A Brief History of Money

Some time ago I wrote a little primer on the origins of money, and the basics of economics. You might enjoy it, or know someone else who would. A forwarded copy of it is below. But, these days, for the most part, the printing presses aren't needed. In fact, the big guys don't even write checks. They do electronic wire transfers. The "money" is really just bookkeeping entries in computers. It's a strange world we live in, eh?

Please indulge me, while I put to paper a little basic economics.

The way to think of money is as a scheme to improve on the inefficiencies of its predecessor economic system, which was barter. That is the entire purpose of money. It exists only to improve efficiency (reduce waste) in the exchange of goods and services, with the result of enriching the participants in the economic system.

NOTE: Efficiency is the core driving principle of economics. You should never think about economics without thinking about waste vs. efficiency.

(That's why it should make you cringe to see all this “stimulus” money being spent to repave roads that don't need it, while teachers are being laid off -- it is a misallocation of resources, i.e., inefficiency.)

Plain barter was the earliest economic system.

It works like this: I have corn, you have fish. I want fish and you want corn. Let's swap.

Or maybe you don't want corn, but you want fishnets, and you know someone who makes fishnets and wants corn. So you swap your fish for my corn, and then lug the corn over to the guy with the fishnets, and swap it for what you really want.

This sort of thing can work, but it becomes progressively more cumbersome and inefficient for 3-way, 4-way, and more-way transactions.

In this case, as far as you are concerned, corn is just an “exchange medium.” You have little use for it, except to exchange it for something else.

But corn is not ideal for that purpose. It has a tendency to spoil (so you can't save it up for very long), and its value varies considerably depending on the quality of the year's harvest. Also, it is bulky and heavy, for its value.

Valuable metals like gold and silver make better exchange commodities. They are more portable, and they don't rot, and mice don't eat them, and they don't fluctuate in value as much.

But they are still rather cumbersome to use. If someone offers you gold dust for your fish, you need to weigh it and assay it for purity. What a pain -- and what a waste of your time (inefficiency).

The next stage in the development of a monetary system was gold and silver coins. Gold and silver can be standardized in quantity for easy use in transactions. So instead of exchanging your fish or corn for fishnets, you exchange them for gold and silver coins, and then exchange gold and silver coins for fishnets.

It is still barter, of a sort, but it is barter for a standardized commodity.

Rather than weigh gold & test its purity with every transaction, making it into coins centralizes that process and makes the system a lot easier to use (more efficient).

That was the first “money.”

Of course, for gold and silver coins to be standardized in weight and purity, a trustworthy authority needs to be entrusted with the process of making the coins. Typically, that is a government mint.

The benefit of that system is a big efficiency improvement over simply bartering silver and gold. But the problem with that system is that an awful lot of valuable industrial metals are still required. The benefit (improved efficiency over straight barter) exceeds the cost (using a lot of valuable metal), but the cost is still substantial.

The next stage in efficiency improvement was the substitution of paper IOUs for actual gold and silver. (Are you old enough to remember Silver Certificates?) Those IOUs are essentially the earliest form of paper money.

The advantage of using paper money instead of actual gold dust/bullion or even gold coin is that it is a lot easier, especially for large-value transactions. Even at $1100 per oz, enough gold to buy something large, like a factory, is more than a little cumbersome. By putting the gold and sliver in a government vault, and just trading certificates which are redeemable for the gold and silver, a lot of trouble can be saved (i.e., it's more efficient).

The gold and sliver are said to “back” the paper.

Once people get used to trading paper instead of actual gold, the gold just tends to sit in the government vaults (Fort Knox). Nobody bothers to redeem it, so it really isn't used anymore.

Therein lies both the opportunity (for further efficiency improvement), and the problem (temptation).

The opportunity is to eliminate the inefficiency of wasting all that valuable industrial metal. The problem is the temptation to unwisely issue too many IOUs, with the result that their value declines (inflation), and the efficiency of the economic system suffers.

Remember that the efficiency of an economic system is dependent on having a fairly stable exchange medium. The less stable the value of the exchange medium, the less suitable it is for use as “money.” That is as true for paper money (and its electronic equivalents) as it is for commodities like gold and silver.

A wisely-managed monetary system based on fiat currency (that is, paper money not backed by gold and/or silver) can be more efficient than a gold-backed or silver-backed system, because it doesn't waste useful and scarce industrial metals for use as an exchange medium. However, that efficiency advantage can be overwhelmed by the inefficiencies caused by inflation, if the issuing authority is unwise or untrustworthy.

Hence any blanket statement that “gold standard is best” or “fiat currency is best” is incorrect. Rather, the determination of which system is best (most efficient) depends on who is running it.


Dave Burton
Cary, NC

“If anyone thinks the words ‘government’ and ‘efficiency’ belong in the same sentence, we have counseling available.”  - Sen. Paul Tsongas (D-MA)


Permalink: http://tinyurl.com/moneyhist