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The Evolution of Money
In order to better understand the different kinds of money, it is important to understand how money has evolved over the centuries of human history. Search the Internet and you can find any number of interesting articles or videos discussing this topic in more detail. Many share a common theme which goes something like this:
In the “earliest days” of human development, individuals and family groups were on their own to provide for their own survival. This included the acquisition of food, water, shelter and clothing. Gradually people discovered they could be more efficient by specializing in a certain field of work. It was just too difficult to make your own clothes, grow your own food and build your own house.
Instead, if each person could focus on producing a single commodity, they could produce much more–enough for themselves and others, and at a much more efficient rate. But in order to do this, they had to have a reliable way to exchange these goods and services with other people who were also specializing in other complementary areas.
One person might grow grain, another could make clothing or shoes, and someone else might make tools of iron. By cooperating and trading their services in this way, each could be more prosperous than if they had to do every task completely on their own.
Initially people attempted to measure the value of their individual commodity in terms of the other commodities they were commonly trading for. In some cases, this might mean figuring out how many bushels of corn would constitute a fair price for a pair of shoes, for example. This process of trading commodities, called barter and exchange, formed the basis of early cooperative societies.
But as the narrative goes, direct exchange posed some problems. Most notably, if you had shoes but you needed apples, you had to find someone who had apples and needed shoes. Otherwise, you had nothing of value to offer for what you needed.
So people eventually figured out there were certain commodities virtually everyone needed. For example, wheat might have value to all people. If everyone eats bread, it would follow that everyone is going to need wheat. So if the shoemaker realized he could ask for wheat in exchange for his shoes, he could then go find someone with apples for sale and, chances are, he could use his excess wheat to make the necessary bargain.
In this case, the wheat would become a type of “commodity money.” The commodity could be consumed for making food, meaning it would be used according to its intrinsic value. Or, the commodity could be used as a standardized way of trading for other useful commodities. This is a clear example of one of the primary purposes of having money–to use it as a medium of exchange.
When one particular commodity becomes widely used and accepted as the standard money, it is normal to assume that “prices,” or the way in which value is measured, would be expressed in terms of that commodity–For example, bushels of wheat. People might become accustomed to the idea that a pair of shoes is “worth” two bushels of wheat. And you can be sure that over time, the “prices” of each item will give a pretty clear indication of how much work goes into the production of each different commodity.
If a pair of shoes is worth two bushels of wheat, it will probably take about the same amount of work to produce the shoes as it does to produce the two bushels of wheat. This example demonstrates one of the other primary purposes of money–to serve as a standard for the measurement of the value, or price, of things.
In the example of the island micro-economy, we used gold coins to serve as our “money.” Just like wheat, gold too is a kind of commodity money. Gold has certain appeals and uses based on its unique character and properties. So it does have its own intrinsic value. But since it is rare and people seem to really like it, it has also been a very successful form of commodity money as far back in history as we can find records. Other commodities such as wheat, oil, tobacco and salt have also been used in various times and places. But gold and its sister, silver have likely been the most prevalent and reliable forms of commodity money for as long as people have been exchanging value.
As the story of money’s evolution progresses, we can next imagine people getting tired of hauling gold around with them everywhere just so they could carry on trade. It was heavy and some people might steal it from you if they could. So instead, people began to deposit their gold with an expert in the matter, the goldsmith. The goldsmith was believed to be much better prepared for storing gold and keeping it safe. So people would just leave their gold with him and pay a small fee for his trouble.
In return, the goldsmith would issue certificates back to the owners of the gold so it could be reliably redeemed at a later date. Now, instead of trading with actual gold, people could begin to exchange these gold certificates with one another. Everyone knew the certificates were as good as gold, so they eventually became just as valuable. This helps us understand the evolution of paper money.
This new system of paper money was good for commerce because it made trade so much easier. But it was not without its own set of problems. Soon, the goldsmiths realized people were starting to leave their gold on deposit for longer and longer periods of time. Since the paper money had become so much more efficient, people eventually didn’t want to bother with the actual gold at all.
