Last time, I suggested that I could go on a digression about the development of currency, and you all voted that this was a good idea, despite the fact that I am neither an economist nor an economic historian. So, before I begin, I’d like to state for the record that I’m more or less going off the top of my head here, and that I may be wrong at parts here.
With that disclaimer out of the way: let’s move on the development of currency.
This last item isn’t really any specific point so much as it is an demonstration of a bunch of the other points I’ve made before, and how it led to the evolution of how money and economic systems developed in our own world.
As I’ve mentioned before, money doesn’t have any intrinsic value. The reason we say it’s worth a certain amount of this resource or that service is because we’ve come to a consensus that a certain amount of currency has a certain precise worth, so it’s easier to exchange those resources and services. Despite what some people might insist, gold and silver don’t have any intrinsic monetary value. A whole lot of people just agreed that these materials had a certain value because they were scarce, shiny, and didn’t rust. While not all societies used these particular precious metals as representative tokens of a certain value, enough of them did that we still consider both metals synonymous with currency, to the point where when a person says “gold” or “silver” they’re more almost more likely to be referring to it in the form of coins or treasure than as simple metals.
In our world, this close association meant that in a lot of places, the value of an item was measured by amounts of gold and silver themselves, with coins serving only as fixed units of measurement for those precious metals. The French “Livre” – from where we also get the British “Pound” – started as a gold coin representing a French pound of silver. Indeed, as time went on, and the authorities responsible for minting coins began “adulterating” them with more common metals for the sake of stretching out a limited supply of gold and silver, the value of the coins themselves began to drop as well. During the Roman Crisis of the Third Century, “silver” coins were so heavily adulterated that a denarius from the time of Julius Caesar was worth many times that of a denarius from the time of Aurelian more than 300 years later – because the Denarius of 44 BC was 95% silver and the Denarius of 275 AD was 5%. This notably caused all kinds of problems, especially for the soldiers who the Roman Emperors relied upon to keep the empire together and themselves on the throne – because those soldiers were paid at a fixed rate of denarii.
This last aspect in particular wasn’t just a problem for the Romans. If only precious metals were acceptable as currency, then that meant any society – or in particular, any government of that society – only had a certain limited amount of currency it could distribute, as limited by the amount of silver and gold it had. This wasn’t as much of a problem when that government was made up mostly of landowners and farmers who fought or governed part-time, because then they could be paid in land or other non-currency resources. However, when professional armies once again became the best way for a society to defend itself, that limitation suddenly became very important. Since professional soldiers don’t have the time or skills to do their own farming or create goods for barter, they have to be paid in currency, which means a government can only maintain an army so long as it has enough gold or silver to pay them.
In the early modern period, this became a huge problem, especially as armies got bigger and more expensive. The Spanish Habsburgs in particular were able to raise vast armies to fight their European wars because they had looted immense amounts of silver and gold during their conquest of the Americas. But even this was not enough, and as a result, the Spanish crown declared bankruptcy over and over again throughout its imperial height. Those limitations were even more pronounced among the countries which the Spanish were fighting against. The Netherlands, for example, who fought a nearly century-long series of wars against the Spanish for their independence (long story), had nowhere near the reserves of silver and gold their enemies did – which was why they were one of the major pioneers in finding a new alternative.
Or rather, a new way to use an old alternative.
What we now call ‘paper money’ started as neither paper nor money. In Han Dynasty China, merchants used pieces of leather with identifying marks as promises of payment, like a form of promissory note. This meant that merchants no longer had to take on the risk of carrying large amount of precious metals around – especially since a single piece of ‘paper’ was able to represent large quantities of copper, silver, or gold. This made large transactions a lot easier, since those wanting to trade in large denominations no longer had to physically transfer precious metal coins, instead simply trading notes backed by an institution which was capable of converting them to those coins on demand. Eventually, these notes became more and more widespread and general purpose, with some individuals using such notes for large-scale business transactions, while relegating coinage to everyday use in small amounts.
At some point, the banking institutions themselves noticed that this meant there was a massive volume of transactions going on which theoretically involved the transfer of gold, but which physically meant that the coin being transferred remained locked in the bank’s vault, while the involved parties merely traded slips of paper determining who owned that gold.
Likewise, those banking institutions also realised that if the coin itself never physically left the vault, then there was no reason to be limited by the amount of precious metal a bank actually owned. So long as all of a bank’s customers believed that the bank had enough coinage on hand to exchange any given banknote (as paper money is still formally referred to today) for gold and silver, the banknotes themselves would be treated as if they themselves were the gold or silver they were supposed to represent. Suddenly, banks (and thus, the institutions which borrowed from banks) were no longer limited to loaning only the value of coinage they physically possessed, now they could effectively loan out as much money as they said they had, even if their actual precious metal reserves were physically empty.
