This site has moved to http://www.economicsjunkie.com/history-of-money/
"With the possible exception of international trade, no topic in economics contains more myths than monetary theory." (http://www.mises.org/story/2057)
I am amazed by the fact that the most important thing that this world and our life seems to evolve around is still the most misunderstood economic topic at the same time.
A thorough discussion about economic issues is impossible though, if you haven't understood the way money functions.
First of all we have to be clear about why money was invented.
The Origins of Money
When society started evolving humans realized very quickly that they can't live in a self sufficient manner.
The crucial need for exchange of products and services and the division of labor arose because humans realized that the best way to improve their standard of living is letting everyone do what they do best and exchange products and services that one party deems less valuable for products and services it deems more valuable.
The reason why division of labor started evolving naturally is the fact that every human has different talents and abilities and that different geographical regions provide different circumstances for production and exploitation of natural resources.
A human being who tries to live in a completely self sufficient manner would be doomed to die from starvation with a very high certainty. Humans need to interact in order to stay alive and improve their status.
At a very early stage humans realized that if party A provides services or products to party B , party B does not always provide services or products that party A has demand for, however party B might be providing services to party C the next day and receive products or services that party A has demand for. Or, vice versa, party A might produce a product that no party in its vicinity has a demand for right away, but at a later point in time.
- Products and services needed to be channeled to their ultimate consumers in the most efficient manner
- In addition, differing time preferences of different parties needed to be bridged
People started using products that would ultimately be used for consumption as mediums of exchange. For example, party A would produce a table, give it to party B, but instead of demanding a product that A would consume, A would rather ask for a product that he/she could give to someone else at a later point in time for exchange against a consumer product.
People started using different things as mediums of exchange, such as cattle, tobacco, tea, beans, or coffee. People started using products that made good mediums of exchange as such.
What are the requirements for a good medium of exchange?
- It has to be easily divisible
- It has to be easily measurable in a certain unit
- It has to be relatively scarce, so there is just enough for everyone to use it
- It should be relatively durable
- It should be homogeneous (same units should not differ in quality, e.g. two different pieces of it, both 1 ounce should have equal quality)
- It should be as widely accepted as possible
This makes it clear that money is nothing but a product. A product that enables exchange which society has a natural desire for. It is not very different from answering questions, such as:
What makes a good lunch dish? (non-poisonous, healthy, pleasant taste, etc.)
What makes a good vehicle? (an object with wheels, etc...)
What makes a good material to build houses?( firm and solid structure, yet easy to apply inbetween bricks)
Individuals in a free market figure out the answers to those questions pretty quickly.
Over the centuries, in a free market, people tried lots of different products as money. Different commodities with more or less moneyish attributes competed against each other. Finally, over time people found that there was one commodity that fulfilled the requirements for a good medium of exchange best.
- It was easily divisible because it could be easily smelted and made solid again
- It was measurable in units of weight
- It was available just sufficiently not to lose value but could be used by everyone
- It was infinitely durable
- It was more homogeneous than any other potential medium of exchange
- It was widely accepted as an ornament and people enjoyed its beauty
Again: People in a free, unhampered exchange market, tried lots of different moneys until the BEST moneys, gold and silver, prevailed. The value of products and services in gold units was determined based on the simple and efficient laws of supply and demand.
Gold Warehouses
People, over centuries, have always stored widgets and commodities in warehouses because they did not need them at that particular point in time but later. Also they did not always want to carry heavy things with them
They would receive a paper ticket from that particular warehouse which represented a claim for the item deposited.
The same was the case for gold.
People would deposit their gold in gold warehouses and receive a paper ticket that served as a claim for the amount of gold (in weight units).
Currency units, such as "Dollar", "Mark", "Pound Sterling" used to be nothing but another way of stating a particular amount of gold. The "Dollar" for example, was defined as 1/20 of a gold ounce, the pound sterling as slightly less than 1/4 of a gold ounce, and so on. This meant that the "exchange rates" between the various national currencies were fixed, not because they were arbitrarily controlled by government, but in the same way that one pound of weight is defined as being equal to sixteen ounces.
