There are two commonly held views as to why money has value:
- People are willing to accept it as payment (social convention).
- The government says so (government decree).
The first reason, that being that money has value because people are willing to accept it as payment is nothing more than a circular argument. It states that money has value because it is accepted. Why is it accepted? ...because it has value!
The second belief is also false. As history reveals, government cannot be trusted to manage money. For a listing of country currencies that have suffered through hyperinflation or complete collapse click here.
Governments of every country throughout the entire history of mankind have sought to continuously erode the value of their currency over the long term. The two most successful currencies, the US dollar and British Pound have lost most of their value since inception.
Under the US Mint Act of 1792, the dollar was pegged at 24.75 grains of gold. There are 480 grains in a troy ounce. Thus it took 19.4 US dollars to purchase a single troy ounce of gold. As of Feb 23, 2007 it takes nearly 683 US dollar to purchase that same troy ounce of gold. That represents a 97% drop in value!
The British Pound originally represented one troy pound of sterling silver back in 1560. Elizabeth I and her advisor Sir Thomas Gresham (of Gresham's Law fame) established the new currency to bring about order created by the "Great Debasement" of 1543-51 when Henry VIII sought to finance his costly wars with both France and Scotland. Sterling silver is 92.5% pure silver. There are 12 troy ounces in a troy pound. As of Feb 23, 2007 it takes 81.9 GBP to purchase that same troy pound. That represents a value loss of 98.8%!
During an economic crisis or war (both during and after), the pressure to inflate the money supply becomes overwhelming, as any alternative is politically disastrous. Even during times of relative stability, governments seek to "stimulate" their economies through increasing "liquidity". In plain speak, they intend to increase the supply of money. That is functionally no different that a counterfeiter increasing the circulation of $100 bills in your neighbourhood albeit on a much larger scale.
Governments will seek to issue increasing amounts of money until the currency collapses at which time the public is given a whole host of explanations - corporate greed, foreigners, market manipulation, terrorism, ad nauseum. What is most ironic about this farce is that the Central Banks are portrayed as being inflation fighters. This makes about as much sense as me lighting your house on fire and than showing up with the fire brigade as a "firefighter".
When the public eyes are finally opened to what the government has done to their currency, the government is powerless to make people value the money. They normally issue price and wage control laws. Those who ignore those controls are treated as criminals. Non-paper assets such as gold may be confiscated in the "interests of the public good". Business and personal assets may be seized.
Despite whatever draconian measures the government imposes, the people will seek financial safe haven by storing their wealth in non-monetary assets, those of a foreign currency, or by hiding monetary metals such as gold and silver.
Thus, we can comfortably conclude that it is false to state that money has value because the government says it does.
Why Then Does Money Have Value?
According to the writings of an Austrian Economist, Ludwig von Mises, the purchasing power of money yesterday determines the demand for it today. This is a straightforward and understandable idea.
If at the end of yesterday, the price for a can of pop was one dollar. Assuming no external events such as a catastrophe wiping out the pop manufacturer overnight, why should we not start today with the price of pop being one dollar?
The price of the pop will fluctuate according to supply and demand for both the pop and the money. If another pop manufacturer begins to flood the market with a similar product, the price may drop to $0.90. On the other hand, if everybody in the community receives a windfall, the pop may rise in price to $1.10.
This is all fine and good, but what determined the value of money yesterday. Obviously it was the day prior. And so on...
But there must be a beginning ... and there is.
What is Money?
Money originally started out as a commodity. Originally, there was no such thing as money, there were only commodities and people exchanged them according to their wants and needs with one another.
Money has to fulfill three things:
- It is a medium of exchange.
- It is a store of value.
- It is a unit of account.
All over the world, different commodities emerged to play a role as an acceptable medium of exchange. We commonly think only of gold and silver, but there were others. On the small group of South Pacific islands of Yap, large stones were used. Cowrie sea shells were used in America, Asia, Africa and Australia. Wampum shells became legal tender in Massachusetts in 1637 for trade with the natives. Tobacco was used in colonial Virginia. Salt was used as a currency in pre-coinage European societies. (The word salary actually derives its meaning from the Latin word salarium which means salt).
What was it that these particular commodities had in common? First off, they were relatively rare in the locales they were used. If we look at history we can see that those people who used a plentiful commodities for money were easily exploited. The stone money of the Yap Islands is a particularly illustrative tale.
The stones were made from a shimmering limestone not indigenous to Yap and thus were very rare. Expeditions to acquire new stones were organized by the chief who would select a group of brave and able men for the task. The main source for the stones was the island of Palau some 250 miles to the southwest. New stones were gotten at great peril, perhaps even loss of life, and were valued most highly.
This unique money system was forever changed when the Irish American David O'Keefe was shipwrecked on Yap in the nineteenth century. He later returned, with a sailing vessel and modern quarrying tools. Seeing a potentially profitable opportunity he exchanged stones for sea cucumbers and copra (coconut meat). With time the stones became so numerous on Yap that they ceased to have value as money and now serve today as a monetary novelty for visiting tourists.
