History of Money
Money is medium of exchange and store of value. In the early days of human civilization people didn’t have money but instead they bartered together exchanging surplus products they produce for surplus products others produce. If farmer Joe has excess wheat and needs eggs and neighbor farmer Tom has eggs and needs wheat they would meet and exchange a number of eggs for an amount of wheat.
The above example could become more interesting if we added farmer Max who needs wheat but can only offer beef. If Max can trade with Joe exchanging some beef for some wheat then he will meet his wheat needs. If Joe doesn’t need beef but Tom needs beef then Max will have to do a double trade. He will first trade with Tom exchanging some beef for some eggs then exchange these eggs for some of Joe’s wheat. In that example Max used the eggs as medium of exchange, which means that he got the eggs to exchange them for other products. Max may keep some of the eggs so he can exchange them later for more wheat from Joe or other farmers who accept eggs. In this use case eggs function as store of value because Max is using them to store the value he got from trading the beef.
Of course eggs and perishable similar goods cannot store value for long and cannot be easily divided. People started to use goods that don’t perish and can easily be divided as storage of value and medium of exchange and these goods played the role of money in addition to their role as commodities. Different civilizations picked different types of commodities to use as money such as types of shells and rocks. The commodities that got used as money were usually scarce and valuable in that civilization. In larger civilizations gold and silver became widely used as money and they started to take the form of coins and governments played a role in standardizing the weights and shapes of these coins.
Owners of gold and silver coins and bullion faced a problem in securing them so they started to save them in warehouses with other commodities such as copper or grains. People began to deposit their valuable gold and silver in these warehouses for a fee and receive warehouse receipts. People then used the warehouse receipts to do transactions so they would exchange receipts for certain amount of gold or silver for products and the merchants who got those receipts could move the silver or gold to their accounts. Warehouse receipts then functioned as money and they are the precursors for banknotes.
Deposit banks were special businesses that specialized in storing gold and silver and issuing certificates or notes to the clients. They issued an amount of notes equal to the amount of specie they stored. Deposit banking was known in Egypt and Greece in ancient times, Damascus in the thirteen century and in Venice in the fourteenth century. In England there were no deposit banks until the civil war in the seventeenth century, so merchant used to store their gold in the king’s mint in the Tower of London.
Deposit banks started to use the specie they store to offer loans by issuing more banknotes than the specie they have and lend them to people in exchange for interest, so banks became involved in both deposit banking and loan banking business. This practice is the source of the modern practice of fractional reserve banking.
Governments started to play larger role through establishing central banks and regulating the different denominations of banknotes representing their currencies. Having a precious metal commodity backing the currency limits the government’s ability to create money, but during wars and major crises governments usually suspended the convertibility of paper money to gold and silver.
Fiat Money is paper money created by government without any gold or silver backing. During the War for Independence and the Civil War the government issued paper money in addition to gold and silver. Paper money started as equal to specie in value but because the government printed so much to cover the cost of war the value of paper money plummeted and people and businesses only accepted gold or silver. One of the famous old sayings in the U.S. is “not worth a continental” which referred to the paper dollar printed by the Continental Congress during the war for independence.
Outside of war times the United States had the dollar always convertible to either gold or silver up to late 1800s then only to gold afterwards. On August 15th, 1973 president Richard Nixon formally ended the Bretton Woods agreement formed after WWII that made the U.S. dollar convertible to gold at the rate of 35 dollars an ounce. This ended the gold standard in the U.S. making the dollar a pure fiat money. It is worth noting that at the time of this writing the price of gold is $1227.50 per ounce.
Choice: Cooperation, Enterprise, and Human Action: Chapter 12.
The Evolution of Everything: Chapter 15: the evolution of Money.