What is money?
Before the invention of money, the exchange of goods and services was very inefficient. As a farmer, if I wanted to buy a table I was forced to find a carpenter in need of grain in order to exchange goods. This is called barter economy. In this economy, if one of the participants in the potential transaction was not interested in what the other side could offer, there is no way to bring the trade to fruition.
I really need that table! I’m eating on the floor 🙁
Hence, humans needed a medium of exchange agnostic to the goods and services they could directly provide in order to facilitate transactions.
The Mesopotamian shekel – the first known form of currency – emerged nearly 5,000 years ago and was conceived as a way to pay the armies. The elites of the time stamped coins of gold and silver to pay their troops.
Other less sophisticated forms of money were found in 525 years BC. The people from what is now Ethiopia used salt bars to pay for goods and services. Salt is a finite good and needs to be mined, it requires effort. These 2 characteristics made salt bars valuable enough to be accepted as a medium of payment.
Coins as opposed to salt bars or other mediums soon became very successful thanks to their portability, durability, transportability and inherent value.
The Spanish Doubloon is one of the most famous commodity currencies
So there it is, now if I wanted to buy a table I just needed to sell my grain to whoever needed it and get coins in return and then use some of those coins to get the table from the carpenter. But remember, the system works because everyone believes they will be able to get stuff for their coins whenever needed. Also, these coins used to be made with precious metals that held intrinsic value. You could potentially melt them down and make jewelry. These types of currencies are called commodity money as they are physical resources and possess utility.
Over time humans would abandoned commodity money and embrace different systems such as the gold standard but eventually all modern economies that exist today use fiat money as a medium of exchange.
Gold standard
The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold and is fully convertible. In other words, you can go to a central bank with your paper money and redeem them for gold or the other way around. For this system to work, central banks need to hold as much gold reserves as circulating currency. This system was first adopted by the British in 1821 and had its sunset in 1971 when Nixon terminated in the U.S. This event marked the beginning of the era of fiat money.
Fiat money
Fiat is a Latin term that means “let it be done”. Unlike commodity money or the gold standard, fiat money has value by government decree and, if not managed carefully, countries may suffer unhealthy types of inflation commonly known as hyperinflation. Fiat money is what we currently have in modern societies.
Benefits Of Commodity Money
Lower Inflation
Because commodity money is based on a physical resource, it is less prone to devaluing from inflation.
The government cannot create more of the physical resource, which means they cannot create new money whenever they want to.
There are many examples of fiat currencies that have become extremely devalued due to hyperinflation: the Zimbabwean dollar or the Venezuelan Bolivar as two of them.
Until the end of April 2016 this note was worth $0.40
Less Artificial Influence
Commodity currencies are less able to be regulated by the government.
Unless the government holds a total monopoly over the physical resource in question, they are less able to artificially influence the behavior of markets by printing new money or setting regulations.
Intrinsic Value
Fiat currencies are often criticized as having no “intrinsic value.” Commodity money is based on something that has actual value (due to its utility).
Cons of Commodity Money
Perishability
Commodity money is prone to devaluation over time, particularly if the commodity is some perishable good such as wheat, barley, or olive oil.
This is precisely one of the reasons why precious metals were often selected for commodity currencies. They are very non-reactive and stay good for a long time. But even precious metals can degrade; silver and gold can tarnish if stored in improper conditions.
Variation in Quality
For any physical resource, some samples of it will vary in terms of their physical quality. Due to variations in quality, in commodity-based systems, commodities of lower quality have a bad tendency to flood the market and push high-quality commodities out of the market.
For instance, if people could pay in wheat someone may try use a lower quality wheat to cheat the sytem.
Slower Economic Growth
Because physical resources take time to grow, commodity-based economies tend to grow slower than fiat-based economies.
In a fiat economy, the government can print more money to increase the money supply to grow the economy. While too much of this behavior can cause bad inflation, a modest injection of fiat currency every now and then is good for a growing economy.
Benefits Of Fiat Money
More Stability
Because fiat money can more or less be controlled by the government, nations are more flexible in regards to responding to economic variables like liquidity, interest and money velocity. While this power can be used to cause serious inflation, it can also be used to manage economic crises.
More Growth
In a fiat economies, the government can increase the money supply by printing new bills, which can stimulate economic growth. Since physical commodities cannot be produced by the government, commodity-based economies tend to grow slower.
Cons of Fiat Money
Inflation
Because the government can potentially print more money whenever they want, fiat currencies can be more prone to inflation. This pattern is almost universally seen in every economy that has adopted a fiat currency; the government prints too much money which leads to high inflation.
Value Tied to Government
Fiat money only has value because it is backed by the country government. As such, the value of fiat currencies is directly tied to the stability of the government. The American goverment has leveraged this in their favour so far successfully. No matter how much money they print people still accept and value the green bill. Having said that, there are several authorized voice out there warning that this could change.
Conclusion
Money is a construct. Sometimes people struggle to understand why cryptocurrencies such as Bitcoin can be so valuable when they are just ether in the cyberspace. You can’t do much with it apart from buying a Tesla.
Well, Fiat money has value because people trust the government and Bitcoin has value because millions of people trust the underlying technology. Now you try to give rounded pieces of metal to a monkey and convince him to go and buy bananas with them. He will most likely throw them to your face. Funny animals we humans are.
Monkeys don’t like hard coins, they prefer soft bananas
