Money is not metal. It is trust inscribed.
NIALL FERGUSON, The Ascent of Money
If people understood how money was created there would be a revolution before breakfast.
HENRY FORD
‘When I was young I thought that money was the most important thing in life,’ wrote Oscar Wilde. ‘Now that I am old I know that it is.’ Money, as Wilde was certainly not the first or last to realise, makes the world go round. But what exactly is money? And how did it originate?
Most people would say that we use money to trade for goods and services: I give you my money in exchange for your goods. Or, alternatively, you give me your money in exchange for my goods. So, behind the question ‘What is money?’, lies a deeper, more basic question: ‘What is trade?’
Rewind the clock maybe 100,000 years. One of our ancestors catches fish. His neighbour makes hand axes. Both need fish and hand axes. Say, the fisherman catches eight fish in the time it takes the axe-maker to fashion four axes. Now, the fisherman could spend half his time catching four fish and half his time making hand axes. But he is not as skilled or as fast at making hand axes as the axe-maker, so he struggles to make one inferior axe. Similarly, the axe-maker could spend half his time making two hand axes and half his time catching fish. But maybe he is not skilled or fast at catching fish, so he struggles to catch two.
This is when one of the men has a genius idea, which he persuades the other makes perfect sense. ‘Rather than each of us doing both things, why don’t we both exclusively do the thing we are best at – then trade our products?’ So they do. And the fisherman swaps four of his eight fish for two of the axe-maker’s hand axes. He therefore ends up with four fish and two hand axes, which is better than the four fish and one hand axe he would have if he had fished and made hand axes. At the same time, the axe-maker ends up with four fish and two hand axes, which is better than the two fish and two hand axes he would have if he too had made hand axes and fished.
It seems like a miracle. Both have benefited. And all because of a simple act: trading.
Of course, the fisherman and the axe-maker could have agreed on another exchange rate which was equally advantageous to both. And, even if the fisherman ends up with the same number of hand axes as when he makes them himself, they are likely to be of superior quality. Similarly, if the axe-maker ends up with the same number of fish as when he catches them himself, they are likely to be bigger and tastier, coming as they do from a better, more experienced fisherman.
Trading in this way clearly relies on both parties being honourable. The axe-maker could renege on the deal, taking the fish but not handing over the agreed hand axes. However, if the fisherman and axe-maker belong to the same group, or tribe, there may be an existing template for honourable trade. After all, men, being stronger, may hunt for meat, which they exchange, or trade, for fruit and berries, collected by women. Also, if women move to other tribes to find mates, this may gradually widen the trading circle. Although there is no way to rule out the possibility of cheating, there might be strong incentives not to cheat, which outweigh any tendency to double-cross.
The trading between the fisherman and the axe-maker is limited, however, because it requires two people to meet face to face. An obvious way to boost opportunities for trade is to get a lot of people with a lot of tradable goods together in one place. Such an innovation is a marketplace. If there are several fishermen and several axe-makers (not to mention bead-makers, fur suppliers, fruit collectors, and so on), then they might meet at some place at regular intervals to trade, with the exchange rate being set by supply and demand. For instance, if fish are scarce and a lot of axe-makers want them, fishermen will trade with the axe-maker prepared to offer the most hand axes. Alternatively, if fish are common, fishermen, in order to attract buyers, will have to swap a lot of fish for other commodities.
But trading is more than simply the swapping of goods. It is the swapping of goods between people who have specialised: between a fisherman, who has specialised in fishing, and an axe-maker who has specialised in axe-making. Without such specialisation, there can be no trading for mutual benefit.
And trading, it turns out, encourages ever more specialisation. The fisherman has an incentive to make better fish hooks in order to catch fish more effectively. If his forte is actually locating fish, it may make more sense for him to concentrate on this, opening up an opportunity for someone else to specialise as a maker of fish hooks. Or fishing nets.
Trading and specialisation create more specialisation, which creates more trading opportunities, and more specialisation … The two feed on each other in a runaway process that, once started, has a kind of unstoppable momentum of its own. Just as evolution by natural selection has created the biological world around us, the idea of trade and specialisation has transformed the human world, creating the commercial world we live in.
