The Origin of Money

In this section we provide a brief introduction to the origin of money. Money is one of our most pervasive social institutions, yet it is also one of the most mysterious. Its history is the story of both a technology, an idea, power, and how we organise society. Over the centuries, human societies have developed various means for valuing and exchanging goods and for storing wealth.

As we will show the origin of money involves three different theoretical perspectives money as commodity, state/fiat and credit. To really understand all the aspects of money, one needs to understand the historical relevance and economic implications of each of these views.

The origins of money / What is money?

The commodity theory of money

The most common theory of the origins of money is the one found in “The Wealth of Nations” (1776) by Adam Smith. According to Smith’s story, money emerged with increasing productivity and the division of labour, as individuals found themselves without many of the necessities they required but at the same time an excess of their own products. Without a common means of payment individuals had to resort to barter in order to trade, which was problematic as both sides of the deal had to have something the other person wanted (the “double coincidence of wants”).

According to the theory certain types of commodities were introduced as means of exchange for goods and services to avoid this inconvenience. Particularly obvious as candidates for such a means were gold, silver and other kinds of metals, as the majority of people found them valuable and as they easily divisible into smaller units, most would accept them in exchange for their own goods or services.

This idea of gold, silver and other kinds of metal as money, is the so-called commodity theory of money, which is found in many text-books.

“Fiat money is the norm in most economies
 today, but most societies in the past have used
a commodity with some intrinsic value for
 money.This type of money is called commodity money. The most widespread example is
 gold. When people use gold as money (or use
paper money that is redeemable for gold), the
economy is said to be on a gold standard.
Gold is a form of commodity money because
it can be used for various purposes—jewelry,
dental fillings, and so on—as well as for transactions. The gold standard was common throughout the world during the late nineteenth century.”

– (Mankiw, 2012)

The theory has thus been widely perpetuated by mainstream or ‘orthodox’ economists and in economic models up until today. From this point of view, money, banks and debt are believed to have no substantial macroeconomic effect other than to “‘oil the wheels’ of trade” and thus can be largely ignored when considering the workings of the economy. This means that today banks, money or debt have almost no place in economic models.

The state-theory of money

The commodity theory is appealing and intuitively logical, as it coincides with the way we interact with money in our everyday economy, in which money functions as means of exchange when we trade goods and services, a store of value for later consumption, and a unit of account for measuring prices on goods, services and various kinds of assets.

Nonetheless, the theory is very problematic when it comes to explaining the actual historical origin and emergence of money, as well as the macroeconomic functionality of money. The commodity theory of money basically tells a story of why it is practically convenient to have a monetary system, but not really the story about what money is and how the monetary system have evolved over time. Why is something money and other things not? And if gold were really money, one should ask, why is it not money today?

Overall, the theory has two important shortcomings. The first problem with Smith’s theory about money is the lack of the factor Smith himself attempted to downplay: the political and physical power of monarchies and states. What historians and anthropologists point out is that if we look at the actual historical evidence, the extraction of gold and silver were under the monopoly of kings and states who then had the complete control of money production (Spufford, 2002).

In the UK, coinage began with the founding of the royal mint in 886 AD, which was under the full control of the sovereign, and in the US the first coins were issued by the Treasury in 1792 following the war of independence in 1775–1783.

The fact that money historically have been a means for concentrating power around the king, the state, the church and other forms of central institutions is underpinned by the so-called state theory of money (chartalism) (Knapp, 1905). According to this theory, the central authority issues coins (and other means of payment) in order to finance expenditures, for example soldiers’ wages, and then subsequently secures the circulation of money by collecting the same coins as taxes. Thus, the only way in which the butcher, brewer and baker in Smith’s story could get hold of gold and silver coins for the payment of taxes was if the central authority had spent them into circulation in the first place.

The theory thereby suggests the need for over-institutional legitimization of the value of money. It is not enough for there to be a simply a need for a mean of exchange, there must also be some political, legal, moral or religious institutions that support the value of money by making it eligible for payment of taxes and defining is as legal tender.

In his 1930s publication A Treatise on Money, John Maynard Keynes famously declared all money to be chartalist:

“To-day all civilised money is, beyond the possibility of dispute, chartalist.”

– Keynes (1930 [2011] p. 5)

This state theory of the historical origin of money is a very important basis for the MMT school of thought.

The credit-theory of money

The second problem with the Commodity theory of money is the idea that money emerged ‘spontaneously’ from barter into metal coins with intrinsic value. The problem with this idea is that, in the words of anthropologist David Graeber,

“… there’s no evidence that it ever happened, and an enormous amount of evidence suggesting that it did not.”

– Graeber, 2011, p. 29

This is not to say that barter does not exist or has not existed in the past, merely that money did not emerge from it. In reality, barter tends to happen only between people who are strangers (i.e. they have no ongoing relationship) or is reverted to amongst people who are used to cash transactions, but for whatever reason have no currency available, such as those in prisoner of war camps. (See Radford (1945) for a fascinating example.)

