Money, as defined by Wikipedia, is “any object that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as a medium of exchange; a unit of account; a store of value; and, occasionally, a standard of deferred payment.”
Wikipedia further states money’s origin as “commodity money.” However, as per PositiveMoney (an international organisation working to shift the economic model to a more fair and sustainable territory), the online encyclopaedia’s categorisation of “commodity money” is not correct as money did not originate in that manner.
There are three theories of the origin of money: that it was created for trading, social, and religious purposes.
Breaking down the theories
Given its flexible nature against traditional bartering (exchanging goods or services for other goods or services without using money), economists assume that money was developed for trading purposes. The assumption makes money a valuable commodity in itself, such as cattle in ancient civilisations, later gold and silver by weight, and finally coinage, gold and silver coins.
The ‘social’ theory suggests that money was created for social purposes, such as establishing the price of a bride or as blood money for somebody killed/injured by another tribe. And talking about the ‘religious’ theory, German historian Bernard Laum in his book “Heiliges Geld” (Holy Money) states that money’s origin was in the “Eastern temples as the prescribed sacrifice to the gods and payment to the priests.”
Between 1500 BC and 1000 BC, the medium of exchange shifted from a cattle standard to gold by weight standard. The temples played a major role in transforming gold into money. As gold and silver kept on accumulating in the temples and not all of them were required for decorative purposes, there was a good motivation for these religious establishments to transform the metals into money or monetise them.
Money was assigned a value by decree by the priests. Therefore money, in the form of gold or silver by weight, was the first fiat currency. It had a value both as a means of payment and also as a commodity.
What do economists believe?
As per the article titled “A Brief History of Money,” published in IEEE Spectrum, in the 13th century, the Chinese emperor Kublai Khan embarked on a bold experiment. China at the time was divided into different regions, many of which issued their own coins, discouraging trade within the empire. So Kublai Khan decreed that henceforth money would take the form of paper. He went against the earlier governance practices of sanctioning paper money alongside coins. Kublai wanted to make paper money (the chao) the dominant form of currency.
How did money become the basis of trade? By the time money made its first appearance in written records, in Mesopotamia during the third millennium BC society already had a sophisticated financial structure in place, and merchants were using silver as a standard of value to balance their accounts. But cash was still not widely used.
In the seventh century BC, the small kingdom of Lydia introduced the world’s first standardised metal coins. Located in present-day Turkey, Lydia sat on the cusp between the Mediterranean and the Near East, and commerce with foreign travellers was common. Just the kind of situation in which money is quite useful.
The Lydian system’s breakthrough was the standardised metal coin. It was made of a gold-silver alloy called electrum. Other kingdoms followed Lydia’s example, and coins became ubiquitous throughout the Mediterranean. This had a dual effect: It facilitated the flow of trade, and it established the authority of the state.
The spread of money throughout the Mediterranean didn’t mean that it was universally used. Most people were still subsistence farmers and existed largely outside the money economy. However, as money became more common, it helped the markets to spread.
The lesson here was that once even a small part of a civilization’s economy was taken over by markets and money, they used to colonise the rest of the economy, gradually forcing out barter, feudalism, and other economic arrangements. Money started making market transactions easy, apart from redefining people’s values, pushing them to view things in economic, rather than social, terms.
Hard currency became mainstream
Governments started embracing hard currency because it facilitated the collection of taxes and the building of military forces. In the third century BC, with Rome’s rise, money became an important tool for unifying and expanding the empire, reducing the costs of trade, and funding the armies that kept the emperors in power.
The decline of the Roman Empire saw a decline in money’s usage too, at least in the West. Parts of the former empire, like Britain, simply stopped using coins. Elsewhere people were still using money to balance accounts and keep track of debts, and many small kingdoms minted their own coins. But in general, the circulation of money became less central, as cities shrank in size and commerce dwindled.
