Lesson 2

Money's Concrete History

VIDEO: A Brief History of Money - By Deek Jackson

Primitive Money and the Invention of Coinage

Now that we’ve discovered the origin, functions and properties, let’s take a closer look at the concrete history of money. Before the invention of coinage in Lydia 2600 years ago there were many forms of primitive money like shells, cattle or grain. Some forms like tobacco in the isolated economy of prisons even survived until today. Another interesting example of primitive money are the Rai stones used by people from the island of Yap. These stones were so heavy and huge that nobody could move them away easily. Each stone had its own publicly known ownership history. Since everybody in the community knew who owns which stone now and who’s owned it before nobody could spend his stone twice secretly. That’s very interesting because it is a monetary system in a manner similar to Bitcoin. Within the Bitcoin system double-spends are as well prevented by a public ledger containing the ownership history of bitcoins. But we’ll come back to that later.

As mentioned afore a big step in monetary history was the invention of coinage in the 7th century BC. The Lydians of ancient Greece used a mix of gold and silver, called electrum, to stamp their coin. Coinage had a decisive advantage over ingots of precious metal used before: The coins were easy to recognize and everybody could rely on how much precious metal they contained. While each ingot had to be analyzed and weighed first to know how much metal was in it, the coin prescribed a reliable standard. That made trading much easier and more effective. Other Greek city states soon adopted the technique of coinage, and so did the Romans later. Coins of precious metal in many variations became the predominant form of money in circulation all over the world. The success of the coin lasted until the 19th century. However, the trust people had in the metal content of coins has also brought fraudsters to the scene. They secretly reduced the amount of gold or silver in coins by clipping tiny pieces off. That’s why issuers started to stamp coins with ridged edges. But even the issuers themselves were defeated by the temptation to cheat a little on the metal content of their products. The economic power of money is so great and seductive that its history has always been a history of fraud.

The Bank of Amsterdam and the Necessity of Money Substitutes

Starting from coins how did monetary items like paper currency, non-face-value coins and bank money as entries in books we use today emerge? Paper money originated from receipts of deposits of coins. Deposit banks evolved mainly for two reasons: to store coins securely and to make trading for merchants easier by issuing easily identifiable and transportable receipts for deposited coins. Now merchants could conveniently trade these receipts instead of the relatively bulky coins themselves. That was an advantageous simplification measure especially for large commercial transactions. The receipts were accepted as a substitute for coins as long as the deposit bank was ready to exchange it for real money any time.

Another reason for the necessity of money substitutes was the huge variance of coins in circulation. In the Early Modern Age there was a fully-fledged coin chaos, since many countries, municipalities and cities stamped their own coins with different metal content. The value of a certain coin was not easy to recognize anymore. Money changers were needed to give orientation on the value of the diverse coins. And for that service they charged a fee, of course. The Bank of Amsterdam, founded in 1609, successfully tried to end that coin chaos. They accepted all sorts of different coins from all over the world, even debased coins, checked their precious metal content, stored them and issued a receipt to the depositor denominated in metal weight. Through this standardization people finally could rely again on the value of the money they got in exchange for their goods and services. That’s why they even preferred bank notes from the Bank of Amsterdam over physical coins, which could possibly be counterfeited or had to be value-checked expensively by money changers. The legal compulsion to use the receipts for transactions above a certain value surely helped the success of the Bank of Amsterdam, too. As a result money changers and coin clippers went out of business and the European currency system became way more efficient.

The problem however with that centralization of currency issuance at the Bank of Amsterdam was that people now had to trust the bank. The bankers could easily issue receipts for more precious metal than they had in storage. This kind of fraud is called fractional reserve banking. Initially the bank kept a reserve of 100%. Every paper bank note or book entry was fully backed by precious metal. But after a while the temptation became irresistible and the Bank of Amsterdam started to speculate with the depositors’ money and lent out some of it to the Dutch East India Company. Because the depositors still had all their paper claims in use, the supply of currency was increased through this in fact illegal lending. If all depositors wanted to withdraw their precious metal at once, the Bank of Amsterdam would not have been able to meet its liabilities. What happened was that the Dutch East India Company went bankrupt in 1794. People were frightened by rumors concerning a big loss of the Bank of Amsterdam and ran to the bank to withdraw their bullion. Those who didn’t run fast enough came away empty-handed. That was the inglorious end of the Bank of Amsterdam as a private bank.