Just look around. Pretty much everyone today has a job – a specialised thing that they do. Everyone trades his or her work for other goods and services supplied by other people, who specialise in different things – people who grow avocados or make light bulbs or supply electricity. In fact, trade and specialisation, feeding off each other in an orgy of mutual reinforcement, have in our world proliferated to an extraordinary, mind -blowing extreme. There are hardly any of us that do not use the specialised work of thousands – perhaps millions – of people, most of whom we have never met, across the length and breadth of the world.
The idea of trade plus specialisation appears to be unique to humans. No doubt we will discover that apes do it too but, if they do, it is to a far more limited degree – after all, it is we who have transformed the world not them. Of course, the social insects – ants and bees – have specialised and traded with each other for hundreds of millions of years (there really is nothing new under the Sun). But their societies are frozen into a limited number of castes that perform particular tasks. Humans are uniquely flexible. Given an education and the opportunity, a human can train to be a vet or an airline pilot or school teacher.
But specialisation and trading alone have not created today’s commercial world. There have been many other innovations, many other milestones, along the road. Each has boosted trade and accelerated specialisation. And, arguably, the most important is money.
One of the problems with straightforward trading is that it has to be done now. The fisherman has to trade his fish quickly because, in a day or so, they may have gone rotten. But what if the fisherman would rather trade his fish for furs, and the fur trader is not expected at the marketplace for several weeks?
Once upon a time, and it was certainly many thousands of years ago, someone came up with another genius idea. ‘I’ll give you this token for those fish and then, at any time in the future, you can swap it for the fish equivalent of fruit or furs, or whatever.’ The token was of course money. At a stroke, it multiplied the possibilities of trade. Money permitted trade to time travel. It was as if someone had invented a Tardis so traders could travel to the future and exchange their goods there. Economists, in less colourful terms, say money is a ‘store of value ’.
Another problem with straightforward trading is that, to engage in it, two or more people must be physically in the same space – the marketplace. But, say the commodity someone has to trade is bulky and heavy – for instance, a stone for grinding corn – and what they really want to trade it for is beads. However, the market where beads are available is a day’s journey over the mountains. Once upon a time, someone had a genius idea. ‘I’ll give you this token for that grinding stone and, then, anywhere else you go, you can exchange it for the stone equivalent of beads or pots, or anything.’ The token, once again, was money. And the innovation multiplied the possibilities of trade. Money permitted trade to travel through space. It was as if people had access to a Star Trek transporter so they could travel to faraway places and trade their goods there. Once again, economists put it in less colourful terms. They say money is a ‘medium of exchange ’.
But the genius of money is that not only does it liberate trade in both time and space, multiplying the opportunities for trade, it has other beneficial properties. Say you do some work for someone who promises that, in a month’s time when you finish, they will pay you in a particular commodity – say copper or wheat. It might sound reasonable enough. However, the value of such commodities might fluctuate, depending on supply and demand. This means that you will not know in advance exactly what you will get paid, making it difficult to budget.
Money changes things, however. If your payment is in money, you will know in advance exactly what you will get – unless, of course, you are unlucky enough to live in a time of hyper-inflation such as post-First World War Germany. Money, say economists, is a ‘standard of value ’.
Of course, if money is to be used as a standard of value, it must be something whose supply does not fluctuate much since scarcity of any commodity boosts its value while plenitude depresses it. One of the first forms of money might have been salt because its source was well known and the technology for extracting it created a supply at a relatively constant rate. Roman soldiers, in particular, were paid in salt, or sal, which is the origin of our word ‘salary’.
Salt has several other properties that should ideally be possessed by money. It should be portable so that it can be easily carried about. And it should be divisible. This allows someone to buy something and get change, which they can use at a later time. Think of the dilemma if the exchange rate is four fish for one hand axe but the fisherman has only three fish. With divisible money, the axe-maker can exchange his axe for the three fish, and receive some change, which he can spend later.
