Money matters: How money works (Part I)

[This is Part I of a two-part series on banking — what it does, and can do, for you. Part II is 5 things banks do for you that’s really important.]

What is money? Seriously, answer the question: What do you say is money? Everyone thinks they have a basic idea what money is, but no two people will come up with the same definition. And chances are none of them are correct.

In order to understand what money really is, we need to first look at its uses and then at the history of banking, because money and banking are so intertwined as to be inseparable.

The Attributes of Money

1. Transfer: Our main use of money is as a means of exchange. Way back in the day, all Farmer Fred had to give Carl Cobbler for a new set of shoes was a bag of wheat. But what if Carl was gluten-intolerant? Then Fred had to schlep the bag of wheat over to Barry Butcher, who had to be desperate enough to unload that side of beef before it went bad so that he would take a bag of wheat. And so on. What a drag, literally. Toting around stuff to barter was very inconvenient.

Money is much easier; we can take it anywhere with us and buy anything with it. (Come to think of it, perhaps that is where our spending problem originated: It has become way too easy to carry around money. If we had to lug around 30-pound bags of stuff to barter, we might be a lot less tempted to spend it, wouldn’t we?)

2. Storage: Money is also a convenient way to store wealth. Carl Cobbler doesn’t need to build a shed to store all those shoes he so diligently makes to tide him over on a rainy day. With money, he can simply sell all the shoes he makes, and then store the money — much more compact than shoes.

3. Valuation: The third use for money is to assign a value to the things we trade. For example, it works much better to express the value of a pair of shoes at $50 than, say, 2.5 bushels of corn or 1/118th of a tractor.

You may have noticed, but, convenient as money is, we rarely use it in its pure form. In fact, if you wanted to pay for a new home or car with cash, the authorities will pay you a visit, and it will not be for a friendly cup of tea. Most money we spend (and earn) is of a different kind.

Moving From Gold to Paper

In earlier days, people used pieces of gold for money (which was infinitely better than bags of wheat or manure). Over time, though, even gold coins became a drag … literally (again) because gold is heavy and easy to steal.

But humans are smart, and invented banks. In his classic book “The History of Banks,” Richard Hildreth tells how it all started with a bunch of rich merchants organizing themselves into what became the Bank of Venice to lend money to the government at an interest rate of 4 percent.

Clearly, the money they lent to the government was money they could spare; so when the loans were repaid (those being the days when governments actually repaid loans), the money just stayed in the new bank.

That led the merchant members to discover the convenience of simply depositing the money they received as part of their trading with this bank.

So, when Maria Merchant had to pay Vinnie Vendor, they would meet in the bank lobby, where Maria would withdraw the money from her vault and hand it to Vinnie, who would take it right back to the teller and deposit it into his account with the bank.

Man counting money before paying

After a while, they realized this was time-consuming, so it didn’t take long for merchants to simply write down instructions to the bank to simply transfer the money from Maria’s account to Vinnie’s account.

Vinnie would present the instruction at the bank, who would make an entry in their books that the 2.5 pounds of gold in the vault no longer belonged to Maria Merchant but to Vinnie Vendor.

Thus, the third function of a bank was born, circulation.

We still use those instructions today. And for all intents and purposes, they have remained pretty much unchanged for the past 700 years. We call them checks. If you carefully read what is written on one of your checks, you will see it is still (after all these centuries) literally an instruction to your bank to take money from your account and transfer it to the account of the fortunate person receiving your check.

Why the elaborate history lesson? It’s to clarify that money is not what we carry in our wallet.

Rather, money is simply an entry in the books of a bank somewhere.

To be sure, we do carry a few notes and coins around with us; but by far, the majority of our money exists in the form of an entry in the books of a bank.

But that’s not all. Someone once said money is like a bunny — built to reproduce. It does so in two steps, lending and multiplication.

The Rise of Lending

Banking, as we noted above, started with lending: the state of Venice pretty much forced the rich merchants to lend it money to protect them and go open new markets for them.

