Money is an enabler for any financial transaction and is regarded as a measure and store of value by people who consent to use it for their transactions. The earliest civilizations denominated money in livestock, food grains, spices, salt, among many other things. Goods were exchanged for these items, for instance, salt was used for commerce and trade in ancient Rome to an extent that historians often speculate, if the salaries to the soldiers in the Roman empire were also paid in salt [1]. Salt was a valuable commodity due to its common use as a preservative for food. In fact, a quick look at the etymology of the word ‘salary’ would suggest that it originates from ‘sal,’ which is the Latin word for ‘salt.’ The monthly allowance received by the Roman army was called ‘salarium’ [2] that made it to the French word ‘salaire’ and eventually into the English language as the word ‘salary.’ While ‘salary’ in terms of ‘salt’ remains a matter of speculation, as there is no hard evidence apart from the claims of a few historians, what all of us very well know is that another commodity, i.e., gold, has definitely been used for paying salaries. Over the past many centuries, followed by the inefficiencies of barter for transactions, money has been a facilitator for conducting faster and efficient business. It has taken various physical forms, as coins and notes, and now also exists as electronically written records. Money serves three important functions in an economy, namely, 1) a medium of exchange (a generally accepted and recognized medium for transaction of goods and serves), 2) a store of value (a means to store value for the future from the current production or trade of goods and services) and 3) a unit of account (a means to make accounting of profits and losses from multiple different transactions of goods and services easier).
Barter system
Almost all civilizations of the world at some point in time have relied on barter system, where people exchanged goods and services for other goods and services in return. Bartering has its own advantages; for example, it does not require any additional item (cash) for transactions, it helps people fulfil their needs by exchanging things that they already have and it is a mutually negotiated deal that does not involve any other party. Bartering remains a mode of transaction for the masses in societies whenever there is a monetary crisis, like the failure of the centralized banking system leading to money being in short supply or high devaluation because of hyperinflation. During the Great Depression of the 1930s, barter became a way of transaction for a larger number of people due to the short supply of money, and similarly as recently as in 2019 people relied on barter because of their currency devaluation during the Venezuelan crisis.
However, barter comes with its own inefficiencies and disadvantages. For example, one of the major problems is the ‘double coincidence of wants,’ i.e., a barter can occur only between two parties who have what the other wants. The second problem is the lack of a standardized and common unit of measure of value for items that would necessitate the exchange ratios for two goods to be negotiated for every transaction. The third is the problem of indivisibility, because of which an agreed ratio of 10 kgs of wheat with 5 chickens will not be realized as a transaction if the person with chickens is interested in only 5 kgs of wheat. Finally, bartering makes it difficult to store wealth, such as, it will be difficult for a person with perishable goods to store wealth for the future unless the person converts those items immediately into durable goods like livestock.
Commodity money
The disadvantages of barter necessitated the introduction of money so that business and transactions can be done much more efficiently and at a much faster pace. The first currencies were in the form of commodities, like salt, shells and silk, and were referred to as commodity money. Grains, such as barley, were used for trade and commerce during the Mesopotamian civilization around 3000 BC [3]. A particular quantity of the commodity used for transactions formed a unit of money and units were exchanged based on the perception of the value of the item to be purchased. The use of commodity money can still be perceived as barter, but the acceptance of a common denomination by masses that represents a unit of account was a significant transition. However, these commodities were soon replaced with another form of commodity money, i.e., metal coins, which were primarily made of gold, silver, copper, tin or its alloys. The transition from commodities, like salt, shells and silk, to coins was important because of the inconvenience caused in their transport, storage and the possible perishing and spoilage. Metal coins were much more durable, easy to store and transport than other commodities. These metal coins that acted as denominations were often stamped with pictures and their exchange value was usually controlled by central governing or religious authorities.