Salt, most people would probably agree, is not an ideal form of money. A better currency is provided by gold, in the form of coins. Although money was used as a unit of account for debts from about 3000 BC, the first gold coins appeared in Greece only around 700 BC.
The trouble with gold is that it is heavy, especially if you are rich. However, there is a clever way around this. Say you are at the goldsmith’s one day to exchange some goods for gold – a lot of gold – and the goldsmith says, ‘I’ve got an idea. Instead of you humping those heavy bars around with you, I will give you an IOU. You will not physically have the gold but you will know that I am storing it here for you. And, any time you want it, just come back, present the IOU, and I will give you the gold.’
Maybe, when you find some goods to buy, you will indeed go back to the goldsmith, present your IOU, carry off your gold and exchange it for the goods. But, sooner or later, you will realise there is a better, more convenient, way. Simply present the IOU to the person you are trading with. After all, they will know that, if they present it to the goldsmith, they will get the gold.
The goldsmith, without perhaps knowing it, has transformed himself into a bank – an entity that stores gold and creates a new kind of money – IOUs. If he stores gold and issues IOUs for other clients as well, sooner or later he will realise that it is highly unlikely that everyone will want their gold back at the same time. So he can create more IOUs than he has gold in the bank. However, if he is prudent – unlike many of the modern banks that triggered the 2008 global banking crisis – he will make sure he has enough gold reserves for an unusual event, when a significant fraction of gold-owners want their gold back simultaneously.
But, just as money is multi-faceted, so too are banks. In addition to creating money and guaranteeing its value, banks perform another key function – they match up lenders and borrowers. Lenders are people who have surplus money they do not want to spend just yet, which they put in the bank. Borrowers are people who need money for some venture – maybe to start a business or buy a house. They expect to earn the necessary money over the following months or years. However, they need the money now, and so they borrow it.
This might look like bringing money from the future – future earnings – into the present. But, actually, the amount of money for consumption at any time is fixed. If you borrow money for a mortgage on a house and have to pay it back and so have less to consume, the bank collects your money and lends it to others. So others get to consume instead of you. There is no net transfer of money.
The bank charges the borrower money on top of what he or she borrows because the bank runs the risks of the borrower not paying back the money, or defaulting, and because the bank is a business that needs to make a return, or profit. Some of this interest is passed on to the lenders, so as to make it attractive for them to put their money in the bank in the first place.
To understand what an innovation a bank is, consider what happened before. If you wanted to fund a venture – say, take a ship to the East Indies and trade for spices – you would have to find a very rich backer. There would be a limited number of such people. And a backer might be hesitant to support you since he or she would be risking a lot.
Contrast this with the situation after the birth of banks. To fund your venture, you go to a bank, of which there are many. Because they have combined the resources of a large number of lenders, not only do they have the resources to fund lots of ventures such as yours, but the risk has also been pooled. Each individual lender has less to lose than a single big investor. And, anyhow, the bank can absorb some failures, knowing the majority of ventures have a good chance of succeeding.
A surprising, even shocking, feature of banks is that they never lend out the money that people have deposited. They hold it as a reserve against losses, and for day-to-day cash transactions. Instead, banks create money. ‘Money comes into existence in the very act of borrowing it,’ says economist John Médaille.1
Compare the situation of the farmer and the banker. ‘The farmer may increase his wealth only by work, the hard work of growing corn,’ says Médaille. ‘The banker may increase his wealth, or at least his assets, by pressing a few buttons on the computer.’ Disturbingly, some banks caught up in the 2008 financial crisis had lent almost thirty times more money than people had deposited with them. By comparison, banks in the nineteenth century lent on average less than five times their deposits.
To reduce their risks when lending money, banks use credit-rating agencies. The banks need to know that you will be likely to pay back what you have borrowed. In fact, credit-rating agencies – and a whole lot of other unseen infrastructure that protects traders – are needed to oil the machinery of commerce. When one person trades with a second person in another country, for instance, he or she needs to know that the second person has the resources to pay and will not simply take the goods and run. The use of credit cards illustrates this well.
