In the 13th century, the Chinese emperor Kublai Khan embarked on a bold experiment. China at the time was divided into different regions, many of which issued their own coins, discouraging trade within the empire. So Kublai Khan decreed that henceforth money would take the form of paper .
It was not an entirely original idea. Earlier rulers had sanctioned paper money, but always alongside coins, which had been around for centuries. Kublai’s daring notion was to make paper money (the chao ) the dominant form of currency. And when the Italian merchant Marco Polo visited China not long after, he marveled at the spectacle of people exchanging their labor and goods for mere pieces of paper. It was as if value were being created out of thin air.
Kublai Khan was ahead of his time: He recognized that what matters about money is not what it looks like, or even what it’s backed by, but whether people believe in it enough to use it. Today, that concept is the foundation of all modern monetary systems, which are built on nothing more than governments’ support of and people’s faith in them. Money is, in other words, a complete abstraction—one that we are all intimately familiar with but whose growing complexity defies our comprehension.
Today, many people long for simpler times. It’s a natural reaction to a world in which money is becoming not just more abstract but more digital and virtual as well, in which sophisticated computer algorithms execute microsecond market transactions with no human intervention at all, in which below-the-radar economies are springing up around their own alternative currencies, and in which global financial crises are brought on for reasons difficult to parse without a Ph.D. Back in the day, the thinking goes, money stood for something: Gold doubloons and cowrie shells had real value, and so they didn’t need a government to stand behind them.
In fact, though, money has never been that simple. And while its uses and meanings have shifted and evolved throughout history, the fact that it is no longer anchored to any one substance is actually a good thing. Here’s why.
Let's start with what money is used for. Modern economists typically define it by the three roles it plays in an economy :
It’s a store of value , meaning that money allows you to defer consumption until a later date.
It’s a unit of account , meaning that it allows you to assign a value to different goods without having to compare them. So instead of saying that a Rolex watch is worth six cows, you can just say it (or the cows) cost $10 000.
And it’s a medium of exchange —an easy and efficient way for you and me and others to trade goods and services with one another.
All of these roles have to do with buying and selling, and that’s how the modern world thinks of money—so much so that it seems peculiar to conceive of money in any other way.
Yet in tribal and other “primitive” economies, money served a very different purpose—less a store of value or medium of exchange, much more a social lubricant. As the anthropologist David Graeber puts it in his recent book Debt: The First 5000 Years (Melville House, 2011), money in those societies was a way “to arrange marriages, establish the paternity of children, head off feuds, console mourners at funerals, seek forgiveness in the case of crimes, negotiate treaties, acquire followers.” Money, then, was not for buying and selling stuff but for helping to define the structure of social relations.
How, then, did money become the basis of trade? By the time money makes its first appearance in written records, in Mesopotamia during the third millennium B.C.E., that society already had a sophisticated financial structure in place, and merchants were using silver as a standard of value to balance their accounts. But cash was still not widely used.
It’s really in the seventh century B.C.E., when the small kingdom of Lydia introduced the world’s first standardized metal coins , that you start to see money being used in a recognizable way. Located in what is now Turkey, Lydia sat on the cusp between the Mediterranean and the Near East, and commerce with foreign travelers was common. And that, it turns out, is just the kind of situation in which money is quite useful.
To understand why, imagine doing a trade in the absence of money—that is, through barter. (Let’s leave aside the fact that no society has ever relied solely or even largely on barter; it’s still an instructive concept.) The chief problem with barter is what economist William Stanley Jevons called the “double coincidence of wants.” Say you have a bunch of bananas and would like a pair of shoes; it’s not enough to find someone who has some shoes or someone who wants some bananas. To make the trade, you need to find someone who has shoes he’s willing to trade and wants bananas. That’s a tough task.
With a common currency, though, the task becomes easy: You just sell your bananas to someone in exchange for money, with which you then buy shoes from someone else. And if, as in Lydia, you have foreigners from whom you’d like to buy or to whom you’d like to sell, having a common medium of exchange is obviously valuable. That is, money is especially useful when dealing with people you don’t know and may never see again.
The Lydian system’s breakthrough was the standardized metal coin. Made of a gold-silver alloy called electrum, one coin was exactly like another—unlike, say, cattle. Also unlike cattle, the coins didn’t age or die or otherwise change over time. And they were much easier to carry around. Other kingdoms followed Lydia’s example, and coins became ubiquitous throughout the Mediterranean, with kingdoms stamping their insignia on the coins they minted. This had a dual effect: It facilitated the flow of trade, and it established the authority of the state.
Modern governments still like to place their stamp upon money, and not just on bills and coins. In general, they prefer that money—whether physical cash or digital—be issued and controlled only by official entities and that financial transactions (especially international ones) be traceable. And so the recent rise of an alternative currency like Bitcoin [see “ The Cryptoanarchists ’ Answer to Cash,” in this issue], which is based on a cryptographic code that allows for anonymous transactions and that so far has proved to be uncrackable, is the kind of thing that tends to make governments very unhappy.
The spread of money throughout the Mediterranean didn’t mean that it was universally used. Far from it. Most people were still subsistence farmers and existed largely outside the money economy.
