The Evolution of Money Explained

Money, the thing that keeps the world turning, has undergone four phases throughout history, with the first evidence of its existence in the 3rd millennium BC. By examining these phases, you gain insight into the origin and evolution of money. Understanding money also helps in grasping the current monetary system and its limitations. Here we have summarized the information about the origin of money briefly. But let's start with the question: what is money actually?

What is money?

Economists describe money as "any asset that can easily be used to purchase goods and services" - in short, a universally accepted medium of exchange. Money has three key functions:

• Medium of exchange

• Unit of account

• Store of value

This definition of money has become particularly dominant since the 19th century. However, a universally accepted medium of exchange has only been present in human societies since the 7th century BC, with the introduction of precious metal coinage. This does not mean that societies before that time did not have monetary systems, as complex societies would not have been possible without prices, debts, and accounting.

However, the invention of coinage did not mean it was always used everywhere. Precious metal coins were often scarce, and economic transactions frequently occurred without them. Thus, it is incorrect to claim that societies without widespread use of coinage were non-monetary. The concept of money is broader than just a universal medium of exchange.

The concept of money is best explained in terms of a monetary system, which includes the arrangements societies use to measure the value of goods and services and conduct exchanges. A universally accepted medium of exchange may be part of this system, but it is not a requirement. Monetary systems can function without a universally accepted medium of exchange. The only essential element for the existence of a monetary system is a unit of account.

A unit of account represents the economic value with which we can express the value of all goods and services in an economy. Economists often view this as the value of one unit of money in the economy. However, this view is not as universal as it seems. We can also use the value of a specific commodity, such as a barrel of wine or a container of grain, as a unit of account. The value of goods and services can then be measured in terms of this unit, even if the commodity itself is not used as a universally accepted medium of exchange.

Once established as a unit of account, monetary systems have various methods for organizing exchanges. This aspect is often overlooked by economists, who tend to believe that exchange must occur through a universally accepted medium of exchange or else through barter. However, this is not always the case.

In the following four chapters, we will discuss the characteristics of each of the four phases of monetary evolution, emphasizing what serves as a unit of account, how exchange is organized, and how societies transition from one arrangement to the next.

Phase 1: Early Monetary Systems and How Barter Changed

The emergence of monetary systems is a complex historical process, which began with the use of fixed units of account in ancient societies. Scholars do not entirely agree on the origin of this idea, but we do know that in ancient Mesopotamia, around 3000 years before Christ, people were already using units of account. This was mainly because early states wanted to manage taxes and expenditures, and for that, they needed standardized measures.

In Mesopotamia, goods such as barley and silver were used as units of account, with fixed exchange rates between these goods. However, to make a unit of account work well, there needed to be stability in determining the value of products and services. At that time, they solved this problem by establishing the values of goods and services based on a range of other products and services. This was intended to show that the state or other social organizations played a significant role in shaping these early monetary systems.

Although the use of units of account by the state facilitated economic management, there also arose the need for individuals to use these units to set prices. This made market operations and resource allocation much more efficient. However, it did not solve the problem of organizing barter transactions. This is where the hypothesis of commodity money came into play, where the good serving as a unit of account also served as a medium of exchange.

However, this hypothesis was challenged by historical evidence, such as an ancient Egyptian legal record from the 13th century BC. In this record, a woman named Erenofre bought a slave by combining various items, each with a designated value in silver units. Remarkably, no actual silver was exchanged, highlighting that precious goods were not widely used in daily transactions due to their scarcity and high value.

Because precious goods were scarce as a medium of exchange, societies in the early stages of monetary development relied on a system of mutual debts. In this system, transactions were often not settled immediately. Instead, people incurred debts in the unit of account, and these debts were offset against each other over time. This reduced the dependence on widely accepted mediums of exchange and demonstrated that early monetary systems could adapt well.

This system of mutual debts persisted even in times when widely accepted mediums of exchange existed but were not readily available. For example, in Europe between the Late Middle Ages and the Early Modern Period, credit played a significant role in various economic transactions, from international trade to daily purchases by urban poor.

In summary: Early monetary systems were characterized by the use of units of account linked to known or prestigious goods. Despite the absence of widely accepted mediums of exchange, these societies efficiently organized barter transactions through mutual debts, which were established and canceled over time.

Phase 2: Coins as a Transformative Force in Monetary History

Over centuries, ancient societies gradually inclined towards the use of precious metals as the basis for their unit of account. While gold and silver in the form of bars were initially used for direct transactions, their rarity and high value per unit weight limited their usage to significant commercial transactions. This period continued until the end of the 7th century BC when societies entered the second phase of the evolution of money and the era of coinage began.

