A short history of money and its implications for UK economic recovery

A common dictionary definition is to describe money as “A medium of exchange in the form of coins and banknotes”.  Although this is true, it is not very accurate as when people think of money, they are generally thinking of something far greater than just the notes and coins in their pocket – they are including the value of their bank deposits, the money their employer will deposit in their account on payday, the amount they could spend on their credit card and so on.  Money, therefore, is more than…just money.

Arguably a better definition of money would be to simply refer to it as ‘a medium of exchange’, as this is suitably vague and allows for the inclusion of everything we might consider as money.  Against this definition it is not clear when the first money came into existence.  Historians often cite the used of cowry shells in China around 1200BC, and since then are records of numerous things being used - from precious stones to totem poles.  But the most reliable medium of exchange throughout history has been gold.

The reason for the success of gold is that it is in limited supply, doesn’t corrode and is small in size relative to its value.   

But carrying around pockets full of gold is neither practical nor secure, so one day someone, believed to be in China again, came up with the bright idea of ‘promissory notes’.  This enabled a person to keep their gold in a safe location while, instead of swapping lumps of gold for goods and services, they simply gave the other person a note promising to pay them at a later date.  Provided the promissory note could be trusted, it could therefore be regarded as having the same intrinsic value as the gold it could be exchanged for.  Moreover, provided the gold was somewhere safe, the person holding the promissory note never needed to exchange it for the gold as they could spend the promissory note instead.  Hence paper currency was invented and banks were created as safe places to store the gold and oversee the issuing of currency backed by gold.  This is why today your bank notes have printed on them the words “I promise to pay the bearer on demand the sum of …”.

The cost of the banking system was paid for by the banks lending money to people and charging interest.  And to attract more gold – so that they could lend more and earn more interest, they paid interest to depositors.  However it didn’t take the banks long to realise that people rarely asked to withdraw their gold.  They were therefore able to lend out more money than they had gold in their reserves.  For example, suppose a bank had £100 in gold but that they knew that it was highly unlikely that anyone would ever ask to withdraw more than £10.  They therefore could lend out ten times their gold deposits and thereby earn interest on £1,000.  Problems would only arise if everyone went to the bank to ask for their money back - as happened to Northern Rock.

For most of our history the banking systems of the world have operated on this basis, with the value of notes and coins in circulation vastly exceeding the value of the reserves of gold, even though their value was based on the value of the gold reserves.  This all changed in 1971 when US President Richard Nixon declared that the US Dollar was abandoning its link to gold and becoming what is known as a ‘fiat currency’. 

The term ‘fiat’ is a Latin word meaning ‘it shall be’, and the term is applied to the monetary system used everywhere in the world because today's notes and coins have no intrinsic value.  The notes may still have written on them words about ‘promising to pay the bearer’, but the promise is an empty one! 

Now this may seem like a bad thing, and in some ways it is, but in other ways it has helped generate enormous wealth.  When currencies were tied to gold, a government could only spend money if it had sufficient gold in its reserves to back it up.  If it wanted to spend more, it had to borrow the money from its citizens.  But then it accumulated debts that would one day have to be repaid.  By moving to fiat money, governments were able to completely avoid this problem – if they wanted more money they could simply print it. 

“Ah ha”, I hear you thinking, there has to be a catch as this sounds too good to be true!

The catch is inflation.  Since at any point in time the global supply of goods and services is relatively fixed, printing more money simply decreases the value of the currency and results in same goods and services costing more.  While this seems like a ‘zero-sum game’ it is not, because inflation does not affect everyone in the same way.  Inflation is only damaging to people with savings - because their savings are now worth less.  But to people who are net borrowers, inflation benefits them because it reduces the value of the debt.  The bigger the debt the greater the benefit, and the biggest debts in the world are held by governments.

This apparent alchemy means that governments can spend beyond their means by borrowing money from their citizens, allowing inflation to reduce the value of the debt and then printing money at a later date to pay for it.  So long as they don’t get too greedy everyone is happy.  This is why the target rate of inflation set by the UK Government for the Bank of England is not zero, but 2.5%.

The worrying thing today is that the solution adopted by governments to the current financial crisis has been ‘quantitative easing’, which is simply a posh term for printing lots of money.  There is therefore a risk that inflation will get out of hand and we could go the way of Argentina in the late ‘80s, when their inflation rate hit 12,000%.  If you look at the following graph, you can see that since the first half of 2012 there has been a dramatic increase in ‘M1’, which is the term economists use to define the total value of notes and coins in circulation.

However, when the same graph is plotted over a 10 year period (see below) the trend doesn’t look too bad.

The economic data therefore suggests that despite the massive injections of cash during the last few of years, money supply growth is not significantly out of line with its long-term trend.  Moreover, if you look at the growth rate of the economy for the 10 year period 2002-2012, UK GDP grew at an average quarterly rate of just over 0.8%.  With the current rate at 0.7%, the implication is that, provided we slow the rate of quantitative easing soon, we may just have got away with it!

About the Author
Alistair Schofield is Managing Director of Extensor Limited.