The evolution of money - based on whatever I have learnt

 

A snapshot of the evolution process...

• In the beginning each person produced different things and since each person could not produce everything there had to be some means of trading. The barter system came into use to solve this problem – exchange of goods for goods; you give wheat and I give cloth but this was possible only if you needed cloth and I needed wheat. Another drawback of this system is that it is not convenient carrying goods from one city to another in search of a person who needs it.
  
• Then came different forms of currencies. Cowry shells (sea shells) were used as a form of currency to buy goods. For example: 5 sea shells for a plate of rice.
  
• Then came metal money (using base metals like iron and copper which corrode) which is easier to carry. They were round with a hole in the middle so that people could carry it on a string. Then came metal money made using scarce metal because something rare is perceived to have more value (gold, silver, bronze).
  
• Leather was used in China and even paper currency was tried out but they kept on printing so much of paper money that it led to hyperinflation and the system was abandoned (more about this later).
  
• To prevent this from happening England pegged the value of its currency to a certain quantity of gold and the US also followed suit. This was the gold standard and this also collapsed in 1970s.
  
• So we started with commodity money (using goods as money) which gave way to representative money (money backed by a commodity) which gave way to fiat money (money backed by nothing but the Government’s word!).
  
  Did you know?
  
  How the word "pay" originated -> derived from pacare (to pacify or make peace with) - money was given to the bride's father because they are losing the service of one person in the family!
  
  How did the phrase ‘pay thro the nose’ originate? The nose was cut for not paying tax in Denmark!

How gold standard came into effect?

• Gold is a rare and durable metal.
• But gold can't be carried easily to trade - carrying heavy coins is a problem. Into the picture comes the bank; deposit gold at a bank and get a receipt saying that you have so much gold in the bank.
• Now instead of using gold for trade, people used the bank receipts to trade. This led to the birth of paper notes. Instead of a receipt, the banker started giving a note saying "I promise to pay the bearer 5 ounces of gold on producing this paper" - this is called a bank note. Now what happens? The bank has a pile of gold lying in its office and not many come to redeem the gold because everyone is happy using the bank notes for trading.

So the bank sees an opportunity to make money – it prints new notes which are actually not backed by gold and circulates them for loans – the assumption is that not everyone will come to reclaim the gold at the same time; and anyway after the loan period is over, the bank will get back the amount of money loaned and so there will be no problems. So now the bank has started issuing notes on a fractional reserve – i.e. it doesn't have 100% gold backup for all the banknotes issued.

 

Banknotes are not commodity money but fiduciary money (fide means trust; you trust that when you return the banknote the bank will give you the gold). You trust the bank will be able to give you the gold whenever you demand for it.

 

If fear sets in that the bank is not sound, everyone will rush to get their gold from the bank; then bank will exhaust its reserves and some people will have worthless banknotes! This has happened in history and is called a bankrun! All this was going on in the 19th century.

 

Then England went into the Napoleon wars and was in need of money; it switched to fiat money - where there is no backing of a commodity but just the command of the government. They reverted back to fiduciary money after the war. In war these things happen and it is during such times that there is an economic boom because of liberal policies set by the government for survival. In the 1900s the Sterling was the main foreign currency and many countries had adopted the gold standard; so it was like 1$ = 0.25 gram of gold, 1 pound = 0.5 grams of gold and so on.

 

Then came the World wars where the US was the least affected country – it produced goods which were bought by European countries for the sake of war. Thus US piled on gold reserves and was the creditor for everyone; it produced and everyone else consumed. After the World Wars England’s condition had weakened and everyone reached an agreement (Bretton Woods agreement) that going forward all currencies would be pegged to the US dollar and the US dollar would be backed by gold.

 

The Bretton Woods agreement basically said that 1 ounce (28 grams) costs $35. Exchange rates were set based on this. With Bretton Woods all countries decided to peg their currency to the US dollar and the US dollar was pegged to gold. So at this time the world accumulated dollars and this marked the start of the dollar as the dominant currency – everyone held dollars and it was the reserve currency used for international trade. Nixon in 1971 ended the gold backing provided by the US – this meant that no longer could US dollars be reclaimed for gold (this happened because the US suffered a huge setback in the Vietnam war and with countries starting to redeem dollars for gold, the US faced problems; they couldn’t redeem every single dollar because they didn’t have 100% backing).

 

The problem with gold standard?

 

 The amount of gold in the world is finite; so effectively you can only have that much amount of money in circulation; but with a rising population and need for credit where do we go for mining gold? The option would be that since the quantity is constant keep increasing the price of gold to support the need - instead of saying Rs.10000 for 1gm make it as Rs.20000 for 1gm! In fact this is what is advocated by supporters for the gold standard.

 

But still the gold standard is a difficult system to manipulate during crisis situations as we shall see later.

 

The advantage is obvious: You cannot simply go on printing money because when people come to redeem the money you have to give them gold; and that is finite! So inflation gets curbed because money supply is limited and controlled.