A Brief History of Money
Historians believe that money was invented much earlier than writing, perhaps anywhere from 6 to 9 thousand years ago. Unsurprisingly, the early history of money is not well-documented.
Before the invention of money, people in need of goods or services would enter into an agreement to trade, or barter. Bartering did not work very well because it was inefficient. If a person wanted apples and only had chickens to trade, he would have to find another person who not only had apples but also desired chicken. Even if those individuals happened to find each other, they would need to come to an agreement on how many apples were equal to one chicken, or vice versa.
Coins, Banknotes, & Commodity Money
Around 3 thousand years ago, civilizations started to select precious metals like gold and silver as their primary currency. Nonetheless, standard units of currency still did not exist. The divisibility of currency remained a problem until around the 7th-6th century BC when societies started to form precious metals into equal weight coins. Despite this development, the bulkiness and weight of coinage was deemed inconvenient. This led to the development of representative money such as banknotes, or paper money. Banknotes functioned as a claim check on the gold or silver held in a treasury and promised by a central bank. Banknotes were equivalent to gold because you could always convert them into gold.
The use of gold as “commodity” money was not accidental. Gold has several unique qualities that make it a good store hold of wealth such as scarcity, durability, easy recognizability, and divisibility. Gold is also very labor intensive to locate, mine, refine, and mint. A significant amount of energy must be expended to generate a relatively small amount of additional gold.
The Gold Standard and Bretton Woods Monetary Systems
In the 19th and early part of the 20th century, many nations adopted a monetary system called the gold standard. In this system, the value of a nation’s currency, or paper money, was defined by a fixed quantity of gold. In 1944, with World War II coming to an end, the Allied Nations met at Bretton Woods New Hampshire to rebuild the international economic system. At that time, the United States held two-thirds of the world’s gold and was emerging as the most prosperous nation in the world. The outcome of this conference was the Bretton Woods monetary system, in which it was decided that the US dollar would be used as the world’s reserve currency.
Under the Bretton Woods system, countries connected their currencies to the US dollar at some fixed rate, and the US dollar, itself, was backed by a fixed quantity of gold; 1 US dollar for 35 oz of gold. In this way, the world’s currencies were still backed by gold through the US dollar.
In the beginning, the Bretton Woods system worked well. While the United States held the majority of the world’s gold the system appeared stable. However, a number of events caused the system to begin to fall apart. In the 1950s and 1960s, the economies of Germany and Japan began to recover while the relative economic output of the US declined. The United States was also in the midst of the Vietnam War and increasing monetary inflation. By 1966, foreign central banks held $14 billion while the US only had $13.2 billion in gold reserves. The dollar continued to drop relative to foreign currencies and nations continued to redeem their US dollars, with some exiting the Bretton Woods system altogether.
The “Nixon Shock” and Fiat Money
In August 1971, in response to increasing inflation, President Richard Nixon announced that foreign governments could no longer exchange their US dollars for gold. This unexpected event became known as the “Nixon Shock.” This historic announcement led to the creation of a new monetary system in which the currencies of the world were no longer backed by gold or any commodity of intrinsic value. This system became our current monetary system.
Most modern paper currencies, such as the US dollar, the euro, etc… are government-issued and not backed by a commodity. They are known as fiat currencies. A basic underpinning of the fiat monetary system is that governments can declare that something of no value, such as a piece of paper, has value. In other words, the value of a fiat currency is determined by government promises and the peoples’ trust in those promises.
The Future of Money
To assess the merits of a currency, one must recognize that money has two primary functions. 1) Money serves as a medium of exchange and 2) it is a store hold of wealth. Fiat money certainly works as a medium of exchange, but many have questioned whether it is a good store hold of wealth. Since, in our present monetary system, money isn’t backed by anything of intrinsic value, central banks around the world have been able to print effectively unlimited amounts of money. Therefore, fiat money risks losing value either because central banks print too much of it, leading to inflation (or even hyperinflation), or because people lose trust in its value.
Earlier this year, the billionaire investor Ray Dalio made headlines for exclaiming, “Cash is trash!” In essence, Dalio was warning about the tendency of people to underestimate the risk of holding cash, a fiat currency, as a store hold of wealth. Dalio pointed out that, throughout history, every currency has either ended or been devalued over long periods of time. It is almost impossible to exactly answer the question, “what is money?” because money is constantly changing and evolving over time. Some people think that the fiat system will persist, others believe we will return to the gold standard, and a small contingent think bitcoin is the next reserve currency. Only time will tell.