Money, an ancient and momentous creation of human civilization, holds the distinction of being one of the earliest and most impactful inventions ever conceived. The money that we hold today is a result of a long process of evolution. From bartering to banknotes to Bitcoin, money has seen a period of fascinating progression.
Today people worry about money, think of ways to acquire more of it, and dream about how it can be spent. But how much in the actual world do we know about money and its history?
How do we define Money?
The academic definition of money says that it needs to satisfy three functions: a medium of exchange, a store of value, and a unit of account.
A medium of exchange is a method of payment that enables you to compensate someone for a product or service or to settle a debt or financial responsibility. In order to serve as an effective medium of exchange, it doesn’t necessarily have to be universally accepted, but it should enjoy widespread acceptance within the specific context in which it is used.
A store of value implies that your money retains its current worth over the short term. To qualify as a reliable store of value, you should have a reasonable assurance that your money will enable you to purchase roughly the same quantity of goods and services in the future, whether it be tomorrow, next month, or next year.
Unit of account means that money can be used as a standard measure for comparing the value of goods, services, assets, or debts. It provides a reliable structure for pricing and evaluating economic transactions. Typically, this is your native currency, but theoretically, you could use any denomination.
It is believed that good money should fulfill all of the three functions but this does not necessarily hold true in today’s context. For instance, the US dollar is the notable form of money we have today which serves as an excellent medium of exchange because of its acceptance in countries other than the United States, a good unit of account as global commodities like crude oil and gold are priced in dollars but maybe poor in terms of store of value. Since the advent of the Federal Reserve System, the buying power of the USD from a consumer perspective has witnessed a staggering decline of 96%.
This leaves us wondering whether today’s money can be categorized as good money!
Bartering: Economic System of Distant Past
Money has been a part of human history even before it was documented. Prior to the introduction of currency, people relied on the bartering system for trade. In this system, individuals exchange goods and services directly without a standard medium of exchange.
Hard to fathom! But it was a world where farmers traded a sack of grain for a piece of clothing and potters exchanged their pottery for livestock. This worked well on a small scale within the communities but as trade expanded its limitation became evident.
The major hindrance was the lack of double coincidence of wants, where both the parties involved in this trade had to desire what the other party had to offer. For instance, if the farmer required a pair of shoes from the shoemaker but the shoemaker did not want what the farmer had to offer, then the trade became impossible. It also suffered the issues of indivisibility and perishability.
To overcome these barriers, society gradually became inclined to adopt various forms of currency. The initial of which is called commodity money, where goods of intrinsic value such as shells, salts, or precious metals like gold and silver [after its discovery] facilitated the medium of exchange. This provided an edge over the traditional system of barter as it served as a standard unit of the unit and eliminated the double coincidence of want.
The Advent of Regularised Coinage
With time, the usage of precious metals as a form of currency saw large acceptance as humans are seen to desire things that are in scarcity and it goes without saying that scarce elements are seen to withhold more value. This paved the way for one of the most significant advancements and that was the invention of coinage. It was during the rule of the Zhou dynasty in China, approximately in 1000 BC, the first iteration of metal money came into existence.
Though it is debatable to pinpoint the exact origin of the coin system, history also traces it back to the ancient kingdom of Lydia, located in present-day western Turkey, during the 7th century BCE. The Lydians are often credited with inventing the first standardized coinage system. These coins, made of electrum (a natural alloy of gold and silver), featured stamped designs and were used for trade within the region.
Coins sparked the transition from the bartering system to a more efficient and sophisticated monetary framework. They were minted in specific weights and purity, making them universally accepted within society. They were portable, allowing for easier transportation and storage compared to bulkier goods. The divisibility of precious metals allowed for the creation of fractional denominations, accommodating transactions of varying sizes. Additionally, coins facilitated the concept of savings, enabling individuals to accumulate wealth and invest in the future.
The problem did not end here! The basic human undying urge for convenience started hunting for problems in the coin system.