Because those paper tickets were claims to gold, people started using those instead of gold as a medium of exchange, always knowing that they could exchange them for the precious metal at any time and at a ratio stated on the paper ticket and stipulated contractually.
Gold warehouses started accepting paper tickets from other respected gold warehouses as a service to their customers. They would then approach the original issuers of those tickets and redeem the tickets for gold and by doing so take that burden away from their customers, of course demanding a price for that service.
Soon the gold warehouse owners would notice that they would always have a certain amount of gold available that would not leave their vaults. Hence they would create more paper claims to gold than they actually had gold lend them s to other people as loans and earn interest money on them.
By doing so they were violating their contractual obligation to their clients. They were committing fraud and thereby violating one of the most basic rules of ethics. At the same time they were causing inflation with its negative effects as outlined in "Negative Impacts of Inflation". Of course their clients were not stupid.
As it is in every type of business in the free market, customers will swiftly notice that something is wrong and switch to a better service provider. In the gold warehouse business, customers would notice that the value of the paper tickets was depreciating and quickly redeem them for gold at the ratio stipulated. Those gold warehouses that printed too many paper tickets would pretty soon be bankrupt and go out of business - a just punishment for their unethical and harmful practices.
The free market puts severe limits on malpractice in any type of business, and so it did in the money storage business. There is a history of bankruptcies of gold warehouses, or "deposit banks" as they would soon be called ("Deposit banking" significantly differs from "loan banking", back then the two proffessions were performed by different types of institutions, but that's a different story.) Bankruptcies, that were the well deserved result of malpractice and low quality service.
Soon it would become a major success determinant for banks to be widely trusted and to make sure their paper tickets don't lose value. It was in their own best interest not to perform malpractice. The forces of the free market ensured that banks would have a natural incentive to make sure their customers could redeem their paper tickets for gold.
The period during which this system flourished in the United States was called the classical gold standard. It was the era between 1815 and 1914. During that period, the USA swiftly became one of the most prosperous and advanced countries in the world. Unprecedented growth and technological progress were achieved, such as the application of electricity, the build up of railroads, and the invention and implementation of telecommunication systems.
As Rothbard puts it: "The international gold standard meant that the benefits of having one money medium were extended throughout the world. One of the reasons for the growth and prosperity of the United States has been the fact that we have enjoyed one money throughout the large area of the country. We have had a gold or at least a single dollar standard with the entire country, and did not have to suffer the chaos of each city and county issuing its own money which would then fluctuate with respect to the moneys of all the other cities and counties. The nineteenth century saw the benefits of one money throughout the civilized world. One money facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labor." (http://www.mises.org/money/4s1.asp)
Government Meddling
Governments pursue the profession of exercising power over people in a forceful and coercive manner. Unlike in other professions and organizations, competition amongst governments leads to bloody and fierce battles. Over history governments have always tried to find convenient ways to finance their wars. Taxes were one option, however back then people were aware of the fact that governments don't spend money responsibly. Any slight increase in taxes would lead to fierce resistance and rebellions that even the police or the military could not withstand easily.
Another option was to obtain loans from industrials and banks. This was a great opportunity for those banks who intended to print more paper tickets than they had gold in their vaults. A fateful collaboration between private banks and governments evolved.
Some banks would print paper tickets out of thin air and supply those as loans to governments. This ensued all the typical effects that inflation has on society. What happened to the blessing forces of the free market? Of course people who were using these banks to store their gold would recognize that their paper tickets were losing value and that they would probably not be able to redeem them for gold ("redeem them in specie"). This would lead to a so called "bank run".
What did the banks do? Usually, in a free, non-coercive market they would not stand a chance, they would go bankrupt and be out of business. However, since they now had the support of a powerful, coercive, and arms-bearing organization, namely government, they sought for help with it. Following the principle "You scratch my back and I'll scratch yours", governments would now permit their banks to refuse specie redemption to their customers. - Probably the most fateful violation of property rights in all of history. Resistances would be crushed violently and people had to accept the fact that they would not be able to redeem in specie. After a precedence was set, governments all over the world would occasionally, and with all their power of arms and police, grant banks that financed their wars the permission to suspend specie redemption.
