History of money

“Permit me to issue and control the money of a nation, and I care not who makes its laws.” © allegedly Mayer Amschel Rothschild

Once you got some attention, it’s time to show your A-game and explain that fiat money are not ‘backed’ by gold, or oil, or an economy of a country of issuance, because the whole financial system has already shifted away from commodity or representative money to electronic fiat money that is not backed by anything since 1971. Modern money is just papers or digits in the databases that people agreed to accept as a means of exchange and store of value.

So how can we explain that to our folks and friends?

Don’t worry, you don’t have to be a professor, because telling people the whole history of money in details will often make them feel bored (I’ve been there multiple times). However, there are some crucial concepts one should know in order to hold a conversation:

And here are the most important events and connections we should be able to explain to everybody:

Gold & silver

Money is a tool to store the time (labor) you’ve spent. Because of money, people were able to get away from cumbersome barter, which allowed complex job specialization.

We should be able to explain what are the commodity money, why silver and gold have value (portable, durable, divisible, fungible, limited in quantity), and how they maintained their purchasing power through the history while fiat currencies have all gone to zero.

How governments debased coinage for deficit spending on wars and public works, so all gold & silver coins disappeared from circulation, because people tend to spend what’s common and keep what’s rare (Gresham’s law). And how that led to the rise of market prices of goods and services. This concept is also a key to understanding how US exports inflation to other countries (more about that in the chapter about quantitative easing).

Paper money

It’s important to know how IOUs evolved from paper money in Imperial China to banknotes in Europe. We should understand how first state-enforced fiat money emerged, and why they had a value (a threat of a death penalty).

What is a bank run and how central banks act as lenders of last resort for commercial banks. We should be able to explain the shift from banknotes issued by commercial banks to national banknotes issued by central banks, which gave more convenience to people, but also centralized the issuance of money.

Rise of US dollar as world reserve currency

It’s important to explain that in 1933, U.S. President Franklin D. Roosevelt prohibited export of gold and forced Americans to deliver their gold to the Federal Reserve in exchange for dollars in order to fight deflation caused by the Great Depression. That accumulated lots of gold in the vaults of the Federal Reserve and allowed the U.S. government to pay its debts in dollars, not gold.

We should tell our folks that many governments suspended a strict gold standard, because they were printing lots of money unbacked by gold to finance their war efforts during World War I and World War II, which led to huge inflation. And how most economies were turned toward war, converting farmers to soldiers, switching from cars production to tanks production, while the U.S. accumulated huge gold reserves exporting food, goods, and warfare machines to Allied nations, which often paid in gold or other minerals.

How currencies of Western European countries, Canada, Australia and Japan have been tied to the US dollar due to the Bretton Woods agreement of 1944.

How Korean and Vietnam wars’ expenses contributed to weakening of the dollar, so other nations started losing confidence in the currency, suspecting that the U.S. printed far more dollars than they had gold to back. As a result, in 1965, France and Switzerland both sent much of their USD reserves to the states for conversion into gold.

That forced the U.S. to unilaterally pull out of the Bretton Woods agreement, abandoning Gold Exchange Standard, which resulted in depreciation of the dollar and OPEC’s statement that they would price oil in terms of a fixed amount of gold.

Petrodollar. Deal with Saudis.

How the U.S. negotiated a military protection for Saudi Arabia’s oil fields, and in return the Saudi’s would accept only USD as a payment for their oil exports and invest surplus oil proceeds into US debt instruments and capital markets. And how by 1975, all of the oil-producing nations of OPEC accepted the same deal.

Why many developed countries were forced to hold large amounts of USD in order to continue importing oil, and how that created a consistent demand for USDs, regardless of economic conditions of the U.S., allowing the U.S. government to run high budget deficits.

How Saddam Hussein started selling oil for euros in 2000, but then Iraq returned the denomination of its oil sales back to the US dollar after the U.S. invaded Iraq in 2003. How Gaddafi was planning to sell oil for gold dinars and how the U.S. invaded Libya for crimes against humanity, so now the country sells oil only for dollars and has open slave markets as a bonus.