Governments and Fractional Reserve Banking

In 1694 the Bank of England was founded. It is still in existence today and is considered to be the prototype of modern central banks. During the costly war with France England’s commercial fleet was attacked and the Royal Navy needed to be upgraded to protect the sea trade. But King William III was out of money and couldn’t get a loan on the market. In this situation a group of businessmen approached him with the following proposal: If he granted them the right to issue some unbacked notes, they would lend the money out to him for a relatively low interest rate and he would never again run out of currency. The king agreed and the businessmen issued unbacked notes as a credit to the government in the amount of 1.2 million pound sterling. Over time this mutually beneficial relationship at the expense of those accepting the bank notes was expanded evermore. Competitors in the banking sector were restricted through regulation and the Bank of England soon gained the effective monopoly on the issuance of paper money. Whenever the bank had liquidity issues due to fractional reserve lending to the government the parliament legally suspended the redeemability of the paper notes to metal. In this way the men behind the Bank of England made easy money while the king had another source of income apart from unpopular taxation. Due to the global power of England with its colonies all over the world the bank soon became the most important financial institute in the world with the pound sterling as the world’s reserve currency.

That changed by the 20th century when the US dollar started to replace the GBP thanks to the high productivity of the US economy, especially in the military sector during World War I and II. The USD as well had its periods of convertibility and non-convertibility to metal. At the Bretton Woods Conference in July 1944 the majority of the nations with industrial power pegged their national currencies to the USD, which in turn was pegged to gold at a rate of 35$ per ounce. To supervise the monetary policies of the many central banks participating the World Bank and the International Monetary Fund were created. At large the world was on a gold standard then – with the subtle difference that only central banks, not citizens, were allowed to exchange their paper substitutes to gold at the Federal Reserve, the US central bank founded in 1913. Again the temptation was too big for the US government to issue more paper dollars than they had gold in reserve, especially during the costly Vietnam War. The construction of the Bretton Woods System made things worse since it was also in the interest of foreign governments that the US inflate the dollar supply. On grounds of their national currencies being pegged to the USD they continuously needed more USD to inflate their own currency. But still 35$ were redeemable for an ounce of gold. Therefore the danger of a bank run to gold by the foreign members of the Bretton Woods System resulting in a worldwide deflationary crash was always present. As a consequence President Nixon ended the redeemability of the USD into gold in 1973. All of a sudden the paper substitutes of money became real money all over the world.

Fiat Money – A Trust Issue

Without any natural limitation of the money supply through finite resources like gold and silver it all boils down to a trust issue. Central banks issue paper money without effort and commercial banks are allowed to lend it out in a fractional reserve style. It is the business model of commercial banks to increase the money supply by lowering interest rates. Lower interest rates make getting into debt and investing in expensive future projects more attractive and disincentivize saving. The additional consumption of resources through debt money created out of thin air finally leads to price inflation. The value of goods measured in money rises to a higher level than expected. The natural market reaction would be that debtors cannot pay back their loans plus interest. As a consequence the banks would have to write off their claims against defaulting debtors. Money supply would decrease and interest rates would rise again due to the higher default risk of credits. This correction would be painful but necessary. With central banks however the correction can be postponed effortlessly. As lenders of last resort they just print more money and bail out banks directly or lower the base rate of interest commercial banks have to pay to get a loan in central bank money on which their fractional reserve lending is based. In this way commercial banks can frequently grant their otherwise defaulting debtors new credits at still low interest rates. That in return leads to even higher price inflation over time. As a matter of fact you cannot have price stability and at the same time permanently postpone the correction of malinvestments caused by credit expansion. One day people’s trust in the future purchasing power of fiat money will end.

