A Brief History of Money

by Patrick O'Shaughnessy

If the entire history of Homo sapiens was represented by a 24-hour clock, money would only have been around for the last 18 minutes. Because it connects people, it is arguably humankind's most important invention, up there with the printing press and the internet. This is a brief primer on the history of money and why money today is like a seed: planted it will prosper, un-planted it will wither. First, I created the below timeline to give a very brief overview of major money milestones. Then I dive deeper into the history of money and the implications for our future.

In his expansive and excellent book A History of Money, author Glyn Davies lists six functions of money:

  1.  Unit of Account
  2. Common measure of value 
  3. Medium of exchange
  4. Means of payment
  5. Standard for deferred payments
  6. Store of Value

Modern paper currencies don’t meet the sixth function—un-invested dollars (or euros, or yen) dwindle in value over time. The modern dollar is an abstraction, created out of thin air. It can no longer be converted into anything at a fixed price.  Yet, for most of its history money was tied to some underlying commodity.

Money itself (in coin form) is only 2,600 years old. At various points in history, money has taken the form of paper, coins, gold, silver, salt, cattle, deerskins, vodka, ivory, wampum beads and sperm whale's teeth. Each type of money was valuable for a different reason.  Roman soldiers, for example, were paid partially in salt, a precious commodity that allowed soldiers to flavor their otherwise bland food. Our word 'salary' derives from the Latin sal, meaning salt. All forms of money as standardized, transportable means of exchange were much more convenient than the barter system.  Were it not for the invention of coins, we might constantly face situations like the one faced by Parisian singer Mademoiselle Zélie, who upon performing a few songs for the people of the Society Islands was paid three pigs, twenty-three turkeys, forty-four chickens, five thousand coconuts, and large quantities of bananas, lemons, and oranges[i]. 

Gold and Silver Coins

The first coins appeared on the Southern coast of modern day Turkey in the kingdoms of Lydia and Ionia around 640 B.C.E. These coins were made of electrum—a naturally occurring alloy of gold and silver.  There was an abundance of electrum in the Pactolus river near the Lydian capital city of Sardis, making it an ideal metal to use to make the first coins.  Greek legend says that King Midas bathed in the river in an attempt to wash away his golden touch, depositing a fortune in the process. Eventually, under king Croesus, the Lydians learned how to separate gold from silver and minted coins from each metal[ii]. Standardized coins spread quickly throughout the Greek empire and played a large role in its scientific and cultural development.

It is fitting that the first coins were gold and silver because these two metals, more than any other, have played a central role in the history of exchange. Gold and silver are terrestrial reflections of the heavenly bodies that rule our skies, so it is no surprise that civilizations around the world have valued them so dearly. Gold resembles the sun but is also literally of the heavens. Most of the Earth’s gold was pulled down to its core during its formation, but all of earth’s accessible gold, which lays near the surface in the crust and mantel, comes from meteorites which crashed into the earth several hundred million years after it was formed[iii]. The “sweat of the sun” and “tears of the moon,” as the Incas called gold and silver, were natural candidates for coins.  They are rare, do not break down, and unlike other metals like iron, they do not rust.  We’ve always lusted after gold. Pliny tells the story of the greedy Roman Septumuleius who, upon hearing that there was a bounty on his friend Gracchus’ head equal to its weight in gold, cut off his head and filled its mouth with lead so as to increase the value of the reward[iv].

Given its prominence in our history and in our culture, it is surprising just how little physical gold there is in the world today.  Melted into a cube it would measure just 67 feet on each side; roughly the size of my small office building. The limited and largely fixed quantity of gold means that each ounce of gold stores value well over time. But a gold-based money system, or gold standard, is also inflexible. Because you cannot create more gold, kings, emperors, and presidents have devalued their currencies throughout history. My favorite example is the devaluation overseen by the Roman emperor Nero: one of history’s true monsters whose greed would make Bernie Madoff blush. Nero’s house was made of gold, he used more perfume at his wife’s funeral than was produced in all of Arabia in an entire year, and he commissioned a statue of himself standing 106 feet tall—one foot taller than the Colossus at Rhodes[v]. Talk about the one percent. Such excess demanded lots of money, so Nero devalued the Roman denarii by taking existing coins, melting them down, and re-issuing coins (bearing his portrait) with slightly less metal in each[vi]As we’ll see, U.S. presidents Lincoln, FDR and Nixon also oversaw currency devaluations.

