🍞 The Money Games - Part 1
A Discussion on the Origins of Earning, Saving, Lending, & Investing Money
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Hello Loyal Bread Crumbers 👋🏻,
As you read above, I’m switching up the Big Baguette format. This year, I’ll be writing fewer posts (~1 per month). By pruning quantity, I’ll increase quality. Each Big Baguette will go deep on a topic I find compelling and think you’d enjoy learning about. My goal is to have each edition improve your mental, physical, or financial fitness. These categories are guide posts, not rules. If I find a topic particularly compelling, I will write about it whether or not it hits on one of those three themes.
The aim for the reading time is somewhere between 5-10 minutes. But if there’s an absolute banger that needs 4,000 words, it is what it is 😈
With that, let’s jump in.
The Money Games - Part 1
Intro
Last month I took you on a wild ride through the history of the stock market, and left you with a nugget of wisdom: check your financial health before diving into the stock market frenzy. No one wants to sling stocks when their wallet's running on fumes, right?
Initially, I thought about hitting you with the classic advice trio—emergency savings, high-interest debt pay-off, and 401(k) contributions. Sounds like the financial equivalent of "eat your veggies," huh? Boring! I'm here to give you more than just a to-do list; I want to explain why it matters.
So, I ditched my original plan and went down the rabbit hole, uncovering the mysteries behind our money moves. Turns out, we're all players in an ancient financial game with rules dating back to the birth of society.
Now, get ready for The Money Games, a five-essay series focused on unraveling the mysteries of money. I’ll show you the rules of the game and how to use them to your advantage. Once you get the game, you can start mastering it.
Here’s a preview:
The Money Games
I. A Discussion on the Origins of Earning, Saving, Lending, & Investing Money
Learn a robust foundation for comprehending the intricate dynamics of the financial world.
II. An Exploration into the Science of Earning Money & The Labor vs Capital Conflict
Gain insights into why certain individuals wield more control over the financial landscape than others.
III. An Argument in Favor of Ramit Sethi’s Philosophy for Saving Money
Discover the straightforward steps outlined in this essay to enhance your savings with minimal effort.
IV. A Simple Man’s Analysis of Investing Accounts
Receive a comprehensive overview of investing and retirement accounts, and learn how to leverage them for your financial benefit.
V. A Quick Word on Why Ignorance is Bliss in Finance
Find tranquility in managing your personal finances through insights shared in this essay.
Grab your popcorn, and let's dive into the not-so-boring history of money.
The Origins of Money
To understand the origins of earning, saving, lending, and investing money, we need to go back to its birth. That story begins with one of humanity’s greatest inventions, trade.
Trade enabled the first humans to allocate scarce resources among the tribe. If I make tools and you hunt woolly mammoths, we can benefit each other. I give you better tools to improve your hunting and you give me wholly mammoth meat to feed my family. This exchange of goods and services for mutual benefit is trade.
Bartering was the earliest form of trade. It involved exchanging goods or services for other goods or services. I gave you a tool and you gave me meat.
When you were in grade school, you probably traded snacks at lunch. Maybe 1 Kit Kat for 2 bags of Cool Ranch Doritos? That’s bartering!
Bartering was useful when populations were small and transaction volumes were low. But as human populations exploded, bartering started sucking. It sucked in 3 ways:
Double Coincidence of Wants: Bartering requires both traders to want what the other has to offer. If you don’t match wants exactly, trading can’t happen. If someone doesn’t want your Kit Kat…no trade for you!
Lack of Standardization: There wasn’t a common unit of measurement. How many Kit Kats is a car worth? Idk, that depends on how hungry I am.
Indivisibility: What if I think something is worth 1/60th of a Kit Kat? I can’t divide that crispy piece of chocolatey goodness into 60 equal pieces.
These 3 critical flaws prevented bartering from scaling. If a baker needed meat, he had to find a butcher who wanted baked goods. If the butcher didn’t need baked goods, the baker couldn’t get meat. Bartering made the friction for trade very high.
