History of Money - Financial Shenanigans #9

Your crash course on the history of money and why it matters.

Money is one of the most important stories ever invented. It's fundamental to how we interact with the world and those around us. As with most great stories, we never really think about or question them. We don't wonder where money came from, what gives it value and what it might look like in the future. For the most part, we just take it for granted.

In the context of financial literacy, the history of money is often an underappreciated subject. But in the words of Maya Angelou, "you can't really know where you are going until you know where you have been."

So without further ado, here's your crash course on the history of money.

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Part I

The traditional economic narrative of money goes something like this.

First, there was barter. Barter is the process of exchanging goods and services directly, without a medium of exchange (like money). It suffers from what is known as a "double coincidence of wants." Which is basically a fancy term for a situation where I don't want your goods personally, and I'm also not sure I can sell them on. You see, in the barter economy, everyone is both a buyer and a seller, and as we don't have a trusted medium of exchange, this "double coincidence of wants" phenomenon prevents effective commerce. If you want a deep dive on the subject, you can start here. 

To solve this problem, some common goods like spices, salt, silk or weapons became a medium of exchange, much like currencies of today. First coinage was invented in Lydia, a Greek kingdom (modern-day Turkey) although there are also signs pointing to the development of primitive money, followed by modern coinage in China. Paper money did originate in China, first as receipts representing deposits of coins. Due to the apparent limitations of coins (weight, small denominations and portability), merchants would deposit coins in exchange for these paper receipts from government authorised deposit shops. 

Eventually, paper money found its way to Europe where in 1609, the Bank of Amsterdam was founded as the first public bank. Up until this time, paper money was still fully backed by coins which, in turn, had intrinsic value due to their precious or industrial metal content. Shortly afterwards, the Bank of Amsterdam began to lend money out of the deposits of others, pioneering what we now know as "fractional reserve banking". This brings us relatively close to how money works today.

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Part II

So how do we determine if something actually qualifies as money? To make that determination, we need to consider the three main functions of money:

1. Unit of account. This just means that prices are quoted in terms of money (dollar or euros) and not other goods (TVs or iPhones). For something to be a good unit of account, its value should be relatively stable. Which is why highly inflationary currencies tend to fail on this measure.

2. Medium of exchange. This is the function that addresses the "double coincidence of wants" problem we discussed earlier. For something to be a good medium of exchange, it has to have certain attributes like durability, fungibility, divisibility, transportability, etc. So even if we denominated everything in gold, for example, making it a unit of account, it would still not be a good medium of exchange.

3. Store of value. Simple, money should preserve its value.

Throughout history, money straddled the line between a store of value and a medium of exchange. Money backed by commodities, including the gold standard, had obvious intrinsic value but was not practical as a medium of exchange. While fiat money, backed by the state, is a perfect medium of exchange but is subject to over-issuance, inflation and debasement. History is full of destructive episodes of currency mismanagement in the developed world and is something that is happening to this day in emerging economies.

We can argue that most currencies today do not satisfy the three main functions of money. Dollar and euro might both be great as a unit of account and medium of exchange, but they are increasingly poor as a store of value. And if they no longer serve their purpose, perhaps we should consider an alternative. 

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Part III

Now for some critical thinking.

The theory about barter essentially facilitating the creation of money was introduced by Adam Smith in 1776. It implies that money was created to enable commerce, painting humans as rational economic actors. This assumption is at the core of the modern-day economic theory.

However, there's virtually no anthropological evidence that a society based on barter has ever existed. According to Caroline Humphrey, an anthropology professor at Cambridge, "no example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money."

The alternative economic narrative is that money was invented to keep track of social credit. In fact, systems of credit pre-date coins by over a thousand years. This distinction is essential as it suggests that social, peer-to-peer credit is the foundation of society.

So did we create money to facilitate the expansion of commerce, or was global commerce an unintended consequence? Was money an unfortunate choice we made or a natural evolution of our rational, economic and calculated species? This article by Brett Scott is an interesting thought experiment and well worth reading.

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The point of this exploration is to question some of the things that we often take for granted. Money is just a story, and if we see it as such, we can begin to re-write it in our own lives.