Very few people nowadays deal directly with cash. Like most people, you probably use Apple Pay, Venmo, Debit, Credit, and ACH bank transfers to settle most of your transactions. However you might be surprised to know we’ve already just described or alluded to 4 different types of money!
Of course, the definition of money varies from person to person. Some believe gold to be money, others believe bitcoin to be money. But for our purposes we will begin by describing the 5 types of money that are integral to the current economic system.
We will start with the most commonly encountered type of money:
#1 Bank Debt
Unintuitively, bank debt and not cash is the most common form of money. When most people think of as money they think of money in their bank account. But when you see the number $1000 in your bank account, you should say out loud “This is how much my bank owes me!”
This is how much my bank owes me!
When keeping money at a bank, you are trusting the bank to keep your money safe. However if the bank goes bankrupt, then your debit card becomes useless. In practice, this rarely happens because banks are heavily regulated and provide FDIC insurance of up to 250k. They are not truly independent private corporations.
This is why banks are safe stores of money for most people. You get the benefits of easy digital transactions without having to carry cash around, make change, and worry about it being stolen.
Notice that when your company sends you a paycheck for say, $1000 dollars, it is essentially a transfer of bank debt from the company to you.* On the bank’s ledger it says “Instead of owing COMPANY X $1000 dollars, we now owe PERSON Y $1000 dollars” (Assuming the company and you both have accounts at the same bank)
#2 Shadow Bank Debt
The second most common type of money most people deal with is actually another kind of debt. This is “Shadow Bank” debt. While the word sounds ominous, a shadow bank is basically any entity that engages in banking-like activity without being regulated as a bank.
This means that Apple Pay, Venmo, Paypal, your Starbucks reward balance and money market funds are shadow banks.
When users pay each other with these payment systems, they are essentially shifting debt around on a ledger maintained by the company similar to how in the paycheck example above an employee is "paid" simply by adjusting the ledger at the bank.
However, because they are not regulated like a commercial bank, they often aren’t fully insured.
This isn’t a big deal for most people because they keep relatively small amounts of money in accounts with companies like Venmo, Apple, and Starbucks.
However, the same can't be said for a 401k or a brokerage account. Similar to a regulated bank, the balance in your brokerage account is the amount of money that your brokerage owes you.
This is how much that company owes me!
Unlike a regulated bank which has FDIC insurance, shadow banks are much more susceptible to bank runs where every individual is trying to withdraw their money at the same time.
According to free market doctrine, this threat is what forces these companies to only lend responsibly. The belief is that if banks are insured, then they have no incentive to keep their customer's money safe and will lend irresponsibly and then wait to be bailed out.
The 2008 Financial Crisis and the 2020 COVID-19 panic were at their core, bank runs on the shadow banking system. Trust in the future was utterly destroyed and everyone rushed to withdraw their assets. In the end, many banks were bailed out b/c the fallout from letting them fail would have cascaded into the entire financial sector and was deemed unacceptable.
You might be surprised to find that cash is actually not that important to the functioning of an economy because it is so small relative to the other forms of money. Nowadays the bulk of transactions are digital.
Cash is unique relative to more commonly seen types of debt above in that cash has the least counterparty risk. This is because cash is a physical object that doesn't need user identification and a 3rd party to maintain a ledger tracking balances. Its "truth" of ownership lies in its possession.
Ledger based forms of money require that the onwer of the ledger remain operational. Cash however is backed by the sovereign nation that has the ability to print the cash.
This is why the US dollar is considered such a strong currency globally. Smaller nations like Zimbabwe or Venezuela aren’t seen as trustworthy relative to a large stable nation like the United States. They often mismanage their currency and create hyperinflation. While the holders of the currency never technically lose any “money”, their real purchasing power is drastically reduced.
For individuals in countries with unreliable national currencies, the US dollar is often used as an asset with the least counter-party risk similar to how gold has been used historically. Transactions can occur entirely outside the local regulated financial system without being tracked.
This can be good for individuals escaping oppressive regimes, or bad in the case of illicit black market activities like drug-dealing and human trafficking.
#4 Federal Reserves
While individuals and companies have accounts at banks to settle transactions between each other, banks also have accounts at a larger bank to settle transactions themselves. This larger bank is the Central Bank. Similar to bank debt, the balance of a bank at the Fed is a liability of the Fed. A bank like Bank of America or Wells Fargo would look at the number and say "This is how much the Fed owes me!"
This is how much the Fed owes me!
Every regulated bank has an account at the Federal Reserve. Only banks and governmental entities are allowed to, individuals are not. The U.S. government even has a “checking account” at the Fed, known as the TGA or Treasury General Account that acts as a source for government fiscal spending and a sink for annual taxes.
This allows banks to digitally settle transactions between each other without having to transport truckloads of physical cash around. When Bank A transfers money from a customer to Bank B’s it transfers a digital amount of fed funds rather than a truckload of cash.
The ledger at the Fed is what is used to track transactions between banks while the ledgers at banks are used to track transactions within the broader economy.
Because only banks and government entities are allowed to have accounts at the Fed, this type of money never leaves the banking system except in the form of cash. This type of money is known as Base Money or M0 money.
M0 can be thought of as “real money” because it is either cash, or a digital form of cash as banks can drawn down their fed balance to have cash shipped to their vaults. This is similar to how bank customers can drawn their accounts to withdraw cash from an ATM except with no risk of a bank run since to the Central Bank not having enough cash is a technical issue of not having printed enough, not an indictement of being insolvent.
Because most of the economy's day-to-day transactions are transfers of bank debt, the total amount of value that is flowing through the economy is much greater than the M0 money supply. Even though it is not as hard or as "real", it is credit and debt that runs the economy.
The reality is most of what people call money is credit. The total amount of credit in the United States is about $50 trillion dollars, and the total amount of money is only about $3 trillion.
#5 United States Treasuries
A treasury is essentially an IOU from a government that pays varying amounts of interest. While they are usually considered a very safe and conservative investment bond, it is also useful to think of them as a form of money.
For example, a wealthy private individual with hundreds of millions in assets cannot store that amount in physical cash or open an account at the Fed. FDIC insurance also only insures up to 250k in assets so a regular bank account is too small for their purposes. For such an individual, buying US treasuries is their equivalent of opening a very large checking account.
Money is essentially an IOU that can be exchanged for assets in the future. For individuals who want the safest kind of IOU, and IOU from the U.S. government is hard to beat. Compared to the IOUs of private individuals, private corporations, or smaller countries, it is considered the safest way to store excess wealth in a highly liquid form. (Though many wealthy individuals actually keep the majority of their wealth in the form of assets that appreciate at higher rates.)
This is true even for countries. When countries like China buy US treasuries they are using the IOUs of the US government to store wealth to buy assets. Since many countries recognize the reliability of these IOUs there is a large network effect where the IOUs can be traded freely between countries for many goods and services. (Well... mostly )
Money is at its heart a way of tracking of who owes who what. Those who hold onto money expect to be able to convert it into goods and services in the future. While this might feel easy and cheap, to do so at a global scale turns out to be much more expensive and much more complex than anyone might have imagined.
Many rightfully feel that the "money" they are being paid doesn't seem to hold onto the ability to buy goods and services across time. No matter how much they save they can't seem to save up enough to buy a house. The goalpost recedes faster than they can keep up. Some resign and see no point in saving for the future. Others may look for shortcuts out of the unfair system and make easy money by buying NFTs or call options on TSLA or Gamestop.
Without a clear understanding of money, individuals can find themselves caught up in scams and fervor that seem to be "easy money" since they are never really sure what it is that they want more of.