In the previous post, we looked at the functions of money (Medium of exchange, Store of value, Unit of account) and what properties it must have (Durability, Portability, Divisibility, Uniformity, Generally Accepted, and Limited Supply) for it to be practical as a currency. However, these traits only provide a present day definition of money. They fail to explain how the concept of money began in the first place or how it evolved to what we know today.
That’s what we’ll be exploring in this post!
Money solved lots of coordination problems
As Nick Szabo brilliantly explains in his essay Shelling Out, tribes used the concept of money to replace the incredibly inefficient barter system. As we’ve discussed in the previous post, bartering is incredibly inefficient as it requires someone to have something of equal value in order to trade for another good. In other words, exchange of goods can only occur if there is a double coincidence of wants between two transacting parties.
Money solves this problem because it creates a new abstraction we can use to trade goods with one another. Instead of both parties fulfilling a symbiotic desire, they merely need to believe in and want this new abstraction (money.)
Instantaneous exchanges of goods is not the only reason to use money, either. Other uses for money included:
1) Reciprocal altruism: If I want to give you something out of the kindness of my heart, I can use money to do so.
2) Wealth transfer: If I want my future children to inherit my success (i.e. wealth), using money allows me to do so.
3) Penalties: If a thief steals from a villager and is caught, money can be used to punish him for his bad deed.
4) Credit: If you need my financial help but want to repay me a later date, we can use money to reach an agreement of delayed repayment.
5) Collateral: If you need to borrow my tractor for a week but I don’t know if I can trust you with my property, you can give me money as a deposit that will be returned to you once you return my tractor.
These are just a few examples of money’s many uses, but the list goes on. In short, money offers us a powerful tool to coordinate with one another. This not only increases our chances of survival, but it also allows us to fulfill our desires in the process.
How has money evolved?
Throughout history, money has taken a variety of forms: cowry shells in Africa, rai stones on the island of Yap, strings of beads called wampum used by Native Americans and early American settlers. Let’s take a tour of a few different forms of money that have existed in that past.
1) Commodity as money
The earliest forms of money were commodities. Commodities could be anything from cattle to yams to rice to whatever else might be seen as valuable within a community. If the commodity became widespread, it effectively became a form of money.
Obviously, commodities were a much better form of money than bartering, but it was still an inefficient system. If you recall from the last post, there are certain properties that money must exhibit for it to be a good form of money: Durability, Portability, Divisibility, Uniformity, Generally Accepted, and Limited Supply.
If we were to use yams as money, for example, it wouldn’t be a great form of money since yams are not very durable, divisible, or easily portable. Moreover, yams may not be accepted as currency across many different societies because some people may not find yams valuable. This is why human civilization eventually realized collectibles were a superior form of money.
2) Collectibles as money
Collectibles consist of small, homogenous items such as shells, beads, teeth, and so on.
Collectibles are a much better form of money than commodities because they are durable, easy to transport, and limited in supply due to their difficulty to find or forge.
The discovery of commodities as money was pivotal in human evolution. It led to much better forms of coordination, like the ability for tribes from different regions to trade and share food. Because some tribes had less access to hunting or growing the food necessary to survive, trading collectibles for supplies was a way for early tribes to meet their basic wants and needs.
Another benefit of using collectibles as money is that it allowed tribes to purchase and store excess supplies. This increased the chance of surviving harsh winter months – a historical equivalent of the modern “saving for a rainy days.”
Using collectibles as money also allowed tribes to specialize their trade. Tribes living in the tropics would trade their specialized crops with tribes living in more temperate climates, allowing each access to crops they would not have been able to grow on their own. This not only gave tribes a wider variety of food to choose from, it also increased crop productivity.
There is, however, one caveat to use collectibles as money: said collectible needs to be widely accepted as currency for it to be a good form of money. This is because there is a higher cost to discover and manufacture a collectible.
Unless the collectible can be used in many transactions, the manufacturing cost may not be worth it. In other words, if it took 12 hours to collect and create a bead necklace to use for trade, but that bead necklace is only used in a single transaction to trade for 10 yams, then the cost of creating that necklace was too high. It would need to be used in tens or hundreds of transactions to justify 12 hours of precious human time.
If you want a more detailed explanation of how and why collectibles evolved to serve as money, I suggest you to read Shelling Out by Nick Szabo.
So, we went from commodities to collectibles. But how did we go from collectibles to the paper money we have today?
The evolutionary lineage of modern paper money really begins with two precious metals: gold and silver. Before we can get to paper money, it’s important to understand the use of precious metals as money.
3) Metals as money
Initially, chunks of gold and silver were used directly as forms of money. Coinage began around 600 BC, when the first coin was minted by a King of Lydia. According to Herodotus, the Lydians were the first people to introduce the use of gold and silver coins as money.
One of the biggest benefits of using coins instead of raw gold and silver chunks was that it lowered the transaction costs by standardizing the quantities of payment.
Additionally, it was far easier to estimate the value of a coin than that of a collectible. For example, it is much harder to agree upon the value of a bead necklace than it is to accept the predefined value of a gold coin. Therefore, there is less overhead in using a coin for transacting, making it cheaper to use coins instead of collectibles.
In the Lydian empire, for example, coins allowed for more efficient markets where people could trade goods much more easily. With more efficient markets, you have more trade happening… which meant there were more taxes to be collected. 😉
The wealth of Lydian kings Midas, Croesus, and Giges is famous for this reason.
How did we go from coins to paper money?
Okay, so we know that money has taken on many forms in the past such as commodities, collectibles, and precious metals. But the money we know and use today is made of paper. So how the heck did we go from using metal coins to trusting pieces of paper as having any real value?
That’s exactly what we’ll learn in the next post.