Lucky for us, our ancestors reduced this friction with a better system, money. The money system did 4 things really well:
Medium of Exchange: Everyone wanted it. So, everyone was willing to trade you for it. Double Coincidence of Wants problem? Solved!
Unit of Account & Divisibility: It could be divided. Divisibility combined with wantability meant it could be traded in smaller quantities which solved the Lack of Standardization and Indivisibility problem.
Store of Value: It held its value over time. People could trust that it would be worth about as much next year as it was today.
Standard of Deferred Payment: All of the qualities listed above make it great for promises of future payment. You didn’t worry about it going bad before you got it.
Money is a system for facilitating trade more efficiently. A money object, like a dollar bill, is the physical manifestation of the system. You know, like how Chris Hemsworth is the physical manifestation of the word “beefcake”
Much like Chris Hemsworth’s abdominals, the 2 oldest forms of money objects will blow your freaking mind! The first two forms of money objects were cattle and salt.
Cattle and salt???
I’ll explain.
As the bartering system became inefficient, some people started to realize that certain goods were wanted by everyone all the time. Those two goods were cattle and salt.
Be a Medium of Exchange:
In the ancient world, salt was accepted because people could use it to preserve food.
A cow was accepted because it provided essential resources like milk, meat, and labor.
Unit of Account & Divisibility:
People used salt and cattle to decide how much other things were worth.
A new hunting tool could be bought for [x] sacks of salt or [y] heads of cattle.
Store of Value:
Salt does not spoil or deteriorate easily.
Cattle can be maintained, reproduced, and used over time.
Standard of Deferred Payment:
Salt and cattle were often used in contractual business agreements.
In ancient societies, rich merchants measured their wealth based on the number of cattle they owned, and Roman soldiers were paid in salt.
Cattle and salt weren’t perfect. They were difficult to transfer, somewhat perishable, and hard to divide.
Money needed a makeover…
Money’s Makeover
Leave it to the Ancient Mesopotamians! If you don’t know about these ballers, read this.
The Mesopotamians stopped with cattle and salt. They started using (and making) an entirely new form of money, silver coins. The coins weighed about a third of an ounce and were named “shekels”. Shekel translates to “1/3 of an ounce of silver”. Creative!
Shekels checked all 4 money boxes:
Be a Medium of Exchange: Silver was rare and could be melted to make jewelry and weapons
Unit of Account & Divisibility: Value could be measured in “# of shekels” ****
Store of Value: Silver did not deteriorate over time
Standard of Deferred Payment: People were willing to use shekels in contractual agreements
Shekels quickly became the primary form of money. The more valuable a person’s good or service, the more shekels they were paid. With more shekels, a person could acquire more resources. The more high-quality resources they had, the more likely they were to meet their basic needs, live a good life, and reproduce.
In addition to increasing your likelihood of self-preservation, having lots of resources gave you a higher status in society. You can see why it feels like we are hard-wired to love earning money.
Origins of Earning Money
When we say we want to earn more money, what we really want is more resources and the freedoms they grant us. Just look at the richest suburbs of Chicago. They have great school systems, high-quality hospitals, and low crime rates. Resource-rich societies (and people) tend to have better lives than others. It makes sense why the majority of Americans want more money.
So, how does society determine who should earn what? By assessing the value of the good or service a person provides. Remember, money is just a trading tool. If you make something everyone wants but only you can create, you’ll get better trading terms. Money is the expression of those trading terms. This dynamic applies to individual people and businesses. Just look at Netflix and Blockbuster.
Why is Netflix worth 189 billion modern-day shekels and Blockbuster is bankrupt?
Blockbuster offered an inferior service that people stopped wanting. Getting up and driving 15 minutes to get a secondhand DVD at Blockbuster doesn’t compare to effortlessly streaming shows and movies with Netflix. Netflix’s services are exponentially more valuable to people than Blockbuster’s. Blockbuster didn’t deserve to stay in business.