Weightless Banknotes: Enhancing Portability
As societies grew and trade expanded, the task of lugging around sizable quantities of coins became increasingly cumbersome. To address this, paper money emerged as a convenient alternative during the Tang Dynasty (618 907 AD). However, paper money was introduced in China during the Song Dynasty (960 – 1279 AD) alongside coins and was backed by the value of precious metals stored in a central repository. It provided portability and ease of use in transactions. The world followed the gold standard for a considerably long period of time. During the early 12th century, a staggering quantity of banknotes was being issued each year, reaching a remarkable annual rate of 26 million strings of cash coins. As the 13th century rolled in, the concept of paper money started to permeate Europe, primarily disseminated through the fascinating tales recounted by travelers like Marco Polo and William Rubruck.
A nation that adhered to the gold standard established a constant valuation for gold, engaging in buying and selling gold at that established rate. This fixed valuation served as the basis for determining the worth of the country’s currency.
From Gold to Paper: The Shift from the Gold Standard to Fiat Currency
The fall of the gold standard started with WW1. Remember, the value of money solely depends on the stability of the Government, and with changing political alliances the Government’s finances deteriorated. The confidence in the gold standard fell and the world required something more flexible to rest its global economy on. Over time, the concept of fiat money emerged, where the value of the currency was not directly linked to a physical commodity [like gold] but rather to the trust and confidence of the people using it. Fiat money is backed by the government and its value depends on the stability of the government and the nation’s economy. This witnessed a massive acceptance in 1971 following the decision made by U.S. President Richard Nixon to abandon the gold standard. This announcement marked the end of the dollar’s convertibility into gold. With fiat money, there is no direct linkage to the quantity of gold held by a government, rendering it susceptible to inflation. Consequently, its value is subject to erosion during times of economic uncertainty, should the government excessively print money, the currency’s value diminishes.
Today, fiat money became the prevailing form of currency worldwide, backed by the stability and credibility of governments and central banks.
Money today has become an abstract concept. What started with bartering, moved to the coinage system paving the way for commodity money. Soon in order to deal with the drawbacks of commodity money, society accepted representative money at a scale where the money in itself did not have any intrinsic value but was pegged to metal coins. Following the abandonment of the gold standard, banknotes transitioned into fiat money, devoid of pegging or inherent value.
With the advent of Bitcoin, a parallel financial ecosystem called decentralized finance (DeFi) has surfaced, providing an alternative to the traditional system.
Fluctuating Fortunes: Exploring the Rise and Fall of the Gold Standard
The period from 1870 to 1939 witnessed a continuous rise and fall of the gold standard. As the banknotes were backed by the underlying metal, their value relied fully on the demand and supply of it. Some metals were easy to mine and hence lost their value as an ideal money over time leaving the world with scarce elements like gold and silver. The gold and silver standards were monetary frameworks where the fundamental unit of account is anchored to a consistent quantity of gold or silver.
Until the 1870s the world was using the silver standard with only 15% operating on the gold standard but by 1913 approximately 70% of the countries were seen to adopt the gold standard. What led to this massive adoption of the gold standard? The global superpower, Great Britain along with its colonies was using the gold standard. As a result more and more countries adopted the standard in order to facilitate trade at a lower cost with Great Britain and its colonies. Over time, it grew to become the universally accepted global standard.
The scenario changed during World War I when the participating countries faced the need for financing. The requirement for proportional gold reserves hindered the printing of additional money. Consequently, several countries, lacking sufficient gold reserves, resorted to printing more money, resulting in their currencies becoming free-floating between 1914 and the 1920s.
However, this did not evade the acceptance of the gold standard completely, primarily because of the British Gold Standard Act, of 1925. The act was a bill to reinstate the return of the gold standard. The production of gold coins ceased in Britain, and redemption of currency for gold was limited to 400 oz. bars of gold.
Nevertheless, the reintroduction of the gold standard resulted in economic downturns, joblessness, and deflation across these economies. This situation persisted until the Great Depression (1929-1939) compelled nations to abandon the gold standard.
The Bretton Wood System and End of Dollar Peg
After World War II, there was a need to stabilize exchange rates to encourage international trade. In July 1944, representatives from 44 nations convened at the United Nations Monetary and Financial Conference, which took place in Bretton Woods, New Hampshire. It was during this gathering that the Bretton Woods Agreement was negotiated. According to the Bretton Woods System, the U.S. dollar was anchored to gold, serving as its foundation, while other currencies were fixed to the value of the U.S. dollar.
