Sunday, May 17, 2009

On the Origin of Currency

Today, we will have a speculative history lesion.

Our prehistoric ancestors lived in small communities. Specialized communities prevailed over generalized ones, since specialization exists in all human groups today, but we don’t see it in other primates, so specialization ruled. Such groups require trade among members—potters need to be able to pay the bakers, and everyone needs to contribute for the soldiers—and to do this human society requires a tool of exchange.

In small communities a “moral economy” forms—people share, but individuals who give more things of greater value to others are regarded by the group more highly than those who gave less. People gave what they had, and took what they needed—and people who gave more were remembered more fondly, and prospered.

As small villages grew into cities, moral economies became impractical. Trading had to be done through barter if the group was too big for everyone to know everybody else. Trust could not be relied upon. An economic exchange had to be sealed at the moment, which meant if one wanted or needed the possessions of another, they had to offer something immediately in exchange.

Currency is an extension of barter. The coin of the kingdom would be a tradable good, desired by many, that ideally would have been convenient in the sense of being (1) easily portable and (2) divisible. For example, if you want a haircut and you have a goat, then exchange is problematic, because the goat is worth more than the haircut, and you cannot cut off a piece of the goat for the haircut. Ideally, currency would be (3) long lasting and not degrade over time, and also it had to be (4) precious to some degree—it could not be too easy to procure. The bartered good that best displayed these properties would be widely accepted as the natural currency.

In World War II, for example, when cash was scarce, cigarettes were used as currency among GIs, and are probably still used that way in prison today. In ancient times, salt was used to pay roman soldiers, which likewise has many of the properties of a natural currency. But it was mostly gold that would prove to be ideal, and coin was preferable to crown or ring, being standardized and more divisible. Over the centuries, gold came to be replaced by bank notes, which were more convenient still, being even more portable than gold. However, trading bank notes was still essentially trading gold, since bank notes could be redeemed for gold.

With the development of fractional reserves, things began to change. Usually you could redeem banknotes for gold, but if the bank ran in to trouble, and there was a run on it, there were more banknotes than actual gold. Notes required faith in a stable economic system. They were riskier, and required there be no economic surprises.

The final stage of the evolution of currency has been a disconnection of bank notes from gold. Bank notes are not longer redeemable for gold, or anything. Cash is not a “natural currency,” and it is not based on faith either; its use is legally enforced. It is legal tender. Whether anybody has any faith in the dollar or not, bond holders must accept it as a means of payment. The law cannot say what its value is though—that is determined by their supply (which is regulated), and individual judgments about the desirability of the goods dollars can buy.

Modern cash has the advantage and disadvantage of manipulability by federal regulators. During times of wealth expansion, the fiat currency system can be easily increased to accommodate growth while preventing constriction of prices due to scarce cash. But regulators can also get it wrong, and expand the currency when the economy isn’t really expanding, except in the form of a speculative bubble. When people think they are in a new economic paradigm, they are really just greater fools getting in a lot of debt to pay excessive prices on speculative assets or commodities.

So that’s the good and the bad of where we find ourselves in regard to cash. It is the central lynchpin of a demand-driven economy.

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