Introduction

The author studied economics for six years. In that time, he reports, he was not taught an accurate understanding of money. Nine years ago he began reading finance and monetary books and summarizing them publicly. He found that much of their content contradicted what he had been taught. He asked a professor he trusted whether these findings were correct. The professor replied, "Yes, all of it." The professor knew the material, but the textbooks presented a different account.

This article, the first part of a series, summarizes the author's account of money. It covers the origins of money, the transition from commodity money to paper money, the role of private banks, and the effects of inflation on savers and borrowers.

Money as an Agreement: The Island of Yap

In 1903, American doctor William Furness traveled to Yap, a small island in the Pacific Ocean. The people of Yap used large stone discs as money. Some discs weighed about 4 tons and were made of solid limestone. The stones were too heavy to carry or move. They stayed in the village, often beside roads or outside houses. When a transaction occurred, ownership changed, but the stone remained in place.

The author cites an incident in which a family transporting a large stone by canoe lost it when a storm sank it to the bottom of the ocean. No one could retrieve or see the stone. The island still treated it as money, because the community agreed that the stone existed and belonged to that family.

The author states that economists John Maynard Keynes and Milton Friedman, who disagreed on most economic questions, each independently wrote about Yap and reached the same conclusion: the value of money rests on a shared agreement.

Origins of Money: Barter or Debt?

The Barter Story

Economics textbooks commonly describe money's origin through barter. In this account, people first exchanged goods directly, such as fish for bread. Money was later introduced to simplify these exchanges. Adam Smith presented this account in The Wealth of Nations in 1776. The author notes that Smith presented it as a logical argument rather than a historical record. Economists and teachers treated it as fact for about 250 years without verifying it.

Anthropological Evidence

Cambridge anthropologist Caroline Humphrey searched for evidence of barter economies. She concluded that no barter economy has ever been documented in any culture, era, or location. The author states that all available evidence points to the same conclusion.

According to the author, barter appears mainly as a fallback. Russia in the 1990s and Argentina in 2002 both saw people return to direct exchange of goods when their currencies lost function. In these cases, barter replaced money after the monetary system failed.

Early Credit Relationships

The author argues that exchanges began as mutual obligations. One person helped a neighbor build a roof, and the neighbor later helped with the harvest. Participants tracked what they owed each other without formal transactions or negotiation.

The oldest known writing, according to the author, is a debt record from more than 5,000 years ago. It was found in Mesopotamia, in present-day Iraq. It records a loan of tools, with a promise to repay after the harvest. Merchants also recorded amounts owed to them. These records were inscribed on clay tablets that are now held in museums.

The first coins appeared about 2,700 years later, in Lydia, in present-day Turkey. The author notes that for more than 2,000 years before coins, societies built cities, paid workers, and sustained civilizations using recorded promises.

Money as a Measuring Tool

The author compares money to a ruler or measuring unit. A unit of measure works because everyone agrees on its value. A minute, for example, contains 60 seconds in Tokyo, New York, and Cairo. No individual can alter this definition. This stability makes measurement useful, because people can plan and rely on it.

The author argues that money should function in the same way, as a stable and reliable measure of value. The key difference is that a minute exists in nature, while money is a human agreement. Human agreements can be changed without notice.

For thousands of years, societies linked money to physical commodities such as gold and silver. These materials could not be produced at will, which limited the ability to change the measure. The author argues that this physical anchor enforced discipline on monetary issuers.

Paper Money in Song Dynasty China

During the Song Dynasty, in the Sichuan region of China, money was made of iron. Iron coins had low value per unit. Large trades required kilograms of metal, which was slow, dangerous, and difficult to transport across the empire.

Merchants developed a solution. They deposited iron with a trusted local shop and received a receipt. They then traded the receipt instead of the metal. Receipts were lighter, faster to transport, and safer from theft. The author notes that ordinary people created this system without government direction.

The system worked, and trade became easier. The government then formalized it by issuing paper money called jiaozi. Government-issued paper replaced many different shop receipts with a single standard.

Government spending on war created the problem. Printing paper cost less than acquiring silver, so the government printed more money. Repeated expansion reduced the currency's value. Once people recognized the decline, they stopped trusting the paper. They returned to heavy iron coins. The author states that China was the first to invent paper money and the first to suffer its collapse.

The London Goldsmiths and Fractional Lending

Receipts for Stored Gold

In 17th-century London, theft, war, and fire made it risky for individuals to keep gold at home. Goldsmiths who already maintained secure vaults began storing customers' gold for a small fee. Each customer received a receipt stating the amount of gold held.