Banks would always try to pursue inflationary practices if they could. They would be amongst the inflation beneficiaries and could maximize their income that way. As we have seen, the free, non-coercive market system put strict limits on these ambitions. However, as soon as governments started meddling with the money market, banks realized the opportunities that this entailed. Those "private" banks that were working in tandem with the government, were the strongest proponents for the establishment of a central bank. Why?
We have seen that some banks have tried to maximize their profit by printing more paper tickets than they had gold in their vaults. We have also seen that this malpractice was prevented in a free money system. Example: If a customer C were to own accepted paper tickets from bank A, but redeemed them with bank B because it is the only bank within its vicinity, ultimately bank B would approach bank A for specie redemption. Any exuberant issuance of paper tickets by bank A would immediately result in bankruptcy of bank A's business, as soon as bank B would approach them for redemption.
If not the customers themselves redeemed their paper tickets in specie with the original issuer, ultimately bank A would approach bank B to redeem tickets from bank B in specie.
Hence, in order to avoid these market pressures different banks occasionally tried to partner up and form cartels were they agreed to inflate the paper ticket supply but not approach each other for specie redemption. However, cartels or monopolies can't exist for a long time in a free , non-coercive market, no matter how large they are. Free market competition, entrepreneurs , and a dynamic venture capital market would always quickly put and end to their practices. In addition, as the paper ticket supply would ultimately lead to hyperinflation, the customers themselves would approach the original issuers and put them out of business.
The Central Bank
The only way for a monopoly to persist in the long run is by teaming up with an entity that specialized in the unethical profession of exercising force and coercion, namely government. This would enable the monopolists to ultimately use the forceful power of arms and police in order to make people accept the way it operates. In addition, government could always force people to accept a suspension of specie payment if needed.
A government supported central bank would give banks the opportunity to finally enjoy government's benign aegis and protect them from the bothersome forces of the free, unhampered money market.
This is how it would work:
- Government would inaugurate a law that would state that only paper tickets from one bank, the central bank, shall be accepted as claims to gold and as mediums of exchange
- The central bank would store gold and provide paper tickets as claims for gold evenly to all private banks
- Private banks would then inflate their paper ticket supply by providing more paper tickets or even just demand deposits (also called checking accounts) to its customers on top of the gold-backed paper tickets (fractional reserve banking)
- People who were not willing to accept the depreciating paper tickets in exchange for products or services were deemed criminals and violently forced by law to accept them
- Whenever an exuberant supply of paper tickets would lead to a bank run, government would grant the central bank permission to suspend specie payment
However, they still weren't satisfied. The biggest problem for them was now the bothersome dependency of paper currency on real money. In order to completely free themselves from any dependency they desired to change the system in a way that allows them to print paper currency without any ties to gold or silver. They desired to be able to print paper out of thin air and completely free themselves from any obligation to redeem in specie. This would finally free them from all remaining checks and balances.
All over the world, sooner or later governments would make their central banks go "off gold". Most of the time this happened with the argument of avoiding monetary "inelasticity". However, it was clear that the ultimate reason was the incentive for government and banks to establish a permanently inflationary system.
This system in essence means that government steps in and forces people to accept a lower quality money instead of a money that has prevailed in the free, unhampered market. Coincidentally, government itself happens the producer of this low quality money.
The exact equivalent of this a market, such as the automotives market, would mean that government produces one brand of cars and does not permit any competition within its borders. This is what the governments of the former Soviet Union experimented with. I think this makes it a little more obvious how devastiating the effects of a 100% government controlled paper money system will ultimately be.
The United States were the last country to go off gold in 1970 under president Nixon subsequent to the collapse of the Bretton Woods system.
This is how we got to the monetary system of today, as described in the article "Negative Impacts of Inflation".
This system can only persist under a strong, forceful and coercive government that constantly violates the most basic ethical guidelines. Over centuries, the centralization and the monopolization of the money market went hand in hand with an ever growing and powerful government.
The government imposed central banking system has reshaped the money market from a decentralized, efficient, and fair system to a centralized, inefficient, and unethical one that allows for major violations of property rights where malpractice is not punished by the natural forces of the free, non-coercive market.
