The history of money doesn’t need to be confined to one specific country or time period. It is rather expedient to outline the role money has played and the changes it has gone through in virtually all countries over time. Some events might have occurred earlier or later in one nation or another. However, the general trend to date has been the same. Understanding this trend is of major importance when it comes to understanding money today. This article describes the imaginary story of a country that went from no money at all to a fiat money, paper money. It is conceptually applicable to any country on earth.
The demand for money arose with the appearance of division of labor, when individuals began producing for others rather than for themselves. This was of course a direct outcome of the law of comparative advantage and the corresponding specialization of labor. If individual A transforms land and produces a good that individual B demands, but B has nothing to offer that A demands for consumption, A might still consider receiving a product M in exchange that he can then give to individual C. C happens to demand B’s product for consumption AND offers something that A also demands for consumption. In this case, from A’s point of view M is a medium of exchange, a money.
With division of labor spreading, different goods would be used as money, such as tea, coffee, beans, salt, or cattle. There are numerous accounts of the usage of these goods as money in history. However, there are goods that are better and goods that are worse than others for usage as a medium of exchange. A medium of exchange needs to fulfill criteria such as durability, divisibility, homogeneity, measurability, sufficient but limited availability and broad acceptance. The metals gold and silver emerged as goods that best fulfilled these criteria when used on the market.
Consumers, entrepreneurs, capitalists, landowners, and workers dug up and/or used gold and silver as money in exchange and credit transactions on the market. Decentralized, competing gold mines would channel gold into the market, part of which was used as money. For a fee, some entrepreneurs began offering the service of depositing money in warehouses, also known as deposit banks, so the owners of the money wouldn’t have to carry it with them. They would issue receipts for the money deposited. Soon the receipts themselves, rather than the deposited gold, would be used as money, hence gaining value as media of exchange.
Some of the gold would not be redeemed but rather stay in the warehouses. Thus the entrepreneurs issuing the receipts started offering their own receipts in exchange and credit transactions which were not backed by their own gold. However, they had to be careful not to issue too many uncovered receipts. Because as the price of their additional receipts would drop, their customers would begin redeeming them in exchange for gold again. If there were too many uncovered receipts issued, the warehouse would ultimately lose all its deposits and hence go out of business.
Thus in the long run those deposit banks who managed their deposits most prudently would be the most successful and profitable ones.
But some of the depositors had loaned receipts to the government and hence accumulated public debt. When they faced the threat of going out of business, due to a massive drain upon their gold reserves they sought help with the government.
The government used its police force in order to prevent the deposit banks from having to redeem their customers’ receipts for gold. It declared the receipts of the banks a legal tender, which means that they became a fiat money, a money that people are forced to accept or face government force if they don’t. The operations of different banks were consolidated within one central bank and numerous fractional reserve banks with the exclusive authority to produce fiat money. In addition, the government forcefully confiscated private gold holdings and declared private ownership of gold illegal.
This central bank was no longer under the constraints that the deposit banks used to face. It didn’t depend upon gold deposits and it could inflate the money supply at will. Without voluntary competition within the country, the result was that the quality of the money produced was low. Inflation became a common phenomenon.
Just as seen in the example of the production of cars in the Soviet Union, the more monopolized and centralized the production of a good, the less competition exists, and the less the consumer is given a choice, the lower the quality of the good produced will be from the point of view of those consuming the good.
Roughly, this has been the History of Money and Banking in the United States and the course of events that led to the establishment of the Federal Reserve Bank.