U.S. Dollar

The history of money in the United States also begins with gold and silver. At its birth in the Coinage Act of 1792, the U.S. dollar was fixed to the price of gold and silver, meaning you could exchange one dollar for 371.25 grains of silver or 24.75 grains of gold[vii].A fixed conversion rate to gold and silver is known as a “bimetal standard,” which ultimately proved less popular than a standalone “gold standard”. Still, silver did have its moments of importance to the American people.  In the late nineteenth century there was a huge push by western farmers, led by the Populist Party leader and two time presidential candidate William Jennings Bryan, to secure a bimetal standard that included both silver and gold. Farmers wanted a bimetal standard because the gold standard had resulted in falling agriculture prices, meaning farmers’ income suffered.  An influx of silver into the market, they believed, would help prices rebound and increase their income. The farmers lost the battle, and a gold standard was secured by President McKinley at the turn of the twentieth century.

There are many advantages to having our dollar represent a fixed amount of gold. One key advantage is that it acts as a check on our government’s ability to create more money. More money introduced into our economy makes every dollar worth less, in that it can be used to buy fewer goods and services. The figure below shows the price of an ounce of gold in U.S. dollars since the original coinage act of 1792.  Though the price was mostly steady, there were occasions when the dollar was devalued relative to gold. The first disruption in the chart, which appears now as just a tiny blip, is the result of the President Lincoln and the Union passing three Tender Acts, allowing them to issue $450 million dollars in paper notes known as “greenbacks” to pay for the northern army in the Civil War. The greenbacks were an early example of what is called fiat money, which in Latin means “let it be done.”  Fiat money like the greenback is created out of thin air, and cannot be redeemed for a fixed amount of gold.  With more currency in circulation, but no more gold, the price of gold shot from $20.67 at the end of 1861 to $46.34 at the end of 1864[viii]. After the shock of the war, the price ultimately dropped back down to $20.67 by 1878.

Gold Price from Global Financial Data

Gold Price from Global Financial Data

While a gold standard does impose a degree of discipline on governments, it is also inflexible.  The supply of gold only grows by a small amount each year as more gold is mined, so a strict gold standard means that our government cannot quickly grow the supply of money to a degree that is sometimes needed. 

Sometimes extraordinary times demand extraordinary measures; this was true in the Civil War, and then again during the Great Depression.  In 1933, Franklin Roosevelt, trying to prevent the Great Depression from becoming even worse, declared through executive order that U.S. citizens could no longer exchange their dollars for gold and must surrender their gold to the government.  Anyone trying to avoid this confiscation was subject to arrest. Citizens would not be allowed to own significant quantities of gold again until 1974. The price of gold was reset from $20.67 to $35, which hugely increased the dollar value of freshly confiscated gold held by the government. All of this gold was housed in Kentucky at the newly built Fort Knox and the increase in dollar value of the government's gold hoard allowed them to issue more than $3 billion in paper currency. This extra money was used by Roosevelt and his administration to combat the Great Depression.

Then in July of 1944 when, with the outcome of World War II all but certain, representatives from 44 allied countries met in New Hampshire to outline the post war global economic landscape. They chose a gold standard. In their resulting Bretton Woods agreement, the U.S. dollar was made the world's reserve currency and the dollar was fixed at $35 per gold ounce. Most other countries agreed to set their currencies at a fixed rate of exchange with the U.S. dollar.  Throughout the post-war economic boom until the late 1960s, the U.S. dollar remained close to the $35 gold price target. 

But in the early 1970s, the U.S. was in a very challenging economic and political position.  Our economy was weak, the bill for the Vietnam War was mounting, and our annual spending burden had risen significantly because of new entitlement programs like Medicare. The government wasn’t collecting enough tax money to cover all of these rising expenditures, so President Nixon decided along with key advisors that the U.S. must end what remained of its gold standard.  Nixon’s decision, known as the “Nixon Shock,” all but dissolved the Bretton Woods agreement and allowed the U.S. to print its own fiat money at will.  This was a crucial moment in our history because ever since, our government has been able to create as much money as it needs. In the decade following the Nixon Shock, the value of the dollar plummeted against gold.  At the end of 1970, an ounce of gold was priced at $37.60, but 10 years later, at the end of 1980, that same ounce cost $641.20—a 17-fold increase.  Gold now represents but a small fraction of the money in circulation. As of July 2013, the U.S. holds roughly $381 billion dollars worth of gold. That may sound like a lot, but there are more than 10 trillion U.S. dollars in circulation.  That means only 3.5% of our money is backed by gold[ix].

In U.S. history, Presidents Lincoln, Roosevelt, and Nixon all presided over massive currency devaluations – performed, of course, with much more noble intentions.  Money printing is not all bad.  The flexibility to print more money may have saved us from another Great Depression in 2008, and the lack of flexibility under the gold standard is an oft-cited reason for the severity of the Great Depression of the 1930’s. Still, in a fiat system, there is no check on government's ability to increase the money supply—and as a result inflation can run rampant.

