What is money: Part 3 - The history of money: From gold to fiat

In Part 2 of the What is Money Series we looked at history to see what patterns, if any, are underlying the search for the best suited tool of money. We discovered that the best money is always whatever is the hardest thing to make. As trade expanded and went global in the late 19th century, gold was effectively chosen as the global tool for money. In this episode we look at the naturally arising question in the 21st century:

If gold was universally chosen as money, then why do we not use gold as money today?

The reason for this is the physical properties of gold. Here is a simplified account discussing the essential steps from the gold standard to where we are today.

The centralization of gold

Gold for all of its properties serves very well as a unit of account because each ounce is assigned the same value. The total stock of gold in the world changes relatively little year after year which makes it the best store of value we could find. This means that by using gold as a tool of money, saving is a good and popular option, as it gives us security and allows us to plan ahead for the future. However gold is not well suited to fulfil the monetary role as a medium of exchange. At 19.3 g/cm³, gold has a high density, which allows it to be stored in a relatively space-efficient manner, but simultaneously makes it heavy and therefore difficult to be transported. As trade expanded in a fast paced, globalized world, it became more and more difficult to trade in physical gold. So what could we do to make gold more useful as a medium of exchange?

We created institutions we call banks, in order to hold the gold for us and issue us promissory bills that were exchangeable back into gold. These promissory bills were much easier to transport, exchange and verify than physical gold.

Such a system made a lot of sense because gold, due to its properties, could transport value over time and with the use of IOU ("I owe you") paper bills, it was much easier to share, transport and verify the value of gold. We worked on two layers, so to speak. Gold as a tool of money as the base layer (store and measure of value over time) and paper money as a representation of the tool of money on a second layer (transport and exchange value through space). Under these conditions, we were able to get the best out of gold as a tool of money. Because there was a 1:1 representation between banknotes and gold, every banknote was directly exchangeable back into the amount of gold it specified. This system was also called the gold standard and it worked well. In fact, it worked so well, that the paper notes basically rendered physical gold unnecessary in people's day to day life. After a while people stopped actually exchanging their paper notes back into physical gold. Gold, after all, was more secure in the hands of the banks. So why would you take the physical gold back into your possession?

The introduction of trust

The introduction of these paper bills mark the birth of our currencies today. Banks created their own paper IOU currencies. Over time, the issuance of currencies has shifted through to a national (or with the euro, an international) level. As we have learnt in Part 2 of the series, money tends to be one thing. Nowadays, a currency is anchored in the legal framework of a state or a monetary union and is usually issued by a corresponding central bank.

There is an important difference between money and currencies. Gold has a relatively constant and unchanging quantity and is the thing people have selected over millennia as the best tool of money. A currency (paper), on the other hand, is merely a representation of the tool money. And these representations are without intrinsic scarcity. Currencies are nothing more than a guarantee by the state and are therefore also referred to as fiat money. The word fiat originally comes from the Latin language and means something like "let it be" or "let it come to pass." So currencies today function as money because the states and monetary unions that issue them, metaphorically use the magic phrase "let there be money." The problem with this is that while money (gold) cannot change and multiply, the representation of the tool money (paper) can. And because it can, it does.

One lesson we have learned in the last episode of the What is money series is that human beings naturally try to make more of the thing that is being used as money because it gives them an advantage.

We basically introduced institutions as middle men that can control the supply of the representation of money and then stopped checking for the real thing.

What would you do if you had the control over the money supply and no one was really checking on you anymore? Right...

The human incentive structure does the rest or as Charlie Munger famously said: "Show me the incentive and I'll show you the outcome." And the outcome was, that we effectively created a monopoly on money. By giving a group of people at the central banks control over the monetary policy and stopping to check on them, we introduced a single point of failure in the whole monetary system. It took human beings millennia to figure out that gold was the best suited tool of money because it was the hardest thing to make, only to more or less collectively forget about it within three to four generations.

The birth of fiat money

The 1:1 coverage of paper money to gold obviously no longer exists in today's world. We do not know, when exactly it was abolished for the first time, because no one really checked. Officially the gold standard was abandoned for the first time during World War I, so that Great Britain could continue to finance its participation in the war. World War I really was a silly war that Britain should not really have had much interest in. Wars, after all, can only be fought as long as we can finance them. When the gold reserves of Great Britain decreased strongly, its central bank simply issued more and more promissory bills, because it could create them at a whim following the fiat money mantra "Let there be money". The representation of the money was printed at almost no cost and the 1:1 cover to gold thereby dissolved. Other countries did the same as the British and the Gini was metaphorically out of the bottle.

The people at the central banks printed more paper bills for whatever cause they saw fitting (war, stimulus, climate saving, economic stability and so on - sounds familiar). As people did no longer use gold in their everyday lives, no one even noticed at first. The inflation of the money supply shares a lot of similarities with the consumption of alcohol.

The dissolvance of the redeemability of the paper (currency) for the money (gold), triggering one of the wildest periods in human history. The printing of paper bills resulted in the hyperinflations of the 1920s, where currencies effectively lost all of their value and people using those currencies lost all of their savings. What followed was the Great Depression and the rise of autocratic leaders such as Mussolini and Hitler which ultimately culminated in World War II.

In 1933 the Executive Order 6102 in the United States made it illegal for people living within the U.S. borders to save in gold. Gold was effectively confiscated. People had to give their gold to the central bank Federal Reserve in return for $20,67 per ounce of gold. Not even a year later the Gold Reserve Act followed which changed the conversion rate of the U.S. Dollar to an ounce of gold from $20.67 to $35. While this was sold to the public as an increase in the value of gold, it merely devalued the U.S. Dollar. The Federal Reserve (FED), by then in possession of almost all of the gold available in the U.S., was therefore the sole beneficiary. The repricing of gold meant, that it required less gold to back the U.S. Currency and the FED was able to print more paper money.

In the Bretton Woods Agreement between the World's leading nations of 1944 the "Gold Exchange Standard" was born. From that point on countries traded in the dollar currency, and all the gold was stored centrally in the United States. In theory, each country could always exchange its dollars back for gold. Effectively, the whole world became dependent on the monetary politics of the most powerful nation in the world.

And guess what... surprise, surprise! The single point of failure did not disappoint. The Americans could not resist the temptation to print more dollar bills than they had gold reserves. After all, the uneconomical wars of the newly founded world police United States had to be financed somehow (e.g. Vietnam war, etc.). As soon as the other countries (led by France who actually sent a battleship to the U.S. to take custody of the gold) started to actually exchange their dollar reserves back into gold, the fictional "Gold Exchange Standard" was abandoned, on August 15, 1971 by U.S. President Nixon.

This event is called the Nixon shock and represents the final abandonment of gold a a tool of money. Nowadays most countries print their own currencies (Euro, Yen, Peso, etc.), but since that moment they have absolutely nothing to do with the conceptual tool of money that we derived in Part 1 of the what is money series. All that money is today, is a paper IOU issued by our respective governments.

In the upcoming episode, we will elaborate the manifold consequences the decoupling of money and currency has had on societies all over the world. So stay tuned!