Date Written: 4/17/2023
Assignment: (1) What is the origin of money? (2) Name and explain three disadvantages that have been identified with fiat money.
Why do we exchange perfectly useful goods and services for little green pieces of paper or metal coins? One doesn’t have to be an economist to see the benefit in such a system. People value money because they know other people are willing to exchange their goods and services for it. But how did this system arise? The first person to accept money for something will have no confidence that anyone else will accept it. Did government one day decide to force everyone to use money or did its use rise spontaneously? In fact, money does arise spontaneously through free-market interactions.
The First Step
The first step on the road to money is the bartering system. This is the most basic form of exchange. In this system people directly trade one good or service for another. For example, 2 people could exchange an apple and a shoe or a hearty breakfast and a history lecture. Obviously there are some shortcomings with this system. If someone wants a shoe and has an apple, then they have to find a person who has a shoe and wants an apple more than that shoe. This will get quite inconvenient especially if someone only has an obscure item to trade, like a vintage Hot Wheels car for example. So, how is this problem solved?
The Second Step
Over time people will notice that there are certain items that many people want. This could be any item, like gold for example. Many people value this thing in and of itself for its intrinsic uses. So, instead of directly exchanging the item with some incredibly hard to find person someone will indirectly exchange their item for gold, then exchange that gold for the item they want. Gold is wanted by many more people, so it will be much easier to find someone who has the item that is wanted and is willing to exchange gold for it.
Let’s continue with the example of the apple and shoe exchange. If they exchanged directly by bartering they would exchange the apple for the shoe, but then the problems with bartering would arise. If an indirect exchanged takes place, the apple owner will exchange the apple with someone for gold. Now the previous apple owner can exchange the gold for the shoe. It will be so much easier for the apple owner to find a shoe owner that wants gold, so the advantages of indirect exchange are clear.
The Final Step
As time goes on, people will realize that gold is a common item being used in exchange because many people want it. Therefore more and more people will value gold simply because they can exchange with it. They may detest gold’s physical properties for some reason, however they will still want it because they know they can exchange it for other things they want. Now even more people will be willing to accept gold in exchanges. This creates a snowball effect. As more people accept gold in exchanges it becomes more valuable, which makes more people want it and accept it in exchanges, which makes it even more valuable. Over time as this process goes on, gold will become the accepted medium of exchange and money becomes a reality.
Can Government Introduce Money
Instead of letting money develop spontaneously what would happen if government tried to introduce it? The government would do this by forcing everyone to conduct all of their exchanges using a certain medium of exchange. There is one main problem with this: no one will know what the new money is worth. Think of it this way: Imagine that someone gave someone else 20 pieces of paper that said 1 tree note. Then they were told to use these 20 tree notes as money to buy things. Well they aren’t going to have any idea what those tree notes are worth. Could they get a house for 20 tree notes, or could they only get a pack of bubblegum for 20 tree notes? There is no way of knowing. This is the problem of government introduced money.
When money arises spontaneously everyone does know its worth. This is because the value of the money is based of all of the past exchanges people have done with it. They can think back and remember that they got 5 dozen eggs for a gold coin or 12 history lectures for 2 gold coins. Everyone knows what the value of the gold is because they have done exchanges with it. Government introduced money doesn’t have this history, so it can’t work.
The Development and Problems of Fiat Money
Now how did we get from using gold coins as money to using green pieces of paper with politician’s faces on them? These green pieces of paper do not have any inherent use like gold does. The green pieces of paper are known as fiat money because it is only valued as money. They aren’t valued for the thing itself like gold is. So, how did we come to be using these green pieces of paper as money today?
It all started when people got tired of carrying around a bunch of gold coins. Therefore, they decided to put their gold coins in the bank in exchange for paper receipts that entitled them to their gold coins. They could go to the bank at any time and exchange their paper receipts for their gold coins. For the sake of convenience, people started to trade with the paper receipts. They knew they could exchange the paper receipts for gold coins whenever they pleased, so the paper receipts held the same value as the gold coins.
But one day, the government decided that no one could turn in their paper receipts for their gold coins. They declared that everyone must only trade using the paper receipts. This is how the dollar was formed. This government declared money avoided the problem of having its value be undefined. This is because the dollar used to represent gold coins. Everyone knew the value of the gold coins because of its exchange history, therefore they knew the value of the dollar.
The Problems with Fiat Money
Even though the dollar is safe from the problem of not being able to determine its value it still has many problems that are associated with fiat money. All of these problems essentially increase the power of governments at the expense of everyone else.
The first problem with fiat money is that it makes it monumentally easier for governments to inflate the money. For example, the U.S. government can create as many dollars as it wants out of thin air. There is nothing to stop it. However if a commodity money, like gold, was used governments would have a much harder time. There is only a limited amount of gold in the world, plus mining it is expensive. When the money is inflated it raises the prices of all the goods in society, for the same reason that if everyone in an art auction is given more money the bids on the art will go up. There are many negative consequences to inflation, so I won’t go into any details here.
Another problem with fiat money is that it enables governments to create the business cycle. Governments can create all the money they want. They use this money to pump the banks full of cash driving interest rates artificially lower, which starts the business cycle. To see how this action by governments causes the business cycle click here.
An additional problem with fiat money is that it encourages consumption and discourages saving. The value of fiat money is always decreasing because it is constantly being inflated by government. So, when someone tries to save up dollar bills for the future the value of those dollars decreases with every passing moment.
Imagine that someone has saved $50,000 so that they can retire in 20 years. Sadly by the time those 20 years are up the value of their savings will have decreased dramatically. A realistic estimate would be around a 50% decrease in value. So in the end there $50,000 will only be worth about $25,000. They would be stupid to let their money waste away like this, so they are more apt to spend it. They will also most likely enter into much riskier ventures, so that they can have money for the future. If a commodity money is used all of this can be avoided because government can’t inflate away its value.
Fiat money also directly increases the power of governments. They can create as much money as they want out of thin air, so they can buy many more things. Now governments can get their grubby hands on more of the resources of society. With these resources it becomes easier to enforce their ever-growing intervention into our lives.
The final problem with fiat money is that its value can potentially drop to zero. A great example of this is the German hyperinflation of 1923 when 1 U.S. dollar equaled 4.2 trillion German marks. The value of the German mark essentially dropped to nothing. This can’t happen with a commodity money as it will always have its use value. The good is valued in and of itself.
Conclusion
Money is an incredible development and government is not needed to facilitate its’ implementation. Money will arise spontaneously out of the voluntary exchanges between individuals. This creates a sound money that holds its’ value. Governments will always try to introduce fiat money into society. It is another tool for them to use to gain even more power, which comes at an expense to everyone else because we have to suffer the negative consequences of fiat money.
I never knew how money started