The Theory of Money, Part 9

Last week, our gold prospector became a banker. And then he precipitated a change in the society to shift from commodity money to receipt money. (I originally named his receipts goldpaper, but I think Goldnotes is a better name, so I changed it.)

As is often the case, in the intervening week since writing the last post, I’ve been thinking about some things that I want to clarify.

First, I’ve never given my official list of all the characteristics of optimal money, and I think that will be useful moving forward. So, here’s my list so far:

  1. Intrinsically valuable: This requires two things. Whatever is used as money needs to have some use independent of its use as money. 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 stable over time. Or, if one rises, the other will rise with it so that the value remains approximately the same after the adjustment. Of course, demand will change for all things over time as new uses–and also new substitutes–for it are found. Economic shifts also affect the demand for things (notably, luxury items will be less desirable when there’s a recession). But as long as labor needs to be exerted to procure the thing being used as money, the supply of it will be linked to demand through market effects: If the demand goes up (and price rises along with it), suppliers will work harder to procure more; if demand goes down (and price decreases along with it), suppliers will not procure as much because it may no longer be profitable to continue using the marginal capacity that they added.
  3. Nonperishable
  4. Easy to determine the quality/value 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: 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 it 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

There might be other things I’ve missed, but that’s what I have for now. Obviously nothing will meet all those criteria perfectly, but it gives us a standard against which we can evaluate any money. So 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.

Goldnotes: Your first impression may be to think that it doesn’t meet the first criterion, but remember what I said last week–Goldnotes are directly backed by something that is equal to their stated value, so as long as you can reliably exchange a Goldnote for a gold coin then it’s not a problem. This is an important caveat, as will become clear over the next few blog posts. In some ways, Goldnotes actually do a lot better than gold coins. They’re lighter and easier to stack and carry. And their value is actually more reliable. Historically, when societies shift from metal coinage to receipt money, the banks automatically do an appraisal of each coin they receive to ensure its stated weight and quality is accurate. People couldn’t get away with clipping off the edges of a gold coin and passing it off as a full coin to the bank! Our blacksmith never would have gotten away with his counterfeiting had there been a bank around performing this service when it accepts deposits. Therefore, historically, because the receipt money’s value was more reliably known than the coins themselves, receipt money actually traded at a little bit of a premium compared to coins. So, because Goldnotes are lighter and more reliable in their value, I’m going to declare this shift from gold coins to Goldnotes an upgrade to a better currency! Thanks to the banker.

The other thing I’d like to clarify is 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 have to have the means of 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.

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.

Clarifying these details took enough space today that I’ll save the introduction of “fractional reserve banking” for next week. That’s where things really start to get crazy.

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