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Money
Money was one arguably the most important invention for development to take place. Money has been independently invented at one time or another in each important civilization in the history of the world. There is also remarkable similarity in how the concept of money has evolved in different times in history and in different parts of the world.
Historically, money has usually gone through four stages. In the first stage, money is made of a rare material, and the value of the money is determined by the amount of the material it contains. In the second stage, money is made of another material, such as paper, with no inherent value but can be exchanged into the physical stuff. In the third stage, money cannot be exchanged into anything physical, but its value is determined by law or custom. In the fourth and last stage, inflation increases to the point that money becomes virtually worthless.
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Physical Money
Physical money has historically come into existence to facilitate trade. In most cases some form of metallic money has been used, but there are also other examples, where shells, or even large stones (on an isolated island) have been used as money. Oil has been proposed by the great Soros. Gold and silver has been used in most of world, but other metals have occasionally been used. Bronze was the basis of the monetary system in early Roman times. Copper has also been used at times, for example in Spain and Sweden. In many cases, combinations have been used, with fixed exchange rates between different metals. Those fixed exchange rates have usually broken down as the relative value of the metals has moved due to changes in supply or demand.
Coins are the basis of almost every metallic monetary system. A coin in a physical money system is a piece of metal with a stamp. The stamp is a guarantee that the metallic weight and content is right. It also makes all coins of the same sort equal. This may not seem like such a big deal today, but it once was a very important invention. Previously, metals had to be weighed in order to determine their value, and that made trade more difficult. In most cases, by the way, coins in metallic standards were named after the weight of metal they contained.
A consequence of the invention of money was that it introduced a unit of account. This was important to facilitate credit. Once money was generally accepted, credit institutions soon developed, that allowed people to borrow against real estate or other properties. The evolution of credit is something that has gone hand in hand with the evolution of money.
Bank Notes and Fractional Reserve Systems
The origin of banking was a place where you could leave your coins for safekeeping or lend it for interest. In exchange you would get an IOU. These IOUs became standardized and non-personal and would circulate much like an alternative currency. The borrowers soon discovered that as the IOUs circulated, they were not all redeemed. Thus it was not necessary to keep enough specie (i.e. coins) to be able to pay all outstanding debt. In some cases, the issuer of the IOUs where originally governments, but usually they where private banks or trading houses.
The system of IOUs often evolved into formal paper bills, that could be redeemed into physical metal. In different times and places, the evolvement of paper money has been different. In certain cases, the IOU stage has been skipped entirely while in other, it has lasted for a long time.
One of the most important consequences of the introduction of bank notes backed by physical money is that it made it possible to drastically increase the supply of money. This facilitated increasing amounts of credit. As long as money had been made of physical metal, the amount of money was limited by the amount of metal in circulation. In the long run, the amount of metal available for coins could change with new discoveries and with changing amounts of metal used for other purposes, but for the short term, the amount of money available was virtually fixed. However, the demand for money would change making the value of money fluctuate.
The classic example of changing demand for money is harvest time in the 1th century America, when farmers would have to borrow money to pay temporary workers. This was, however, less of a problem in older times. Then, times of war were the times of increasing demand for money.
The availability of credit also enabled more speculative businesses than before. Foreign trade, something that was often very risky, is the perfect example. At certain times in history, credit financed trade expeditions would flourish. At other times, when credit was not readily available, foreign trade was effectively monopolized by established trading houses.
In most cases the paper money, fractional reserve system has eventually been monopolized by the government, as it has been a very lucrative business. Once the government has control over the bank notes, it usually does not take long before the monetary system evolves into the next stage.
Fiat Money
In a fiat money system, the money is not backed by a physical commodity. Instead, the only thing that gives the money value is its relative scarcity, and the fact that people seem to want it. Why people want fiat currency has been the subject of much debate. If you were an alien, visiting the earth for the first time, you would certainly be amazed at how the earthlings seem to prize little pieces of paper with paint on them.
One idea to explain the value of fiat money is debt. If you are in debt, you have no alternative but to try to obtain the pieces of paper in order to repay your debt, and if the paper is scarce, you have to compete for it. Interestingly, indebtedness seem to go hand in hand with fiat money, but that is no conclusive evidence for this theory.
Another way to explain the want for money is that people got used to paper money in the fractional reserve system. Once the metallic backing was removed, people continued to use money as they had become accustomed to. One argument for this thesis is that the fiat money systems that have worked best historically, are the ones where the physical backing was removed slowly and secretly.
A third way to explain the value of fiat money is that it is valuable because the government says so. This theory has often been tested in practice, and it can be rejected with confidence. Nevertheless, governments from time to time still try to inject value into paper by law and price control. This never works in the long run, and usually lead quickly to the next step, hyperinflation.
Although a fiat monetary system often evolves out of a fractional reserve system, this is not always the case. Sometimes the fractional reserve period has been skipped altogether. The most well known example is probably the Roman empire, where the silver based metallic system gradually evolved into a fiat monetary system based on token coins. The silver content in coins was slowly lowered, until coins consisted almost entirely of tin. This took place over a period of centuries, and that is probably the longest lasting fiat monetary system in the history of the world.
In a fractional reserve system, the amount of money that can be created is still limited by the amount of metal available, but in a fiat monetary system, there is no such physical restrain on the amount of money that can be created. This also allows unlimited credit creation. Initially, a rapid growth in the availability of credit is often mistaken for economic growth, as spending and business profits grow and frequently there is a rapid growth in equity prices. In the long run, however, the economy tends to suffer much more by the following contraction than it gained from the expansion in credit.
In most cases, a fiat monetary system comes into existence as a result of excessive public debt. When the government is unable to repay all its debt in gold or silver, the temptation to remove pysical backing rather than to default becomes irresistible. This was the case in 18th century France during the Law scheme, as well as in the 70s in the US, when Nixon removed the last link between the dollar and gold.
Hyperinflation
Hyperinflation is more or less by definition the terminal stage of any fiat currency. In hyperinflation money loses most of its value practically overnight. Hyperinflation is often the result of increasing regular inflation to the point where all confidence in money is lost, but there can also be other immediate causes. It is important to understand that in a fiat monetary system, the value of money is based on confidence, and once that confidence is gone, money irreversibly becomes worthless, regardless of its scarcity.
It is often argued that all fiat money eventually will become worthless. This has certainly been the case in the past. On the other hand it could also be argued that the current fiat monetary systems have not led to hyperinflation, and it seems unlikely that they will. It is not a very convincing argument, though, as hyperinflation never seems likely until it is well underway. Looking at the past, there is certainly a lot of evidence that all fiat money will eventually lose its value.
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