This same dynamic applies to our professional lives. If we want to earn money, we must deserve it. To deserve it, we must learn skills that enable us to create a good or offer a service that people want.
If you make something of value for other people, they will trade you money for that thing. The better your thing, the more money you can get. Netflix’s service was more valuable than Blockbuster’s. So, people took their money and started trading with Netflix instead of Blockbuster.
Once you start earning money, you’ll often get advice to save it. But why?
To answer that question, we need to head to Ancient China.
💡 But, before we move on to the origins of saving money, let’s take a timeout for a quick recap:
The origins of money are rooted in the concept of trade which allowed early humans to allocate scarce resources effectively among their tribes.
Bartering was the earliest formal system of trade where a person would exchange a good or service with another person for a different good or service.
The Bartering System couldn’t scale with human population growth because of three flaws: (1) double coincidence of wants, (2) lack of standardization, and (3) indivisibility
The Bartering System evolved into the Money System where a specific good, valued by everyone, was used as payment in all trades
For a good to be considered money it needed to meet four criteria:
Be a Medium of Exchange
Unit of Account & Divisibility
Store of Value
Standard of Deferred Payment
The first forms of money were cattle and salt. Eventually, humans started using silver coins called “shekels”
If more shekels are paid for [x] than [y] that means people believe [x] has more value than [y]
The more shekels an individual has, the greater their chances of acquiring scarce resources
People are incentivized to want more shekels because acquiring scarce resources typically leads to a better quality of life.
If an individual wants to earn more money, they must create a good or service that is valued by other people
As a good or service becomes less desired (i.e. less valuable), the amount of money people are willing to trade for the good or service declines. Blockbuster’s implosion is an example of this phenomenon.
Origins of Saving Money
The use of coins, created by the Mesopotamians, spread to China.
The explosion of coin money in China forced merchants to haul hundreds of bags full of coins. The merchant's stores, ships, and caravans quickly became thieves’ favorite targets.
To solve this problem, the Song dynasty allowed certain merchants to open “deposit shops” where other merchants could store coins securely for a fee.
Humans saved resources long before the Song dynasty invented deposit shops. Take the most basic human resource, food. Hunter gathers smoked, dried, and froze extra meat to preserve it.
Saving excess food supplies was massively important in early human civilization because obtaining food was an uncertain and highly volatile art. The future is uncertain. Savings behavior is an adaptation for dealing with the future. Say a flood destroyed two society’s crops. Society A preserved and stored the surplus from last year’s harvest. Society B consumed it all. Society A survives. Society B starves.
Storing gold and silver coins is based on the same fundamental concept. The future is uncertain and saving today’s surplus mitigates the risk of tomorrow’s shortage.
If you’re a merchant in Ancient China and your horse dies, you can’t travel and sell your goods.
If you’re a merchant in Ancient China (with gold coins in storage) and your horse dies, you can buy a new horse and continue to sell your goods.
Unfortunately, other people will want to steal your gold. In Ancient China, you could either (1) guard the coins yourself, (2) buy a vault to store them, or (3) pay a small fee to your local deposit shop. Option (1) is dangerous. Option (2) is expensive. Option (3) it is!
For each deposit made, the merchant would receive a paper receipt. The receipt could be exchanged for the amount of coins stated on it. The paper receipts were easily transportable and less likely to be stolen. Smart merchants started using these receipts as a replacement for physical coins.
The government caught on to this system, took control of deposit shops, and created their own paper money - jiaozi. One jiaozi represented a specific denomination of coin deposits.
Paper money started replacing the coin system in China and eventually spread to Europe. Deposit shops in Europe were unique. The shop owners were goldsmiths.
Goldsmiths owned large, protective vaults to store their supplies. Goldsmiths started offering unused vault space to people in exchange for rental payments. These goldsmiths set the foundation for today’s three hundred and seventy trillion-dollar banking industry.
Origins of Lending Money
From personal gold storage to the birth of modern banking, the concept of saving and protecting resources has evolved. However, the core principles of today’s banking system were created by European goldsmiths in the Middle Ages.
