A Brief History of Money, Part 1

Before Money Existed

If you go back far enough in history, everybody was broke. Paper money didn’t exist until the Chinese invented it in the 11th century. Coins only go back to 600 BCE. Before that, nobody had any money at all.

Before money, people bartered or traded stuff. If I had hunted down a mammoth, I might trade you a mammoth hock for some berries that you gathered. But it was inconvenient because I could only barter with someone if I had something they wanted at the same time that they had something I wanted.

After a while, people realized that some commodities were almost universally valued. If I had salt, which was quite valuable until modern times, I could trade it to you for some berries, even if you didn’t want to use the salt right now. It would keep well, and you could use it to trade with someone later. Early forms of commodity money included seashells, salt, livestock, and metals.

The First Coins

Roughly 2,600 years ago, in a place called Lydia (now part of western Turkey), someone invented the coin. The invention has been credited to King Alyattes or his son Croesus, but I suspect that the idea really came from one of their accountants who was tired of using clay spreadsheets to convert seashells into cows. It was pretty simple. Make a little round disc of electrum (a natural mixture of gold and silver) and stamp a royal image on it. Now you had a standard unit of money that everyone could use.

Those first coins weren’t stamped with the date 600 BCE on them. First, they didn’t know that it was 600 BCE because they counted the years differently back then (for reasons that are hopefully obvious). They also didn’t put the year on coins. That was a later invention started in the Seleucid Empire in the 3rd century BCE. We’ve dated those original coins based on what they were buried with, along with some references by people like Herodotus, Aristotle, and Xenophanes, saying that the Lydians were the first to mint coins.

Note: You may be wondering why I’m writing BCE instead of BC. The former stands for “Before Common Era,” and the latter stands for “Before Christ.” Sometime in the 1990s, it became popular to switch to the religiously neutral BCE. Besides, BC didn’t make much sense since we know Jesus was born a bit before 4 BCE, so it always seemed strange to have Christ living for several years “Before Christ.”

Back to the invention of coins. I don’t think the sun had set on the day that the first coins were introduced before someone had the idea of counterfeiting them. They quickly learned that you could make a coin from cheaper metal and then coat it with electrum. They also learned that you could shave a bit of metal off the edges of a coin. When you do that to a bunch of coins, you end up with enough shavings to make an extra coin. If you’ve ever wondered why quarters and dimes have those ridges around the edge, it’s to make it easier to see if someone’s been shaving coins. For money to be useful, people need to have a shared faith in its value, so a lot of effort has gone into preventing counterfeiting. More about that later.

The First Debts

If you’re reading this and longing for the days before money was invented and thinking how great it was to live in a non-financial, debt-free world, I’ve got some surprising news for you. Loans and debts predate money. While the first cash only dates back to roughly 600 BCE, the first recorded debts go back to sometime around 2,500 to 2,000 BCE in Sumeria. It was possible to already be in debt before anyone had any money. The debts were for things like grain, silver, and livestock. The interest rate was typically 20% for silver and 33⅓ % for grain. People used land, livestock, and even family members as collateral. Debts back then could not be forgiven through bankruptcy, with debtors becoming slaves to creditors instead, somewhat like our modern student loan system.

The First Paper Money

The invention of coins as money was a huge step forward. Another big step occurred in China in the 7th century–they created the first paper money. Its use expanded in the 11th century under Kublai Khan (yes, he’s the Xanadu pleasure dome guy and grandson of Genghis Khan). This money acted as a promissory note for coins. As long as you could trust that the issuer would actually exchange the paper for coins, it was a great way to carry money. Marco Polo wrote about it with amazement back in the 13th century.

The biggest problem with paper money is that the issuer is tempted to create more of it than they have in coins and metal to back it. If people start to lose faith in the issuer, the value of the paper money drops, and you have inflation. This eventually happened in China and they switched back to silver.