Historically the minting of coins was the privilege of sovereigns, but money as unit of account emerged long before coinage. The first money in the form of precious metals shaped into coins appeared in three separate places (northern China, northeast India, and around the Aegean Sea) between around 600 and 500 BC, but the emergence of money as a unit of account can be traced all the way back to the Mesopotamian temple and palace administrations in 3500 BC (Hudson, 2004).

Here, money evolved as a simple bookkeeping and accounting process to keep track of who owed what to whom. Money thus evolved not as metal and coins but as credit in form of debt relation between temples, states and merchants. As David Graeber explains:

“Our standard account of monetary history is precisely backwards. We did not begin with barter, discover money, and then eventually develop credit systems. It happened precisely the other way around. What we now call virtual money came first. Coins came much later, and their use spread only unevenly, never completely replacing credit systems. Barter, in turn, appears to be largely a kind of accidental by-product of the use of coinage or paper money: historically, it has mainly been what people who are used to cash transactions do when for one reason or another they have no access to currency.”

– Graeber, 2011, p. 40

Credit is a promise to pay in the future. The issuer promises to pay the bearer some specific species (coins, goods etc.) – either on demand or on some specific time in the future – in exchange for a deposit or a debt contract.

Over the course of history, credit systems have evolved in many different forms: sometimes driven by private banks, but more often controlled by state authorities in forms of temples, states and later central banks. What is special about credit is that it holds no intrinsic value in itself, but its value is almost solely based on the trust to the issuer.

One of the most well-known examples of the emergence of privately issued credit-money is the story about the London goldsmiths, who evolved into banks in the 16th century. First by issuing promissory notes in exchange for coins, bullion and other valuables, and later as people began to accept the promissory notes as money in place of coins, the goldsmiths exploited the opportunity of issuing and lending additional promissory notes (which would be seen by the borrower as a loan of money) in exchange for interest bearing debt, effectively giving them the status of money-issuing banks (He, Huang, & Wright, 2005).

The emergence of banking in the UK to some extent supports the idea of money evolving from the market’s need for a means of exchange, but only as a substitute for coins, and definitely not in accordance with the commodity theory and the idea of money as neutral medium of exchange. The goldsmiths made a lot of profit from issuing credit.

What banking crises later showed is that a private credit system eventually needs the support of a central authority and credit of a higher order in order to survive. Again, the existence of a central authority is absolutely crucial for these credit systems to work efficiently. As for credit to circulate as money it is of absolutely necessary that there is a general trust in the issuer. As Minsky puts it: “Everyone can create money; the problem is to get it accepted.”

– Minsky, 1986, p. 228.

Also, during history most credit systems have been either directly controlled by (or at least largely supported by) the public. In a sense, money issued by a state or a central bank can be seen as a special form of credit money. In the US, the first paper money was issued by the authorities at the Massachusetts Bay Colony in 1690, and later the first dollar notes came about during the civil war 1861-1865 as the North issued so-called Greenbacks (Demand Notes), which were not redeemable in gold and silver coins. Instead it derived its value from being legal tender, meaning it could be used to pay “all dues” to the federal government. This was the very first purely state-issued money. At the same time, private banks were allowed to issue their own bank notes according in accordance with the National Currency Act of 1863, but only if backed by government debt.

Summary

Today most money is credit issued by private banks.

The credit-theory of money thus best explains how money is created in the modern economy, but – just like the commodity theory – it does not explain the existence of denominations of currencies, such as. Pound Sterling. Why, for example, does Barclays not issue loans in their own “Barclay Pound”?

Overall, one can say that none of the three theories about money are unequivocally correct, but at the same time none of them are unambiguously wrong. The three theories of money live in symbiosis with changing domination to changing times.

In the UK/US, goods and services are exchanged for Pound/Dollars because the state legislates them to be legal tender and they are redeemable for paying taxes, but at the same time they are issued as credit by private banks denominated in Pound/Dollars, and used to settle the majority of transactions in the economy at a scale that would be absolutely impossible without an effective means of exchange.

References

Graber, D ., 2011. Debt: The First 5.000 years. Melville House

Hudson, M., 2004. The Development of Money-of-Account in Sumer’s Temples, in Hudson, M. and Wunsch, C. (eds.), Creating Economic Order. Bethesda: CDL.

Keynes, J.M., 1930. Treatise on money: Pure theory of money Vol. I.

Knapp, G.F., [1905]1924. The state theory of money. McMaster University Archive for the History of Economic Thought.

Mankiw, G., 2012. Macroeconomics. 8th ed. New York: Worth Publishers

Minsky, H. P., 1986. Stabilizing An Unstable Economy. New Haven: Yale University Press.

Radford, R.A., 1945. The economic organisation of a POW camp. Economica, 12(48), pp.189-201.

Spufford, P., 2002. Power and profit: the merchant in medieval Europe (p. 27). London:: Thames & Hudson.