When the conquests were over, the loans got repaid, the merchants got even richer, and banking developed the deposit and circulation functions mentioned above. Merchants came and drew their money every now and then, like when they financed an expedition of a few ships to find new treasures to bring back and trade at big profits.

But gradually, it became evident that the vast majority of deposits just sat there, never touched.

It didn’t take long for men to figure out that all this idle money could be put to use. Here’s what would happen: Dina Developer thought she could buy one of those Venetian islands in the lagoon, put some bridges over the canals, have a parking lot for the gondolas, and build and sell a few mini-palaces, all with a nice view. However, she needed a hundred thousand or so to get started. She happened to know Bennie Banker very well, and one night over dinner she mentioned her dream to him. A penny dropped in Bennie. He thought of all those bags of gold just sitting there in his bank, idle. They weren’t his, but who would miss a hundred thousand for a few weeks?

So Bennie lent Dina the money, she developed her property, and repaid the loan. For that, Bennie received interest — without using any of his own money. He used depositors’ money, and made sure to put the money back where it came from when it was repaid. But he kept the interest. Money for nothing. Bennie rubbed his hands, realizing that this could be the start of something good!

It wasn’t long before others began to do the same thing. Bennie had discovered something nobody had in mind when the merchants left their money with the bank for safekeeping: You can make money for yourself using other people’s money. (Well, we don’t know his name, but if Antonio Benedetto can change his name to Tony Bennett and become a famous singer, we can work with Bennie Banker!)

But if you think that was a good thing, wait… there’s more (again, literally).

The Supply of Money — Multiplication

How much money is in America? You would think that would be easy to calculate: Simply add up the balances in everyone’s accounts. Unfortunately, it’s not that simple.

Let’s say back in the day Bennie Banker, the guy running the Bank of Venice, sent his assistant to add up all the balances on their bank’s books and the total came to a million dollars. How much money did Venice have? A million dollars. That was easy.

But the next day Dina showed up to get the loan Bennie promised over dinner a few nights earlier. Bennie, of course, handed her a check. What did she do with the check? She deposited the money in the new account Bennie opened for her. So, the following night, when Bennie sent his assistant to count all the balances again, the total came to $1.1 million.

Bennie had just expanded the money supply by 10 percent. He created money out of thin air. How did he do this?

By making a loan.

Amazing, isn’t it? Bennie was not stupid. He had $1 million to work with, so he started making loans like crazy.

He couldn’t lend out all the money on deposit, because he had to leave some to cover any withdrawals. So, let’s say he decides he can lend out 80 percent of what he has in the bank. At the end of the first week, his deposits would have swollen to $1.8 million, an increase of $800,000.

Bennie now had an extra $800,000 he could lend to even more people. When he lent the money to those people, they would deposit their loan checks into their accounts, generating new deposits of $640,000 (80 percent of $800,000). At this point, the total money supply totaled $2,440,000.

After lending out 80 percent of the next round of increase, the total money in Venice would have climbed to about $3 million.

So, just with three rounds of loans, Bennie tripled the total money in Venice from $1 million to $3 million.

We call that the multiplier. By making loans, bankers increase the amount of money in circulation. You probably understand now why bankers try so hard to be careful when they lend money to others: It’s not their own money they are lending out; and if anything happened to that loan, they have to make it good to the depositor from their own funds.

You also understand why, in the crisis of 2008, everyone was so concerned about making loans to keep the money supply from shriveling back to nothing.

From this first part you have an understanding of what money is, where it comes from, and how important banks are to the money supply in any country. In the second part, we will draw the discussion closer to home.

Did you answer the question correctly? Have you experienced a barter system? If so, how efficient was that system? Have you thought about how money stores value, for example, or about the other attributes of money?

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There are 12 comments to "Money matters: How money works (Part I)".