But as money became more common, it encouraged the spread of markets. This, in fact, is one of the enduring lessons of history: Once even a small part of your economy is taken over by markets and money, they tend to colonize the rest of the economy, gradually forcing out barter, feudalism, and other economic arrangements. In part this is because money makes market transactions so much easier, and in part because using money seems to redefine what people value, pushing them to view things in economic, rather than social, terms.
Governments were quick to embrace hard currency because it facilitated the collection of taxes and the building of military forces. In the third century B.C.E., with the rise of Rome, money became an important tool for unifying and expanding the empire , reducing the costs of trade, and funding the armies that kept the emperors in power.
The decline of the Roman Empire, starting in the third century C.E., saw a decline in the use of money as well, at least in the West. Parts of the former empire, like Britain, simply stopped using coins. Elsewhere people still used money to balance accounts and keep track of debts, and many small kingdoms minted their own coins. But in general, the circulation of money became less central, as cities shrank in size and commerce dwindled.
The rise of feudal society also undercut money’s role. The basic relationship between master and vassal was mediated not by payment for services rendered but rather by an oath of loyalty and a promise of support. Land was not bought and sold; it belonged, ultimately, to the king, who granted use of the land to his lords, who in turn provided plots of land to their vassals. And feudalism discouraged trade; a feudal estate, or fief, was often a closed community that aimed to be self-sufficient. In such a setting, money had little use.
Money’s decline in feudal times is worth noting for what it reveals about money’s essential nature. For one thing, money is impersonal. With it, you can cut a deal with, say, a guy named Jeff Bezos , whom you don’t know and will probably never meet—and that’s okay. As long as your money and his products are good, you two can do business. Similarly, money fosters a curious kind of equality: As long as you have sufficient cash, all doors are open to you. Finally, money seems to encourage people to value things solely in terms of their market value, to reduce their worth to a single number.
These characteristics make money invaluable to modern financial systems: They encourage trade and the division of labor, they reduce transaction costs—that is, the cost incurred in executing an economic exchange—and they make economies more efficient and productive. These same qualities, though, are why money tends to corrode traditional social orders, and why it is commonly believed that when money enters the picture, economic relationships trump all other kinds.
It’s unsurprising, then, that feudal lords had little use for the stuff. In their world, maintaining the social hierarchy was far more important than economic growth (or, for that matter, economic freedom or social mobility). The widespread use of money, with its impersonal transactions, its equalizing effect, and its calculated values, would have upended that order.
Money's decline didn't last, of course. By the 12th century, even as the Chinese were experimenting with paper currency, Europeans began to embrace a new view of money: Instead of being something to hoard or spend, money became something to invest, to be put to work in order to make more money.
This idea came with a renewed interest in commerce. Trade fairs sprang up across Europe, frequented by a community of merchants who had begun to do business across the continent. This period also saw the emergence of a banking industry in the city‑states of Italy . These new institutions introduced a host of financial innovations that we still use today, including municipal bonds and insurance. The banks fostered the use of credit and debt, which became ever more central to the economy as kings borrowed to finance their military adventures and merchants borrowed to fund their long-range trades.
The invention of the bill of exchange , which laid the groundwork for the emergence of paper money in the West, also occurred during this period. The bill of exchange was a sort of precursor to the traveler’s check: a document representing a quantity of gold that could be exchanged for the real thing in a different city. Traveling merchants liked the bills because they could be carried around with far less risk (and exertion) than the precious metal.
By the 16th century in Europe, many of the ideas about money that shape our thinking today were in place. Still, money remained a physical thing—that thing being a piece of gold or silver. A gold coin wasn’t a symbol of value; it was an embodiment of it, because everyone believed that the gold had intrinsic worth. Likewise, the amount of money in the economy was still a function of how much gold and silver was available. The rulers of Spain and Portugal didn’t quite appreciate the limits of this system, however, which led them to plunder their New World colonies and accumulate vast hoards of precious metals, which in turn triggered periods of rampant inflation and enormous tumult in the European economy.
These days, countries have central banks to oversee their money supplies, as well as to set interest rates, combat inflation, and otherwise control their monetary policy. The United States has the Federal Reserve System , the Eurozone has the European Central Bank , the Maldives has the Maldives Monetary Authority , and so on. When the Federal Reserve wants to increase the money supply, it doesn’t have to go looking for El Dorado. Neither does it phone up the United States Mint and order it to start printing more dollars; in fact, only about 10 percent of the U.S. money supply—about $1 trillion of the roughly $10 trillion total—exists in the form of paper cash and coins.
Instead, the Fed buys government securities, such as treasury bills, on the open market, typically from regular private banks, and then credits the banks’ accounts with the money. As the banks lend, invest, and otherwise spend this new money, the overall money supply that’s circulating increases. If, on the other hand, the Reserve wants to decrease the money supply, it does the opposite: It sells government bonds on the open market, again typically to private banks, and then deducts the sales price from the banks’ accounts. The banks have less money to spend, and the money supply shrinks.
The sophisticated and relatively opaque machinations by which central banks keep economies afloat may make the Spanish Empire’s inflationary foibles look quaintly naive. But in fact the fine-tuning of monetary policy—the delicate juggling of interest rates, money supply, and other financial mechanisms so that an economy keeps expanding at a steady, manageable rate, without excessive inflation, unemployment, debt, or boom and bust cycles—is still a work in progress, as the ongoing economic woes in both Europe and the United States demonstrate.