A Brief History of Money

By James Burowiecki
IEEE Spectrum, June 2012

Edited by Andy Ross

Economists typically define money by the three roles it plays in an economy, as a store of value, as a unit of account, and as a medium of exchange. All of these roles have to do with buying and selling.

In the seventh century BCE, the small kingdom of Lydia, located between the Mediterranean and the Mideast, introduced the first standardized metal coins. Coins became ubiquitous throughout the Mediterranean. They facilitated the flow of trade and established the authority of the state.

Money encouraged the spread of markets. Once part of your economy is taken over by markets and money, they tend to colonize the rest of the economy. Money makes market transactions easier and using it redefines what people value. Governments embraced hard currency because it let them collect taxes to build military forces.

The rise of the Roman Empire led to an increase in the use of money. It was used to unify and expand the empire, reduce the costs of trade, and fund the armies. Several centuries later, the fall of the Roman Empire led to a decline in the use of money. Cities shrank in size and commerce dwindled.

The rise of feudal society undercut money. The basic relationship between master and vassal was mediated not by payment for services rendered but rather by an oath of loyalty and a promise of support. Land belonged to the king, who granted use of the land to his lords, who in turn provided plots of land to their vassals. A feudal estate was often a closed community in which money had little use.

Money is impersonal. With it, you can cut a deal with a stranger. As long as your money and his products are good, you two can do business. As long as you have sufficient cash, all doors are open to you. These characteristics encourage trade and the division of labor, reduce transaction costs, and make economies more efficient and productive. These same qualities let money corrode traditional social orders.

By the 12th century CE, Europeans saw money as something to invest in order to make more money. A banking industry emerged in Italy. The banks introduced such financial products as municipal bonds and insurance. They balanced credit and debt and invented the bill of exchange, which was a document representing a quantity of gold for use by traders and travelers.

In the 16th century in Europe, the amount of money in the economy was still a function of how much gold and silver was available. The rulers of Spain and Portugal plundered their New World colonies to accumulate vast hoards of gold and silver, which triggered inflation and tumult in the European economy.

Today in the United States, the Federal Reserve can increase the money supply without looking for gold or printing more dollars. Only about $1 trillion of the roughly $10 trillion money supply exists in the form of paper cash and coins. The Fed buys government bonds and treasury bills from banks and then credits the banks accordingly. As the banks lend, invest, and otherwise spend this new money, the overall money supply increases. To decrease the money supply, the Fed sells bonds to banks and then debits their accounts. The banks have less money and the money supply shrinks.

The view of money as commodity began to shift only with the widespread adoption of paper currency. In 1862, Congress finally allowed the government to print paper money. Before then, private banks were issuing bank notes, in theory backed by gold but with no firm guarantees.

The Bank of England adopted the gold standard in 1821, promising to redeem its notes for gold upon request. As other countries followed suit, the gold standard became the general rule for developed economies. The gold standard brought price stability but deflation. Economies falling into recession could not do anything to quickly set things right, so they took a long time to recover from downturns. But banks made loans freely against their gold reserves. The amount of paper currency in circulation dwarfed the amount of gold and silver behind it.

The First World War finally derailed the gold standard. Governments needed more money, so they just printed it. Currencies today are fiat currencies, backed by the authority of the issuing government. Many people say reliance on fiat money gives too much power to the government, which can recklessly print as much money as it wants. Yet even with the gold standard, governments revalued their currencies from time to time, in effect dictating a new price for gold.

The notion that gold is somehow more real than paper is a mirage. Gold is valuable because we say so. We can say the same for colorful rectangles of paper. Instead of worrying about finding more gold and silver, we can focus on managing the money supply. Central banks have much more flexibility in dealing with economic downturns. Recessions have been shorter and less painful since the gold standard was abandoned.

Critics of fiat money dread talk of central bankers tinkering with the money supply. They believe it will lead to runaway inflation. We cling to the belief that money needs to be backed by something solid. But when a bank makes a loan, it simply credits the borrower's bank account, so with each loan it adds incrementally to the money supply.

The recent crisis should remind us of the dangers of runaway credit. But it's a mistake to yearn for a more solid foundation for the monetary system. Money is a social creation, just like language. What matters is not what it is, but what it does. Successful currencies lubricate commerce and help people work and create.


The Future of Money
IEEE Special Report