Throughout the subsequent two millennia, coins became the symbol of money and captured the collective imagination. Their success lay in facilitating impersonal exchanges, a departure from the millennia-old practice of bilateral (two-sided) debts relying on mutual trust between parties. Coinage provided a solution to the growing problem of trust as societies expanded and people specialized in various economic activities.

The widespread acceptance of coins caused a shift in the nature of money. Instead of valuing goods in terms of the weight of metal, societies began to express value in units of coinage. This change in the unit of account occurred because the value of a coin was no longer solely determined by its metal content, which could be altered by the state without affecting the nominal value.

As a result, the monetary system was characterized by the state defining an abstract unit of value and producing objects, in this case coins, which were declared to have a value corresponding to multiples of this unit. Although coins retained intrinsic value due to their composition of precious metal, their value as objects did not necessarily match the value assigned by the state. The public widely accepted this system for its convenience, and the state enforced compliance not through coercion but by setting an example, notably by accepting coins for tax payments.

Had states issued unchecked coinage without intrinsic value to maximize revenue, they might have made coins from base metals like lead or even materials such as leather or paper. However, during the reign of coinage in the West, this did not occur; the metal content of coins corresponded to the value set by the state. In England, for example, the difference between the value of coins and their metal content rarely exceeded 10 percent and generally remained below 5 percent from the Late Middle Ages to the 16th century.

The refusal of the public to accept coins with extremely low intrinsic value, especially for large denominations, played a crucial role. The public understood that the value assigned by the state was a social convention that could collapse. In that case, coins would revert to their intrinsic value as objects, risking significant loss of wealth.

Exceptions to this general trend occurred during periods of national emergency, such as wars, when the public recognized the need for the state to generate additional revenue. Currency devaluation—reducing the metal content of coins while maintaining their stated value—was a common practice during such crises. However, this occurred within the limits set by the public's tolerance for low intrinsic value.

In summary, the invention of coinage marked a significant shift in monetary development. It was not merely a repackaging of precious metals but the introduction of the first universally accepted medium of exchange. Coinage transformed the unit of account from the value of a unit weight of metal to the value of a unit of coinage, determined by supply and demand forces. Although universally accepted, coinage often suffered from scarcity over the following two millennia due to constraints on the supply of precious metals, leading to the organization of transactions through bilateral debts.

Phase 3: The Rise of Credit and the Role of Banks

Throughout history, the concept of money has undergone transformative phases, with credit playing a crucial role in shaping economic systems. The earliest instances of credit can be traced back to ancient Mesopotamia, where clay tablets recorded debts owed to a tamkarum, enabling the transfer of such obligations between traders. Despite these early forms, credit remained largely subordinate in monetary systems until the Late Middle Ages.

In the medieval period, modern credit prominently emerged, particularly through instruments such as banknotes issued by merchant banks. These banks facilitated international payments without the need for physical coins, marking a shift in the nature of money. However, these early forms did not endure to the present day.

The turning point came with the rise of modern banks, which first appeared in Athens in the 4th century BC and later flourished in ancient Rome. These banks engaged in ancient banking activities, accepting deposits and providing payment services. Roman law grappled with the evolving nature of bank deposits, distinguishing between regular and irregular deposits. Irregular deposits enabled banks to provide loans.

The evolution continued into the Late Middle Ages in Italy, where modern banking principles emerged. Unlike their predecessors, modern banks discovered they could issue loans, in the form of bank deposits, to borrowers seeking credit. This marked the beginning of modern bank lending, a crucial development that transformed credit into a widely accepted form of currency.

The crucial shift occurred in 1694 with the establishment of the Bank of England. Unlike earlier banks, it issued liabilities in the form of paper banknotes, backed by the government and redeemable for precious metal coins. These banknotes became the primary medium of exchange, as the government mandated their acceptance for tax payments. State endorsement lent credibility to this form of bank debt, setting the stage for the rise of credit money.

Banknotes gained prominence in the 18th century and constituted a significant portion of the money supply. Adam Smith noted that in Scotland, three-quarters of the circulating money existed in the form of banknotes. The Bank of England served as a model for central banks worldwide, confirming its role in maintaining monetary stability.

Governments, recognizing the importance of credit money, began regulating its production, with the Bank Act of 1844 in Britain marking a significant step. While restrictions were imposed on private institutions issuing banknotes, such restrictions were not imposed on bank deposits. Over time, bank deposits became the predominant form of money, accounting for 97% of the money supply by the 20th century.