Fiat money
Convenience drove the evolution of paper money, when merchants in China as long as 1500 years ago issued promissory notes to avoid using a bulk of metal coins in large commercial transactions with wholesalers. In such cases, the metal coins were left by the merchants with a party trusted by the transactors and the merchant could issue a slip of paper in return of the material received from the wholesaler [4]. The actual coins could later be collected by the wholesaler from the party entrusted with keeping the coins. Similarly, small pieces of cloth having exchange rate mentioned on it against silver have been used as a means of trade in Europe as long as 1000 years ago. A rapid inflation of precious metals with the exploration of more and more reserves compelled a rethinking regarding how money works. In Europe, gold coins evolved into bank notes in the 17th century, when goldsmith bankers of London started giving out receipts as payable to the bearer of the document irrespective of who was the original depositor. This converted these bank notes into modern-day currencies as it could be exchanged for transactions with the goldsmith providing the security [5]. Of course, the goldsmith bankers also realized that they could issue a greater value of bank notes than the physical value of their reserves as not all the notes would be redeemed simultaneously.
A conversion of the large value receipts to multiple smaller fixed denomination receipts for ease of transaction essentially converted these bank notes to currencies with a written order by the goldsmith bankers to pay the amount to whoever was in the possession of the bank note. Interestingly, issuing bank notes that exceed the value of the precious metal in possession of the bankers leads to a counterparty risk that the bank may not be able to make the payment when presented with the note. The evolution of gold coins into bank notes led to the gold bullion standard in which gold coins no more circulated in the economy, rather an authority promises to give the bearer of the circulating currency an equivalent amount of gold bullion.
Historically, gold standard and silver standard have been used in monetary systems where the unit of account is based on a fixed quantity of gold or silver. In fact, gold was the basis for international monetary transactions until as late as 1970s, where some international currencies used gold as a backing, which determined the exchange rates. Most countries had legal minimum ratio of gold to currency notes that they need to maintain, and the international balance of payment differences were settled in gold. Post-World War I, several industrial countries abandoned the gold standard as the monetary system because of the constraints that it puts on the governments on using the supply of money as an instrument to manage recessions.
The necessity of being able to convert currency notes into gold whenever the bearer of the notes demands it, puts a strict restriction on the amount of currency notes that can be circulated. These issues led the countries to transition into fiat money where the currency is not backed by any commodity, like gold or silver, rather derives its value from the trust that people place on it, given that it has been issued by a central authority like a government institution of a country. Fiat money does not have any intrinsic value but can still be used as a medium of exchange because of the trust which people place in it and the value which they assign to it. While bank notes backed by bullion in the 17th century Europe was a form of representative money as it represented something of value stored elsewhere, fiat money is not even a form of representative money. It is a legal tender issued by a state or any other institution that serves as a medium of exchange. It does not derive its value from its form, as it is a non-valuable object, but through a measure of its demand and the extent to which it makes transactions easy.
Out of the various forms of money in history, some forms have worked better because of one or more of the following characteristics that make them useful, i.e., durability, transportability, divisibility, uniformity, scarcity, counterfeitability and acceptability [6]. Fiat money in paper form has often suffered on two characteristics, namely, durability and counterfeitability.
Recommended by LinkedIn
Cryptocurrency
Bitcoin is one of the earliest cryptocurrencies (digital currency) and an alternative to a state or central bank-controlled fiat money. The question is, what is bitcoin similar to? It is not a commodity that can be put to use, it is not similar to a precious metal like gold, and nor it is similar to fiat money that is backed by a central authority. However, if one looks at the functions and characteristics of money that we highlighted earlier, one will observe that it does fulfil most of the criteria. Let us look at the characteristics mentioned earlier individually: a bitcoin is durable as it can live on the network for as long as the network exists; a bitcoin can easily be transported on the network through digital transactions; a bitcoin is highly divisible (up to eight decimal points); a bitcoin is uniform that means one bitcoin can be exchanged for the other; a bitcoin is scarce that means its supply is limited; and a bitcoin cannot be counterfeited easily. The only characteristic that if fulfilled will make it a widely acceptable currency is ‘acceptability.’ Given that a bitcoin satisfies the important characteristics of money, it serves the functions of money as well, i.e., a store of value, a medium of exchange and a unit of account. As we just saw, a currency derives its value not from the consumption or physical attributes, but through a measure of its demand and ability to stimulate trade and commerce. While it can be argued that, for some of the characteristics of money, bitcoin outperforms fiat currency, it is noteworthy that Bitcoin has faced its own challenges in recent years in terms of hacks and frauds.
