas it was possible to carry a relatively large value of gold around. If you compare physical assets like gold to digital assets today, it's easy to see that digital assets have generally a higher portability score.
Divisibility
Good money must also be sufficiently divisible to be able to conduct transaction of any size with it. Remember our example from an imagined barter world where you try to barter lunch but only have an expensive watch as medium of exchange. Or just imagine a world where only 100 dollar bills exist.
Verifiability
Good money must also be easily verifiable against counterfeiting. Otherwise, no one would likely accept it, since you are always unsure if you actually got paid or scammed.
Analyzing Money Against These Properties
To analyze how well a good is suitable as good money, one can just analyze it against those properties. The commodity under review gets a score for each of those property values. Different commodities can then be compared along those dimensions.
Gold has the best scores for most of those categories and thus was widely used as money for a long time. Most importantly gold has consistently had the highest S2F ratio while being very durable and fungible at the same time. This means Gold has been best suited to transport value into the future and thus been a great store of value. While not that perfect on dimension of being able to transport value in space it was historically still the best for a long time. The portability, especially for transaction over large distances is not efficiently scalable to a global economy. Moreover, it's not super easy to quickly verify the purity of gold. It can be that it is mixed or that it's only attached from the outside. We'll come back to Gold's monetary role and its pros and cons in the next blog post where we discuss why our money is broken.
Those are necessary properties but not sufficient. A commodity that is well suited as money still has to get adopted and thus needs to be widely accepted. So, acceptability isn't just another inherent property of good money but an emergent phenomenon that transforms a good into an actual form of money. Just as a telephone became more useful the more people have a phone, money becomes more useful the more people use it. This is referred to as a network effect by economists. This effect historically contributed to the fact that only 1-2 forms of money become widely accepted in a free market. Namely the ones with the best inherent properties as explored above. If the money is not scarce and the supply increases quickly one would naturally not accept a good as money. The same is true if something rots quickly or is easy to counterfeit while not easily being verifiable. Sooner or later it will be known that you can't trust a good to be fake and thus the acceptance will naturally go down. If a form of money is very portable and divisible over another those properties will also naturally lead to a better acceptance. If you think only about a big Rai stone compared to a Gold coin.
This statement can be challenged when looking at what we use as money nowadays because governments enforce a certain type of money as legal tender in its jurisdictions. We'll get back to this in the next post.
Conclusion
The Venezuelan refugees crafting wallets from worthless bolivars remind us that money's properties have real consequences. Throughout history, societies gravitated toward gold not by chance, but because it was best suited at storing value across time with its high stock-to-flow ratio and durability.
To summarize, good money transports value effectively across time and efficiently through space. In our next post, we'll examine how our current fiat currencies measure against these criteria and why understanding these flaws matters for your financial future.
But which properties actually determine how well a form of money can hold up to those dimensions? That's what we'll discuss in the next post.