Few concepts in economics are more confusing than the nature of money. That is unfortunate because cryptoassets like Bitcoin, trends like growing inequality, and public policy debates over fundamental issues like tax policy required a thorough understanding of where money came from, what money is, why we made it up, and how it evolves over time. For this reason, we wrote a four part article about money:
The Nature of Money
No Conservation of Value
How Money Evolves
The Future of Money
The history of money goes back thousands of years, but we won't go through all of it here. Instead, we start with the early adoption of Money in the American colonies. The reason is that paper money in the American colonies is not so different from the electronic money we use today. We then list three principles of money that we deduce from this historical example in order to apply to parts 2-4.
Benjamin Franklin ... American Father of Paper Money
Many have heard of Benjamin Franklin, but few know that he was instrumental in guiding the colonies earliest experiments with paper money. Gold and silver had been used as a medium of exchange and store of wealth for many centuries, but the colonists didn't have much. During the 1600s the colonists spent most of their gold and silver to purchase manufactured goods from England leaving them without a convenient way to trade.
Benjamin Franklin observed that the lack of "money" was tough on the economy. Colonists resorted to "efficient barter" systems that relied heavily on trust between those who frequently did business with each other. Credit was very hard to come by because money was so scarce that colonists often had to pay more than 8% interest in real terms making it hard to fund investment in new businesses.
The solution? Paper money.
Colonial paper money like the bill above began its life as government issued debt. Debt was common, and had been since long before the Roman Empire. Paper money was also nothing new, having been first adopted by the Chinese as early as A.D. 618.
The brilliance of colonial paper money was getting people to value a piece of paper near the stated value...in this case "three pence" or pennies. The colonists had a shared understanding of what a "pence" was worth because it was their "unit of account" back in England. Colonial governments managed to create demand for their new "money" by allowing colonists to pay taxes with it.
Pennsylvania generated the supply of money by hiring Benjamin Franklin who conveniently owned a printing press (he also wrote the anonymous letter advocating the printing of money...tricky). By printing money the government solved two problems. First, the government of Pennsylvania was able to finance infrastructure projects like roads and other public goods well worth the interest. Second, they were able to give the colonists a more efficient means of transacting than barter. In Franklin's own words...
There is a certain proportionate Quantity of Money requisite to carry on the Trade of a Country freely and currently; More than which would be of no Advantage in Trade, and Less, if much less, exceedingly detrimental to it. - The Nature and Necessity of a Paper-Currency, 3 April 1729
Debates over money during the time of Benjamin Franklin had many parallels to today. As people tend to do...both the wealthy and the working class supported policies that stood to benefit themselves. For the wealthy, that meant sticking with gold and silver as the only forms of money. This kept the supply of money low and interest rates high. The lack of money also kept land prices low because they were the only ones who could afford to buy it. The wealthy also argued that printing money would lead to inflation (i.e. a decrease in the value of money as measured by higher prices for real goods and services).
Benjamin Franklin spoke for the working class...explaining that lower interest rates made it easier to start a business and trade. Taken together, these forces allowed the colonies to grow rapidly ... even without much gold or silver or much of a banking system. Inflation should be muted because higher economic growth would offset the increase of money supply. In the end, Franklin won the day and the colonists (wealthy and working class alike) were ultimately better for it.
The growth of paper money in the colonies is a case study on how wealth can be created from nothing. Not only did the quantity of wealth increase by allowing paper substitutes for gold or silver...land prices rose as well because more families gained access to affordable credit. The economy boomed because previous reliance on "efficient barter" was replaced by pricing of goods and services in a single unit of account. Having a single unit of account allowed for easier pricing on an ever increasing variety of goods and services.
So to be clear this one creative solution to the lack of money in the colonies led to a near universal increase in wealth for everyone.
Principles of Paper Money
The nature of money has changed a lot since the days of Benjamin Franklin, but there are several core principles that we can take away from the experiments of the colonists.
1. Money improved coordination between people. This increased economic growth in a way that benefited everyone. The big economic challenges of the 1700s included a lack of currency with which to facilitate local trade, high interest rates on loans, frequent wars and related political instability. Today, we face totally different challenges...namely the ever increasing need for a highly educated workforce. When judging policies we should focus on the impact to sustainable and shared economic growth.
2. Inflation is created when demand for goods and services exceeds supply. Many colonists feared that printing money would lead to inflation...fears that were never realized because the added supply of currency helped facilitate trade which in turn increased the supply of goods and services. Demand for goods and services went up...as did supply...so the overall purchasing power of money was (for the most part) largely unchanged. Today, we worry about different threats such as trade wars, inequality class warfare, and an increasing dependence on central banks to prop up demand for risky investment.
How these threats impact inflation will ultimately rest on the demand and supply for real goods and services. For example, trade wars tend to increase prices due to higher cost of production from disrupted supply chains. Large scale transfer payments from the wealthy to the working class will likely increase inflation unless it is done in a way that supports economic growth. Central bank buying of financial assets (quantitative easing) is unlikely to impact inflation unless it allows governments and businesses to purchase more real goods and services.
3. The value of paper (and electronic) money ultimately rests on the issuing government's demand for taxes paid in said money. The colonists were some of the greatest entrepreneurs of all time. They knew how to take calculated risks...and they applied this thinking to paper money. They knew that these paper bills would be worthless in the event that the issuing government ceased to exist...as sometimes happened in the colonies. Today, electronic money has become so abstract that we often fail to remember this simple fact. What this means is that governments can sometimes run up large debts in their own currency, but so long as they continue to demand taxes in this currency, it will continue to have value in an amount that fluctuates in a manner consistent with principal #2.
Paper money is central to many controversial topics today like politics, investing, and inequality. By telling the story of how paper money took off in the American colonies we hope to shed light on what it is any why its so important. Our three principles of paper money boil down to essentially one truth: Money is a tool for improving coordination between all the working people of an economy.
In our next piece we explain why there is "No Conservation of Money". In political debates and discussions about asset valuations, we sometimes forget this simple fact. We think that money is like matter...that when one person gets rich another must be getting poor...that when a company's valuation goes up that another must have gone down. But this is not the case. When we apply the principles of money (above) and accept that there is no conservation of money better public policy outcomes and investment decisions become apparent.