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The Moron’s Guide to Money: What gives money its value? And what is the gold standard?

O.K., you don’t have to be a moron to not know how money — especially paper money — gets its value. I learned some things, too, as I did the research for this article.

To start with, money may not be what you think it is. Ninety percent of the money in the United States does not exist as either coins or paper bills. Most money in the United States exists as credits on balance sheets in computers and never becomes hard money. So, what gives money its value when it is usually not even real in the sense of tangible? The following is a short version of the history of money.

A brief history of paper money before we delve into the history of money in America

The first paper money, known more formally as “notes,” was invented in China in about A.D. 700 when it was determined that moving physical coins around was much too difficult because of their weight and bulk. The Chinese were first to realize that a whole cartload of coins could be summed up on one sheet of paper that was a pledge from one individual or institution to another.

A person could trade goods for, say, 100,000 coins of a certain value in a city he often travelled to on business, but it would take two asses and two carts to move all of that money back to his home city. Since he came her often, it would sure be easier if he could just leave all the coins here. So, he would go to the buyer’s bank or even just the buyer’s own place of business and get just a note stating the coins were being held in deposit for him in that city. Three months later, he could return and sell something in that city to someone else in exchange for that note because the next person also recognized the note and the institution behind it. The original bearer of the note might never actually see the coins, which would just be changed in ownership to someone else.

As it soon turned out, the coins did not even have to be held in the vaults of the institution that issued the note. So long as the note said he had that much money with that institution that was all that mattered. If the institution was a band that had a reputation back in his home city, he could even give the bank note to someone in his own city to complete another sale there. Bank notes became preferable when it came to transaction involving large amounts of precious metals or coins. Paper money depended on the perception of value in the institution standing behind it and the credibility of note (i.e, whether or not a buyer could trust that a given note was really from the institution it claimed to be from).

A brief history of money in the United States of America

Precious-metal coins and paper currency have run alongside each other in the United States since long before the thirteen English colonies revolted and became the United States of America. Paper money history in America began with the Massachusetts Bay Colony in 1690. Believe it or not, none of it was issued by Colonial governments. In fact, money issued by the government came along late in the day. The United States of America did not begin with the “Gold Standard” you’ve heard of. It did not begin with any standard at all. The history of American money is one of experimentation. The Massachusetts Bay Colony printed its own money, used within the colony like company scrip an spreading gradually beyond the colony in acceptability among people outside who traded with the colony.

Instead of government money as we take for granted, banks issued their own bank notes that people could use as cash. Just as in China, it was a promissory note (a promise) that the bank would give the bearer of the note gold or coin in exchange for the note, so the note could be used as a ready substitute for the gold so long as you trusted that bank. Again, the value of the note depended on the reputation and financial strength of the bank. As a result, people traded many different kinds of paper money because of its convenience but preferred coin because paper money could easily become worthless if the institution issuing it failed. One buyer might accept company scrip, another might take only raw gold. So, trading depended not just on establishing an agreeable price between two people, but on their finding a mutually agreeable currency.

The Continental Congress tried to establish the first national paper money in the U.S., which it called the “Continental.” It was not intended so much to establish a mutually agreeable currency throughout the land as to raise money for the Revolutionary War. It was not backed by any asset (no gold), but was simply a pledge that could be used as cash between bearers with the promise from the Continental government that it could be redeemed eventually for gold or coin after the war. It was a pledge from the upstart government against revenue that would come in from future tax money if the war was successful. People were literally banking on the success of the American enterprise at its core in those days — banking on the success of America itself. Using the new money was an act of patriotism.

The history of US money (i.e., the history of lawful money) got off to a rough start, for Continentals turned out to be easily counterfeited. In spite of all the noble intentions behind the,  they quickly lost value in the end because all kinds of them came into being out of nowhere … more than Congress could ever honor. Paper money was not just dependent on the strength of the institution behind it but on the credibility of the actual note. As a result of that bad start, the Continental Congress went out of the money-printing business and limited states to producing money in the form of gold and silver coin at about the time that the U.S. Constitution came into being. Which brings up the next question.

Money 1.0: How do coins get their value?

So, let’s step back for a moment to the simplest and most broadly accepted kind of “tender” for trade, which is coin — usually gold of silver. Here the value is easy to understand. Originally, the value of the coin is in the metal it contains. Coins have intrinsic worth because almost all human cultures have valued gold and silver throughout human history, and they are rare enough that you cannot easily go out and dig up your own. Coins have always been more trusted than paper because of this intrinsic value.

Trust in coins, however, is not failsafe or assured. How do you know how much gold or silver is in a coin and what it’s worth? The purpose of the government mint was to overcome this concern by stamping the worth on the gold or silver on the metal as a seal that it met a government standard of content. People were actually trading gold or silver, and the mint merely assured all parties of the value of gold or silver in the object. You could know the value of precious metals in each coin because of the trusted government mint.

Or could you? It’s not hard to fake a government-minted coin by making an impression of one and casting your own of baser metals. Thus, people bit coins to try to test their hardness or maybe scratch through the surface to make sure the gold was not just a thin plate. Another disadvantage of coin, besides its cumbersome weight is that the open-market value of the precious metals or semi-precious in the case of lower-value coins like pennies and nickels) contains may change. Whenever the open-market value of gold and silver exceeded the face value of coinage, coins were hoarded and melted down so that money evaporated out of the monetary system without anyone’s knowledge of how much was gone.