Over time, goldsmiths noticed folks rarely used their gold. So, they hatched a plan: "Why not cash in on that neglected gold by lending it out to people who need it and charge interest?”
The model worked something like this:
Reassure clients their gold is safe and can be reclaimed anytime.
Charge clients a fee for safeguarding their gold.
Take 80% of the unused gold and lend it for immediate use like starting a business or buying a house.
Keep the other 20% for depositors who occasionally withdraw their gold.
Make borrowers repay the loan and charge them an interest fee for borrowing the money.
Sit back and enjoy the rental and interest fees!
This playbook works like a charm, but there's a tiny hiccup. The whole thing hinges on a tricky thing called trust. Depositors must trust that the goldsmith always has enough gold stashed away in the vault. To the goldsmith's credit, he's good for a depositor’s everyday needs, but he can't handle everyone withdrawing their deposits.
Remember, he keeps only 20% of all deposits in the safe. The rest is loaned out to folks.
Now, if one person thinks the goldsmith might run out of gold due to bad loans or not enough reserves, they will rush to get their gold. That sets off a chain reaction – one person runs to withdraw his gold, the neighbor sees this, panics, and does the same, and so on and so forth until the whole town is banging on the goldsmith's door.
That's trouble, and it can bring the whole system down. Sure, once all the loans are repaid, he'll have enough gold, but that could take years. If the loans don't come back quickly enough or not at all, he's in a tight spot.
Despite its vulnerability, this system did benefit society. It connected savers with borrowers and facilitated massive economic growth and invention. New businesses and consumers now had a formalized, central place to access capital. Lending became so popular that some goldsmiths transitioned away from shaping metals and just focused on storing gold and lending it out. They would typically conduct business on benches in markets. In medieval Italy, people started associating these moneylenders with the benches they did business on. The Italian word for bench is “banco” and as these moneylenders became more powerful and formalized, the name stuck. They became the world’s first bankers.
This goldsmith system of only holding a minority of deposits in the bank and lending out the rest became known as fractional reserve banking. Every country in the world uses this system today.
Governments have put restrictions in place in response to massive financial collapses and bank runs created by bankers who committed fraud or made bad loans. For example, the Federal Reserve was created in 1913 in response to bank runs and financial panics that plagued the U.S. Prior to 1913, Jerome Powell’s job literally didn’t exist.
Okay, so why did I tell you all this? Because our entire economy is underpinned by massive amounts of lending. Your student loans, your credit cards, your mortgages, your checking account, your savings account. They all rely on this fractional reserve system.
If the government wants people to save more and spend less, they increase interest rates. Each dollar you borrow costs more money and each dollar you save earns you more money.
When you put your money in the bank, the bank takes that money and lends it out. The bank takes a tiny portion of the interest income they make and gives it to you. They keep the majority of the interest income for themselves!
But they do a pretty good job of protecting it for you and making it easily accessible. Banks provide the infrastructure that enables the buying and selling of goods and services. In part three of this series, we will cover which banks offer the best savings accounts.
The money that sits in a bank savings account is typically low-risk and low-return. In 2023, we are in a unique time where certain savings accounts will pay you 5% interest. That’s because the government is trying to reduce the demand for goods and services. When demand greatly outweighs supply, the price of goods/services rises rapidly. The % increase in prices from one year to the next is the inflation rate. Too much inflation (above 3%) is dangerous for an economy.
To reduce demand, the government uses interest rates. Higher interest rates incentivize people/businesses with extra money to stop spending it and put it in the bank. High rates also incentivize people/businesses to borrow less money because it’s more expensive. If you have $1,000,000 in debt at a 1% interest rate, your interest expense is $10,000. When you increase that rate to 5%, your interest expense is $50,000.
In most cases, your savings account will pay you 1% as opposed to 5%. That’s why smart people who have enough money in their savings account for month-to-month expenses and emergencies take excess money and buy ownership shares in public companies. These investments are more risky than a savings account, the company could fail and its shares would be worth $0. For example, if you owned $10,000 of Bed, Bath, and Beyond shares in 2000, those same shares are worth $0 today.