Credit cards are a form of short-term credit. In effect, someone takes out an ultra-short-term loan to buy some goods, a loan that is typically paid back in less than a month. Credit cards can be used anywhere in the world to buy goods. And the seller accepts a card as payment because he or she trusts that the issuer of the card checked that the card-holder had the resources to pay. Even if the issuer got it wrong, the seller knows that the issuer, who has shouldered the risk, will guarantee the payment.
In addition to banks, money and the rest, there have been many more milestones on the road to the commercial world we live in, each of which, to a lesser or greater degree, has boosted the number and frequency of trades. Many people still live in poverty. But the result of the frenzy of trading over the millennia has been steadily to increase the standard of living of the average person. Today, a typical home in the First World boasts a variety of goods that a couple of centuries ago would have been owned only by a king.
However, today’s standard of living has not been brought about solely by an ever more extensive web of global trading. Hand in hand with the expansion of trade has been a rise in the amount of energy consumed per person. Once upon a time, a person had no choice but to use his or her own labour or – as too often happened – the labour of other people as slaves. Later, with the domestication of horses, a person had access to the energy equivalent of maybe ten people. This was later magnified by technological innovations such as windmills and water-powered factories. But the most significant boost in the energy available per person came with the utilisation of fossil fuels such as coal. These were resources laid down hundreds of millions years ago – trees, which had soaked up sunlight, died, and became buried and compressed deep in the Earth. This enabled each person to have access to the energy equivalent of maybe 150 people. Whereas windmills and water-powered mills exploited today’s sunlight – which of course drives the wind and evaporates water, which falls as rain – coal brought into the present-day economy the resource of yesterday’s sunlight.
So it is debatable whether it is trade or the exploitation of ever more potent energy sources that is responsible for the rise in the standard of living of the average person over past millennia. Trade makes it commercially viable to mine coal and develop nuclear power stations. And the energy made available boosts trade.
But all is not rosy in the financial garden. Not only do a large number of the people in the world remain in poverty but the global financial system has a tendency to lurch from boom to bust. The reasons for this are much debated. Certainly, in the boom times, people have a tendency to become over-optimistic and borrow more than they should. So, when the bust comes, they have debts to pay, which starves the recovering economy of any money they might invest. It means that the peaks of the financial cycle are steeper and the troughs deeper than they would otherwise be. But, although this exacerbates busts, it does not explain the reason for the booms and busts.
One possibility often touted is that they are caused by shocks from outside. Everything is chugging along nicely, goes the story, then along comes a technological innovation that throws a spanner in the works – for instance, the World Wide Web, which triggered the infamous dot-com boom, followed inevitably by the dot-com bust. Another possible reason for booms and busts is that investors put the money into the construction of factories to supply certain goods. The factories employ many people. But eventually there are so many factories making the goods that they supply more than is needed. Because of this supply over-shoot, people lose their jobs. Ultimately, it is all down to the fact that, while investment sky-rockets, what people consume very definitely does not.
Another possible reason for booms and busts is that, when demand for goods slackens off, the suppliers of those goods do not react by reducing prices. One reason for this is that they know how much resistance there will be to cutting wages. By cutting wages and the prices of goods, demand might have been stimulated. Instead, demand falls and people lose their jobs.
Booms and busts, despite the periodic claims of economists, appear to be uncontrollable. The question then arises: do we really understand the complex, multiply connected commercial world we have created? The answer, worryingly, appears to be no. As the Canadian economist John Kenneth Galbraith said, ‘Economics is extremely useful as a form of employment for economists.’
Nick Leeson is infamous for sinking Barings, Britain’s oldest merchant bank, in 1995. In an interview on 30 September 2012, The Sunday Times asked the rogue trader, ‘What’s the most important lesson you have learned about money?’ His answer? ‘None of us ever knows enough about it.’
1 John Médaille, ‘Friends and Strangers: A Meditation on Money’, Front Porch Republic, 20 January 2012, http://tinyurl.com/6q3pbsy.