The Origin of Money
This is the first episode of a series of articles that aim to explore the evolution of the financial system from its historical roots to its present form. It’s a complex topic. My primary goal is to deepen my own understanding of why finance operates the way it does today. There is no shortage of criticism directed at the current financial system, nor is there a lack of voices in support of it. Through my research and (re)study of economy, I hope to uncover the underlying logic that justifies both the critiques and the defenses of the system. From there, I can form my own informed opinion. Writing this series allows me to share my research process and the development of my views. I encourage anyone to comment and ask critical questions.
When discussing the economy, the first topic we must address is money. What is money? There are numerous theories from different perspectives. My approach is to examine history and empirical evidence to understand:
- Why was money created?
- What problems does money solve?
- Why is gold the most long-lived form of money?
The origin of money
When humans lived in small tribes, there was no need for money. People engaged in the direct exchange of goods and services. For example, I hunt a sheep and give it to you, and in return, you would give me a basket of rice. Alternatively, I could give you a sheep today without needing anything in return immediately, but I would expect you to hunt for my family when I fall ill. This system of direct exchange, known as barter, worked well in small communities where everyone knew each other. Trust was inherent, and people were willing to wait until a favor was returned. Additionally, the volume and variety of exchanged goods and favors was limited, making it easy to keep track of them — sufficient just through mental notes.
The situation became more complicated when people began interacting with other tribes they didn’t know. There was no established trust between them, and they might only meet once. If they were to exchange something, the exchange should happen “on the spot”. This is where the term “spot trading” originates. We might have sheep, and they might have spears. If, by chance, we wanted spears and they wanted sheep, a trade could happen. This is the Coincidence of Wants — each party has something the other desires and desires something the other can provide. However, without this coincidence of wants, trade couldn’t happen.
How can two parties who don’t know each other, and don’t have the luxury of time to wait till their favor can be returned, make a trade? To solve this problem, people began using certain items as a medium of exchange. This medium served to overcome the issue of the “coincidence of wants.”
The ideal medium is something that everyone wants at all times.
For many tribes before the Common Era, shells and shell beads became an early choice for money. Historical records show that shells were used as currency in various ancient civilizations, including those in China, Africa, and the Pacific Islands. These items played a crucial role in trade networks that spanned vast distances. Shell beads were particularly valued as an early form of money due to their distinct attributes:
Aesthetic values. Shells were beautiful. People wanted to possess and keep them.
Portability. Shell beads were small and can be made into wearable accessories. People didn’t need to bring them in hands.
Durability. Shells don’t rot and are resistant to wear and tear over time.
Social significance. Possessing a large number of shell beads was a sign of value. It indicated that the person had likely provided significant value to others to have accumulated so many.
Making shell beads required proximity to coastlines, labor, and time. But who controlled the amount of shell beads in circulation? The answer lies with nature and those who possessed the techniques to craft shell beads. When a more advanced tribe mastered the ability to produce shell beads on a large scale, they could flood the market with new beads, leading to their devaluation. Over time, the advent of metal tools and technologies that greatly improved shell processing rendered shells an unsustainable medium of exchange.
Gold won
Over thousands of years, various forms of money have risen and faded — tobacco, cocoa, rai stones, feathers, and grain…These forms of money diminished due to issues such as unstable supply, lack of durability, poor fungibility, or ease of counterfeiting. The evolution of money is a process of natural selection, where only the most reliable forms endure.
Gold has proven to be the most enduring form of money in human history. Its use can be traced back to ancient Egypt between 3000–2000 BCE, where it played a crucial role in culture and trade. In 600 BCE, the Kingdom of Lydia minted the first standardized gold coins, a practice that spread to ancient Greek city-states between 500–100 BCE, and later to the Roman Empire. Gold continued to be a key medium of exchange through the Islamic Caliphates, Medieval Europe, the Age of Exploration and Colonization, and into the Gold Standard Era of the 1800s, when the world’s major economies adopted gold standards. Under this system, currencies were directly convertible into a fixed amount of gold.
Gold outlasted its competitors, proving to be the best form of money over the longest period in history. By observing history, we can identify certain attributes that make a good particularly desirable as a form of money.
Scarcity: A desirable form of money should not have a rapidly increasing supply, as historical evidence shows that a surge in supply leads to devaluation.
Adam Smith, in The Wealth of Nations (1776), discussed the relationship between the available stock and the annual production of commodities, highlighting how scarcity impacts value. Carl Menger’s Principles of Economics (1871) further developed the understanding of how scarcity and production influence value. Ludwig von Mises analyzed commodity money, particularly gold, in alignment with these principles, emphasizing how the existing stock of money relates to new production in determining its value and purchasing power over time.
