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The Genesis of Money
It is impossible to understand money and how it functions, and therefore how the Fed functions, without looking at the logic of how money, banking, and Central Banking developed. The reason is that money is unique in possessing a vital historical component. You can explain the needs and the demand for everything else: for bread, computers, concerts, airplanes, medical care, etc., solely by how these goods and services are valued now by consumers. For all of these goods are valued and purchased for their own sake. But “money,” dollars, francs, lira, etc., is purchased and accepted in exchange not for any value the paper tickets have per se but because everyone expects that everyone else will accept these tickets in exchange. And these expectations are pervasive because these tickets have indeed been accepted in the immediate and more remote past. An analysis of the history of money, then, is indispensable for insight into how the monetary system works today.
Money did not and never could begin by some arbitrary social contract, or by some government agency decreeing that everyone has to accept the tickets it issues. Even coercion could not force people and institutions to accept meaningless tickets that they had not heard of or that bore no relation to any other pre-existing money. Money arises on the free market, as individuals on the market try to facilitate the vital process of exchange. The market is a network, a lattice-work of two people or institutions exchanging two different commodities. Individuals specialize in producing different goods or services, and then exchanging these goods on terms they agree upon. Jones produces a barrel of fish and exchanges it for Smith's bushel of wheat. Both parties make the exchange because they expect to benefit; and so the free market consists of a network of exchanges that are mutually beneficial at every step of the way.
But this system of “direct exchange” of useful goods, or “barter,” has severe limitations which exchangers soon run up against. Suppose that Smith dislikes fish, but Jones, a fisherman, would like to buy his wheat. Jones then tries to find a product, say butter, not for his own use but in order to resell to Smith. Jones is here engaging in “indirect exchange,” where he purchases butter, not for its own sake, but for use as a “medium,” or middle-term, in the exchange. In other cases, goods are “indivisible” and cannot be chopped up into small parts to be used in direct exchange. Suppose, for example, that Robbins would like to sell a tractor, and then purchase a myriad of different goods: horses, wheat, rope, barrels, etc. Clearly, he can't chop the tractor into seven or eight parts, and exchange each part for a good he desires. What he will have to do is to engage in “indirect exchange,” that is, to sell the tractor for a more divisible commodity, say 100 pounds of butter, and then slice the butter into divisible parts and exchange each part for the good he desires. Robbins, again, would then be using butter as a medium of exchange.
Once any particular commodity starts to be used as a medium, this very process has a spiralling, or snowballing, effect. If, for example, several people in a society begin to use butter as a medium, people will realize that in that particular region butter is becoming especially marketable, or acceptable in exchange, and so they will demand more butter in exchange for use as a medium. And so, as its use as a medium becomes more widely known, this use feeds upon itself, until rapidly the commodity comes into general employment in the society as a medium of exchange. A commodity that is in general use as a medium is defined as a money.
Once a good comes into use as a money, the market expands rapidly, and the economy becomes remarkably more productive and prosperous. The reason is that the price system becomes enormously simplified. A “price” is simply the terms of exchange, the ratio of the quantities of the two goods being traded. In every exchange, x amount of one commodity is exchanged for y amount of another. Take the Smith-Jones trade noted above. Suppose that Jones exchanges 2 barrels of fish for Smith's 1 bushel of wheat. In that case, the “price” of wheat in terms of fish is 2 barrels of fish per bushel. Conversely, the “price” of fish in terms of wheat is one-half a bushel per barrel. In a system of barter, knowing the relative price of anything would quickly become impossibly complicated: thus, the price of a hat might be 10 candy bars, or 6 loaves of bread, or 1 /10 of a TV set, and on and on. But once a money is established on the market, then every single exchange includes the money-commodity as one of its two commodities. Jones will sell fish for the money commodity, and will then “sell” the money in exchange for wheat, shoes, tractors, entertainment, or whatever. And Smith will sell his wheat in the same manner. As a result, every price will be reckoned simply in terms of its “money-price,” its price in terms of the common money-commodity.
