The Nature of Money

PatM · May 20, 2005

A primer for those who've never really thought about it.

Money is merely a method of exchange (remember this)

First, what came before money? The Barter system - where people exchanged goods or services with one another to get things they couldn't produce or do for themselves.

Maybe you have two extra pigs and I know how to thatch a roof - I could eat pork chops for a few months and you could have a dry night in bed.

There were problems with the barter system though. Its fairly diffucult to carry a pair of pigs around while you look for a thatcher. And what if the only thatchers around had enough pigs already? If you didn't have something a thatcher wanted, you had to make due with a soggy bed.

This is where money comes in handy. If a society decides that a certain, easily transportable item (that doesnt need to be fed) has value to every person, they can barter that item for whatever goods or services they want. Since everyone wants it you never have to worry about having something that nobody wants. Although the barter system is considered outdated and not part of our currency economic system, our system really is a form of barter.

The best thing to use as money is something that has an intrinsic value. The item itself is worth something to everyone. It might be pretty sea-shells (wampum), gems (too rare for widespread use) or semi-rare metals (silver, gold).

Precious metals were the favorite choice for money - rulers would engrave them with their images to make it look all formal and proper but, the value of that money was in the metal itself - not in its markings. Melt down the metal and cast it into a different shape - it still had its intrinsic value.

There were some drawbacks though. Many rulers would undersize their coins - marking it as X value but only having Y weight. Some would be a little sneakier and add "filler" metals to make the coins heavier (thus the biting of coins to check their worth). All in all though, it was a good system. Didn't matter if a ruler was deposed and his money decreed worthless, you could melt it down and eliminate any connection to the disfavoured ruler - preserving the worth of your money.

The biggest problem with precious metals is that the supply is finite. While prices may stay the same, populations keep growing. Unless you can constantly add enough metals into circulation to keep the proportion of metal per person the same, the metal starts getting scarcer. As the metal becomes scarce, people are willing to give more goods or services to get it - its worth increases but fewer people can have it.

The same, but opposite, is true if too much of the metal is added into circulation. As it becomes more abundant, people are willing to give more of the metal in exchange for goods and services.

One often overlooked fact about the Spanish conquest of the "New World" is that Spain (and a fair chunk of the rest of europe) went through a hefty inflationary period. So much gold and silver was entering circulation that they lost their scarcity and thus their value.

As populations grew and economic output increased - metallic money started to become a problem. Sending someone 10,000 pound of silver was no easy task and it got harder and harder to find enough new metal to satisfy the needs of trade.

The answer people found was to use a representation of the precious metal. In England, instead of carrying around a bunch of metal, they would use sticks marked in a specific way and split down the middle to represent the metals. England used this system of "tally sticks" for hundreds of years.

Sticks got to be a bother so someone came up with the idea of using pieces of paper instead. The paper was a promise to pay a specific amount of the metal specific when presented to the issuer of the paper. Basically, an IOU or cheque.

At first the IOUs were held for as short a time as possible. People wanted their metals! Again, this became a bother since most people kept all their metals locked up in castles way hell and gone from where the person with the IOU lived.

There were some ingenious tradesmen around - goldsmiths. They had to have secure places to keep their own gold and generally worked in towns and cities. People got the bright idea of leaving parts of their metal hordes with goldsmiths. When they wrote their IOUs they were usually in towns and cities conducting business anyway so the receiver didn't have to go so far to get their metal. The goldsmiths liked this because they would get paid to hold gold for people.

Goldsmiths, being the smart little devils they were, figured out that they could "lend" portions of the metals they were keeping for people. As long as the depositors didn't all want their money at once, who would notice? When people were short on metals they'd go see the goldsmith and borrow some. Paying it back later with, of course, a little extra for the goldsmith.

After a while people started getting comfortable with just passing around the IOUs and leaving the gold at the goldsmith's for safekeeping. After all, giving someone and IOU for a pound of silver was pretty much the same thing as giving them a pound of silver. Thus banks, and paper money, were born.

Paper money has no intrinsic value - its only value is in its promise to pay. As long as you believed you would get the face value of the paper back in metals when you wanted it - it was just as good as the metal itself. If you couldn't get the metals, it was worth only as much as the paper it was made from - almost nothing.

Goldsmith are incredibly intelligent - they even figured out how to create money (IOUs) without even using the slips of paper. I you wanted to pay someone 10,000 lbs of silver, you could stop by the goldsmith's and tell him to change the ownership note in his ledger from you to the person they wanted to pay - no need for an IOU to be carried around. Goldsmiths, being as clever as they were, figured out they could lend money the same way. You want a loan? They just create a ledger entry and voila, you now have a loan. You can now pay people simply by telling the goldsmith to transfer some of your balance to someone else. it didn't matter that there wasn't enough gold on deposit to cover all the IUOs since everyone was passing around IUOs instead of metal.

If you ever wondered why english money is called "pounds sterling" now you know. A one pound note was exchangable for one pound of stirling silver at the goldsmith.

Gold Standard

A common misconception about the gold standard is that you could only "print" as much money as you had gold. This is incorrect. As the goldsmiths knew, how much you printed didn't matter. What mattered is how many people tried to collect the metal. As long as people were happily trading the IOUs around and not all trying to get the gold at once, you could make as many IUOs as you wanted.

The gold standard was only a requirement of what the goldsmith had to give in metal in exchange for an IOU.

After a while, metals were rarely exchanged and people realized that the metals themselves weren't actually needed. People were quite happy to exchange IOUs for their entire life without ever handling metal - so why go through all the bother.

That is how we got to our currenty money system. That $20 bill you have in your pocket has no actual value - it is only a promise of payment. There is no metal "backing" the value of that IOU.

DONT PANIC! (Plagerizing from the Hitchiker's guide - sorry)

That promise to pay sitting in your wallet is just as valid for "money" as a precious metal. Remember what money really is - a method of exchange. The value of precious metals is not fixed - It is dependant on scarcity, the scarcer it is, the more people want it. Its intrinsic value is whatever you think its worth. Paper money is identical - its value is whatever you think it is worth.

As long as people are willing to exchange a good or service for whatever you're offering, the thing you offer has value. If people wanted seashells, seashells could be money (wampum anyone?).

Was that understandable? I tend to ramble a lot... Sorry for all the misspellings!