The Difference Between Money and Currency: Realities in Developed vs. Developing Economies

Two weeks ago, I wrote about a question I see asked a lot: ‘Should the Central Bank of Nigeria float the Naira?’. If you have not already read the article, I based my arguments on the ‘social value’ of the currency, and I recommended that the Naira remains a managed-float. Although I still stand by the article’s conclusion, upon reflection, I realized I had failed to outline the difference between money and currency. 

What’s the difference?

As we know it, a currency is a medium of exchange issued by the central bank of a nation. On the other hand, money is also a medium of exchange that exhibits all the qualities of currency but serves an extra function; to act as a store of value. Generally, a store of value is anything that retains purchasing power over a long period. For example, you could safely store gold for 100 years and be sure it will have a similar if not, higher value in the future. On the contrary, store a 100 Naira note under your bed for three years, and ……well, we all know how that ends. 

An understanding of the difference between Money(e.g., gold) and Currency (e.g., Dollars) is essential because it dictates the realities of developed versus developing economies. You see, currency is nothing but a piece of paper with a fancy government stamp on it. But the more people perceive a currency as ‘valuable,’ the more the currency starts to camouflage itself as ‘money’ (a less volatile medium of exchange). To understand what I mean, let us see how we evolved from trading with money to trading with currency. 

Brief History of Purchasing Power

In the early days, trade was made by barter (e.g., you give me milk, I give you rice). To perform a simple economic transaction, you would need to find someone who has what you want and wants what you have. As you can imagine, this was time-consuming, and in some situations, you might have to complete several legs of trades before finally arriving at the person who exhibits the qualities listed above. To make matters worse, if no one perceives what you own as valuable, trading could be challenging. This disadvantage inevitably led to people searching for a commodity that everyone equally perceives as valuable and could serve as a medium of exchange. 

Fast forward a couple of centuries later, Gold became that commodity. In order to reduce the stress that came with carrying gold around (see the story of goldsmiths), countries started issuing notes (currency) that were directly backed by gold. This meant that people could trade with the currency, and at any point in time, they could walk into the bank to redeem their currency for gold.

So during this period, Money (Gold) = Currency (e.g Pounds)

You could not game the system!

During this period, countries had a monetary system referred to as the Gold Standard. Here, the value of a nation’s currency was determined by the amount of gold the nation had. More importantly, since trade amongst countries were settled in gold and gold cannot be ‘printed,’ wealth was simply transferred from one nation to another. More exports equaled more gold and hence greater economic wealth. Conversely, import-intensive countries saw their gold reserves decline, and wealth diminish. 

This seems like a fair system, right? If you are productive, you are rewarded with economic wealth, and if not, you are penalized. Well, it was all good till World War I emerged, and countries such as England figured out they could not ‘print’ gold to finance their military expenditure. This led to England temporarily suspending the gold standard since government finances had deteriorated.  Essentially, England issued fiat currency so they could print cash to stimulate growth. 

The US, on the other hand, was smart enough to serve as the Allies’ main proprietor of weapons, supplies, and other goods during world war I, collecting much of its payment in gold. So much so that by the end of the war, the US had 75% of the world’s monetary gold. Since the dollar was the only currency still directly backed by gold and many countries had run down their gold reserves, in 1944, 44 countries met and created another monetary system called Bretton Wood. In this system, the world’s currencies couldn’t be linked to gold, but they could be linked to the U.S dollar, which in turn was linked to gold.

Currency (e.g Pounds) = Currency (Dollar) = Money (Gold)

This period officially crowned the dollar as the world’s reserve currency. Instead of countries holding all of their reserves in gold, they simply held some of it in dollars, since it could be redeemed for gold. 

If money can be printed, it will be!

So the agreement was, the US dollar will be backed by gold and issue notes equal to the value of the gold in the vault. But trust the US to print more notes than they had gold for :)

When countries found out, it sparked concerns over the stability of the dollar, and countries began to convert their dollar reserves into gold. As demand became unbearable, in 1971, President Richard Nixon announced that the dollar would no longer be redeemable in gold. Instead, it will be backed by the value, power, and full faith of the government. 

Currency (Dollar) =/= Money (Gold)

Finally! Money grows on trees!

The main reason countries were happy to create fiat currency (currency not backed by anything of value) was so they could print their way into growth. Instead of increasing productive capacity in order to accumulate money(gold), countries could just print cash, pay for goods and services, and boost economic growth. But countries can’t print too much cause of ‘inflation.’ 

Inflation, as we know, works through demand and supply relations. If the demand for an item is high, and the supply remains relatively stable, the price of that item will rise until demand equals supply again. The same logic works for currency supply. If the currency is printed and the new ‘dollars’ go out to chasing goods with limited supply, the price of goods in the economy will rise. Due to this, what your one dollar could buy today, will be less than what your one dollar could buy two years ago. In other words, inflation erodes  ‘purchasing power.’ So with ‘currency’ purchasing power declines at a faster rate than money(gold), because money is limited in quantity(can’t be printed).

The most interesting part about inflation however is who it chooses to penalize first.

The Naira has lost more than 99.7% of its value since it was introduced 47 years ago, while the US Dollar had lost about 96% since inception 106 years ago. So it took inflation a longer time to erode purchasing power in the US. 

Why is that?

Because developed economies ‘export’ their inflation to developing economies.

Here is how it works: The feds print currency, which is meant to reduce the value of the existing pool of dollars through inflation. However, because the rest of the world demands dollars to conduct global trade, that excess demand for dollars raises the value of dollars back up. So, in essence, the ‘value’ we place on the currency stabilizes it. This relation works for other dominant currencies in the world because they exhibit ‘money’ like characteristics, so freely floating them is fine. 

On the other hand, developing economies do not share in this ‘value’ quality. Firstly, they hold their foreign reserves in dollars, actively ‘consuming’ the excess inflation that comes with the U.S Feds printing dollars. Secondly, they are mostly import-intensive, rarely completing the trade using their own currency. Thirdly, due to the absence of the rest of the world ‘demanding’ their currency, their currencies are limited to serving only as a medium of exchange and not as a store of value.

To sum up, although currency and money are often used interchangeably, it is essential first to analyze whether a country's currency acts more like ‘money’ or ‘paper.’ A country with the latter will be more exposed to value-erosion from inflation. It hence would be better off implementing a managed-float system to preserve the welfare of the society.