With time, coins no longer contained the metal of value, but just the stamp. Since they were still the legal tender for transactions and the government kept them sufficiently rare, they remained of value. Once they have passed to this level, they are really just a maker of earned credits for paying debts. Perception is reality with respect to the value of money. What gives money its essential value is that everyone recognizes that it is either made out of something that nearly everyone wants or is backed by an institution that will exchange it for something that everyone wants and that you cannot just readily get as much of it as you want. You have to work to extract them from the economy. Value, in other words, is perceived and always involves some degree of trust.

Money 2.0: Paper currency, and what is the gold standard?

Many people today assume that paper money in the U.S. was on “the gold standard” in the beginning, but this is not the case. When The U.S. government did start printing money, it was alongside the banknotes printed in the country by many other institutions. It was, in other words, one option for money in the U.S.. When the U.S. did go on a precious-metals standard, it operated under a “bimetalic standard” for part of its early years until after the Civil War, not a strict “gold standard.” In fact, it was not until the gold standard was established in The Coinage Act of 1873 that the U.S. finally required people to use its own minted money. The bi-metal standard based the value of U.S. currency on a combination of the value of gold and the value of silver.

The idea of the gold standard is like the Chinese basis for paper money: the government states in its own policy that it can only print as much paper money (notes/bills) as it can back with the value of gold in its treasury. The good faith of the government stands behind the bills as the government pledges to exchange the bills for gold to the bearer upon demand. People put a lot of confidence in the paper currency if it is backed by a government that is highly trustworth with its money. Early U.S. paper money started off as gold or silver “certificates” that looked like our dollars today, which gave the possessor the advantage of not having to pack around the heavy ballast of metal along with the confidence of knowing they could easily get the metal if they wanted it.

But there is a problem with paper currency based on a metal standard as well as with coins, either has the problem of limiting currency to the amount of gold a nation can hoard in its own coffers. As the nation needed more and more of it, it actually had to make it illegal for people to own gold over a certain quantity. The government’s hoarding of these metals took huge amounts gold and silver forever out of industrial use as well — “forever” meaning as long as the government staid on the gold standard. The difficulty of getting enough of the metals to back money also put limits on money supply based solely on ability to find precious metals and obtain them. With an ever burgeoning population, that became a problem. The government had a hard time collecting enough gold just to keep the balance per capita even through years of immigration and natural population growth.

So, the U.S. began to sort of cheat its own standard by devaluing the money in order to be able to print enough of it. It did that by essentially decreeing, “From now on only a percentage of our currency will be backed by gold and the rest by good faith in the government.” In other words, “We’ll now allow ourselves to print 10% more “money” than what we hold in gold and other precious minerals in order to let the economy expand to match an expanding population and growing industrialization because we cannot find gold fast enough.” (Bear in mind, this is a simplified version, for the price of gold could be and was regulated for a time, but that is problematic when it is sold on a world market that doesn’t observe the same regulations.)

Once the U.S. started devaluing its money on the gold standard, one could no longer get the full value in silver or gold by redeeming the bill. As pointed out above, though, the value of currency is based largely in trust in the institution issuing it. (Trust that the institution will give you the gold if asked or that they have the gold and that they are protecting their currency from counterfeiters, etc.) So, money in any form is based on trust that has to be protected. Eventually, U.S. notes had been used for so long that they were perceived as having value, regardless of how much gold was behind them, simply because they worked and kept on working … well, usually kept on working, but several crashes brought down the value of U.S. currency, too.

In short, when everyone perceives the money has value, the the money does have value for the same reason gold has value — everyone wants it. Gold, of course, has intrinsic value because you can use it to make jewelry and electronics, etc.; but most of its value comes from the fact that everyone desires it and it is rare. So, the secret of maintaining the value of currency is to keep it sufficiently rare and keep everyone wanting it.

After the United States had gone down the path of cheating on its own standard so long that the dollar was only backed about 10% by gold, President Nixon decided the government might as well do away with the gold standard altogether. Why be tied to something that had become more of a quaint reminder of what money used to be than a reality? Since most of the money of paper currency came from trust, even before the U.S. was on a gold standard, the main thing was maintaining that trust.

In summary, the trust that creates value in paper money is an art and science of monitoring the money and regulating it and protecting it with diligence by policing countefeits. The U.S. did not always have a central bank to do this regulation. From the beginning, it has experimented with various monetary systems concurrently and has existed in and out of having central banks from the time of the First Bank of the United States under Alexander Hamilton — its charter signed by President George Washington. The longest stretch with no central or government bank in the U.S. was almost half a century. The US also found that it experienced a great deal of volatility in it currencies when it tried operating without a central bank. A solid central bank is the component of a monetary system that maintains the trust … along with a police force and court system to back the regulations that keep money sufficiently rare and sufficiently trusted to be used as exchange in trade. The present Federal Reserve System is what has evolved out of those sometimes volatile experiments to maintain the value of US money, and that will be discussed in the next article: The US Federal Reserve System for Dummies.

 

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