What's Money Anyways? (Part Two)

There are two forms of currency. The first is fiat money which like the dollar and most currency around the world, is government issued and has no intrinsic value. The key to fiat legal tender is the trust that it will be accepted in exchange (liquidity). This may seem trivial in the US where the dollar has always been a fairly strong currency, fully backed by the government (printed is “This note is legal tender for all debts, public and private”); yet a failure in trust for any reason can cause economic ruin and has in the past. A notable example of such an occurrence dates back to World War II. During this period the German Mark became so inflated by depression and wartime spending, citizens simply could not use it and as was reported, were better off burning Marks than buying firewood. This is illustrated today by the Zimbabwean dollar which though once more valuable than the USD, is now hyper-inflated to the point that currency exchanges often have to update the country’s exchange rate every half hour or more and $100 billion legal tender is printed.

The second form of money, commodity money, is fairly immune to such fluctuation because it possesses intrinsic value and therefore is trusted & accepted around. This form of currency has prevailed for much of history up until just over a century ago, primarily in the form of gold (gold standard economy) and occasionally other precious metals. Though this practice has largely died out and one cannot walk into a store offering a hunk of gold as payment, many invest in gold for fiscal security (especially in times of recession). I found an interesting example of commodity money from Mankiw’s Macroeconomics 5^th ed. which also appears in the commendable Maus series. In the Nazi POW camps during World War II, the Red Cross provided prisoner with food, clothing, cigarettes etc.  These resources were fairly, evenly allocated without attentions to individual preferences. Eventually, the soldiers allocated cigarette values to commodities such as 80 cigarettes for a shirt. Soon these became an accepted medium of exchange at the camps.

Despite its safety, commodity money quickly becomes cumbersome and difficult to manage; as you can imagine carrying around a pouch of gold gets heavy and measuring commodities isn’t very convenient. But how do you get a society to begin using and accept fiat money especially considering it has no intrinsic value. This process can be best explained through an example which has occurred in the past repeatedly. The process begins as the government issues gold or similar commodity money of standard value to replace commonly used raw gold bullion. In time the government can offer gold certificates which can be reclaimed for the original standard issue gold. Nonetheless, this is the intermediate phase to fiat money for it requires that people trust the government will at any time provide gold at any time in exchange for the certificates. In time as this trust becomes universal and more money is printed, the gold collateral becomes meaningless and a fiat system takes root.

And there you have it; the story as money as we know it. So the next time you lay down that dollar bill, think about the history, the evolution and the trust that makes the whole system possible.