Once gold certificates went into circulation, they often just stayed there. And the gold itself just ended up sitting idle in the goldsmith’s vault. So certain unethical goldsmiths started to figure out how to cheat.
This could be done in two ways:
- They could borrow or even steal a little of the gold, knowing it was unlikely everyone would come back to claim their gold;
- Or, just as bad, they could create extra certificates for themselves over and above the gold actually in the vault. They could then spend those phony certificates in order to buy what they wanted and needed.
The unethical goldsmiths quickly became both very rich and very prosperous. They discovered they could effortlessly manufacture paper money out of nothing while everyone else had to come by it the hard (and honest) way.
In addition to simply spending this extra money, the goldsmiths could also lend it out to people in exchange for a future interest charge–a fee assessed for using the borrowed money. Perhaps this was even easier to justify since the loans would presumably be paid back eventually. And when they were, the number of outstanding gold certificates would no longer outweigh the actual gold in the vault. No one would be the wiser, yet the goldsmith could benefit from the interest he had earned in the meantime.
But, like a lot of things that seem too good to be true, this one was too. Eventually, the public caught on. The goldsmiths were charging a storage fee for gold and also earning interest on loans made against those same gold deposits. In order to keep people depositing, the goldsmiths were eventually forced to start sharing these returns with their depositors. And this is the explanation for the interest bearing deposit accounts we enjoy in banking today.
The evolution next continues into our modern system of central banks and fractional reserve banking. It goes something like this:
The goldsmiths gradually morphed into banks. As they did, people worried about the potential pitfalls of issuing more certificates than the bank actually held in gold deposits. Even in cases where the extra certificates were only lent out, ultimately to return, still there were too many certificates to match up with the physical gold on deposit. If all depositors did happen to show up at the same time to redeem their gold, the bank would go out of business. When they did, the remaining certificates would be worthless and the people holding them would be irreparably harmed, having lost all their money.
Even though most people preferred to leave physical gold on deposit indefinitely, they would not want to keep it in a potentially insolvent bank. So sometimes just a rumor about a bank having problems would spread, people would panic and rush in to collect their gold. This type of “run on the bank” could quickly drain a bank of all its reserves and force it out of business.
With each occurrence of a bank failure or monetary panic, pressure mounted upon government to do more to regulate the banking industry. Everyone with even a little common sense could understand, the problem with bank insolvency stemmed from attempting to lend out more money than a bank had on deposit. But instead of banning the practice, government regulators instead institutionalized it. And thus our modern system of “fractional reserve banking” was born.
Today, this practice is not only allowed, but is standard in virtually every country throughout the world. In essence it means banks can lend more money than they have. Said another way, the equity, or net value owned by the bank represents only a fraction of the total money created by the bank.
If you are paying close attention, you noticed the wording: “money created by the bank.” This is our first clue into the question of how money is created. Yes, money is created by the lending activity of banks–not just by the government.
This may be different from what you thought you knew. But remember, the certificates issued by the goldsmith were created by him and they were the first paper money. So he was literally creating money. Was he creating it out of nothing? Not at first.
Those gold certificates served as vouchers, or claim receipts for real gold kept on deposit by the goldsmith. They were created out of gold–not out of nothing. We showed earlier how money derives its value from the commodities existing in the economy. This is a great example of how that happens. In an instant, a certain amount of gold disappears from circulation and in its place, some money appears which carries the very same value.
In this example, money is being created out of gold. What is more, if a customer of the bank shows up to reclaim his gold, he will have to relinquish his money in order to get it. In this case, the money is destroyed–but not the value. The money will disappear from the economy and the gold will reappear back in circulation.
But once the goldsmiths began to print phony gold certificates, that was a completely different scenario. Since they were made in excess of the actual gold deposits, there was no commodity anywhere to back up their value. The public had no way of knowing which certificates were real and which are not, so all certificates were considered equally valuable in the market, regardless of whether they were real or phony.
In one sense, all certificates issued by that goldsmith were real–even the phony ones. But with the issuance of each of the new, unbacked certificates, all prior certificates became just a little bit more phony. In other words, all the certificates lost a little bit of their value all at once.