“The rise of feudal society also undercut money’s role. 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. The land was not bought and sold; it belonged, ultimately, to the king, who granted use of the land to his lords, who in turn provided plots of land to their vassals. And feudalism discouraged trade; a feudal estate, or fief, was often a closed community that aimed to be self-sufficient. In such a setting, money had little use,” IEEE Spectrum explains.
However, the above phase didn’t last long, as by the 12th century, even as the Chinese were experimenting with paper currency, Europeans began to embrace a new view of money: Instead of being something to hoard or spend, money became something to invest, to be put to work in order to make more money.
Trade fairs sprang up across Europe, frequented by a community of merchants. A new industry, called banking, emerged in Italy. These new institutions introduced a host of financial innovations, including municipal bonds and insurance. The banks fostered the use of credit and debt, which became ever more central to the economy as kings borrowed to finance their military adventures and merchants borrowed to fund their long-range trades.
The invention of the bill of exchange laid the groundwork for the emergence of paper money in the West. The bill was a sort of precursor to the traveller’s check: a document representing a quantity of gold that could be exchanged for the real thing in a different city. Merchants liked the bills because they could be carried around with far less risk (and exertion) than the precious metal.
By the 16th century in Europe, money remained a physical thing, the thing being a piece of gold/silver. 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 didn’t quite like this system. This led them to plunder their “New World Colonies” and accumulate vast hoards of precious metals, which in turn triggered periods of rampant inflation and enormous tumult in the European economy.
The gold standard
The view of money as a commodity began to shift only with the widespread adoption of paper currency, which became popular in the American colonies. In 1690, the Massachusetts Bay Colony issued paper money to fund a military campaign, and did so without explicitly promising to redeem the bills for gold/silver.
During the American Revolutionary War, the Continental Congress printed “continentals” to pay for the country’s war efforts against the British. These bills were in principle backed by gold, but so many were issued that their collective value far exceeded the available gold.
The Bank of England, on the other hand, adopted the gold standard in 1821, with a promise of redeeming its notes for gold upon request. As more countries followed suit, the gold standard became the general thumbnail for the 19th century global economy. The discovery of major new gold fields over the years ensured that the money supply kept growing.
The gold standard brought stability to prices and became beneficial for property holders and lenders. However, it also brought deflation (fall in prices), because as countries’ populations and economies grew, their governments had no easy way to increase the money supply. So money became scarcer.
The gold standard also didn’t prevent economies from falling into recession. During the Long Depression, which lasted from 1873 to 1896, adherence to the standard made it difficult for the nations to undertake course-corrective measures like cutting interest rates or pumping more money into the economy.
However, banks could still make loans against their gold reserves. Economic historians now believe that the amount of paper currency in circulation dwarfed the actual amount of gold and silver that banks had on hand. During the First World War, governments needed more money for their armed forces. So they simply began printing it. Although countries tried to return to the gold standard after the war, the Great Depression ended that experiment for good.
The rise of fiat currencies
Post the Great Depression, emerged the “fiat currencies,” the currencies backed by the authority of the issuing government. However, critics believe that the reliance on fiat money gives too much power to the government, which can recklessly print as much money as it wants. However, the flaw with this theory is that, even with the gold standard, governments revalued their currencies from time to time, in effect dictating a new price for gold, or they ignored the standard when it proved too limiting, as during the First World War.
Abandoning the gold standard has given central banks much more flexibility in dealing with economic downturns. Let’s play out a scenario here. During recessions, instead of spending and investing, people and businesses hold on to their cash, shrinking overall demand, which forces businesses to cut back. This creates unemployment and shrinks demand even more.
Governments face the challenge of spending more. For that, you need interest rates to drop and for the money supply to increase, thereby making it easier for people to borrow money and spend more to shore up the demand. Central banks can pull off the task of dropping interest rates, without worrying too much about maintaining the gold standards. Ever since the gold standard has been dropped, recessions have been shorter and less painful.