This period represents the third phase in the history of money, characterized by the prevalence of credit money in its modern forms. By the end of the 19th century, a three-part money supply structure had emerged, with governments issuing precious metal coins, central banks issuing redeemable notes, and commercial banks issuing deposits. The link between the unit of account and precious metals strengthened, ensuring convertibility and stability in the evolving monetary system.

In summary, the evolution of money has seen the rise of credit money, propelled by the innovations of modern banks and backed by the state. This transformation laid the foundation for the monetary systems prevalent today, in which credit money, in various forms, dominates the financial world.

Phase 4: Transition from Gold to Paper

In the history of money, there is a significant moment: the transition to what we call the fourth phase. Here, we depart from the old idea that money must always be redeemable for gold. Why? Because with the growth of the economy, expansion of markets, and rise of mass consumption, the old rules no longer worked. Larger economies needed more money, but sticking to gold as a basis was no longer viable.

In earlier times, especially during emergencies like wars, governments stopped pegging their money to gold. A well-known example is Great Britain during the Napoleonic Wars (1797-1821). But until the early 20th century, experts believed this was only temporary. They thought that once the crisis was over, they would return to the old rules. But everything changed in the 1930s, after the Great Depression. To combat the crisis, a lot of money needed to be put into circulation, and the link to gold was abandoned. Interestingly, governments worldwide found that their monetary systems continued to function without that link to gold.

Now, without the link to gold, the value of money can continue to decline over time. This is because the amount of money in circulation is no longer constrained by the available amount of gold.

At the same time, something important changes in the type of money in circulation. Central banknotes, along with coins of precious metals, had legal tender status before the link to gold was abandoned. Once precious metal coins were discontinued, central banknotes became the sole legal tender—meaning creditors cannot refuse them as payment.

The transition to fiat money brings a unique dynamic. Banknotes, now seen as 'tokens', derive their value from the public's acceptance of them. Economists say people accept worthless pieces of paper because others do too. But what is often overlooked is the role of the government.

Modern forms of money have value not only because many people accept them, but also because the government stands behind them. The government promises to accept this money as payment for taxes, regardless of what others do. This is not just a game between many small players, but a game between one big player (the government) and many small players (the people).

Government acceptance for tax payment has long been a way to ensure that money continues to circulate. When the government became large enough and credible enough, and the public became accustomed to using money without intrinsic value, this mechanism proved sufficient to keep the money in circulation.

The transition from being tied to gold to fiat money means not only a change in the technical aspects of monetary systems, but also a profound change in the relationship between the state and the currency (money) it issues.

What is the Future of Money?

Let's explore the shortcomings of traditional fiat currencies and the need for alternative forms of currency.

What are the limitations of fiat money?

The current monetary system, whose long-term evolution we have depicted in the previous chapters, has remarkable characteristics. Since the vast majority of the money in circulation is in the form of bank deposits, changes in the money supply depend on the willingness of commercial banks to issue such obligations to finance borrowers and on the willingness of potential borrowers to incur debt.

This way of creating money has rarely led to shortages, which was the usual drawback of regimes based on precious metals. We are now faced with the opposite problem: periods of rapid money creation, excessive accumulation of private and government debts, and debt-driven speculation.

Additionally, the power of money creation lies in the hands of a limited number of central banks, mainly the Federal Reserve, the European Central Bank, and the People’s Bank of China, with half of global trade settled in US Dollars.

As too much money is put into circulation by various central banks, inflation rapidly increases, and determining value becomes more complicated, making the global society increasingly unstable. This also leads to people worldwide losing confidence in the existing money and seeking alternatives.

The Need for Alternatives to Money

To increase stability in today's global society, two major developments are underway that stand out; cryptocurrencies, including Central Bank Digital Currencies (CBDCs), and the rise of BRICS countries.

Cryptocurrencies as an alternative to fiat money will be further discussed in the following blogs. We will also explain the pros and cons of cryptocurrencies.

BRICS countries aim to ensure that global trade transactions are more evenly distributed, also known as de-dollarization, without exclusion or sanctions for members of this organization. In addition, this organization wants transactions to always be conducted in the currencies of the trading countries so that the currencies of smaller countries will strengthen. This will increase stability within these countries, which can lead to significant economic growth in the long term.

Another concern that BRICS countries want to address is that commodities such as oil, gas, gold, and other metals play a role in the value of a country's currency. This could mean that the rule that money does not need to have intrinsic value, as has been the case since the 1930s, may be reversed.

There are more reasons why there is a need for alternatives to fiat money. We will discuss this further in the following articles.

In conclusion, it could be said that humanity is about to experience the next phase of money, which will lead to significant changes in the balance of power in the world.