Building on these theoretical frameworks, the stock-to-flow ratio was developed as a metric to measure the scarcity of a good. In this ratio, “stock” refers to the total above-ground liquid stock, and “flow” refers to new annual production output. Gold has consistently maintained a stock-to-flow ratio between 25x and 100x, meaning new annual production cannot significantly reduce this ratio. Historically, apart from the discovery of new continents, the supply of gold has rarely increased by more than 2% per year, while most other commodities have a stock-to-flow ratio below 1 or 2.
Durability: a good form of money should be easy to save and maintain its integrity over time. It does not rot, rust or break easily. Gold is chemically inert and fire resistant,making it exceptionally stable over long periods.
Divisibility: Money should be divisible into smaller units to facilitate transactions of varying sizes. Gold, being relatively soft compared to many other metals, is highly malleable and ductile in its pure form. This means it can be easily shaped, bent, or divided without breaking, making it an ideal medium for trade.
Portability: A good form of money should be easy to transport across distances. While gold may lack the portability of today’s paper money, it has a very high value-to-weight ratio. For example, a 500g gold bar is worth approximately $39,000 at current price. In this regard, gold outperforms other bulky goods like grain, making it a practical medium for storing and transferring wealth.
Fungibility: individual units of the money should not differ from each other, one unit is as good as any other. An ounce of pure gold is equivalent to any other ounce of pure gold, regardless of its form — whether it’s a bar, a coin, or in some other shape.
Verifiability: the authenticity of money should be easily checked and difficult to counterfeit. Gold, however, falls slightly short in this area. Like other metals, verifying the authenticity of gold isn’t instantaneous and requires careful examination.
Salability: a good form of money should be easily exchanged in the market. This is called Salability, the ease with which a good can be sold in a market at any convenient time at current prevalent prices. Ideally, the seller does not need to make a big discount to sell a large quantity quickly. Most goods experience a decrease in value as supply increases. The more a good’s marginal utility declines with rising quantities, the less suitable it is as money.
Over time, certain goods naturally emerge with a lower rate of diminishing marginal utility, making them more desirable to hold. This leads to increased liquidity and further enhances their salability. Gold, throughout history, has proven to be a highly sellable form of money due to these characteristics.
Ability to Maintain Purchasing Power: a key attribute of money, especially when used as a medium of exchange over time, is its ability to maintain purchasing power. People choose to hold money primarily to preserve their purchasing power. For instance, if I exchange a hunted sheep for a gold coin with the intent of buying five bags of rice later, I expect to still be able to buy those five bags when the time comes, not just four or 3.5 bags. Historical and current events have shown time over time that when a currency is debased and loses its purchasing power, it will eventually be abandoned. The market will naturally gravitate toward a more stable and reliable form of money.
The Roman Empire’s dilution of the Denarius led to inflation and social unrest, eventually causing it to lose its status as the principal currency and significantly undermining the Roman economy. During the French Revolution, the over-issuance of Assignats resulted in hyperinflation, forcing their withdrawal from circulation. This crisis eventually led to a return to a hard currency system, with gold and silver reestablishing themselves as the standard. In modern times, Argentina’s repeated currency crises have driven people to favor the U.S. dollar over holding pesos.
Money, A Result of Market Selection
Throughout the course of civilization, gold’s desirable properties and its expanding use in trade led states to mint coinage to standardize currency. This standardization improved trade efficiency and bolstered the power and status of the states. Before the advent of standardized coinage, payments were made with various metal bullions, which required checking for purity and weight to establish their value. By minting coins of consistent weight and purity, states were able to speed up transactions and enhance trade efficiency.
It is important to note that gold’s role as money was established through market selection, not conferred by government authority. Gold was first adopted in the free market, and only later did states standardize its use in coinage. Historical and empirical evidence supports the argument that money is not a state invention but a result of natural market evolution.
Gold lost its role as currency when the United States ended the Bretton Woods System, effectively disconnecting the dollar from gold. This event marked the beginning of the modern fiat standard. Nevertheless, gold has continued to serve as a valuable investment asset to this day.
The next episode will be about why and how gold lost its role as currency.
References
An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Adam Smith
Principles of Economics (1871), Carl Menger
The Theory of Money and Credit (1912), Ludwig von Mises
Principles of Economics (2023), Saifedean Ammous
Broken Money (2023), Lyn Alden
Coinage Timeline, https://www.worldhistory.org/timeline/coinage/
Gold coin of Croesus, https://www.bbc.co.uk/ahistoryoftheworld/about/transcripts/episode25/
The Decline and Fall of the Denarius in the Third Century A.D.(1916), C.Oman
Assignats or death: The politics and dynamics of hyperinflation in revolutionary France (2022), Bryan P. Cutsinger, Louis Rouanet, Joshua S. Ingber
