Red-Blooded Risk: The Secret History of Wall Street

A General Theory of Money

The point that derivatives are the new money is essential for understanding the modern economy. Let's go back to the three functions of money. First is to be a medium of exchange. What does that mean? Suppose A wants goods that B has, but A doesn't have anything B wants. In a barter economy A and B have to look for a C, possibly also D through Z, to make a complete circuit of exchange. But in a money economy, A pays B in money, B uses the money to buy from C, and eventually, possibly via D through Z, someone uses the money to buy something from A. A medium of exchange is just a clearing mechanism for barter.

As a clearing mechanism, paper money has some advantages over precious metal. You can create as much paper money as you want; there is never a shortage. Clearing can be virtual; you don't have to lug gold or silver around to settle accounts. Paper is lighter and easier to carry. It can be given features like serial numbers or require countersigning to protect against theft. However, paper money is easier to counterfeit and is more perishable.

The biggest advantage of paper money, before the government monopoly, is you can choose from a variety of clearing mechanisms. Some are reliable locally and others are better for longer-distance transactions. Some guarantee that the clearing circuit involves only people with solid credit, and are backed by banks with large reserves to protect against losses. Other paper money is softer, with more risk of loss. ...