Concepts Explained: Money

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The video below focuses on “money,” it covers questions including: where did money come from? How did people trade before inventing money? Was it a masterstroke or madness (or both) to let banks create money? Today money is generally accepted as payment for goods and services or repayment of debt. But governments still fret about whether there’s too much (or too little) in circulation, economists cannot agree on what it is, and the enduring popularity of alternative or crypto-currencies shows rumbling discontent with the official version. These 10 short animations chart the evolution of money from stones and whale teeth to modern monetary policy and banking, and takes a hard look at money’s role in economic crises. Transcripts are below the video.

Sections

  1. Early Money  Where did the need for money come from?
  2. Metal Money  Why did we start making money out of metal?
  3. Paper Money  The benefits of using paper money.
  4. Controlling Money  Complications of trying to control money.
  5. Money and Inflation  What’s the connection between money and inflation?
  6. International Money  How did British pounds trigger the American War of Independence?
  7. Money and building banks  How do banks make money?
  8. Money and saving the banks  Tackling financial meltdown.
  9. The power of money  Why does the world trade in US dollars?
  10. Future money  What type of money will we use in the future?
  11. Understanding Debt  A quick overview of private and public debt.

History of money (Duration, 10:58)

Source: Open University (2012). History of money

^ Early Money
Long before money was invented, people were quite happy making, doing, and growing things for one another. In small communities, they could largely remember the payments and receipts of what was exchanged. Keeping tabs – or tallies – of these exchanges, helped with a key requirement, which was to record who’d been paid and who was still owed. But as communities grew, so the exchanges became more and more numerous, and as people created things for the common good, and rulers began to impose taxes, so the accounting was increasingly hard to keep track of IOU notes might have been a neat solution, but unless you knew the individual issuer personally they were hard to enforce or verify. So instead people started to use objects, such as whales’ teeth, as a kind of IOU. This intermediate step in the exchange process meant that people were free to trade with anyone and they could even store up purchasing power for later use, with their re-tradable IOU tokens. So at the same time that humans invented money, they’d also invented debt.

^ Metal Money
Once people start using money to facilitate trade, whether in the form of shells, barley, feathers, or whales’ teeth, some useful characteristics of money become apparent. Barley, for example, is heavy to carry, so not portable or even durable. Whales’ teeth are hard to split into two. So not easily divisible. Shells can be picked up on any beach, so not exactly scarce. And if the token standing as money does not have much intrinsic value, like feathers, it is hard to trade outside your immediate community. Another noticeable feature of money was that having a lot of it made you powerful. And power could get you a lot of it. So kings hit on the idea of minting coins from precious metals, stamping them with an emblem that guaranteed their weight and value. Metal money ticked all the money boxes, and because it had intrinsic value, it could be used to trade with other communities. But the success of metal money brought temptation, and sovereigns soon realised that by slimming down the coins, or slipping cheaper base metals in to the mix, they could make money, by circulating debased currency worth less than face value.

^ Paper Money
Carrying around large quantities of coins could be exhausting work and it was early Chinese rulers that hit on the idea of keeping their heavy coins back in the palace while issuing IOU certificates on paper for long distance trading. Although the paper had no intrinsic value, people trusted that it was worth what it said it was worth, and they could always exchange it for gold or silver, or the coins it represented. As global trade grew, the idea of paper money caught on, but traders and lenders were concerned that it was a bit too easy just to print money, so they tried to link the value of money to the value of gold, which had the benefit of creating a standard for exchange between different currencies. Attempts to peg currencies to a fixed gold standard continued for centuries, but the need for flexible exchange rates always prevailed, and since the early 1970s the world has stopped trying to keep to a gold standard. So today the only thing that distinguishes the value of a bank note from any other paper is trust.

^ Controlling Money
Years ago, on the Pacific island of Yap, the nearest thing to gold was the rai stone, notable for its enormous size and weight. From the days the chiefs decided to ask for their taxes in raistones, it meant that for all tax payers, the currency became universal, unavoidable, and under the control of the chief. The most valuable rai stones were just so heavy that the Yap population tended to leave their currency in one place and then trade effectively on promises. Any trader who owned a rai stone on Yap could issue a promissory note against the value of their stone and thus banking was born. And once the chiefs accept these promissory notes instead of rai stones for their taxes, they effectively lose control of the amount of money in circulation – the money supply. In the 20th century some economists argue that the amount of money in circulation directly affects economic performance and it is important for governments to try to control it. But this is not easy, especially when it is private lenders that create most of it.

^ Money and inflation
In the 16th century, Spain brought home massive additional supplies of precious metals from the colonies. But what seemed like a dream come true, and should surely have boosted trade, turned sour when traders simply put up the price of their goods to match this new purchasing power, so the returning explorers were no better off, and those without the new gold were even worse off. It was only those who had debts, which had in effect got smaller, who were actually better off. This was the first appearance of the theory that too much money, chasing too few goods can cause inflation. Unless, that is, the traders produce more goods, or unless the newer, bigger money supply circulates less rapidly, by people saving more, either because they’re rich enough, or because they’re particularly gloomy about the future.

