The evolution of money is hurting us. Here’s how

The process by which banks create money is so simple that the mind is repelled. — John Kenneth Galbraith How did the modern system of money evolve? It all started with the barter system. As George Cooper writes in The Origin of Financial Crises - Central banks, credit bubbles and the efficient market. “Long, long ago, the first trade was conducted via barter. All good were exchanged directly for all other goods.”

But this mode of exchange had its problems. “It wasn’t a great system; if you wanted to swap your chicken for a loaf of bread, but the baker happened to want firewood, you were stuck with the task of traipsing around the market square until you could find someone with firewood who just happened to want chicken,” writes Cooper.

But someone somewhere realised that barter as a mode of exchange is just taking too much time, and the world moved onto gold as a medium of exchange.

As Cooper writes “Under the new system, everyone agreed to accept gold in return for whatever they were selling. This transition allowed the swapping of chickens for gold and then gold for anything else — the baker could jolly well find his own firewood.”

Thus the concept of gold as “money” evolved. The thing with gold was that it was indestructible and could be stored for the future. As the author points out “Once gold took on the role of recognised means of exchange, it also inadvertently became a store of value. If in one reason you happened to have a lot of chickens, you could swap all of chickens for gold, spend only part of the gold on bread, and keep a few a nuggets for a rainy day.”

Once gold became a medium of exchange, it did not take much time for the world to start using gold coins. Having gold coins as a mode of money created its own set of problems.

“Governments, especially when in financial trouble, would recall their coinage, melt it down and reform the metal into more coins with a lower gold content… For government …it generated a nice new pile of gold for conversion into coins for their own coffers.”

But debasement of currency became a huge problem and this led to the development of certificates of gold deposits. As Cooper writes “Debasement… and the larger monetary transactions, due to economic expansion, meant that gold coins became difficult to deal with. Each transaction required that the coins be counted, weighed and checked for purity and authenticity. In addition to which there was the constant problem of security.”

So this led to the development of gold depository banks where “groups of merchants got together to from merchant banks that would hold their gold securely at a central location.
The quality of the coinage was checked, and the depositor was issued with paper certificate of deposit. The certificate of deposit represented his holdings of gold within the bank and the holder of this certificate was entitled to present the certificate back to the bank, who would, on demand, exchange it for the same amount of gold coins originally deposited.”

These banks soon realised that the owners of gold rarely came back to collect it. As a result, gold was lying idle with them most of time. So these bankers came up with a money making scheme of their own.

As Cooper writes “The bankers would issue their own certificates of gold deposit, and would lend those certificates to merchants. These merchants would use the new certificates to buy goods, which they would then sell on at a profit. Provided everything went well, the merchant could borrow the certificate, buy and sell the goods to make the profit, and repay the bank before anyone ever realised that the gold had left the vaults — which of course it never had.”

Now, what this did was that “there were always more certificates of deposit in circulation than there was gold in the vaults of banks.” This in turn led to crisis situations during which individuals with these certificates landed up at the bank asking for their gold back. The trouble was that the bank did not have enough gold to make good against all the certificates it had issued. As this news spread, more people landed up at the bank, leading to a bank run.

This soon led to a situation where central banks which would fight financial instability being created. “In return for the backing of the central bank, the commercial banks gave up the right to issue their own gold depository certificates. From now on, there would only be one type of depository certificate and these would be printed by the government, and be distributed through the central bank to the commercial banks. In addition, gold reserves of the commercial banks would be collected together at the central bank,” writes Cooper.

This created the concept of currency notes issued by the government. But what this also did was give the government a monopoly on printing money. And unlike the kings of earlier age, who had to call their gold coins back to debase them, governments could simply print more and more paper money as and when they deemed fit. And this right, as we know, has more or less been responsible for the current financial crisis.