Modern Implications

But, as George Goodman (a.k.a."Adam Smith") points out, “The trouble with paper money is that it rewards the minority that can manipulate money and makes fools of the generation that has worked and saved.”  Under a fiat money system, higher inflation slowly confiscates savings. Wall Street and the financial sector have been viewed with scorn in the aftermath of the 2008 global financial crisis, but one positive development in the world of finance is that we no longer have a “minority” that can use money to their advantage—anyone can do it. For a long time, only the privileged rich could access global market opportunities, but thanks to innovations like exchange-traded funds and low-cost online trading accounts, participation in the global stock market is cheap and easy.  Because of the now low barriers to entry, all investors can protect themselves from inflation and grow their wealth.

Born after 1980, millennials are the first complete generation of Americans born into a world of dollars without an anchor. No anchor means no check on inflation, no check on money printing, and therefore no check on the value of our U.S. dollar.  With inflation eating away our purchasing power, we should invest in assets that grow at the highest real rate (after-inflation) over time.  

Cash is Trash

In a fiat money system the value of a dollar and any cash we hold in bills or in our checking accounts inevitably suffers. Between 1926 and August 1971, when Nixon closed the gold window, annual inflation was roughly 1.8%, meaning that the purchasing power of a dollar declined by an average of 1.8% per year.  But since 1971, inflation has more than doubled roughly 4.1%.  In a higher inflation environment, the value of a dollar deteriorates faster and inflation acts as a hidden tax on cash and savings accounts. The value of a dollar is transitory. A Ford Model T cost $260 at one point, about the price of a single car tire in 2013.

Inflation of four percent may not sound like much, but the problem compounds over time. A dollar that was worth a dollar in 1971 is only worth 17 cents today.  Put another way, this means that more than 80% of the dollar's purchasing power has vanished, and anyone holding cash or holding money in a checking account over that period has suffered the consequences. That percentage decline is roughly equivalent to the percentage loss for the stock market during the Great Depression.  The difference is that the stock market quickly began to recover, but inflation will persist making the value of cash decline even further. The bottom line is that holding cash over long periods of time is very dangerous. Inflation has been more muted lately—about 2.4% since 2000—but it can strike at any point and decimate the value of our cash.

Stocks are better

Stocks have almost always provided the best real rate of return, in every major country around the world.  The below table highlights the real rates of return for the three major asset classes (stocks, bonds, bills) in 20 different countries. Two time frames are shown: the long stretch between 1900 and 2012, and a shorter time frame between 1971 and 2012 (post Nixon Shock).

Annual Returns from Dimson, Marsh, Staunton 

Annual Returns from Dimson, Marsh, Staunton 

Over the long run stocks have outperformed bonds and bills, usually by wide margins[xi].  And while U.S. bills and bonds did provide slightly positive returns after inflation during this period, bonds and bills in other countries lost money between 1900 and 2012.  Investments in supposedly “safe” short term bills lost purchasing power in Germany, Japan, France, Italy, Belgium, Finland and Austria. In the U.S. and in countries abroad, bills and bonds have failed to help investors build wealth.

Real Returns

The US Federal Reserve and other central banks control the amount of money in the global system and therefore have a large influence on inflation rates. Ben Bernanke, former chairman of the US Federal Reserve, has even admitted that “inflation is a tax.” Inflation is here to stay, because the money supply continues to explode.  Between 1948 and 1971, the money supply grew fourfold. Since 1971, it has exploded, growing 16-fold. There is no reason to expect this trend to slow or reverse, so inflation will remain a hidden threat to the value of our money.

Money isn't a long term store of value anymore. Investors—young ones especially—need to plant their money in assets that growth at the best real rate over time. That means that over the long-term, savings accounts and cash aren’t safe, even though they seem like they are. We’ve come a long way since Lydia’s electrum coins, and in the modern world of unfixed dollars, investors should park their money (“savings”) in a global stock market portfolio.

 

[i]Money and the Mechanism of Exchange by William Stanley Jevons

[ii]A History of Money by Glyn Davies

[iii]The tungsten isotopic composition of the Earth’s mantle before the terminal bombardment, Matthias Willbold, Tim Elliott, Stephen Moorbath, Nature 477, 195-198 (October 2011)

[iv]Natural History (Classic) by Gaius Pliny

[v]Natural History (Classic) by Gaius Pliny

[vi]The History of Money by Jack Weatherford

[vii]A History of Money by Glyn Davies

[viii] Price per ounce of gold in U.S. dollars, data from Global Financial Data

[ix] Money is defined as M2, data from the World Gold Council, St. Louis Federal Reserve, author’s calculations

[x]http://media.ford.com/article_display.cfm?article_id=858

[xi] Data from Elroy Dimson, Paul Marsh, & Mike Staunton