^ International money
In the 18th century the British forced their colonies in America to pay their taxes in pounds, and they made it illegal for the British colonies to print their own money. This meant that the colonies were forced to trade with the motherland to access the currency. According to Benjamin Franklin, the American War of Independence was caused by the sheer burden of British taxation and the disadvantageous trade needed to access British pounds. And the hard-won freedom after the war allowed the Americans to create the American dollar. Which, because of the country’s vast trade and tax base, eventually became the most widely used currency on the planet, leading many countries, including Britain to store large reserves of dollars. But by choosing to keep a reserve currency in dollars, the UK ceded at least some power back to those runaway Americans.

^ Money and building banks
By the 19th century, banking had become a thoroughly respectable business. Making a profit by basic money lending, banks paid a lower rate of interest for the money they took in, than they charged on the money they loaned out. But the banks soon realised that as long as depositors didn’t all ask for their money at once, they could in fact lend out many times more money than they had on deposit. This is known as fractional reserve banking. On rare occasions when depositors all tried to get their money out at once, there was a run on the bank. And the effect on the wider economy was so serious that government started to ensure customers’ deposits to prevent it happening, and thereby enabling banks to loan out more and more. By the 21st century, some banks had taken fractional reserve banking to a whole new level, funding most of their loans not from cash deposits from savers, but with loans from other banks, often secured against bundles of previous loans. So when there was a run on the bank in 2007, banks like Northern Rock not only didn’t have enough money to pay out, but the effect went way beyond just one bank.

^ Money and saving the banks
To understand how governments tried to prevent global financial meltdown after 2008, economists distinguished between two kinds of money: money created by banks inside the banking system, and money created by governments outside the banking system. When a bank creates money by making a new loan the bank acquires a new private asset – the loan – with an equivalent private liability to the borrower to pay it. This is money created inside the banking system. Governments can create money by selling new bonds. These bonds go into circulation as new private assets but there is no equivalent private liability to pay them. Instead, this outside money is added to the public debt. Although it is normally a very small percentage of total money in the economy that was used to buy up the banks’ bad private debts and write them off. The private sector retained its wealth with new assets inside the system supported by government, with public debt from outside the system.

^ The power of money
Since the last traces of a gold standard disappeared in 1973, the world has carried on trading in US dollars even though these aren’t backed by anything of intrinsic worth. The US government’s decision to borrow billions for its bank rescue and stimulus plan dramatically increased the supply of dollars and some predicted that this would lead to a big fall in the dollar’s value, on the basis that economies which print money so that they can consume more than they produce will suffer price inflation and exchange rate depreciation. But six years on this still hasn’t happened. Why then does the dollar retain its value? Perhaps with so much of the world holding its wealth in US dollar assets people simply have faith that the dollar will retain its value. And the knowledge that so many others share that faith reinforces the general optimism that the dollar will stay strong.

^ Future money
Minted coins and paper money, once the cutting edge of technology are now used in only 2% of transactions. Credit card and electronic banking technology has enabled massive global transactions to take place in the fraction of a second. And digital technology is enabling new currencies to be created – Linden dollars, bitcoin and other crypto currencies which exhibit the enduring characteristics of money, being hard to forge, durable, portable, divisible and limited in supply, and which may even challenge the power of government backed money. But until a government accepts taxes in bitcoins, or other privately issued currencies, or banks start lending in them, they are not much different from any other token, such as whales’ teeth. One sign that a new form of money has become important will be when governments and banks try to control it. And if governments and banks continue to have the power to control money, those who use it will always wonder to what purpose will they put that power.

^ Understanding debt
People and businesses take on private debt because they want to buy something today and pay for it in the future. For example, buying a home or factory with a loan gives people access to a property before they generate the income to pay for it. And in this case, the building itself can be used as security to be seized if the borrower does not repay the lender. This is widely seen as good debt, as everybody benefits. But if, for example, property prices fall, and the security is worth less than the loan, as happened before the crash of 2008, and if the borrower does not have the income to repay, it becomes bad debt, where somebody is bound to lose out. People on low income needing to borrow for current consumption, like food, can rarely offer any security and with such a high risk of a bad debt, rates of interest on so-called “pay day loans”, for example, can be massive. Debt often gets a bad name, but nearly all innovation, art, medicine and food production requires up-front spending before income can be achieved. And it is debt that can help people without wealth to create some. Public debt is essentially the government’s overdraft, the total amount borrowed which is still outstanding. Governments borrow to spread the cost of current projects across future years. And hope to achieve long term benefits for their future populations, solve medium term fluctuations in their economic activity, and fix short term economic crises. And because governments don’t retire or die, and particularly as big governments already own a lot of assets for security and can always increase their income by raising taxes from the private sector, they are seen as credit-worthy and trusted to borrow large sums over long periods of time, by issuing bonds and hoping that future growth or indeed inflation will reduce their debt over time. So even with massive debts, the United States government is able to keep on borrowing, while smaller countries require the support of development banks and back-up from aid agencies such as the IMF if they are going to borrow anything at all.

 

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BIG IDEAS
01. Beginnings
02. Who am I?
03. Being human
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CONCEPTS EXPLAINED
01. Astronomy
02. Microgravity
03. Thoughts on theory
04. Theology explained
05. History of the English language
06. History of Money
07. Economics explained
08. The European Union explained