We have all heard the saying ‘Money makes the world go round’ but what exactly is money?
There are a lot of good books which look at the concept of money but to distill this for my readers, Money simply is a ‘go-between’, a medium of exchange. Way back when bartering ceased to be an efficient way for humans to exchange goods, money was created as a concept to allow people to use it as a ‘go between’. Let’s take a brief tour of the history of money.
After initially bartering, people would trade their ‘cattle’ for ‘money’ and their money for ‘wheat’ for example. This is because the person who wanted to sell the wheat didn’t necessarily need the cattle. By creating the medium of exchange, money created some degree of efficiency in the flow of goods from suppliers to users. It has taken numerous forms. It could be a seashell, some pretty beads or more familiar to the general reader, some gold coins or US dollars.
Because it was used as the common ‘go between’, it became practice to reflect the value of goods and services in ‘money terms’. It became the common denominator. Over the ages, what was used as money has changed and evolved. In the modern era, fiat currencies, in particular the US dollar, has become the de facto global standard of such expression. We will get into this a little later.
Now for money to be effective and universally accepted, it needs to exhibit some key characteristics. These are well documented and commonly known as:
Durability – it should not perish and deteriorate and as such represents a ‘store of value’.
Portability – it should be able to be moved easily to facilitate trade in diverse locations, etc.
Divisibility – it should facilitate large and small transactions of varying denominations.
Uniformity – it should be uniform to allow consistency and general acceptability.
Limited supply or Scarcity – it should be something which is scarce so as to preserve its value over time.
These characteristics allow ‘money’ to fulfill some fundamental roles key being: medium of exchange, store of value and a unit of account.
All that glittered was Gold:
Given these characteristics, it was no surprise that gold was considered global money for the ages with its sibling, silver a close second. The ancients loved gold and silver for the above mentioned characteristics as well as its luster (it looks pretty) and in the interests of full disclosure, my long time followers will know that I love gold mainly because I’m a magpie. I mentioned my allocation to gold in this piece (Markets at an all time high – What are you Yellen about).
Ooh so shiny!
However, not even gold and silver were immune to meddling by profligate governments as was evidenced by the ‘Roman debasement’ around 2000 years ago. The struggling Roman treasury dealt with runaway spending and finite supply of gold and silver by decreasing the quality of its coins (effectively printing money). The consequences weren’t so great culminating in some beheadings and the eventual demise of the Roman Empire a couple hundred years later (yes macro cycles can take time).
In more modern times, it has been a tussle between gold and fiat money. In short, fiat money can be described as paper money issued by a government which isn’t necessarily backed by any asset. In fact since the late 1700’s and early 1800’s government’s sought to remedy the ills of paper money by ‘anchoring’ paper money to gold giving rise to the ‘Gold Standard’ and the bi-metallic standard which anchored the ratio of silver to gold as well.
A formal global gold standard arose by 1871 but the ensuing centuries’ wars saw many countries leave the standard and by the end of WW2, the US dollar (by then the US possessed around 75% of the world’s monetary gold anyway) was the only global fiat currency still backed directly by gold. WW2 gave rise to the Bretton Woods agreement which sought to peg or manage how far fiat currencies could drift and effectively used the US dollar as the underlying peg. This made the US dollar the global reserve currency.
As a side note, global reserve currencies have come and gone. They were seen to correlate with nations who dominated global trade (and sometimes naval powers) in their respective ages. Up to the Renaissance, they included the Roman denarii, the Arab dinar and Florentine florin, gravitating to the respective mercantile power of the time. In more modern times, the Spanish peso, Dutch guilder, and British pound all served their time in the limelight.
As such, the transition to the US dollar was no surprise. The US dominated the world as a superpower, naval power and the center of world commerce. Then Vietnam happened and the US followed the route of abandoning the gold standard which by 1971, was officially severed and saw the eventual demise of the Bretton Woods agreements.
But this didn’t erode its role as the reserve currency of choice. It did, however, confer upon the US the exorbitant privilege of being a reserve currency without any traditional anchor and allowed the US to run substantial deficits while being comfortable that the world would continue to fund its expansion.
Enter the era of rampant monetary largesse. This is why in my following discussion, I largely use 1971 as the start for much of the analogous comparison. Since 1971, pace of monetary expansion (evidenced in the blue line below) has continued unabated. In fact, if we just use consumer inflation as a guide (I will discuss other inflation later) $1 from 1971 is worth about $7 today. Perhaps the inverse is more intuitive. The purchasing power of $1 today is worth about 15c in 1971!
The structure of inflation has not been uniform. For example, since 1971, the cost of medical care in the US has risen over 15 fold (1500%) and housing over 10 fold, compared to generalized inflation around 7 fold.
With markets, gold and real estate all rising in dollar terms since 1971, this begs the question of whether it has been the value of our assets increasing or merely the value of our money decreasing as alluded to above. I have posted a separate article (Is it Money or is it Time?) which draws simple analogies of what assets have done in gold terms as well as how I think we can consider the abstraction of money.
It is this debasement of value of fiat currencies which has given rise to the need for something more concrete. In this era of digital economies and electronic finance and commerce, the internet has become the equivalent of the seas of old and the country which can dominate the internet will see its time rise as a possible reserve currency.
Or perhaps the last century of distrust in fiat currencies, governments and central banks has given rise to a decentralized non-sovereign contender in the reserve currency stakes. Enter Bitcoin. Bitcoin and cryptocurrencies in general will warrant a whole separate post but suffice to say it is born out of the context presented above. Whether you like it or not, the problem which needs solving is one of creating a store of value which will not be beholden to any sovereign or central bank and one which the world will look to trust over the coming decades.
Whether Bitcoin or some other future contender will take this place will be tested in times to come but suffice to say, change is upon us and in the process, it is best that we understand what change is needed to address the core problems we are looking to solve.