Money. We use it continuously. We keep it in our pocket. Most of us spend more than a third of our entire life trying to earn enough of it, and yet we cannot define precisely what it is….
The short story
The very short story is that money is not what we normally think it is and we are the only ones determining its actual value, by accepting it as a mean of exchange.
The longer story – but still short enough – is that bank notes are not backed by a precious commodity (like gold) anymore but are just a mean of exchange, and their value just comes from the fact that we accept them in exchange for goods.
The long story
The (really) long story is that money hasn’t always been what it is now. Money is fundamentally an accounting unit (i.e. measure of value or price), a reserve of value (e.g. savings) and a mean of exchange, all in one.
Since Aristoteles, it was known that money was born together with the community in order to support the measurement of value and, nearly simultaneously, it became a mean of exchange. At the time, coins were made with precious metals and the material was holding the value – not the coin. Starting from the Roman Empire through the Middle Ages up to Modern Times, money has always been associated to the value of a precious metal. Since the first Gold Standard (introduced in 1717 by Isaac Newton) until the beginning of the XX century, each currency was either made or convertible into a pre-determined amount of precious metal, gold or silver. This is what gave the name to the British currency: pound of silver sterling. By the way, knurling the coins (i.e. putting pictures in relief or inscriptions on their edges) is not an aesthetic feature: it has been invented around the middle of the XVI century in order to contrast the activities of some thieves who would shape the coins edges to get some small quantities of precious metal, modifying this way their weight and value!
Relying on the intrinsic value of the material the coins were made of was actually guaranteeing the stability of the monetary system, because, applying the law of supply and demand, there would be an equilibrium between the value of the material and the amount of coins. The introduction of banknotes (as paper receipts for deposited gold) just avoided the circulation of the precious metal, but the fundamental properties of the monetary systems were kept because gold was the reserve for the whole quantity of money that was circulating. More importantly, the amount of gold that – for example – the Bank Of England was keeping in the vaults was defining the amount of credit that could be circulating in the form of banknotes.
The first nation to adopt the Gold Standard after Great Britain was Germany. After the Franco-Prussian war, Bismarck was able to get an exorbitant quantity of gold from the defeated France, from which he could create the Gold Deutsche Mark, and founded this way the Reichsbank as the central bank and sole emitter. Between 1871 and 1900, the USA and most of the European countries adopted the same approach.
Given that every currency had a fixed conversion factor with gold, this actually meant fixed exchange rates between currencies. However, economy growth could not be supported by any flavour of the Gold Standard because of gold scarcity. Some attempts have been made during World War I to abandon the approach, in order to fund the war itself, and this ended up being encouraged by the isolationism that came after the 1929 crisis. The Bretton-Woods Agreements in 1944 fundamentally resumed the linked between money and gold, by introducing the dollar (fully convertible into gold by the Federal Reserve at the fixed rated on $35 per ounce) as the world base currency. Therefore, all currencies with fixed exchange rate with the US dollar would de facto be convertible in gold.
But US dollars, because the US dollar was the world base currency, kept on being printed , “forgetting” of the convertibility….
Year 1971 represents a turning point. On August 15th, President Richard Nixon, under threat from the Allies to convert all their dollar reserves into gold, breaks the link between dollar and gold: there wasn’t enough gold to convert all the money. At that moment, money became what it is now: it holds by itself – not because of the material that it is made of – the property of reserve of value. This was called Fiat Money (literally Let-It-Be Money).
With the gold link broken, what is then going to give value to money?
Tricky question, because Governments will give legal value to money, simply attributing the value of $20 to a piece of paper by printing this on it. But, without the ability to refer to gold and with the fixed exchange rate system dismantled, markets will determine its actual value, i.e. what goods can be purchased with a determined amount of currency or, alternatively, by the price of a determined basket of goods: as John Maynard Keynes said:
Money matters only for what it can provide.
In other words, inflation measures the speed a particular currency depreciates at. Thus, more generally, being linked to the goods it can purchase, the value of a particular currency becomes dependant of all other macro-economic parameters.
The fundamental aspect is that every individual in the community accepts money as a mean of exchange by trusting the ability to purchase or sell goods through it: this is the fundamental source of its value. One of the proofs of this can be observed in countries where the local currency doesn’t have the full trust by the communities despite being legally valid (e.g. Eastern Europe): there are significant exchanges happening in US dollars or in Euros, which are better trusted.
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