What is money? Money is a human invention that solves the problem of a double coincidence of wants in a barter (primitive) economy. Man's earliest form of trade was barter: my rock for two of your bones. The problem with barter - as anyone who has been to a swap meet will understand - is that I have to want something you have and I have to have something you want. What if I don't want any bones and all you have to exchange for my rock is bones? Money emerges from barter as the good which is in greatest demand, or the most marketable good. The reason for this is simple: if you are going to accept a good which you don't want for its own sake (money) in exchange for something you have, you want to be sure that you can get rid of that good to someone else in exchange for something they have that you really want. You can only be confident that this will be the case if the good you are accepting in exchange for what you have is very marketable.
There are other properties which money has which are more technical. What is most important to understand is that money emerges from barter, it is the most marketable good and it takes on the role of the medium of exchange in an economy. Many things have functioned and function as money. Seashells, tobacco, pelts, gold, silver, tokens, currency, banknotes, checks and cigarettes are a few examples. In each case, however, money always emerges from barter as the most marketable good. What the market chooses to be money is not arbitrary. Money cannot be created by fiat and never has been.
Today, this is somewhat confusing because market money has largely been coopted by legal money. Legal money is a medium of exchange whose marketability is not derived from its innate physical properties, but from its special legal status. Gold and cigarettes are physical objects which serve the function of money in certain markets by virtue of their physical properties which make them suitable for consumption as human luxuries (gold as adornment, cigarettes for neurological pleasure.) Modern fiat currencies serve the function of money by virtue of their special legal status combined with their historical connection to gold and silver. It is the fact that modern fiat currencies have a historical connection to gold and silver that differentiates them from any other kind of piece of paper with special legal status and makes them money.
What is wealth? Typically, when we think of wealth, we think of money, or perhaps material possessions or maybe even land. Wealth, however, is even more broad than this and includes every aspect of one's circumstances which brings pleasure to oneself. Living across from a well-manicured park may make you wealthier, even though the park or its state of upkeep is not among your possessions. There are a vast variety of intangibles which are a part of wealth. What is important is to understand that wealth and money are not synonymous - you are wealthier than the amount of money you have. Also, wealth and money do not vary linearly. A multi-millionaire will not be twice as happy upon earning his second million dollars as he was earning his first million. There is a decreasing marginal utility for every good, including money.
Also, we must be careful to distinguish between individual wealth and social wealth. More money held by an individual increases that individual's wealth. More money in an economy, on the other hand, has either no net change or a negative effect on social wealth. This is because money plays a different role for the individual and the economy as a whole. In the economy as a whole, money is the solution to the problem of double coincidence of wants - you can always exchange money for something you want. Increasing the amount of money in the economy does not help the problem of double coincidence of wants get solved better. It is equally well solved by any finite amount of money. For the individual, any increase in the amount of money which he holds is an increase (though not linear) in his wealth.
Unfortunately, this is the source of a great deal of confusion, in my opinion. People assume that as wealth increases, the amount of money should increase as well. But there is no reason for the amount of money in the economy to increase. There are arguments to the effect that there are benefits to increasing the amount of money in the economy, but none of these arguments claim that more money helps better solve the problem of double coincidence of wants.
So what does increase social wealth? Social wealth increases as a society becomes more productive. Aliens looking down on humans from space could discern that people living in 2008 just have more things of all kinds than people living in 1608. Increases in productivity are the consequence of social and technological innovations. New business processes like the assembly line and new technologies like the steam engine enable society to greatly multiply its productivity. The benefits of this process of innovation spill over onto everyone. If you are a young adult, you will become wealthier throughout the duration of your working life even if you never move up in the business world. The equivalent (inflation-adjusted) income will buy more and more over time as an inevitable consequence of productivity innovations.
Social wealth also increases with trade. Two people only trade if each values the thing they receive in trade more than what they traded to get it. I'll only trade my rock for your two bones if I value the bones more than the rock and vice-versa for you. After we have traded, the total social wealth has increased.
I will take a diversion to explain by what measure social wealth increases. Economists use the word "value" or "utility" to describe the degree to which something is useful to a particular individual. The subjective theory of value (the predominant view) holds that no good or service has intrinsic value but what is conferred upon it by subjective, human valuation. iPods are valuable because humans desire to have them very much (doesn't matter why). That is, humans have a high subjective preference for iPods over other things like dirt, rocks or fingernail clippings. This preference is revealed whenever an individual exchanges something he has (e.g. money or labor) for something he wants (e.g. iPod or money). If you own many things I would prefer to have and I own many things you would prefer to have, when we exchange, the utility of the things we own increases, that is, our wealth increases.
Comparative advantage and specialization also play a crucial in the exchange of services. If you are a painter and I am a mechanic, and your car needs repair and my house needs painted, it will be more efficient if we agree to exchange services - the car will have been fixed and the house painted with less total expenditure of human time and effort. As a consequence of trading, we have economized our time and more total houses can be painted and more total cars can be repaired.
Social wealth also increases with consumer choice. A millionaire living in Dar Es Salaam is hardly as wealthy as a millionaire living in New York City - there are so many more choices available of how to spend one's money in New York City than in Dar Es Salaam.
What is key to understand is that wealth is not a zero-sum game. That is, when you and I trade, we both become wealthier. When Apple charges me $200 to purchase their iPod, I am happier with the iPod than I was with the $200 and Apple is happier with the $200 than they were with the iPod they just manufactured. Unlike money which cannot grow indefinitely (though the inflationists have always given it their best shot), wealth can grow indefinitely.
People sometimes speak of relative wealth (net worth percentile) versus absolute wealth. Some studies suggest that people would rather have greater relative wealth (higher social status) than greater absolute wealth. Would you rather live as a king circa 1608 or live in the lower-middle class in 2008 with things like iPods, internet, jet travel, and modern medicine? Fortunately, social status is not measured solely by the amount of money one has or earns. Wealth, beauty, fame and prestige are among the most universal measures of social status, but they are not universal. Clearly, if we measured relative wealth in terms of net worth percentile or income percentile, we are dealing with a zero-sum game. In order for me to move up, I must displace someone else.
However, since there are an abundance of measures of social status, relative wealth is also not a zero sum game. All the money in the world could not buy the world chess championship, and the world chess champion is top-dog in the world he cares most about. Given the choice between being the richest man in the world or the world chess championship title, I doubt even one world chess champion would accept the money instead. This is not because chess champions are more selfless than rich people, but because chess champions measure their relative wealth in a different way than someone like Paris Hilton.
In summary, remember these two principles:
- Money is a medium of exchange, not a measure of wealth (even though "wealth" and "money" are synonymous in colloquial usage)
- Wealth is not a zero-sum game (even if income percentile is)