A Brief History Of Money

Money is a commodity that has value in and of itself. It doesn't matter if it's precious metal, shells, or even grain (although that doesn't stand the test of time - it only keeps so long). The essential characteristic of money lies in that convertibility. That it is of value to everyone, everywhere that you may want to trade with.

Currency began as simply a more convenient way to exchange goods. Instead of having to cart around all kinds of sizes and weights of money, the commodity itself was stored at a trusted warehouse (or, in most cases, a vault) and the paper was a claim payable to anyone that showed up with it at that place. As the owner of that money you paid them for this service. That's how the original banks made their profit - simply a charge for services rendered.

The more widely trusted the holder, the wider the geographic region that would accept those claims in payment. If you needed to go wider afield, you had to take care of the shipment of the actual money and banks also arranged that with trusted couriers.

Internationally gold and, to a lesser amount silver, became the standard. Gold is valued everywhere in and of itself and has a high value per weight. It is scarce, it is durable and easily divisible. All countries that had a paper currency measured it's value in terms of the amount of gold a denomination was exchangeable for. Country's currency exchange was still actually gold exchange as you could go to the central bank and actually get the gold any time you wanted.

A few hundred years ago, bankers realized that it never happened (almost never - as long as the bank remained trusted) that everyone wanted the actual gold at any point in time. That meant they could loan out notes - more notes than they had actual, physical gold to back. That was where fractional reserve banking started. It started out small. Just a little more than they actually had. After all, you needed to make sure people believed that anyone and everyone could actually get their gold whenever they wanted or the whole scheme would fall apart. In this way, the banks created money out of thin air. They have 100 tons of gold in their vaults, but 200 tons worth of notes in circulation.

The danger was that if people thought their savings were at risk, they would all go to pull it out ... a "run" on the bank. Generally bigger banks would bail out smaller ones if it they thought is was financially sound, but, for example, someone started a rumor that got out of hand. Otherwise the whole scheme could go kaput. As long as it remained private, banking crises were usually localized and/or of short duration.

Then governments started sticking their fingers in the pie. Previously they only minted metal coins. When they devalued their coinage, they alloyed it. The more alloy they mixed in, the less it was actually worth. Essentially the same process as inflation but far easier for the average person to understand.

But governments quickly learned to love central banks. Why let private business get all the rewards? It lets them play with the money supply and rake some of it off the top without it being very noticeable, whether that's just a little alloy mixed in or a small increase in the number of currency notes on their reserves. Then, under the guise of "protecting" their citizens, they took complete control.

Central banks now set the amount of reserves banks were required to keep, unconstrained by any business considerations. They would act as the lender of last resort, not other banks who actually risked their own depositors' money when they bailed another bank out. They thought they could create perpetual prosperity by continually expanding the "money" supply, loaning it out left and right. That conceit, along with the trade wars of the late 20's after the war triggered the worldwide Great Depression. In the US they then made it worse by over-correcting in the other direction and drastically reducing the money supply instead of their proclaimed role of being the lender of last resort to shore troubled banks up. The other banks had been told they shouldn't do that any more, the government would take care of it and they should leave it all up to them.

Then things went from bad to worse.

In 1933, FDR stopped allowing currency to be convertible into gold inside the US as a measure to fight the depression, but it was still convertible internationally at a fixed $35/oz. That was a significant increase over the prevailing rate of about $20.67/oz on the open market, instantly making the US dollar "worth" more as far as current accounts went. The idea was that this boost would stop the deflation that was occurring because of all the currency the FED was pulling out of the market and it did do that, at least for a time. Over a few years the prices adjusted and levelled back out at the same amount of work got you the same goods as before.

Then towards the end of WWII, with most of the industrialized world in ruins, one of the first issues the nascent UN dealt with was the value of currencies. As the only major untouched industrial base, and with the US preparing to bankroll a lot of the rebuilding, a meeting was held in Bretton Woods, NH in 1944. At that meeting the allied powers decided to peg everything to the dollar instead of gold itself. Remember that gold was still 100% convertible into gold, which is where the saying "a dollar is as good as gold" came from. So at that point we still were dealing with worldwide currency that could be redeemed for gold at any time. That meant that for most of the world you no longer had to worry about transferring the physical gold, just the currency.

Then came the 60's. The Great Society and the Vietnam War. The US was deficit spending at levels never seen before in what was still, essentially, peacetime. Other countries started to wonder if we truly had enough gold to cover all the dollars that were being spent. Some of them started grabbing the gold - the actual physical gold, which, under Bretton Woods they always had the right to do.

August 15, 1971. Nixon signed a "temporary" executive order ending the ability for *anyone* to redeem dollars for the actual gold. That's when we really went off the gold standard. That's when the dollar became a fiat currency, a piece of paper backed by nothing. The subsequent wage and price freezes, the OPEC refusal to sell oil just for dollars causing the energy crisis, as well as the high inflation and interest rates of the 70's were all results of that as well as the regular, and much bigger than previously, economic roller coaster the world has been on ever since.

While most currencies are still "priced" in terms of dollars, nothing is fixed any more. Everything floats. There has been talk, and not just talk, but serious proposals to end the centrality of the dollar and replace it with a "basket" of several countries' currencies. That way the world isn't tied so closely to the US economy and what happens here doesn't affect everyone else as quickly and completely as it has since '44.

When that happens, and I expect it to within the next few years, the dollar won't be the almighty paper any more. It won't be "as good as" anything. Treasury bonds will drop in value like a rock. We won't be able to get all the foreign financing for our government debts (and remember, those debts are for *government* spending, not for trade purposes, no matter how many times protectionists try to pass it off as such). *That* is when we start learning the lesson the hard way that the dollar is actually *only* worth the goods it can be exchanged for.

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Posted in Economics.