In 1661 in Stockholm, a Dutch-born financier named Johan Palmstruch created the Stockholm Banco (Bank of Stockholm) and started issuing banknotes. Just like in China, you could exchange these banknotes for coins at that bank. With them, you could carry around a few pieces of paper instead of pounds and pounds of coins. They were a huge hit. So huge in fact, that Johan issued a lot of them, more than his bank had in coins to redeem them.

At first, everything went well. People loved the convenience of paper money. But after a little while, people became skeptical that they were as safe as Johan claimed, and their value began to drop. For the note holders, they got their first experience with inflation, and they didn’t like it. When a lot of them tried to exchange their notes for coins, it created a run on the bank. Johan couldn’t redeem all of the notes, and by 1667, the scheme collapsed, and Johan was arrested.

You might think that experience would be enough to sour people on paper money, but people liked it so much more than carrying bulky coins that they kept trying. They learned some lessons from the experience, but the idea of paper money caught on and spread. One reform was the creation of a government-backed central bank in Sweden–the first modern central bank.

Money In Early America

In the early days of the American colonies, there was no official local currency. People used whatever was convenient, including bartering. Spanish pieces of eight were popular coins. Each coin was worth 8 Spanish Real. In fact, you could cut one into 8 slices called “bits” and each was worth 1 Real. This is where we get the phrase “two bits”, which is a quarter.

When the revolution started, the Continental Congress began issuing its own currency - Continental Dollars. These weren’t backed by gold, silver, or anything else. They printed about $200,000,000 of them, and they steadily eroded in value until they were almost worthless. In 1790, Treasury Secretary Alexander Hamilton offered to redeem the Continentals for interest-bearing federal bonds, but at only 1% of face value. It was an inauspicious start for American currency.

The First American Coins and the Bi-metallic Standard

Congress realized that it needed to do a better job. The need for a strong enough federal government to back a stable currency was one of the driving forces behind the shift from the Articles of Confederation to the U.S. Constitution, with its stronger federal government. One of the early acts of Congress was the passage of the 1792 Coinage Act.

The act did two interesting things. First, it established decimal currency. In Britain at the time, you had a farthing (¼ of a penny), the halfpenny, penny, Shilling (12 pennies), Crown (60 pennies), and Pound (240 pennies). Could you imagine making change back then? The US effectively decided to go metric with a simple system: Penny, Dime (10 pennies), Dollar (100 pennies). We threw nickels and quarters into the mix, but it was still pretty simple.

Second, they tied the value of the dollar to both silver and gold. A dollar was worth 371.25 grains of pure silver or 24.75 grains of pure gold. That values gold at exactly 15 times what silver is worth, which was pretty close to the ratio of their market values at the time. Using two metals to define the value of the dollar was called a bi-metallic standard.

The problem with a bi-metallic standard is that the ratio of the market value of silver to gold doesn’t stay stable. When silver was worth less, people hoarded their gold coins and spent silver coins. Congress tried adjusting the ratio from 15:1 to 16:1 in 1834, but that was just a band-aid. By 1870, it was apparent that the bi-metallic standard was a bad idea, so the US (and most other countries) switched to a gold standard. That reduced the demand for silver, and at the same time, new mines and better extraction techniques were increasing the supply of silver. By 1900, the market ratio between silver and gold had grown to 40 to 1, more than double what it was just a few decades before.

If you’ve ever heard William Jennings Bryan’s marvelous “Cross of Gold” speech, that’s what he was talking about. Bryan was a populist opposing the elite bankers. He saw the gold standard as deflationary and a silver standard as inflationary. Deflation helps creditors because they get repaid with more valuable dollars, while inflation helps borrowers because they get repaid with cheaper dollars. His views were the equivalent of a modern politician pushing for a dovish Federal Reserve to lower interest rates.

