The Theory of Money, Part 9

In Part 8, our gold prospector became a banker. And then he precipitated a shift from commodity money to receipt money by inventing Goldnotes.

I think this is a good place to finally give my official list of of all the characteristics of optimal money, which will be useful moving forward as we track the evolution of Avaria’s money. Here is my list:

1. Intrinsically valuable (scarce): This requires two things. Whatever is used as money needs to have some use independent of its use as money, and the more uses the better so that a replacement for one of its uses doesn’t significantly alter its overall demand. But that alone isn’t enough. If something is freely available without exerting any labor to procure it, it won’t necessarily cost anything even if it does have an important use. Oxygen at sea level, for instance. So the second requirement is that labor needs to be exerted to procure it, which now puts a price on getting it. The importance of this becomes clear when I get to the second characteristic . . .
2. Value is stable over time: This requires supply and demand to be fairly stable over time. Or, if one rises or falls, market forces will temper its degree of change and will also cause the other to rise or fall with it (as explained already in Part 6). The more industrial (non-monetary) uses for this commodity, the more its price will be dependent on many more things than just its monetary use, which will help keep its value stable when different countries shift to (or away from) using it as money. Also, if it has many different industrial uses, that means if one industrial use goes away due to innovation, that will not alter its demand (and, thus, price) quite so much. Choosing something whose supply and demand is less susceptible to economic shifts (i.e., choosing something that isn’t strongly a “luxury good” or an “inferior good”) can also help its value remain stable during times where stability in the value of money is most important, although this is less important in a society that has commodity money because the economy will not be subject to severe booms and busts like economies based on other monetary systems. (This point will be explained later in this series.) But even without so many booms and busts, if the commodity is firmly in the luxury good category, for example, then its value will drop significantly in a recession (thus messing with the WU:money exchange rate and making the money price of things unstable and unreliable), which makes a recession even worse.
3. Durable (and nonperishable): The importance of this one is obvious. We don’t want our money to suddenly become worthless if it goes bad or dies, nor do we want the edges of it to easily wear away through common use.
4. Homogenous (easy to determine the quality/worth of it): If metal is being used, this is easier to determine the purity and weight (and, therefore, the value) than, say, a cow, or a share in a new business.
5. Can be precisely measured: This is similar to the last one, and these days there isn’t as much of a challenge in measuring things, although back in the day this would have been an important consideration, especially if the type of money being used had a very high value-to-weight ratio, because that would require especially precise measurement instruments.
6. Easily divisible into the right amount for payment, and dividing it doesn’t alter its value: A live milk cow cannot be easily split into smaller values. Something like corn, on the other hand, meets this criterion perfectly. Or metal that can be melted and divided into different sizes, although that’s not as easy to divide as corn.
7. Not too heavy (portable): People would rather not be burdened by having to carry really heavy money.
8. Value-to-size ratio is in the sweet spot: If buying something takes a whole wagonload of money, that’s inconvenient, even if the money isn’t very heavy. On the other end of the spectrum, if you’re using diamonds for money, even losing a tiny diamond is a significant loss.
9. Impossible to counterfeit: We don’t want any loopholes that significantly alter the number of Wealth Units required to procure more of the thing we’re using as money. I suspect no good contender for being used as money is truly impossible to counterfeit, but this is a list of the optimal characteristics, and the goal is to get as close to as many of these as possible.
10. Aggregate quantity not easily manipulated by anyone: If there are only a few sources of the the commodity we’re using as money, then gaining control over those sources is much easier for a single person or a small group of people. This would then give the owner(s) of the sources of money the ability to manipulate the money supply in ways that benefit themselves and their investments. So the commodity being used as money needs to be able to be sourced from many places that cannot easily be monopolized.

Obviously nothing will meet all those criteria perfectly, but it gives us a standard against which we can evaluate any form of money.

Why don’t we do that right now and see how well gold coins and Goldnotes do?

I won’t go through every criterion listed above for each, but we can at least cover the highlights pretty easily.

Gold coins: Looking through the list, gold coins do a great job overall. They’re a little heavy maybe, but at least they’re fairly small (without being too small), and different-sized coins can be minted quite easily to suit different values. I said our blacksmith figured out how to counterfeit gold coins, but that was admittedly not super believable, and in modern times it would be very difficult to counterfeit gold coins and get away with it for long. Gold is unfortunately squarely in the luxury good category, so that’s another downside, although the degree to which this is important goes down as a higher percentage of the total gold supply is dedicated to its monetary use compared to its other uses (I will explore this idea further in future posts).

Goldnotes: Your first impression may be to think that it doesn’t meet the first criterion, but remember what I said in Part 8–Goldnotes are directly backed by something that is equal to their stated value, and they can reliably be exchanged immediately for that thing, so the fact that they’re made of paper is actually not relevant. In fact, Goldnotes actually do better as a form of money than gold coins, for several reasons. They’re lighter and easier to stack and carry. Their value is also more easily determinable, which I’ll explain briefly. Historically, when societies were using both precious metals and receipt money for money, the receipt money would often trade at a slight premium compared to the equivalent amount of precious metals because the value of the receipt money was more reliable than a metal coin. Why was the value of a metal coin less certain? There were a lot of reasons–counterfeit, coin clipping, etc. But when any coin was deposited into a bank, before the receipt money was given in return, an expert appraiser would check each coin to determine its exact value. So the receipt money circulating was basically like a guaranteed-face-value coin, which made it worth more than the sometimes questionable coins that were also circulating. Our blacksmith never would have gotten away with his counterfeiting had there been a sophisticated bank around performing this service! Overall, because Goldnotes are lighter and more reliable in their value than gold coins, I’m going to declare this shift from gold coins to Goldnotes an upgrade to a better currency! Thanks, banker.

The other thing I’d like to clarify in this post is the standardization of gold coins. I’ve just been talking about them all along as if 1 gold coin was a set weight and quality. This doesn’t happen automatically of course. You could forego standardization and go around using little nuggets instead, but everyone receiving gold as payment would need a means of accurately weighing them and assessing their purity. So standardization makes using metal coins much easier to use for exchange.

Historically, this is where governments would help. For example, the solidus (AKA bezant) was a gold coin minted by the Roman and Byzantine empires for several centuries. It weighed about 4.5 grams and was 24 karats. So presumably someone who found a gold nugget could take it to a mint, where its purity would be verified and, for a fee, it would be stamped into a standardized hard-to-counterfeit shape.

In this post I won’t get into how governments figured out that they could mint them with a little less gold for the sake of keeping some for themselves, but that happened too and generally led to the failure of the coins as reliable currency.

We’ll be evolving Avaria’s money in a big way in Part 10 because I will be introducing “fractional reserve banking,” which is where things really start to get crazy.