Of course, as with any system ultimately based on belief, this led to problems. When people who’ve put their money in a bank start to lose confidence in it, then they tend to all want to withdraw their money in the form of precious metals (or ‘hard’ currency) all at once. If the bank doesn’t have enough on hand to actually pay out, then it fails – which means that everyone who’s put money in that bank lose their savings, and everyone who’s borrowed money from it lose their loans. However, it also means that when banks do have the confidence of their customers, they can offer loans far in excess of their actual reserves. That also means that an institution in need of an enormous amount of money and possessed of enough stability to seem able to pay the interest on any loan (like say, a government) can suddenly borrow far more money than their supply of precious metals would usually let them.
This is the basis of fractional reserve banking, a system which massively increased the amount of money available to a given state without actually increasing the amount of precious metals that state actually owns. Indeed, such a system became so effective that most states eventually created their own central banks, which exist primarily to loan a given government the necessary funds it needs to pay its soldiers and maintain its bureaucracy and public policy. So long as the people governed by a state had enough confidence in the idea that the government would remain stable enough and possessed enough precious metals to meet its financial obligations (which is to say, to pay the interest on its ‘sovereign’ debt to the central bank) then that government effectively had access to as much money as it could ever need. Naturally, this proved a massive advantage against states which didn’t have a system like this, and meant that relatively small countries with developed central banks and fractional reserve banking could outspend bigger ones which still relied on their reserves of precious metal entirely.
However, even at this point, the system still indirectly rested on the value of precious metals. The banknotes of the central bank (which, in most cases, eventually became the state’s universal currency, what we think of as ‘paper money’) were still ‘backed’ by gold or silver. This meant that the value of the currency was still affected by the perceived value of the precious metal in question – and that the central bank and the state still had to keep considerable reserves of precious metals on hand, to maintain public confidence that if necessary, the state could pay back its debts, and the bank was still solvent enough to offer loans and ‘back’ the banknotes they distributed to ordinary citizens. This limited the ability of the state to create ‘new’ money – a distinct problem when economies grew, because if the increase of goods circulating in the economy was not met by the amount of money in circulation, money would be perceived as growing more valuable over time, with the end result that people would save their money in the hopes that it would grow more valuable, and thus preventing economic activity altogether.
The solution to these shortcomings was to cut the idea of precious metals out of the monetary system altogether. Instead of being backed by the value of a precious metal, the central bank’s banknotes would have a certain value simply because the state says so. This is what we refer to as ‘fiat currency’.
Fiat Currency comes in for a lot of scepticism and mockery from some quarters, and that’s because the idea comes across at first glance as something absurd: why accept that a thing has value when it is not backed by something valuable? But those who have been paying attention will remember that value is a social construct, and those who understand how states function might have already realised that fiat currency is backed by something: namely, public confidence in the state to maintain the peace, uphold its laws, provide its promised public goods, and do all the other things the state has promised its people it would do. Just as most people in a functioning society obey that society’s laws not because of a direct threat of punishment, but because their association of lawbreaking with punishment has become so heavily internalised that they automatically associate the two in their heads, a stable state capable of enforcing the value of its fiat currency reliably is one where the people within associate the idea of that currency with its declared value so heavily that it becomes second nature to do so. The value of the state’s currency becomes a consensus, because it’s backed by something (the state’s ability to provide security and enforce its policy) which is more stable, and generally considered more useful than gold or silver.
Of course, as I’ve mentioned before, I’m not an economist, or even an economic historian, so I’ve probably missed some details and generally made some mistakes, but I think the broad outline of all of this is correct. It also provides some basic principles to adhere to as a creator when worldbuilding the development of a society’s economy. Namely, that societies will innovate new ways to calculate and exchange value when they feel limited or disadvantaged by existing systems, that they’ll often do this by using existing systems in new ways. It also shows that the result is often a system that relies on a more abstract definition of value, albeit one which is still recognisably a social construct agreed upon – ultimately – by the consensus of those engaging in it.
Hopefully, this rather extended and somewhat rambling digression into economics has helped flesh out an understanding of economics (or at least, demonstrated what I *don’t* know about economics) for some of those reading this. Next time, we (hopefully) go back to a subject I actually have some formal expertise in.