The First Greenbacks

After the disaster of the Continental Dollars, the US didn’t issue any paper money for a very long time. Some banks issued their own paper money with mixed results, but there was no national paper currency. That changed in 1861 when they needed money for the Civil War. Borrowing from the old Revolutionary War playbook, they started issuing paper money not backed by anything. This type of unbacked currency is called 'fiat money' because its value comes from government decree rather than intrinsic worth. The new dollars were printed with green ink and were called greenbacks. Remembering how things went with the Continentals, people didn’t trust them, and their value fell to the point that one greenback dollar was worth just $0.35

Following the war, things went very differently. The federal government started repaying its debts. While people were slow to come around, the government continued to honor greenback dollars. In 1875, Congress passed the Resumption Act of 1875, which pledged that, starting in 1879, greenback dollars could be redeemed for gold dollars. By 1878, the value of the greenback dollar had risen to be equal to a gold dollar. US citizens could exchange their paper dollars for gold until 1933, but we’ll get to that later.

Fractional Reserve Banking

As the economy grows, the number of dollars (the money supply) also needs to grow. If the money supply grows more slowly than the output of the economy, prices fall, and we have deflation. If the money supply grows faster, we have inflation. The number of greenbacks was fixed in 1878 at $346,681,016. And it didn’t change. There were two ways that the money supply grew with the economy: an increase in the amount of gold (from mining and inflows from other countries) and from bank lending.

Banks use a system called “fractional reserve banking.” When you deposit money in a bank, it doesn’t keep your cash or coins sitting in a vault. It keeps a portion in reserve, but it lends out the rest. In the late 19th century, reserve requirements varied but were typically around 25%, so when you deposited $1,000 in a bank, it loaned out $750 to someone who deposited that in another bank. And that bank loaned out $562.50 to someone else who deposited it in another bank. This process continued from bank to bank, so every dollar of actual currency could support multiple dollars of bank deposits.

The problem with that system is that it makes banks susceptible to panics. If you withdraw your $1,000, the bank has to take money out of its reserves. It can’t instantly claw back the $750 it loaned out, so it has to use money from other people’s deposits to pay you. That’s OK during normal times, but when people get nervous and all start to pull their money out at once, the bank can’t pay everyone back. That’s called a run on a bank.

Keep in mind that there was no US central bank or Federal Reserve at that time. When a bank got into trouble, it tried to borrow from other banks, but panics often spread and other banks got into the same trouble.

Financial Panics

And because the amount of money in circulation was much larger than the official gold value of those dollars, due to all that fractional reserve banking activity, even the federal government couldn’t bail out the banks by creating more money. About once a decade (1873, 1884, 1893, and 1907), we had major panics. It was scary and messy and sometimes caused terrible economic depressions.

The 1907 crash was the worst. The Knickerbocker Trust Company, which was the third-largest trust company in NYC, tried to corner the copper market. They failed and collapsed. Everyone with investments in Knickerbocker lost their money. That triggered a liquidity crisis where everyone wanted to get their hands on safe gold instead of trusting the banks and the entire financial system teetered on the edge of collapse.

When the Panic of 1907 hit, there wasn’t much the federal government could do to stop it. They couldn’t guarantee people’s deposits. They couldn’t magically create new dollars. Treasury Secretary George Cortelyou did what he could, including depositing tens of millions into the larger banks, but it wasn’t enough. The nation had to turn to its richest citizens, particularly its richest banker, J.P. Morgan. He gathered the nation’s top bankers in his library on October 20 and literally locked them in the room, saying, “You must decide to save the Trust Company of America before you leave this room. You cannot leave until you do.”

The Trust Company was another large trust (something like an investment bank) that was financially sound but also caught up in a liquidity crisis. Morgan realized that if they could raise enough cash to see the Trust Company through the crisis, everyone could get their money back, and the banking system wouldn’t collapse. The bankers ultimately fell in line behind Morgan and committed the funds. The banking system was saved, but nobody was happy that it was saved only because one super-rich, brilliant banker had the force of will and the connections to make it happen.

End of Part 1

The crisis made it clear that we needed a better way to prevent banking crises and handle them better when they did occur. I’ll save that for part 2. It will include the creation of the Federal Reserve, suspending gold convertibility, banning the private ownership of gold, Bretton Woods, and completely dropping the gold standard. I’ll talk about how the Fed manages the money supply today. I’ll also discuss floating currencies, cryptocurrencies, stablecoins, and other changes to money that are happening today.