History Of Money

Originally published in Smart Investor (Singapore), June 2013.

Money, along with the wheel, is one of the greatest of all human inventions. It provides three basic functions, namely as a medium of exchange, unit of account and store of value. Money works best when everyone agrees on its value, and that they can swap it for goods and services.

Earliest forms of money were basic commodities — a wide and liquid market, but bulky and perishable (so, not a good store of value). The solution? Expressing a fixed weight of barley (11 grams) in terms of pieces of metal that had equivalent value — both portable and durable. For most of history, it was silver that was the metal of choice (gold was too rare to be used in a liquid market).

The key challenge of "commodity money" was whether it contained the amount of commodity it was supposed to, so it could pass from person to person without being reweighed and checked for quality. This saw the evolution of pieces of metal into coins, with rulers stamping the metals to certify weight and purity. Greed and war, however, saw debasement and "clipping," where the real value of the coins fell below face value.

England (1616–1717): The Accidental Move to Gold

In 1661, King Charles II of England ordered all coins to have a "milled edge" (similar to using holograms and other security measures today). It failed, though, because "good" money drove out "bad" — Gresham's Law. The public hoarded the new coins with higher silver content and used the older, debased coins to make new counterfeit money. Similar problems arose with gold coins in 1663, when England used a windfall of gold from West Africa to mint a series of gold coins known as guineas (while the silver shilling was official money, the gold guinea was an asset, with a suggested value of 20 shillings).

The solution was to standardise all money in circulation, so there was no "good" and "bad" money. The Great Recoinage of 1696 saw all old, degraded coins withdrawn and melted down to produce new, machine-milled 100% silver coins. The new problem was to fix the exchange rate between these and the gold coins — a task assigned to Sir Isaac Newton. In 1717, via royal proclamation, the exchange rate for gold guineas was set at 21 shillings.

While the prices of assets such as land, diamonds, or copper were freely set by demand and supply, gold guineas were guaranteed to be worth 21 shillings. Gold was now legally as good as silver — it too was money. Given the arbitrage created by lower gold prices in Europe, "bad" gold money drove out "good" silver money to become the principal money in circulation. Britain had moved to the gold standard, by accident.

At the same time, the convenience of larger denominations led to an increase in circulation of paper-based notes, issued by the Bank of England and legally bound to be exchanged for a fixed weight of gold.

Birth of Banking

Continental Europe (1717–1720): Paper Money

Across the Channel, France was experimenting with replacing precious metals with paper money. Since metal was hard to come by, John Law proposed that the government issue paper money backed by land. French coinage had been thoroughly debased to finance the wars of Louis XIV, and the idea found ground in 1717. While it initially provided stimulus to the cash-starved economy, large amounts of paper money were printed to pay off the massive debts accrued by the royal family. This led to high inflation, and by 1720 France had abandoned fiat money and returned to metal money.

Across the Pond (1792–1862): Silver, Gold & Paper!

Initially the US dollar was backed by both silver and gold reserves — the new nation didn't have enough of either metal to meet demand for its currency. This raised the same question England faced in 1717: what should the fixed ratio between gold and silver be, and how to prevent bad money from driving out good. The Coinage Act of 1792 undervalued gold, and America found itself de facto on a silver standard. Changes by Congress in 1834 tipped the scale the other way, and the US dollar joined the pound as a de facto gold-backed currency.

The Civil War of 1861–1865 led the federal government to print money without the precious metals to back it (similar to England's wars with France). With the public reluctant to accept the debased currency, Congress passed the Legal Tender Act of 1862, requiring all Americans to accept the new paper notes — the Supreme Court initially judged this unconstitutional, but reversed its decision given the resultant chaos and threat of federal government insolvency. With peace returning, the US returned to the gold standard.

The Wars & the Wall Street Crash: Abandonment of the Dollar Standard

WWI (1914) led the European powers to spend beyond their means and suspend the gold standard. Post-war, the gold standard was restored in 1925 — not easily, and only with austerity to earn back dollars paid out during the war. The Wall Street Crash of 1929 and the resultant American recession and decline in world trade made this harder still, and Britain finally quit the gold standard in 1931. The US remained on it, but at the cost of export competitiveness and declining growth — finally abandoning the gold standard in April 1933.

Germany had funded WWI by printing money: in 1914 the dollar was worth 4.2 marks, but after the war, 65; by August 1923, 620,000; and by November, 630 billion! By the end of 1924, Germany returned to its post-war exchange rate of 4.2 marks — but its new currency, the Rentenmark, was worth 1 trillion of the old Reichsmark. In 1948, the Reichsmark was replaced by the new Deutschmark at a rate of 10:1. The French Franc, meanwhile, traded at 5 to the dollar in 1913, 25 to the dollar in 1920, and slumped to 119 after the war. By 1958, a further devaluation took it to 500 — at which point the French knocked off two zeros and restored the 5/$ rate.

Bretton Woods (1944): The Dollar & Fiat Money

The war years saw a large outflow of gold from Europe to the US; by the end of the war, America controlled nearly 75% of the world's gold reserves. A gold standard could not work if one country held all the gold. The alternative, agreed at Bretton Woods in 1944, was that rather than every currency being fixed to gold, the US dollar — as anchor currency — would be fixed to gold, and all other countries would be "pegged" to the dollar. This allowed both the maintenance of money's value and greater flexibility to meet individual countries' needs.

Under Bretton Woods, dollars were as good as gold. But how were countries to get dollars? Over time, this required countries to build up a surplus against the US (and the US trade position to deteriorate). By the 1960s, US debts to foreign countries exceeded the value of its dollar reserves. US gold reserves steadily declined as Germany, France, and Japan rebuilt their war-ravaged economies. The dollar had become overvalued, but devaluing the anchor currency was fatal — and without a gold anchor or full capital controls, fixed exchange rates aren't really feasible.

In 1968, the promise to exchange dollars for gold was restricted to central banks only, creating two parallel markets for gold. In 1971, the fixed gold rate was removed altogether. We had fiat money — the value of the dollar, and all other currencies, now based solely on the credibility of the government that printed it.

Rohit Gupta has over 22 years of consumer banking experience with Citi and HSBC across India, Indonesia, Singapore, Malaysia, Mexico and Turkey.

Originally published in Smart Investor (Singapore), June 2013.

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