  1. My Factoring Network says 08 December 2015 at 04:14

    It’s true that we all are running after money to secure our life and future, and we have made it a race and competition. We actually are in a confusion of what money is. The attributes of money are were counted before and even too. It forms the basis of our Financial economy. Very informative post. Thanks for sharing. It has cleared many doubts of mine.

  2. Mrs. Money Monster says 08 December 2015 at 04:35

    I have never experienced a barter system, but I do find them fascinating. Since most of our money is stored electronically, I often wonder what would happen in the face of a major glitch (or terrorist attack). Without actually having a storage shed filled with money, we would be wiped out in a millisecond. Everyone would be back to ground zero. Bartering would surely rise up quickly as a means of obtaining anything. I enjoyed this history lesson this morning.

    Mrs. Mad Money Monster

    • David S says 14 December 2015 at 09:29

      Actually, most likely another form of currency would arise. The issue with barter systems is that for most things it is hard to trade perishable items which is actually the majority of items we buy today. Most likely another nonperishable instrument would take its place like precious metals, ammunition, toilet paper, etc. 🙂

  3. GlorifiedPlumber says 08 December 2015 at 13:33

    For further reading, interesting takes on the history of money and such can be found in the books:

    Pre running his stupid mouth Nial Ferguson’s “The Ascent of Money”

    David Graeber’s “Debt, The First 5000 years”

    Ferguson talks a lot about the medieval city states of Venice and Genoa and their impact on matters financial. I found that book to be fascinating, especially a lot of the information regarding cotton and the US pre civil war south and the economics of the time.

    Interestingly (assuming I am remembering correctly, has been YEARS since I have read it), the barter system is always thrown around as what existed pre-money, but David Graeber makes a very interesting argument about how it was more of a “credit” system than a barter system, since trading cows for chickens was pointless when you had a need for something else.

    • Gail King says 11 December 2015 at 20:02

      Thanks for the book recs!

      I’m getting them from my local library, looked them up at

  4. MrRicket says 09 December 2015 at 00:29

    Amusing story 🙂 It reminds me of my Economics days at school 🙂 I am still not sure how this whole money creation thing is even legal, but anyway, money talks…

    Thanks again for sharing.


  5. lmoot says 09 December 2015 at 08:05

    I can’t explain why the idea of the inevitable control of distribution of all money by banks, scare me, but that is why I like the idea of keeping my money tangible whenever I can (which no longer is a simple thing to do). The biggest way I can do this is paying off my house ASAP. I’m not a conspiracy theorist, but the 2008 crash is a perfect example of institutions and corporations trying to outsmart, outwit, and out theorize each other (and doing it above all the heads of the average Joes).

    Intangible money is not a new thing, but it has finally become the status quo, and not long before it becomes the only option…which I have my own theory that this will actually increase bartering/ trading, since that will be the main, possibly only alternative for those who are banking-averse.

    Me personally, I’ll always feel more comfortable earning income, than relying long-term on dividends…which is why I am pursuing real estate as a major way of funding my retirement. At this point I am matching my 401k, in the next couple years I’ll max my ROTH…but I seriously doubt I’ll do more than that and will choose to put the extra money instead, into property.

    • lmoot says 09 December 2015 at 08:15

      To add…one has to wonder after the creative financing these banks cooked up before the crash, was exposed, if they hired philosophers instead of accountants.

      • Jane says 10 December 2015 at 00:09

        No they hired mathematicians, economists, and physicists.

  6. Gail King says 11 December 2015 at 19:58

    Thanks for posting this — I’m still getting my head around the process of creating money where there wasn’t any before, but this is helping.

  7. Tristan @ Dividendsdownunder says 12 December 2015 at 03:11

    The way the world works, it takes a lot of reliance and trust for the whole system not to come crashing down. But it doesn’t, every single year. It still exists, even after 1930, even after 2008, it’s still all good and will continue to be.

    Nice examples and description. Inflation is an interesting thing. It’d be interesting to see how much ‘money’ there is listed in the world over time. How much money is there? $50 Trillion? $100 Trillion?

    Who knows if it’s a good thing or not.

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