Currency, and how it is made

I recently ran into some weird theories about currency, from theory that only gold and silver are proper currency to the theory that one can simply create an imaginary currency out of thin air, as long as it remains scarce enough, and by the pure power of make-believe there goes the Bitcoin.

What I found out is that almost everyone is completely and utterly ignorant of what money is and how it works, so I’ll try to make things a bit clearer.

The concept of money became interesting when people initially began to trade. Since it was always a problem to decide how many chickens you need to give for a goat, and how many beaver furs are worth one bear fur, sooner or later people came up with some universally desirable item that can be readily traded for anything else. Before you think of gold, some other things were thought of first. Animal furs were apparently among the first forms of money, which is why Croatian money is called “marten” (kuna in Croatian). Of course, since carrying furs around and trading them for things isn’t always practical, the role of universally acceptable goods was soon taken by precious metals, as soon as their universal desirability and acceptability was established. Their main advantage was durability, in a sense that they could change hands many times without becoming much worse for the wear.

Paper money became interesting as a way of carrying more value with you than could be done practically and securely with precious metals. In Europe, the first to issue paper money were the Knights Templar. Since people were traveling frequently between Jerusalem and Europe, and often carried substantial amounts of money with them, being robbed was a genuine concern, so basically the Templars offered a service in which they would exchange your money for a paper, which you could exchange back for gold coins on the other end, minus a fee, of course. This became so popular, and they so powerful, that the Pope decided to get rid of them, but the principle served as a basis for the current methods of debt clearing. The banks started issuing promises to pay cashable by the bearer, that could be exchanged for metal coins, and soon those banknotes were traded among the people as proper money, because it was understood that they could be converted into “proper money” at any given moment. Soon, national banks started issuing such banknotes, exchangeable for gold on demand, and guaranteed for by the nation’s gold reserves.

But this is where the trouble started. You see, when people understood that paper money was as good as metal money, they stopped being in any hurry to exchange the banknotes for gold and were content to simply use them indefinitely. This means that the state came to the “brilliant” idea of printing much more banknotes than it had the gold reserves, which was actually necessary because of the immense industrial growth in the 19th century, which would otherwise be constrained by the insufficient amount of money in circulation.

This is an aspect of money that few really understand: that there must be enough money in circulation, that it can cover all needs of trade. Basically, if object a is traded for object b, and both are worth a certain amount of money, and both are independently traded for money, this mandates that the total amount of money in circulation necessary for unrestricted trade must essentially be equal to the value of all goods and services in circulation, basically that the amount of money in circulation must be some function of the gross domestic product (GDP) of the state. Since it’s unlikely that the state will manage to mine enough gold to exactly match its GDP, tying the exploding GDP of the industrial revolution to a finite resource was an immensely bad idea, because scarcity of money in circulation would artificially raise its value and therefore constrict commerce. Essentially, when one horse was commonly traded for x gold coins, if the GDP rose by the factor of two, the scarcity of money would mandate that the twice as large GDP would still be traded for the same amount of gold, basically artificially raising the value of gold and the horse would now be traded for x/2 gold coins. This kind of static monetary practice doesn’t acknowledge the fact that new value can be introduced to the market, and it therefore had to be reformed. This was done by acknowledging the fact that the state guarantees for its money not only with its gold, but with all of its assets, and the direct convertibility of banknotes to gold was first disabled (with laws that prohibited “gold hoarding”) and later completely ended.

This means that a state guarantees for its currency not only with its precious metal reserves, but also with its entire asset sheet, which includes foreign currency reserves, loans by the central bank to the commercial banks etc. This works basically like this: you want to buy a house. You deposit guarantees to a commercial bank, including mortgage to your house. The commercial bank then requests a low-interest loan from the central bank, and forwards your guarantees. The central bank creates new money, guaranteed for by the mortgage to your house, the commercial bank then insures the loan with an insurance company, adds cost of insurance, adds its own interest, and you pay for the entire package. The basis of the entire thing, of course, is the fact that you have a job, which allows you to pay installments monthly, so basically the true backing of this emission of money is GDP, which includes your job.

It’s not just printed out of thin air, or pulled out of one’s ass. It’s not “worthless” because it’s not backed by gold; no, gold is merely one of the metals traded on the free market, and its value relative to printed money is determined dynamically. It’s also not “bullshit”, so that it could be readily supplanted by other bullshit items such as Bitcoin. First of all, nobody’s mortgage guarantees for the emission of Bitcoin. Its quantity in circulation cannot be increased when the GDP increases, which means it is a finite resource which would restrict commerce and its value would artificially rise due to scarcity, and is therefore completely unsuitable for the role as currency. Something like Bitcoin could work, but only if it can be created based on guarantees by some real asset. Since it is unbacked by any assets, it is essentially worthless, and is accepted only because people are stupid idiots who don’t know shit about how money actually works. You can’t base currency on make-believe.

However, if you separate the currency from a single tangible asset, you make it more volatile and prone to fluctuations and abuses, which is a topic for the next article.