The Evolution of Money

ITS JUST PAPER I TELL YOU
Around the 9th century AD, the first official paper currency was introduced in China under the Song dynasty. It was quite different from today’s modern currency though because it was in very short supply, had an expiration date and was only available in some regions. However, the main benefit was that wealthy people did not have to carry a ton of currency around. In fact, the origin of paper currency was that rich merchants who owned lots of coins, started to leave their wealth with a trustworthy person and in turn received a promissory note (representative money), which could be redeemed afterwards.

These occurrences coupled with a shortage of copper, led to the government implementing one of the first forms of fiat money in human history. However, about five hundred years later, this currency was eventually abolished because there was mass printing of bank notes, which led to rising inflation. Notably, this was still several years before the Europeans would adopt paper currency and several centuries before it would become widely used.

Then came Stockholms Banco, a private bank in Sweden founded in 1657 by Johan Palmstruch. Four years after its foundation with the collaboration of the government, it became the first bank to issue European banknotes, which could be exchanged for a specific amount of silver coins at the bank. These banknotes became very popular, as they were easy to carry around (rather than the metal currency of the time) and could be exchanged for goods at the market.

Unfortunately, the bank issued more notes than it could redeem for silver coins and so when people started asking to have their notes honoured, the bank did not have enough reserves. This led to a loss of confidence in paper currency, ending with the Swedish government taking control over the bank, settling debts and quickly thereafter closing it down.

As these two examples show, establishing paper currency was far from easy. For the next few centuries, several attempts were made with banknotes, until eventually they became accepted by the public. The only reason why people did eventually become comfortable with paper (fiat) money that was worth nothing was when governments backed them with their own reserves. This prevented banks like the Stockholms Banco, from becoming bankrupt but introduced a truly new evil to the world: inflation.

To battle this problem, several countries started to adopt the gold standard, which is when countries start to fix their currencies to a set value in gold.

The gold standard reduces inflation because it is very difficult to manipulate the economy’s demand for money when it’s backed up by gold. Specifically, one can only produce as much money as there is gold; but since the world’s gold supply is fixed, the amount of money in the world would remain the same unless one discovers a new gold mine or new method of alchemy.

Unfortunately, this strength was also its eventual undoing, as the gold standard was short lived. During the Great Depression, the system completely collapsed after many economists blamed it for being unable to revive the economy through monetary policy (i.e. increasing the money supply to pump funds into the market, as we saw governments do following the 08-09 economic meltdown).

The new system that followed arose at the end of World War II, where the International Breton Woods System replaced the gold standard. Under this agreement, all countries agreed to tie their currencies to the US dollar, which was pegged at $35 per ounce of gold. This occurred mainly because the US was the world’s largest economic power and because it held the majority of gold reserves.

This system endured until 1971, when the dollar started to devalue and other countries did not want to appreciate (raise) their currency value due to the damage it would do to their export dependant industries. As a result, the United States abandoned the fixed value of the dollar and let it float in the world’s money markets (fiat currency).

This is how the world’s monetary system now works and has become very important in international trade and globalization. Fiat currency, which is used in most of today’s developed countries, is issued by the government as legal tender and is not convertible into anything such as gold or silver; making it virtually useless were it not for its acceptance in transactions (i.e. by society’s willingness to believe that government backed pieces of paper have value).