What is the Evolution of Money? And the Principles of its Development

What is the Evolution of Money? And the Principles of its Development
The range of commodities used over time as money is very wide; it includes cattle, grain, knives, spades, shells, beads, bronze, silver, and gold. The oldest recorded use of money dates back 4,500 years to ancient Mesopotamia, now part of Iraq. About 3,500 years ago, cowrie shells from the Indian Ocean were used as a means of payment in China. Passages in the Bible indicate that silver was used as a means of payment in the time of Genesis.The first coins--lumps of "electrum," a natural mixture of gold and silver--were introduced in Asia Minor in the seventh century B.C. in Lydia, now part of Turkey.

Driving the evolution of money, from the earliest emergence of commodity money, has been the desire to increase the efficiency of carrying out exchanges. In the absence of money, trade is accomplished by barter, the direct exchange of commodities or services to the mutual advantage of both parties. Such exchanges require a double coincidence of wants or multiple trades. If I have apples and want grain, I have to find someone who has grain and wants apples. Alternatively, I can engage in a series of intermediate trades that ultimately result in the exchange of apples for grain. In primitive societies with a small range of goods, barter can work well enough, but as the range of goods expands, barter becomes increasingly inconvenient and costly.

Several considerations have affected the evolution of commodity money itself--from cattle and grain toward shells and then bronze and ultimately to silver and gold. Commodities are useful as a means of payment and store of value if they were are less bulky in relation to their value, more durable, more homogeneous, and more easily verified as to their worth than other commodities. These considerations favored the use of the precious metals, for example, over cattle and grain, encouraged the use of gold and silver rather than bronze and copper, and further affected the way that silver and gold were used as money over time. Early commodity money, for example, was weighed, not counted, including the early uses of silver and gold. The introduction of coins that were stamped with their weight and purity allowed money to be counted and again reduced the costs associated with making transactions. Silver became the dominant money throughout medieval times into the modern era. Relative to silver, copper was too heavy and gold was too light when cast into coins of a size and weight convenient for transactions.

The next important evolution was the introduction of "representative" paper money. Warehouses accepted deposits of silver and gold and issued paper receipts. These paper receipts in turn began to circulate as money, used as a means of payment and held as a store of value. The paper was fully backed by the precious metals in the warehouse. Once again, efficiency was enhanced by the convenience of carrying paper money as opposed to the bulkier silver or gold coins.

Owners of the warehouses soon learned that the holders of the paper receipts would not simultaneously redeem the gold deposited with them. The warehouses could therefore lend the gold--in turn, often converted into paper notes--holding a reserve of gold that allowed them to meet the normal demands for redemption. This is the beginning of fractional reserve banking.

Seventeenth-century English goldsmiths are usually credited with this transition to modern banking, though the first paper money was introduced in China in the seventh century, a thousand years before the practice became widespread in Europe. Paper notes and early banking were introduced in Europe in medieval times and further advanced by the great banking families of the Renaissance. The spread of paper notes and fractional reserve banking opened up the potential for credit expansion to support economic development but also introduced the possibility of runs and liquidity crises as well as the risk of insolvency through the credit risk associated with the lending.

In the nineteenth century, many countries were on a bimetallic standard, allowing the minting of both gold and silver coins. But by late in that century, many countries had moved to the gold standard, and currency and bank reserves were backed exclusively by gold. Barry Eichengreen (1996) describes the gold standard as "one of the great monetary accidents of modern times," owing to England's "accidental adoption" of a de facto gold standard in 1717. Sir Isaac Newton was master of the mint at the time and, according to Eichengreen, set too low a price for silver in terms of gold, inadvertently causing silver coins to mostly disappear from circulation. As Britain emerged as the world's leading financial and commercial power, the gold standard became the logical choice for many other countries that sought to trade with and borrow from, or emulate, England, replacing silver or bimetallic standards.

England officially adopted the gold standard in 1816. The United States moved to a de facto gold standard in 1873 and officially adopted the gold standard in 1900. The international gold standard refers to the period from the 1870s to World War I, during which time the major trading countries were simultaneously on the gold standard. Though many countries went off the gold standard during World War I, some returned to a form of gold standard in the 1920s. The final blow to the gold standard was the Great Depression, by the end of which the gold standard was history.

Eichengreen argues that the emergence of the gold standard reflected the specific historical conditions of the time. First, governments attached a high priority to currency and exchange rate stability. Second, they sought a monetary regime that limited the ability of government to manipulate the money supply or otherwise make policy on the basis of other considerations. But by World War I, economic and political modernization was undermining the support for the gold standard. Fractional reserve banking, according to Eichengreen, "exposed the gold standard's Achilles' heel." The threat and, indeed, reality of bank runs created a vulnerability for the financial system and encouraged governments to seek a lender of last resort to provide liquidity at times of distress. Such intervention was, however, inconsistent with the gold standard. 

The international gold standard involved adherence to certain "rules of the game." First, the national unit of currency had to be defined in terms of a certain quantity of gold. Second, central banks had to commit to buy and sell gold at that price. Third, gold could be freely coined, such coins represented a significant part of the money in circulation, and other forms of money were convertible into gold at a fixed price on demand. Fourth, gold could be freely imported and exported.

With the collapse of the gold standard, countries moved to fiat money systems. Fiat money is inconvertible, meaning that it is not convertible into nor backed by any commodity. It serves as legal tender by decree, or fiat, of the government. Its value is based on trust--specifically that others will accept it in payment for goods and services and that its value will remain relatively stable. This trust is based, in part, on laws that make the fiat money "legal tender" in the payment of taxes and, in the United States, also in the payment of private debts.

Fiat money consists of both paper currency and metal coins the face value of which exceeds the value of the metal content of the coins. The need to finance wars encouraged early efforts by governments to issue fiat money. Early examples include the continentals issued by the American government during the Revolutionary War, assignats issued during the French Revolution, and the greenbacks issued during the Civil War. Most such issues of fiat money were followed by severe increases in prices, as governments tapped to an ever greater degree the easiest--in some cases perhaps the only--source of revenue. These experiences highlight the importance of control of the money supply for achieving price stability.

Today, money consists of currency, coin, and transactions deposits (that is, checking accounts) at depository institutions, including, in the United States, commercial banks, thrift institutions, and credit unions.It is not clear when the first check was written. The earliest evidence of deposits that might be subject to checks is from medieval Italy and Catalonia. But at that time, the depositor had to appear in person to withdraw funds or to transfer them to the account of another customer. Checks did not come into widespread use until the early sixteenth century in Holland and until the late eighteenth century in England.

The payment system has evolved further in recent decades with the spread of credit cards and then debit cards. Credit cards allow consumers to purchase all kinds of goods "on credit," making payment to the credit-card company for a collection of purchases later by check. In effect, the use of credit cards separates the purchase of goods from the ultimate settlement but increases the efficiency of exchange. Debit cards allow the consumer to make a purchase from a checking account through an electronic instruction to debit the account instead of by writing a check, another advance in efficiency.

Even more recently, electronic money has been introduced, still perhaps more in concept than in practice, at least in the United States. I will return to the role of electronic money today and the potential for the spread of electronic money in the future.
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