However, they have unlimited upside. If the company you buy is super successful, your ownership share could multiply in value. For example, if you owned $10,000 worth of Amazon shares in 2000, those same shares are worth $744,791 today.
Origins of Equity Investing Money
Equity investing and lending are like two sides of the same coin. They both involve entering into an agreement to give another party money in exchange for a future return of that money plus profits. The difference is the rules that govern the agreement. These rules dictate the risk and reward associated with the money provided.
When an individual provides money to another person in the form of debt (lending), the borrower agrees to pay back the debt with interest. If the borrower cannot pay back the loan, the debt holder can seize the borrower’s assets.
When an individual provides money to another person in the form of equity (investing), the investor gets a % of ownership in the new venture. The investor gets that % of all future profits generated by that venture. The venture can include any type of profit-producing asset (i.e. business, apartment, office building, etc.).
For example, say a person decides to open a corner store. The business owner (equity investor) invests $50,000 to fill the store with food and buy any other supplies. He borrows $100,000 from the bank (the lender) to build the store.
If the store owner can’t sell anything and runs out of money, he will default on his loan. In a default, the lender can come in, sell the store, sell the inventory, and any other items. Let’s say someone buys all these items for $100,001. The lender gets $100,000 of that money and the business owner gets $1. The lender has the first claim to all of the business assets.
If the store owner does amazing and makes $2,000,000 in profits within the first year. The owner can take $1,000,000 of those profits and pay back the bank. With the lender paid off, the owner has the right to all current and future profits. He gets the $1,000,000 in profits and any future profits generated (including the sale of the store and inventory).
The equity owner has unlimited upside but he takes on more risk. He has the last right to assets if the business fails. The lender had a capped upside but he takes on less risk. He has the first right to the assets if the business fails. However, any profits above his interest and principal are off-limits.
As we talked about last week, the first-ever equity investors were ancient Mesopotamian merchants. They owned 100% of their business and were entitled to all profits. If the 3 Mesopotamian traders got together and started a business with even equity, they would all be 33.3% owners.
All of the profits (and losses) would be split evenly among them. Equity investing for most of human history was relegated to rich people or entrepreneurs. Rich people had enough gold in the bank to support themselves for at least a year (or more). They could take that excess gold and invest in riskier ventures like the Dutch East India Company. If you make an investment in a business, you can’t just walk up to the owner and say give me my gold back. You would have to find someone to buy your ownership shares which could take a long time. If you had gold in a savings vault, so long as there wasn’t a panic, you could just walk up and say please give me my gold.
The rule of thumb is that you should use your savings account to store money for short-term needs (emergencies, vacations, furniture) and your equity investing account to fund long-term needs (retirement, college tuition, inheritance). We’ll discuss how to save and invest in the third installment of this series.
Before we do that, I need to show you the social dynamics that underpin money. It will help you see why some people have been rich for many generations and others have been stuck in poverty. With that knowledge, you’ll be able to appreciate why earning, saving, and investing is important. That essay will be coming out at the end of November.
Enjoy your Thanksgiving.
If you enjoy reading Bread Crumbs, recommend it to your Blackout Wednesday drinking buddies and Turkey Bowl teammates.
Cheers,
Paul
Next Essay Teaser
Look at you! You made it to the end. For all that hard work, here’s a sneak preview of the next essay.
🔥 Hold onto your wallets! 🚀 In the next newsletter, we're diving deep into the thrilling world of money magic! ✨ Uncover the secrets behind the Science of Earning Money and the epic showdown between Labor and Capital. Ever wondered why some folks dance with dollars while others are stuck in financial quicksand? 🤔 Get ready for an eye-opening exploration into the forces shaping the financial cosmos. Buckle up for revelations on why certain individuals hold the keys to the kingdom! 💰💼 Don't miss this ride into the heart of the Labor vs Capital clash! 🌐💥