When we shove a dollar bill in a vending machine or slap down a 10 spot to pay for lunch, few of us stop to ponder the remarkable commercial innovation that money represents.
Our entire global economic system depends upon it as both a store of value and a medium of exchange. And yet the complex interactions that underpin our monetary system are not well understood. So, what is money and why do we trust it?
Christopher HopkinsPrimitive economies relied upon barter. A bushel of wheat in exchange for a pair of sandals. This allowed each person to improve his standard of living through specialization, but suffered from limitations in scale and depended upon finding counterparties needing each other's goods.
By 9,000 B.C., certain commodities with universal appeal began to function as rudimentary forms of money. Cattle, grains and shells were commonly traded, not for use by the parties but as a medium of exchange.
These early iterations of money possessed intrinsic value in and of themselves, but also served as forms of payment that could then be traded for other goods. Salt, a valuable preservative, made up part of a Roman soldier's monthly pay in the 1st century B.C. Called the "solarium," it is the source of our word "salary." A substandard soldier was "not worth his salt."
Ultimately, hungry animals and cumbrous minerals were replaced by representative icons: coins and eventually paper currency. By 1,100 A.D., China circulated printed bank notes, each of which represented a claim against a specific quantity of precious metal or other valued commodity. This proved to be a crucial moment in the development of money.
With the adoption of paper notes, commercial transactions necessarily involved a third party. Besides the buyer and seller, a separate person or entity stood behind and guaranteed the currency used to complete the transaction. Technically this was still barter, trading goods for gold, but substituting a paper claim on the gold in lieu of exchanging physical coins or bars.
Clearly the quantity of money was limited by the supply of the underlying commodity, typically gold and silver. This placed a fixed limitation on the potential growth of an economy. The next important innovation positively revolutionized global commerce: fractional reserve banking.
Paper currency represented a claim for a quantity of physical specie. But banks soon realized that not every note holder will show up simultaneously to claim their gold. This allowed more notes to be issued than total stores of specie in the vault, so long as a sufficient reserve was maintained to cover expected withdrawals. The excess over the reserve could then be lent out by the bank at interest. Here is where the true magic begins.
Borrowers deposit their loan proceeds in another bank. These deposits can then be re-lent to new borrowers, again after reserving a suitable cushion to cover expected withdrawals. New loan funds are deposited, and another round begins.
This is the mechanism through which money is actually created in a modern economy: by multiplication through the lending process. Central banks like the Federal Reserve don't actually create money, but regulate the lending process by which money is created by managing reserves and interest rates.
Why do we trust it? Until 1971, our currency was backed by deposits of gold held by the U.S. government. This is no longer true. Essentially, we believe it because it works.
Modern economies could not function without money, and we have developed sufficient confidence in the process that we rarely contemplate its mechanics. Our modern monetary system is essential, reliable and somewhat magical when you think about it. But it works.
Next week: the gold standard and why we will never return to it.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.