With trade, people exchanged goods and those that were plentiful in some locations were transported to those were they were rare and valued. From this mechanism, only those commodities that were globally rare remained as a form of money.
Another trait of money is that it has a high level of marginal utility. That is to say, demand is not easily satisfied. This is why goods such as diamonds and gold are so valuable. Not only are they rare, but also a person will continue to desire them even after he has acquired some. The value of each subsequent acquired unit continues to be indistinguishable from the first.
Take an example of water. If I am thirsty, naturally I will desire some. I would even be willing to part with one hard-earned dollar for a bottle. After drinking that bottle, I would desire a second one much less and would be only willing to part with $0.50. After that purchase, I wouldn't be interested in another. Water has a very low marginal utility.
Gold, as history has shown, has a very high marginal utility. Most of the 155,000 tonnes that have been mined since mankind began extracting it from the ground are still around. This fact does not deter mining companies from continuing to spend more money on the exploration of gold that any other metal. No other commodity is hoarded to the same extent as gold.
Silver, was a monetary metal for a long time alongside gold. However, it was found to have usefulness in industrial applications, namely photography and electronics. It seems that the value we placed upon silver was less than the value we placed upon photographs of Fido the family dog.
Rarity isn't the sole factor that determines if a commodity has a high marginal utility suitable for being money. Consider platinum that is priced much higher than gold. It isn't hoarded to anywhere close to the same extent and is consumed irrecoverably in industry - primarily for catalytic converters in automobiles.
So far, we haven't found a use for gold sufficient to justify us consuming it. As a result of gold's high marginal utility it has served as mankind best store of value out of all the commodities.
Finally, gold is denser than most metals, immutable and does not corrode. These factors enable money exchangers to quickly test and verify gold for what it is. Any base metal available at the time would decrease its density or react to the reagents such as nitric acid that gold is impervious to. Gold is the most malleable and ductile metal known. As such it is easily divisible and historically was used to make coins that couldn't be made counterfeit. These qualities ideally suit gold for fulfilling the last quality of money, that being a reliable unit of account.
From these arguments, we can clearly see that gold emerged as mankind's first choice for money.
Paper as Money
Paper money was first used in China during the early ninth century A.D. After numerous reforms due to excessive printing, the Chinese abandoned paper altogether in 1455.
The Mongol Empire that by 1236 included parts of China began issuing money, reaching a substantial level by 1260. The Persian city of Tabriz experimented with paper money in 1294 with disastrous effects described in Rashid al Din's History of the World. In the early 14th century both India and Japan experienced short-lived imitations of Chinese currency.
The earliest evidence of paper being used in Europe was that of an English goldsmith's note in 1633. Goldsmith's notes not only acted as receipts for reclaiming deposits but also as evidence of ability to pay.
Around 1660 goldsmiths' notes became widespread as evidence of ability to pay. In effect, they were as "good as gold". They were a much more convenient alternative to handling coins or bullion. This realization by the general population marked the start of banknotes being used as money.
For the following centuries, gold predominantly backed paper currencies. China was an exception to this as they used silver. Other countries such as those in Latin America, France and the US periodically used bimetallic standards - both silver and gold.
Countries would go off the metal standards so they could inflate the money supply in order to finance a war. The results were always disastrous as price inflation took hold. Until the resolution of WWII, countries normally returned back to the metal standard once peace resumed.
After WWII, the United States emerged as having the strongest economy of the world. In 1945, the U.S. produced half of the world's coal, more than half of the electricity, and two-thirds of the coal, it held a majority of investment capital, manufacturing production and exports, over 65% of the world's total gold reserves, and was the sole possessor of the atomic bomb.
Before the end of the war, delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire and signed the Bretton Woods Agreements during the first three weeks of July 1944.
The Bretton-Woods conference established, among other things, a new relationship between gold and paper money. As the prominent world power, the currency of the U.S. would become the reserve currency of the world and was itself redeemable in gold to the arbitrary amount of US$35 per ounce. Important commodities such as oil would be traded for in U.S. dollars.
As time progressed and the welfare/warfare state of the U.S. grew, the need for additional money was accomplished by the simple printing of money. Consequently, foreign nations began to value gold more than the dollar due to the fundamentals of supply and demand. Instead of taking dollars they demanded gold and the gold reserve of the U.S. began to dwindle.
Things came to a head in 1971 when it was observed that the U.S. would shortly run out of gold if the trend continued. On August 15, 1971, president Nixon unilaterally "closed the gold window", making the dollar inconvertible to gold directly, except on the open market. This effectively severed any last remnant of paper money being backed up by gold.
This continues to be the situation today.
Using Mises' framework of thought, also known as the regression theorem, we can infer that money did not emerge as a result of a government decree or social convention. The theorem shows that money must first emerge as a commodity. That commodity was predominantly gold.
Our money today is not backed up by anything other than governmental promises and insistence that it is worth something. Its value today is based upon its value yesterday subject to the events of the day. One of those things is the ever-continuing issuing of more money. Remember what happened to those people of the Yap Islands?