Money is one of those weird concepts.
First we have barter. I offer you 5 chickens, you give me 6 bushels of wheat in return. Except the problem with this is, what if I have chickens, and you want chickens, and you have wheat, but I want something else besides wheat?
And so the next evolution is the concept of a key good. This is a good that people are willing to trade for, not because they want the good itself, but because they know they can trade that good to someone else to get the thing they really want. Lots of things have been used as key goods…cacao beans, cigarettes, whiskey, cows, shells…and metals. If I have 5 chickens I can trade them to you for 3 bottles of whiskey. I don’t want the whiskey, but I know if I take that whiskey to the person who has the goods I want, he will readily take the whiskey in exchange. And he might not want the whiskey either, but he knows that he can trade it for what he wants.
Goods that make useful key goods are compact, valuable, fungible, durable, storable, transportable, interchangeable, and divisible. You want something you can easily carry around, something where each bit is equivalent to each other bit, something that can be broken apart without losing value. And it turns out that metals, especially certain rare metals, make excellent key goods. Gold can be used to make jewelry and other ornaments, that’s its main use. But gold is compact, it lasts forever, it can be cut up into small bits without losing value, every lump of gold is equivalent to every other lump of gold, so you don’t have to haggle over whether this is an especially high quality or low quality lump of gold.
So I can trade you my chickens for a few lumps of gold or silver. However, it makes things easier if we have standardized ingots so we don’t have to weigh and assay the metal each time. These ingots are called “coins”, and they make barter very easy, no one barters directly for they goods they want, instead they barter for the metal ingots and use the metal ingots to barter for what they want. And so precious metals became the most important key good in the ancient world, and you could travel from Spain to China with gold in your pockets and know that you could exchange that gold for other goods no matter where you were. But note that gold or silver coins, while they are money, are still just a key good that can be used to facilitate barter.
Now we next have an interesting development. Gold can be stolen easily. So people would sometimes arrange to keep their gold in a safe location. And this was often at a goldsmith’s shop. Since the goldsmith had a lot of gold sitting around, he had to have a secure safe to keep it. And so other people would give their gold to the goldsmith, and he would keep it safe for them and give them a reciept. Now, this reciept is very interesting. Because it is a paper representation of actual gold.
If you’ve got gold deposited at the goldsmiths, but want to buy some good, you’d have to go to the goldsmith, withdraw your gold, and trade it to the person who had the good. But suppose you could instead just trade him the reciept? You hand him a piece of paper, and he hands you the goods, because the peice of paper entitles him to go to the goldsmith’s and get the gold himself. And now we can see that this reciept is really the first form of paper money.
But the goldsmith can do some interesting tricks. He doesn’t have to issue reciepts for the exact same gold you deposited, he can instead just promise to give you a certain weight of gold, and it can be any gold, just as long as you get the same weight back you don’t care. And so the goldsmith can issue more reciepts than he has actual gold, he doesn’t have to keep every ounce of gold in the safe, as long as he guarantees to return a certain amount of gold. And so the goldsmith isn’t really a goldsmith anymore, but is now a banker. He can issue paper reciepts that entitle people to a certain amount of gold, and it doesn’t matter how much gold he actually has, as long as he’s able to pay back anyone who wants the actual gold. Most early paper currencies were of this type. The British Pound was a receipt for a literal pound of silver.
But of course we see the possibility for mischief. If the banker goldsmith issues lots of notes, and suddenly everyone wants their gold and silver, then he’s in trouble because he doesn’t have it all in the vault. And of course, governments decide to get in on the game rather than leaving it to bankers. Goverments have been issuing gold and silver ingots, but now they start issuing paper money. And this is the “gold standard”. But then someone notices something interesting. Nobody actually wants the gold, they just want to be able to trade easily. You can have fractional reserves, where only a small amount of gold is available for redemption. And this reserve can get smaller and smaller. But what if the reserve is zero? Why should that make any difference?
And so we trade pieces of paper that do not represent a promise by the government to redeem for a certain weight of precious metal. All it represents is a promise that you can pay your taxes and debts with this piece of paper. And no one cares, because no one wanted the gold anyway, gold was just a proxy. So now we have fiat currency.
And of course, it doesn’t stop there. How often do you use paper money? I get paid electronically through direct deposit from my employer to my bank account. And I pay my bills electronically through a credit card, and transfer the amount from my bank account to the credit card company every month. No actual worthless paper has changed hands, all that changes is the number written on some bank’s computer memory. And so we have the ultimate form of money, electronic money that isn’t represented by anything, not even a piece of paper. Just try buying a house or a car or anything important by bringing in a wheelbarrow full of paper money, the mortgage company will look at you like you tried to bring in a truck full of chickens to barter for your house.