Introduction

Introduction

Money serves four basic functions in an economic system. It acts as: (1) a medium of exchange; (2) a unit of measure; (3) a store of value; and (4) a standard of deferred payment.

As a medium of exchange, money must be universally accepted in exchange. It must be something always accepted in trade. In prisoner-of-war camps cigarettes have served as a medium of exchange, and in the northern reaches of the earth furs have circulated as a medium of exchange. Livestock and precious metals have a long history of service as mediums of exchange.

Money must also act as a unit of measure, comparable to yards, gallons, tons, cubic feet, or any other measure. Pounds sterling, American dollars, Japanese yen, German marks, and French francs all serve as units of measurement. A consumer can buy 10 gallons’ worth of gasoline or $10 worth of gasoline. The Hudson Bay trading posts in Canada measured sales and profits in terms of beaver pelts, and Virginia colonists priced goods in terms of pounds of tobacco.

Anything meeting all of the demands placed on money must be satisfactory as a store of value. That is, it must preserve its value over a length of time. Perishable commodities rarely serve as money because wealth stored in perishable commodities is doomed to extinction. Precious metals such as gold and silver, known for resistance to corrosion and natural deterioration, are the most prized as monetary commodities and have few rivals as commodities that preserve value over time. Livestock reproduce, allowing them to preserve value over time, and even earn a form of interest. Inflation is the chief enemy of paper money because it renders the paper money useless as a store of value.

Money should also furnish society with a standard of deferred payment, enabling debtors and creditors to negotiate long-term contracts. Creditors want assurance that debtors cannot legally discharge debts with money possessing less purchasing power than the money originally borrowed. An unanticipated depreciation of the currency shortchanges creditors and gives debtors a windfall gain, arbitrarily redistributing income from creditors to debtors.

On the other hand, if money becomes unusually abundant, debtors easily find the means to repay debts, and creditors find the money repaid to them is worth less. Debtors are at risk if currency unexpectedly appreciates, increasing what debtors have to repay creditors in real terms. Unexpected currency appreciation redistributes income in favor of creditors over debtors. Because those who need to borrow money are usually worse off than those who have money to lend, an income redistribution favoring creditors is likely to cause hard feelings among those who already feel they get less than their share of income. Monetary issues are the focal point of a not-so-secret war between debtors and creditors.

Money falls within two broad categories, commodity money and fiat money. Commodity money makes use of some commodity, such as tobacco, rice, gold, or silver, that has an intrinsic value, or market value independent of any government decree sanctioning the commodity as legal tender for payment of private and public debts. Commodity monetary standards may make use of tokens or paper circulating money, but the circulating money can always be redeemed in a monetary commodity at an official rate. Under the gold standard the United States government committed itself to selling gold for $35 per ounce. Fiat money has no intrinsic value; that is, it has no market value independent of a government decree establishing it as legal tender for private and public debts. Modern monetary systems are called inconvertible paper standards, because the fiat money issued by these systems cannot be converted into a commodity at an official rate. Fiat money has value because governments give themselves a monopoly on the privilege to issue fiat money, enabling them to limit its supply, and governments use their power to adjudicate disputes to make the money legal tender for all debts. By limiting the supply and creating a need, the government confers value on paper money that has little or no intrinsic value.

Two commodities, gold and silver, have been lifted up as the aristocrats of commodity money. Until the nineteenth century silver usually prevailed as the predominant form of commodity money, punctuated by intervals of bimetallism, which made use of both gold and silver and established a fixed ratio that set the value of each metal in terms of the other. Aside from the Byzantine period, when gold reigned supreme, the hegemony of silver lasted from the time of Alexander the Great until the nineteenth century.

Historically, precious metals have had a funny way of showing up and disappearing as civilizations waxed and waned. The silver mines of Laurium helped finance the golden age of Greece, and the decline of the Roman Empire coincided with the exhaustion of the silver mines in Spain and Greece. The stagnation of Western Europe during the middle Ages may be explained by the virtual disappearance of precious metals during that era. The economic expansion of Europe that led to the eventual world dominance of European civilization in the nineteenth century followed the European discovery of vast precious metal deposits in the New World.

The much-vaunted gold standard, the demise of which is still mourned by a few true believers, actually represents a relatively late development in monetary history. The gold standard is a recent upstart compared to silver and bimetallic standards. Only in the 50 years preceding World War I (1914–1918) did gold become the sole standard of purchasing power, completely eclipsing the role of silver in the world’s monetary system.

The fascination with gold may be a relic of the awe that surrounded money in some primitive societies. The word taboo originated from the sacred character and atmosphere of mystery that surrounded primitive money in islands of the South Pacific. On the Fiji Islands sperm whale teeth, called tambua, a variant of taboo, acted as money and conferred social status on their owners. The power of a whale tooth guaranteed compliance with any request that accompanied it as a gift. On Rossel Island some of the most valuable units of shell money could only be handled in a crouched position, and many of these units were thought to have been handed down from the beginning of time. In parts of the Philippines women were not allowed to enter sacred storehouses where rice money was kept.

John M. Keynes, a famous English economist in the first half of the twentieth century, observed in his Treatise on Money, Volume II (1930), that gold had “enveloped itself in a garment of respectability as densely respectable as was ever met with, even in the realms of sex or religion.” Concerning the power that a relatively small amount of gold played in the world’s monetary affairs, Keynes wrote in the same work that “[a] modern liner could convey across the Atlantic in a single voyage all the gold which has been dredged or mined in seven thousand years.” The world’s supply of gold has increased since Keynes wrote these words, but the supply remains small in comparison to the important role it has always played in monetary affairs. Even during Keynes’s time monetary gold lay out of sight in the underground vaults of central banks, and gold transactions took the form of changing the designated owners of gold by paper notations (earmarking), rather than physically moving gold to different locations.

The strength of gold as a monetary commodity lay in the hold it commanded upon the human imagination, but its weakness lay in its restricted supply, which failed to keep pace with the growth of trade. The gold standard forced the world’s economies to struggle constantly against what today would be called a tight money policy. Although fresh supplies of gold occasionally burst forth, furnishing a brief respite from tight money, the long-term trend was one of deflation owing to the limited money supplies.

The world’s trading partners severed the connection between domestic money supplies and domestic gold reserves in the 1930s, hoping that more lax monetary policies would reinflate the depression-ridden economies of that era. Under the Bretton Woods system of the post–World War II era, domestic currencies remained convertible into gold at the request of foreign central banks, but not at the request of private individuals. During the Bretton Woods era, gold reserves failed to keep pace with the need for monetary growth, and by agreement of the members of the Bretton Woods system, a form of “paper gold” was created called standard drawing rights. Standard drawing rights are really only entries in accounting logs, but they act as reserves of gold or foreign currencies.

Since 1971 the world’s major trading partners have been on inconvertible paper standards. The United States dollar and other major currencies became strictly fiat money, inconvertible into gold even at the request of foreign central banks.

The burst of inflation of the 1970s may be due partially to a void in monetary discipline left by the departure from the last vestiges of the gold standard. The world’s monetary authorities learned, however, to restrict the rate of monetary growth to noninflationary levels, and by the mid-1990s inflation had subsided to insignificant levels virtually worldwide.