Let’s recap, OPEC countries were forced to sell oil for USD only, which created a constant demand for USDs across the world, allowing US to print dollars for deficit spending without runaway inflation.

Inflation

We should be able to explain our folks that fiat money pretty much constantly loses value over time, which punishes savers, enforcing the need to invest or speculate. How governments inflate their currencies to decrease the real value of their debt and also make their export goods more competitive on the international market.

How the U.S. government with a help of Treasury creates bonds (IOUs) and, using banks as middleman, sells these bonds to the Federal Reserve, which creates money out of thin air. How the government then spends money on social programs, public works, and wars. How those money are then deposited into the banks and that the vast majority of money is created not by the government, but by the fractional reserve banking system, which expands money supply by ten fold, creating money out of debt, because money gets redeposited and relent over and over again. Side note: some analysts claim that fractional reserve is a myth and that banks make loans far ahead of reserve requirements.

Why inflation is a form of taxation, a result of debt-based monetary system. How currency is losing its purchasing power during high inflation, so people want to buy goods as soon as possible, increasing the velocity of money, which drives the inflation even higher. I.e., higher prices lead to expectations of higher prices, which lead to even higher prices.

Why mortgages can lead to rising home prices, because consumers will have more money to bid up the prices for goods and services, causing demand-pull inflation. And how low interest rates and speculation contribute to creating even bigger bubbles, because the price of an object is determined by market expectations, rather than by its intrinsic value (the greater fool theory).

How US Treasury bills (T-bills) have a significant impact on the risk premium charged by investors across the entire market, because they act as the safest investment, so other investments have to offer a risk premium in the form of higher returns.

2008 global financial crisis

How the US Treasury yields were constantly decreasing, so large investors (the global pool of money), who were looking for a low-risk high-return investment, started pouring money into US housing market, creating a demand for more mortgage debts.

How in early 2000s, after the dot-com bubble, the Federal Reserve significantly lowered interest rates (Federal Funds Rate) from 6% to 1% in order to fight recession, giving people an access to cheap credit and incentivizing Wall Street to use lots of leverage for their risky deals.

How large financial institutions (Wall Street) took advantage of low interest rates and started borrowing billions of dollars to buy thousands of individual mortgages in order to bundle them together into mortgage-backed securities (MBSs) and collateral debt obligations (CDOs) and then sell them to big investors. And how credit ratings agencies were telling investors that these MBSs and CDOs were safe investments with AAA rating.

How banks were selling mortgage debts to Wall Street, rather than holding by themselves for 30 years, so they loosen their standards and issued loans even to people with very low credit score (subprime mortgages), which increased demand and drove housing prices even higher.

How unregulated over-the-counter derivatives such as credit default swaps (CDSs) allowed speculators to bet large money on whether the value of mortgage securities would go up or down. And how financial institutions such as AIG provided those CDSs without sufficient capital reserves to pay the swap insurance.

How from 2003 to 2006 the housing market was in a classic speculative bubble, because home loans were easy to get, so more people were buying houses. The increased demand for houses caused prices to increase, which created even more demand, as people started to see homes as low-risk investments.

How the housing bubble burst in 2007 when many home owners defaulted on their mortgages, putting lots of houses back on the market for sale, creating more supply, so house prices crashed. As prices fell, many borrowers suddenly had a mortgage for more than their home was worth, so they also defaulted, pushing prices further down. As a result, lenders, large financial institutions and big investors were stuck with bad loans.

How the fear spread across the economy, so companies couldn’t borrow money for their needs on commercial paper market, because nobody wanted to lend money. As a result, many companies filed bankruptcy or shut down some business activities, leading to a rise of unemployment. Consumers’ confidence fell down, so people started hoarding instead of spending, dramatically decreasing velocity of money.

How the largest US investment banks either went bankrupt (Lehman Brothers), or were sold to other banks, or were bailed out by the government with emergency loans (TARP). How trading and credit markets froze, stock market crashed, leading to a global recession that crashed demand for fuel.