However, it was challenging to control the movement of capital (money) across borders. By the 1960s, the controls put in place to restrict such movement were not completely effective. Investors found ways to bypass these controls by moving their money from local currency deposits to foreign currency deposits in offshore accounts. Some even used tricks in accounting to shift their money from one currency to another.
As it became more evident that U.S. policies primarily favored its own interests, the assurance of converting dollars into gold gradually vanished. Consequently, some countries began to frequently devalue their currencies or even abandoned the peg to the U.S. dollar altogether. The Bretton Wood System finally came to a close after the announcement of Richard Nixon ( then US President) to abandon the gold standard in 1971 paving the way for fiat currency.
What is Fiat Currency?
The emergence of fiat currency was not a sudden occurrence but rather a gradual outcome of the evolution of the monetary system. Countries initially attempted to adhere to the gold standard but faced difficulties as they required economic flexibility in regulation.
Fiat currency is recognized as a legal tender by government regulation and lacks intrinsic value; its worth is solely derived from government backing or the consensus among participants in transactions.
Fiat money encompasses the following characteristics:
- Government-designated currency accepted as legal tender
- State-issued money lacking a fixed value or convertibility to other assets as per legal regulations.
- Money is devoid of inherent value, functioning solely based on government mandate.
- An object without inherent utility; that merely serves as a medium of exchange (also known as fiduciary money).
However, vesting all the powers in the hand of the Government creates a few other problems. The value of the money is completely dependent on the stability of the government, any turmoil causes its value to depreciate. Also, Fiat currency is susceptible to inflation, as governments have the authority to increase the money supply, which can lead to a decrease in the currency’s purchasing power over time. Uncontrolled or excessive inflation can erode the value of savings and disrupt economic stability.
Bitcoin’s Emergence: A Paradigm Shift in Money
In the midst of economic upheaval, Bitcoin was born in 2008, introduced by an individual or group known as Satoshi Nakamoto. In the white paper, Satoshi Nakamoto challenged the prevailing trust placed in centrally controlled currencies issued by central banks.
“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.“
—Satoshi Nakamoto
Bitcoin stands apart from traditional forms of money. It does not fall into the categories of commodity money (lacking intrinsic value), representative money (not tied to something of inherent worth), or fiat money (not supported by the government). Instead, Bitcoin is a unique form of currency known as decentralized money, existing on its own terms.
While Bitcoin has gained popularity, it does come with certain limitations:
- Slow confirmation: Transactions on the Bitcoin network typically require at least one hour to achieve finality.
- Limited throughput: Bitcoin has a restricted capacity to handle a large number of transactions simultaneously.
- Knowledge requirement: Using Bitcoin effectively necessitates users to possess a certain level of technical expertise.
These shortcomings are not applicable to physical forms of money. Consequently, addressing the scalability issue of blockchain technology becomes crucial for enabling the widespread adoption of Bitcoin and other cryptocurrencies for everyday transactions.
Prior to the advent of Bitcoin, there were digital currencies like the DigiCash and e-gold all of which failed due to their centralized nature. The decentralized nature of Bitcoin ensures that no single authority can create more of it arbitrarily. This unique characteristic establishes Bitcoin’s scarcity, firmly grounded in decentralization.
Bitcoin possesses most of the qualities of ideal money and has the potential to disrupt the prevailing centralized fiat monetary system. Although it may take some more time for Bitcoin to solidify its position as a universally recognized medium of exchange, the global cryptocurrency user base reached 425 million by the end of 2022, representing a substantial 39% increase since the beginning of that year. As a result, Bitcoin and other cryptocurrencies are well-positioned to play a central role in humanity’s ongoing pursuit of a superior monetary system in the forthcoming decades.
Disclaimer: This article was created for informational purposes only and should not be taken as investment advice. An asset’s past performance does not predict its future returns. Before making an investment, please conduct your own research, as digital assets like cryptocurrencies are highly risky and volatile financial instruments.
