Somewhere out there in the in the Eastern Pacific Ocean, there’s a tiny island called Yap. There’s no gold or silver on Yap. But hundreds of years ago, explorers from Yap found limestone deposits on an island hundreds of miles away. And they carved this limestone into huge stone discs, which they brought back across the sea on their small bamboo boats. These stones are called ‘Rai Stones’. Economists love it because it helps answer this really basic question: What is money?
What is money?
Wikipedia defines money as
any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context.
Fundamentally, money is based on the ‘trust’ that any person owning it will be able to use it to get some value in exchange of it. The only reason why money only exists and works is because we all believe in it, and trust that in accepting it in exchange for a given good or service that we produce, we can later exchange it again for a good or service that someone else produces of an equivalent value. Money is the myth we all, since eons have chosen to believe in.
“Put not your trust in money, but your money in trust”
- Oliver Homes
From Barter to Banknotes: The evolution of money
The currency of ‘trust’ originally was based on barter, which then expanded to commodities like coin shells, and gold, eventually giving birth to the modern monetary system. Each of these shifts happened because the currency being used to trust was not able to solve new requirements which arrived with the growth of human civilization.
- Barter: Before the birth of money, there was barter. In ancient times, when human civilization was just starting up, and agricultural societies were blooming, most people just made one or two of the many things required. Since societies there were smaller and local, most would exchange the commodity they had in access for something they wanted. Barter was simple give and take of value and it worked!
- Commodity money: Barter worked great for small societies and local markets. As human civilization and availability of goods and services, barter across made trade increasingly difficult. Hence lots of different cultures standardized some commodity to be used as a reference. Arrowheads, grains, cows, seashells, all of these found novel ways of usage. This need to standardize the unit of measurement was the first step in moving towards a currency.
- Coins and gold: As time passed civilizations evolved from tribes and villages to cities and empires. Humans started trading and exchanging value not only within these empires but also across them. Trade route were made and transport systems were built. Commodity money was great as long as the trade was restricted to local communities. Large scale adoption of the same commodity money required the commodity to be standardizable, portable and the empire had to ensure the acceptance. Thus coins and gold became the new standard for trade and exchange of value.
- The banking system: Traders amassed large amounts of wealth global trade flourished which lead to a very interesting problem. These traders wanted a place to keep their money safe. Temples became the default place to store gold because no one dared steal from god!. The temple priests used to give out ‘payslips’ which guaranteed coins/gold to the holder of the slip. Thus were formed the first ‘promissory notes’ and the first ‘banks’. Over time goldsmiths took up this role and the banking system from there on flourished.
- Paper money: With the invention and large scale usage of paper in china, the Sung Dynasty gave out what might be the first set of paper notes instead of coins. Soon the economic and logistical advantages of paper notes became apparent which lead to large scale printing of these notes. Travellers like Marco Polo introduced the west to the usage of paper as notes. Coupled with the rise of commodity backed banking system and the thirst of empires to colonize and trade across the world, paper note took over as the new standard of money exchange.
- Digital money : The rise of computers, globalization of trade and penetration of internet have changed how we trade and exchange value. To facilitate this, money had to change too. Today ~$75 trillion of money exists across the globe of which only about 7% is physically held in the form of coins and notes. Software has eaten paper money for lunch.
Properties money should have?
“The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, sometimes, a standard of deferred payment. Any item or verifiable record that fulfills these functions can be considered as money.”
From grains, to sea shells, to gold coins to bank-notes, as a civilization we have gone through multiple different kinds of monetary systems. As we saw above, each of these systems had certain drawback because of which they were replaced by better systems. Having said that all monetary systems have some common properties and desired features.
- Money is a medium of exchange: Money should be widely accepted as a method of payment. For a local grocers, to the railway ticket counter, from paying taxes to depositing it in the bank. Acceptance of money is what drives its usage.
- Money is a unit of account: Humans are hardwired to think in relative terms. As a result, having money as your standard yardstick helps you easily compare prices and hence value of various goods and services. Creating and using this standard for measurement is fundamental to money.
- Money is a store of value: If you sell corn today and get $100 in return, I can hold on to the money before I spend it because you know it will hold its value until tomorrow, next week, or even next year. Thus money is used as a store of ‘value’ created from selling corn today and can be used to redeem it at any point in time in the future. It is because of this that you are able to trust and use money effectively in the economy.
Apart from these, money should also be
As we saw, these properties were not always required but evolved as a result of how human civilization evolved and grew. All of these together is what creates the giant system of value exchange which we call the monetary system.
Where is money going next?
“I think the internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing but that will soon be developed, is a reliable e-cash.”
- Professor Milton Friedman
The increasing penetration internet, globalization of trade, rise of machines and availability of data all have opened up new challenges. Sitting in India, if you want to sell fertilizer to farmer in Africa there are multiple challenges that need to be solved. Money needs to be modified to enable:
- Global Trade: To pay someone in a currency that is not native to your country requires special permission and more often than not very high transaction fees.
- Instantaneous settlement: When you are trading and exchanging value, you would want your money to come to you instantaneously and not in ‘weeks’ as it happens now.
- Security: Paper money in digital format is highly vulnerable to large scale theft and dependent on multiple central organization to operate at the highest level of security. These overheads lead to inefficiencies and hamper growth.
- Programmable: Currently there are programs that can be run to send/receive money from someone. However, the person who runs the program has control over what happens to the money. With programmable money you can set up rules that are enforced by the money itself. People that agree with these rules can use the money and can be absolutely certain that they will receive it if they do the thing the rules demand.
- Beyond human: With the rise of data and machines, exchange of value will not only be amongst mankind but also across machines. We will need to build a monetary system which enable machines to equally participate in the economy.
Paper money in the digital form is no longer enough. Over time money has evolved along with the needs of the civilization. For society to grow it needs to evolve again.
Cryptography, blockchain and tokenization of assets make all of the above possible. I believe that we are on the verge of a major change in how monetary system across the globe work. Bitcoin may or may not become the new currency of the globe but large scale adoption of cryptocurrencies is an eventuality driven solely by economic incentives just like paper money achieved large scale adoption.
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