We should explain to our folks that large financial institutions were bailed out from their own greed and bad management without paying the cost for bad decisions. That created a dangerous precedent, because if big banks know that they will be bailed out by the government in case of a catastrophe, they have incentives to make risky bets with lots of leverage. If they succeed, then rich people will become even more rich, but if they fail, the Fed will bail them out at the inflationary expenses of the lower classes.

Quantitative easing

When the Federal Reserve or other central banks write a check, they are creating money, because there is no bank deposit on which that check is drawn.

It’s important to explain how the Fed, trying to prevent the next depression, flooded an economy with money created out of thin air by giving out emergency loans to financial institutions and buying troubled assets such as mortgage-backed securities (MBSs).

In other words, quantitative easing is just a fancy name for massive fiat currency printing to encourage landing and investment, so the U.S. expanded their monetary base from $850 billion to $4 trillion from 2008 to 2014.

However, even though the Fed was pumping money in the financial system, the majority of that freshly printed $3 trillion were not available for the mainstream in the form of new loans, but rather ended up in Fed excess reserves, earning 0.25% interest.

We should explain to our folks that QE is the largest monetary fiscal experiment in the human history, and that risk assets became addicted to cheap money, so the Fed has to continue pumping money into the economy in order to prevent a potential economic turmoil.

At this point your folks might ask you why runaway inflation didn’t show up in US yet. Well, there are a few explanations to that:

Velocity of money significantly decelerated (e.g., Fed excess reserves increased), because people were afraid to lend or spend money. However, once economy starts to recover, people will become more confident and thus less money will end up in Fed excess reserves, which can trigger a high inflation. There was lots of technological innovation in the last decade, which is very deflationary (e.g., smartphones become cheaper every day). Skyrocketing prices of stocks, bonds and real estate are also a form of inflation, meaning that money is losing its real value, so we already experience high inflation, but it’s not so obvious for an average consumer. Fun fact: US and UK don’t include house prices in inflation calculation. This allows governments to state that cost of living is not rising, because inflation stays low, even though house prices are skyrocketing. Since there is high demand for dollars across the world, US frequently exports inflation to other countries. How does it happen? US imports real goods and resources from a developing country in exchange for USDs, so many dollars end up in the local economy of that country. Since people are generally more confident in USD than in local currency, they start to hoard USDs (Gresham’s law), while local currency ends up on the market, decreasing the purchasing power of that currency, leading to higher inflation and potentially to full currency substitution. For example, global food prices skyrocket after 2008, spurring the Arab Spring.

It’s important to point out that quantitative easing has greatly increased asset prices. Since most assets are owned by the most wealthiest people, it’s fair to say that QE made rich people even richer, leading to social unrest.

System of control

We should explain that money is no longer only means of exchange, unit of account, and store of value, but also a system of control — total surveillance and law enforcement beyond jurisdictions. Authorities can freeze your bank account and prevent you from accessing your money. For example, in 2015, the Greek government froze all banks and imposed capital controls, limiting how much savers could transfer to overseas accounts, and limiting personal withdrawals to only $67 a day. In 2016, Indian government suddenly abolished 500 and 1,000 rupee notes (86% of the currency in circulation) to fight with corruption, but created a huge cash crisis and put the country’s economy into chaos (warning: violence).

We can also explain that under the traditional democratic theory, if the government wishes to expand its activities, it has to ask the citizens to increase tax payments, so the citizens have a control over the government agencies. However, in the era of central banks and fiat money, governments can print out money (or increase its debt) for public spending without a consent of citizens, slowly shifting from democracy to tyranny. It’s also important to mention that in the times of deflation issuance of debt goes down because the value of debt increases.

Education material

To better understand the concepts above and their connections, you can either read or watch (5 hours) a great crash course by Chris Martenson.

I’d also suggest to watch the first 6–7 episodes of Hidden Secrets of Money series (3 hours) by Mike Maloney.

And if you want a shorter version, The History of Paper Money series (50 mins) will give you a basic understanding of many concepts mentioned above.

Extra

Economy: you can also check out Crash Course Economics (6 hours), because knowing bases of economics might be helpful in any crypto discussion.