Many residents used the same goldsmith. When one customer paid another, the goldsmith could settle the transaction by moving ownership of gold within his vaults. Customers exchanged receipts instead of physically moving gold. The author states that this arrangement reduced effort for all parties.

Lending Customers' Gold

The goldsmith observed that, on any given day, about 10% of depositors came to collect their gold. The remainder circulated receipts instead. He began lending a portion of the stored gold to merchants and charging interest.

Depositors were not informed of this lending. They believed their gold remained in the vault. The goldsmith kept the interest, while depositors bore the risk. The author compares this to a car owner who rents out a car parked in a garage without the owner's knowledge.

The author acknowledges that lending had economic value. Idle gold produces nothing, while gold put to use can finance businesses, jobs, and projects that otherwise would not exist.

Issuing Unbacked Receipts

The goldsmith then issued more receipts than he held in gold. In the author's example, he held 100 pieces of gold and printed 150 receipts. The 50 extra receipts had no backing. Genuine and counterfeit receipts looked identical, so depositors could not distinguish between them. Prices began to rise, and the cause was not immediately clear.

The Bank of England and the Institutionalization of Credit

King William III needed funds for his wars and could not borrow from lenders. He observed the goldsmiths' methods and sought similar power for the crown.

In 1694, the Bank of England was founded. A group of merchants lent the crown £1.2 million. In exchange, the king granted the bank an official license to issue paper money. This money was backed by the king's promise to repay rather than by stored gold.

The author states that the goldsmiths and the Bank of England used the same method. Both created money through receipts or bank notes that exceeded their physical reserves. The author argues that the process gained legitimacy through state authorization. Other countries adopted the model. For this reason, the Bank of England is often called the "mother of all central banks."

Bretton Woods and the End of Gold Convertibility

After the Second World War, Western countries agreed to tie their currencies to the US dollar and the dollar to gold. The official price was $35 per troy ounce. Europe rebuilt during this period, and living standards rose.

The United States spent heavily on wars and domestic programs. It financed the gap by printing money. Dollars accumulated abroad, while the US gold supply did not keep pace. Other countries began to question whether gold would be available if all holders demanded conversion at once.

France was the first to demand its gold. The US gold reserve declined rapidly. On a Sunday evening in August 1971, President Richard Nixon announced on television that the dollar would no longer be convertible to gold. The author describes this as the removal of the last monetary anchor. Currencies worldwide became paper money backed by trust rather than a physical commodity.

The author states that a $100 bill held in August 1971 would purchase only$8 worth of goods today. According to this account, the bill's nominal value remained unchanged while about 92% of its purchasing power was lost.

Bank Money Creation

The author states that 97% of money today is digital and created by private commercial banks, not by central banks or governments. The author contrasts this with the common description of banking, in which banks act as intermediaries. In that description, banks accept deposits, hold 10% as reserves, and lend the remainder. The author states that this description does not reflect how banks create money.

The Loan Process

The author describes a $10,000 loan as follows:

1. A borrower signs a loan contract with a bank.
2. The bank records the borrower's promise to repay as an asset.
3. The bank credits $10,000 to the borrower's account.

The author states that money is created at the moment of signing. The bank does not need to use existing savings or deposits to fund the loan. The borrower can spend the funds, but must repay the $10,000 plus interest.

The Interest Problem

The author notes a structural issue. If a borrower owes $11,000 after repaying principal and interest, the additional$1,000 was never created. The author argues that the only way to obtain this amount is for another borrower to take on new debt. That borrower also owes more than the amount borrowed, which requires further borrowing.

According to the author, repaying all debt requires that new debt be created continually. The author argues that the system depends on continuous expansion of credit.

Inflation and the Distribution of Costs

As money supply grows faster than the output of goods and services, the value of each unit of money declines. The author argues that this makes each dollar purchase less over time.

Major central banks target 2% annual inflation, which they call price stability. The author states that compounded at 2%, inflation reduces the value of savings by about half every 35 years.

The author argues that inflation benefits borrowers. Borrowers repay debts with currency that has lost value, so the real burden of the debt shrinks. Governments are the largest borrowers. The author states that government debt can become manageable through inflation over decades, even if repayment in real terms would be unrealistic.

The author concludes that savers bear the cost of inflation, while borrowers receive the benefit. He describes this outcome as a feature of the monetary system rather than an error within it.