Today some people regret bygone times of precious metal money. But there is a reason why gold and silver were the historical predecessors of fiat money. History shows that metals need substitutes for easiness of trade. The impracticality of coins in global commercial transactions necessitates simplification and standardization through less bulky substitutes. Digital substitutes would be ideal. But here comes the problem: With substitutes you always have to trust the issuer that he doesn’t run a fractional reserve scheme. And the more people trust him to be honest, the lower the risk and the bigger the temptation gets for him to secretly lend out the depositors’ money. Therefore it would surely be much better, if we had digital money without the need for substitutes and trust at all.

Bitcoin’s Blockchain – The Idea of Trustless Digital Money

Bitcoin perfectly bridges this gap in the money market. A bitcoin is a digital accounting unit within a payment system using accounts secured by very strong cryptography. To create a digital good supposed to function as money Satoshi Nakamoto, the inventor of Bitcoin, had to come up with a solution to the double spend problem. Digital data can be copied easily. So how can the counterfeiting of digital money be prevented? How can spending a digital account balance more than once be made impossible – without having to trust a central institution again? Nakamoto’s ingenious solution is the blockchain. The blockchain is a public ledger containing the transaction history of every account in the Bitcoin system. Each node connected to the Bitcoin network over the internet can download the current version of the blockchain and know the exact transaction history of all accounts ever used. Whenever somebody tried to double spend money from his account the network of nodes would immediately recognize that and reject the transaction.

This aspect of the blockchain is quite similar to the above mentioned Rai stones used as money on the isle of Yap. Other than the potential Bitcoin users Nakamoto had in mind the few people on Yap knew each other personally so it was no big deal for them to reach a consensus over the ownership history of stones. But how to achieve such a consensus over transaction history within a decentralized worldwide network with pseudonymous actors? Nakamoto’s problem was to motivate the nodes to agree on a single latest version of the blockchain. He solved it by the combination of two measures. Firstly he motivated the users to do the bookkeeping by programming the issuance of bitcoins in such a way that whoever adds an entry into the ledger gets the newly created bitcoins as a reward. By the way: The reward halves every four years so that the total amount of bitcoins is strictly limited just like the amount of gold and silver available on the planet. But now another problem arises: Everybody would want to write the latest history into the book to get the new and scarce bitcoins for himself and nobody would accept the history written by others. To nonetheless make egoistic nodes consent Nakamoto secondly implemented a proof of work algorithm as a requirement for the bookkeepers. If a node wants to gain the new bitcoins by adding the latest block to the chain of transactions it is required to solve a computational puzzle. The difficulty of the puzzle gets adapted automatically to the computational power of the network so that a certain reliable time period for the confirmation of transactions by the network can be observed. Whenever a node solves the puzzle and publishes it as a block together with the transactions it wants to be written into the ledger the other nodes basically have two options: They either reject the block and try to find another solution themselves or accept it and try to compute the next block. If they chose the first option they too would have the problem to convince the network to accept their block and grant them their reward. That’s why egoistic nodes choose the second option and voluntarily accept the latest block and the longest blockchain. They realize that their only chance to get the block reward is to accept the longest blockchain and to compute the next block on top of that. Maybe that consensus does not take place right from the beginning. But the node that solves the first block can go on and compute the next one on top that. So the node with the longest blockchain just has to wait until the other nodes understand that it makes no sense for them to not accept the longest blockchain. From that point on the longest chain wins through a voluntary consensus of decentralized nodes.

If the network manages to keep the computational power decentralized, Bitcoin accomplishes something most desirable when you look at the history of money: really trustless digital money.


comments powered by Disqus

You will get an awesome place to trade your
Bitcoin and more. Click for further information!

Choose your topic

and start the journey