A brief history of money

In our prehistory, when humans lived in nomadic bands, when bands would meet they would sometimes exchange a few goods based on barter.  However, it is with the development of agriculture and settlement of stable populations that money developed.  There are two theories of how money developed, and they are probably both right and were probably mutually reinforcing.  The first is that with agriculture, farmers need to wait for the harvest to have revenue, but they would need seeds and tools well before the harvest, so that need to borrow, and to keep records of the debt led to the precursors of money.  The other view is based on transactions.  Farmers would deposit their harvest in the temple, which would keep track of how much grain each farmer deposited and give them a clay tablet as a receipt.  Farmers could then trade the receipts.  In fact, the term “shekel” comes from ancient Mesopotamia, and referred to a unit of barley. 

When civilizations traded with each other, such local tokens would not do, and such trade was based on weights of gold or silver.  Coins started to be developed in China, India and Greece and Asia Minor around 1000 BC.  They were generally stamped with the head of the monarch, and guaranteed a certain weight and purity.  In this way the coin carried intrinsic value, rather than as a token referring to value stored elsewhere. 

Banknotes were introduced in China in about the 11th century AD.  They were much easier to carry than coins.  They were issued by the monarch and were convertible to gold.  However, the monarch could issue more banknotes than he had as reserves because most people would not request the conversion.  Banknotes were introduced in India a few centuries later, and Marco Polo brought the idea back to is Europe.  In the late middle ages in Europe, primarily the major trading houses in Italy and Holland started the use of bills of exchange and letters of credit to facilitate trade.  During this period the Islamic world was very highly monetized. 

The first central bank was the Riksbank in Sweden, which was established in 1668 and this was followed by the Bank of England in 1694 and in some other European countries over the course of the next few centuries.  Many of these central banks became monopoly issuers of banknotes, and were established to support their national governments. 

By the time of the First World War most currencies were on the gold standard, which meant that they were convertible to gold on a fixed basis.  This created a system of that constrained a country’s money supply to its reserves of cold and created a world of de facto fixed exchange rates.  The financial stresses of World War I caused many countries to introduce income taxes (as a temporary measure!) and to go off the gold standard, issuing more currency.  The interwar period saw some countries struggling with contractionary monetary policy to return to the gold standard, but with the advent of the Great Depression, it was abandoned again.

Currently the world uses what is called fiat currency, which means that it is not backed by anything.  However, even when money was backed by gold, was it any safer?  Does gold have any intrinsic value, or is it just a somewhat pretty metal?  It seems to me that gold is just a psychological crutch to help us believe that money has value.  In fact, the concept of value itself is a human construct that is culturally derived.  At any rate, the use of fiat money means that monetary policy is not constrained by a country’s gold reserves but by the good sense of its Central Bankers.