Thus, suppose that butter has become the society's money by this market process. In that case, all prices of goods or services are reckoned in their respective money-prices; thus, a hat might exchange for 15 ounces of butter, a candy bar may be priced at 1.5 ounces of butter, a TV set at 150 ounces of butter, etc. If you want to know how the market price of a hat compares to other goods, you don't have to figure each relative price directly; all you have to know is that the money-price of a hat is 15 ounces of butter, or 1 ounce of gold, or whatever the money-commodity is, and then it will be easy to reckon the various goods in terms of their respective money-prices.
Another grave problem with a world of barter is that it is impossible for any business firm to calculate how it's doing, whether it is making profits or incurring losses, beyond a very primitive estimate. Suppose that you are a business firm, and you are trying to calculate your income, and your expenses, for the previous month. And you list your income: “let's see, last month we took in 20 yards of string, 3 codfish, 4 cords of lumber, 3 bushels of wheat … etc.,” and “we paid out: 5 empty barrels, 8 pounds of cotton, 30 bricks, 5 pounds of beef.” How in the world could you figure out how well you are doing? Once a money is established in an economy, however, business calculation becomes easy: “Last month, we took in 500 ounces of gold, and paid out 450 ounces of gold. Net profit, 50 gold ounces.” The development of a general medium of exchange, then, is a crucial requisite to the development of any sort of flourishing market economy.
In the history of mankind, every society, including primitive tribes, rapidly developed money in the above manner, on the market. Many commodities have been used as money: iron hoes in Africa, salt in West Africa, sugar in the Caribbean, beaver skins in Canada, codfish in colonial New England, tobacco in colonial Maryland and Virginia. In German prisoner-of-war camps of British soldiers during World War II, the continuing trading of CARE packages soon resulted in a “money” in which all other goods were priced and reckoned. Cigarettes became the money in these camps, not because of any imposition by German or British officers or from any sudden agreement: it emerged “organically” from barter trading in spontaneously developed markets within the camps.
Throughout all these eras and societies, however, two commodities, if the society had access to them, were easily able to outcompete the rest, and to establish themselves on the market as the only moneys. These were gold and silver.
Why gold and silver? (And to a lesser extent, copper, when the other two were unavailable.) Because gold and silver are superior in various “moneyish” qualities—qualities that a good needs to have to be selected by the market as money. Gold and silver were highly valuable in themselves, for their beauty; their supply was limited enough to have a roughly stable value, but not so scarce that they could not readily be parcelled out for use (platinum would fit into the latter category); they were in wide demand, and were easily portable; they were highly divisible, as they could be sliced into small pieces and keep a pro rata share of their value; they could be easily made homogeneous, so that one ounce would look like another; and they were highly durable, thus preserving a store of value into the indefinite future. (Mixed with a small amount of alloy, gold coins have literally been able to last for thousands of years.) Outside the hermetic prisoner-of-war camp environment, cigarettes would have done badly as money because they are too easily manufactured; in the outside world, the supply of cigarettes would have multiplied rapidly and its value diminished nearly to zero. (Another problem of cigarettes as money is their lack of durability.)
Every good on the market exchanges in terms of relevant quantitative units: we trade in “bushels” of wheat; “packs” of 20 cigarettes; “a pair” of shoelaces; one TV set; etc. These units boil down to number, weight, or volume. Metals invariably trade and therefore are priced in terms of weight: tons, pounds, ounces, etc. And so moneys have generally been traded in units of weight, in whatever language used in that society. Accordingly, every modern currency unit originated as a unit of weight of gold or silver. Why is the British currency unit called “the pound sterling?” Because originally, in the Middle Ages, that's precisely what it was: a pound weight of silver. The “dollar” began in sixteenth-century Bohemia, as a well-liked and widely circulated one-ounce silver coin minted by the Count of Schlick, who lived in Joachimsthal. They became known as Joachimsthalers, or Schlichtenthalers, and human nature being what it is, they were soon popularly abbreviated as “thalers,” later to become “dollars” in Spain. When the United States was founded, we shifted from the British pound currency to the dollar, defining the dollar as approximately 1/20 of a gold ounce, or 0.8 silver ounces.