The creation of money allows this search process to be greatly simplified by breaking it down into two parts. First, you find a person who wants your Jeep Cherokee and is willing to pay you, say, $4,000. Then, in a separate trade, you find someone else who will rent you a beach home for two weeks in exchange for that same amount. It still takes some time, but you no longer feel like you’re looking for a needle in a haystack.
You can see why a system that uses money would lead to an explosive growth in the amount of economic activity versus the old bartering system. That’s why the development of money as a means of exchanging goods and services between buyers and sellers is one of the most important “inventions” in history.
Notice, however, that money works only so long as sellers are willing to accept it in the belief that it will hold its value long enough for them to eventually trade it for something they want. As we’ll later see, this matter of people having confidence that money will act this way is of immense importance.
Let’s return to the scenario in which we saw nails develop as a form of money in a small economy. It seems that Jones, the nail-maker, got a little greedy and began manufacturing (and spending!) thousands of extra nails. Soon, all the local farmers, craftsmen, and merchants had all the nails they wanted—far more than they could put to any practical or trading use for months to come. Nobody wanted to accept nails as money anymore because they weren’t sure if they’d be able to spend them later, or if they could, how much they would buy.
The town mayor asks you to serve on a committee that will come up with something else that will serve as money now that the townspeople have lost confidence in nails. At your first meeting, your committee makes a list of all the good things they liked about using nails.
1. They had intrinsic value. Nails had uses which gave them value apart from their use as money. It was the fact that people all over the community wanted nails to build things with that made them desirable in the first place.
2. They were durable. You could store them for as long as you liked, and you knew they wouldn’t break, rot, or mildew. They’d never go completely bad because they’d always be useful for building things. (The fact that money shouldn’t be perishable rules out crops or anything else that deteriorates over time.)
3. They were easily divisible. That’s what sold Smith the furniture-maker on the idea in the first place—he couldn’t “make change” from a king-size bed. With nails, he could easily divide his supply into small amounts for making everyday purchases. (Things that aren’t easily split into small units are at a disadvantage as money, so land and livestock aren’t good choices.)
4. They were consistent in quality. One nail was like every other nail. Unlike precious gems or works of art where there can be different grades, there was no risk of being stuck with a “bad” nail. Knowing this greatly simplified negotiations.
5. They were valuable in relation to their weight. If you wanted to transact business, you didn’t have to bring along several wagonloads full of nails. Before “nail-inflation” got out of control, you could do a lot of shopping just with the nails you easily carried around with you. This made them more versatile than barrels of oil or sides of beef. This portability is important.
In retrospect, nails made pretty good money. They lacked only one important characteristic which, as it turned out, was the one thing that doomed them.
6. Whatever is used as money must be relatively scarce. Its scarcity is what allows a high value to be placed on a small amount of it. Furthermore, the total supply in circulation must either be held constant or allowed to grow only at a slow, predetermined rate over time.
After giving the matter much thought, the committee can think of only two commodities that met the criteria as well as nails did and that also had some degree of scarcity: gold and silver. Consider how well gold, the more valuable of the two, met their criteria:
1. Intrinsic value. Gold is the most malleable and noncorrosive of all metals. Next to silver, it is the most reflective of light and the most conductive of heat and electricity. It has countless industrial uses apart from its traditional use in jewelry.
2. Durability. As one of the natural elements, gold is virtually indestructible.
3. Divisibility. Gold can be divided into small increments or used as dust without losing any of its inherent value.
4. Consistent quality. One ounce of gold is interchangeable with any other ounce of gold of the same fineness.
5. Valuable in relation to weight. Presently worth more than $1,300 an ounce, a large amount of wealth in gold can easily be transported.
6. Scarcity. Less than 165,000 tons of gold are known to have been mined in all of history—that’s “barely enough to fill two Olympic-size swimming pools,” according to National Geographic magazine.
For thousands of years, gold has been prized for its unique properties and has proven itself as a “storehouse” of value. This is important, because to be accepted as money a commodity must have the ongoing confidence of buyers and sellers. No government can, for long, force its people to use a form of money that they distrust.
So your town committee, knowing that your fellow citizens have a high regard for the yellow metal, votes to recommend the use of gold as the community’s new money. Nothing is perfect, however, and soon they become aware that gold has two shortcomings.
The switch from gold to paper money
The first shortcoming of gold is obvious: having to get out a scale and weigh the correct amount of gold dust every time someone wants to buy a newspaper or a Big Mac is inconvenient. Fortunately, this problem is solved rather quickly when one of the town’s more entrepreneurial thinkers, a young fellow named Ben, steps forth with an offer to shape raw gold into various standard sizes and weights—in other words, to convert it into coins. For a modest service charge, of course.
On the front of each coin, Ben promises to stamp the exact amount of gold inside so people will know how much it was worth. Since Ben enjoys a reputation for honesty, many of the townspeople take him up on his proposal and begin bringing in their gold. (Still, you can’t be too careful, so at first everyone checks the coins to make sure they weigh what they were supposed to. When months go by without anyone catching Ben in a mistake, it becomes generally accepted around town that his coins can be trusted.) Ben’s mint becomes a thriving business.
But then there is gold’s second shortcoming. The villagers discover that some of the very qualities that make gold such an excellent choice as money also make it a favorite target for thieves! It is valuable, easily transported, easily divided, and, since everyone’s gold and coins look alike, they can’t be identified as stolen property.
Listening to the concerns of his customers, Ben comes up with another inspiration— he’ll add a special vault inside his mint so that people can store their gold in safety. He will issue receipts each time they put gold on deposit, and they can come by and claim their gold anytime they want. All for a modest service charge, of course.
It isn’t long before Ben’s “gold warehouse” business is up and running. And as more and more of the townspeople use Ben’s vault for keeping their gold safe, a curious thing begins to happen.
When negotiating a purchase, shoppers engage in this kind of conversation with storekeepers: “Say, do you have a gold storage account at Ben’s warehouse? You do? I thought you might since you take in a lot of gold here at your business. How about saving both of us a little time and trouble? Rather than me going over