This feels a lot like the laws of supply and demand: when the paper money becomes more plentiful than it should naturally be, its value begins to drop. No one has to regulate this–it just happens automatically. If there is more money around, people spend it just a little more carelessly and so it loses a little of its value. This is one cause of inflation: when money becomes more plentiful than the commodities that back it.
Unfortunately in the example of gold backed money, if people start to “run” the goldsmith to get their deposits back, they don’t get a discounted amount of gold back. Rather, those who get there first get all their gold. Then when the gold runs out, the unfortunate late-comers get nothing.
As government developed banking regulations, certain aspects of the fractional reserve practice were allowed and others were prohibited. For example, it would not be allowed to just invent money out of nothing and spend it for their own internal purposes. However, the idea of lending money not backed by actual deposits would continue and in fact, be embraced.
The primary restriction on this practice would be to limit the amount of loans to a multiple of the reserves maintained on hand by the bank. For example, if the bank had $10,000 of deposits, it might be allowed to write loans in the amount of $100,000, or 10 times its deposits. So to emphasize the key point: the bank’s deposits themselves would not be lent out to customers. Rather, the deposits would simply be used to calculate how much in new loans the bank could write. And as those new loans are made, new money would literally be created as a result of the loan.
Here’s an example. For purposes of simplicity, assume “the bank” represents the banking system, or in other words, your bank, and any other banks it might borrow from, up to and including the Federal Reserve.
It works like this: A customer comes to the bank to borrow money. As security, he will typically have to allow the bank to place a lien on his house or car. This means if he fails to repay the loan, the bank will have the right to repossess that asset. Next, the bank will give the customer a receipt, or statement, showing the loan proceeds now on deposit with the bank. Think of this deposit as a promise or an IOU payable by the bank to whomever is in possession of it.
In common financial parlance, we call this a “note” and it is the newly created money we are talking about. At the same time, the borrower gives a promise or note pledging to repay the bank the same amount of money in the future. The borrower’s note is payable over time and he has to pay interest back, in addition to the principal he borrowed. But the bank’s note is what we see emerge from the transaction as normal money. And it can be redeemed at any time by any one who holds it.
Once the new money is in the borrower’s deposit account, he can begin to spend it. This is typically done by way of a check or its equivalent. The check can be made out in any amount and the intended recipient can present it at the bank and receive cash.
Alternately, the recipient can deposit the check in his own account. It is pretty easy to understand what would happen if he deposits the money in an account at the same bank where the loan had originated. When the loan was first made, all the bank had to do to create the new money was to debit its loans receivable, an asset, and credit its deposits payable, a liability. So far, nothing of substance has really taken place. The bank’s balance sheet didn’t get any bigger or smaller. It just traded one note for another.
Likewise, when a check is drawn on one account in a bank and deposited in another account in the same bank, not much of substance occurs. The bank just debits the deposit account of the borrower and credits the deposit account of the person who received the check. The transaction is entirely internal to the bank and no actual cash has to change hands.
It gets a little more complicated when a check is drawn on one bank and deposited in another. In this case, the two banks would have to conduct some kind of cooperative trading of promises or notes between themselves to balance out their books. This has the effect of moving money from one person to another, even though no physical gold or other commodities would ever be transferred. In our modern banking system, the transaction can be carried out simply by moving numbers around in a complex computer network.
This mechanism of fractional reserve banking forms the basis of how money is created and destroyed–the topic we will discuss in more detail in the next section.
We should remember, this story about the evolution of money is extremely over-simplified. While it is instructive to imagine the evolution from barter and exchange up through our modern banking system, it didn’t really happen in such a single, serial string of events. And we have skipped over a lot of details in order to keep things more understandable.
In reality, monetary systems have been continually evolving and devolving in different places throughout the world for as long as people have been exchanging goods and services with each other. As one simple example, we know barter and exchange was often used in the American Frontier. Yet clearly, much more sophisticated monetary systems have existed earlier in history.
Perhaps it is safe to say, when people have reliable monetary systems available, they will use them. But if those systems break down due to corruption, mismanagement, or economic failure, people revert to more primitive forms of exchange in order to accomplish their desired trades.