Most of the discussions in the media about cryptocurrencies are about its volatility and valuation. The volatility for such currencies is often high as people speculate about the future use and valuation of digital currencies. This often raises a question as to how one would even do the valuation of such currencies. Let us assume that an individual is confident that in 10 years, the 21 million bitcoins in circulation will support the production of goods and services globally to the tune of 10 trillion USD annually. This can be thought of as a country that has an annual GDP of 10 trillion USD. Assuming that the amount of currency required for supporting a GDP of 10 trillion USD is 20% of GDP (i.e., 2 trillion USD), it would put the value of 21 million bitcoins at 2 trillion, or the value of a single bitcoin at 95,238 USD in 10 years. Assuming a time discounting rate of 5%, this amounts to a value of 58,471 USD today. Of course, the real picture is much more complex than this simple explanation. The speculation on the chances of bitcoins supporting a multi-trillion-dollar economy and the true size of the economy over the next few years leads to volatility in the currency. Any threat to the technology puts a question mark on this long-term assumption and pushes the value down, while any country or organization showing support or accepting bitcoins for transactions adds weight to the assumption and pushes the value up.
One is often curious about how cryptocurrencies are able to eliminate a centrally controlled authority and sustain on their own through decentralized nodes in a network. In a blockchain network, decentralization implies the shift in the power from a centralized authority to a dispersed network. One of the important aspects to achieve decentralization would be to ensure that the dispersed nodes in the network do not have the ability to collude to form a centralized authority that can corrupt the potency of the network. However, at the same time, some level of coordination and collaboration is expected among strangers based on an agreed set of rules that help in the sustainability of the network and create value through efficiency, equitability and privacy. Often referred to as peer-to-peer network, where the nodes interact or communicate with each other, the network facilitates democratization through distribution of power and evolves through consensus. We often outsource trust for a fee to a third-party that ensures that a contract between two parties is backed by the legal system to uphold one’s rights in case of the violation of an agreement. The underpinnings of a decentralized system, like bitcoin, lies in the game-theoretic design of a network where trust is established through an incentive structure for a large group of nodes. For instance, the authenticity of a transaction made from one user of the network to another user of the network is authenticated by group of nodes through a consensus; the game-design ensures that the nodes establishing trust are incentivized and any collusion or attack from these nodes is expensive for them to an extent that it is almost infeasible in practice.
Finally, cryptocurrencies can be programmed through logic to create contracts that would get auto-executed when the pre-determined conditions between the buyer and the seller are met. This makes such digital currencies programmable and opens a massive space of smart contracts that eliminates intermediaries, thereby leading to savings in execution time and fees. Over the years several other cryptocurrencies apart from bitcoins, known as ‘altcoins,’ have spawned in the crypto-space. Most of these ‘altcoins’ have specific use-cases that span beyond digital money or decentralized finance; for instance, some of the most talked-about use-cases are in the areas of supply chain management, internet of things (IoT), asset digitization, data security and management, original content creation, etc.
REFERENCES
Círillo, M., Capasso, G., Leo, V.A.D., & Santo, N.G.D. (1994). A History of Salt. American Journal of Nephrology, 14(1), 426–431.
Millar, F. G. B., & Burton, G. (2016). salarium. InOxford Research Encyclopedia of Classics.
Edens, C. (1992). Dynamics of trade in the ancient Mesopotamian “world system”.American Anthropologist,94(1), 118–139.
Moshenskyi, S. (2008).History of the Weksel: Bill of exchange and promissory note. New York: Xlibris.
Kim, J. (2011). How modern banking originated: The London goldsmith-bankers' institutionalisation of trust.Business History,53(6), 939–959.
Greco, T. (2001).Money: Understanding and creating alternatives to legal tender. Chelsea Green Publishing.
Ankur Sinha is a faculty member at Indian Institute of Management Ahmedabad (IIMA). The above article has been extracted from the Communique (January 2022) released by the Centre for Data Science and Artificial Intelligence at IIMA. The article can be referred to as follows:
Sinha, A. "From Barter to Crypto: The Evolution of Money." Communique, Centre for Data Science and Artificial Intelligence, Indian Institute of Management Ahmedabad (January 2022).
