Philosophy of Currency
Thoughts on the origin & meaning of currency, credit, and debt.
By Davis Clute
There are at least two major theories on the creation of currency, credit, and debt. The first is that credit is a byproduct of currency. The second is the exact opposite — that currency is a byproduct of credit. I’ll go through both of these theories with pictures, examples, etc. Finally, I will attempt to answer the following question: “Assuming the second theory above, how does one explain QE & inflation?”
Theory 1: Bartering → Currency → Credit/Debt
The traditional economics story goes like this: Ancient economies used bartering. Bartering only worked as long as there was a ‘coincidence of wants’ — i.e. if I want your stone tools today, you must also want my chickens today. This ‘coincidence of wants’ was improbable to constantly occur — thus, currency was created to take the place of bartering. After currency was created, concepts like credit and debt emerged. We see credit/debt emerge only after the prevalence of a stable currency/monetary system. See the below picture for a visual representation of this:
Theory 2: Credit → Debt/Currency
The second theory is completely inverted from the first, and relatively counterintuitive. Imagine the same above scenario: I have a chicken and Gort has a stone tool. I need a stone tool today and would be willing to trade my chicken for it. Unfortunately, Gort doesn’t need a chicken today. Although he doesn’t necessarily need his stone tool today, either. Gort instead gives me his stone tool in return for an IOU — and this IOU is ‘equivalent’ to one stone tool (see below picture). Especially pay attention to the beginning and ending totals. We started with just one chicken and one stone tool — but now we have one chicken, one tool, and one ‘stone tool IOU.’ We have literally just created currency and economic activity out of nothing. Interestingly, this is exactly how early trade and economics worked according to anthropologist David Graeber. He makes quiet a strong case that Theory 1 (bartering first) never happened. He criticizes mainstream economics for perpetuating this ‘bartering myth’ — as Graeber contends it is blatantly incorrect. He surmises economists continue to use the bartering story because it provides a simple, tidy story for the origin of money and economics in general.
Now that Gort has an IOU for an equivalent stone tool, he could now trade it to a 3rd party. As long as I am trusted to pay back the IOU, it could trade hands 1,000 times. In a village of 500 people, though, this can quickly get complex to keep track of. Many in history have cut notches into a reed rod to keep track of how many ‘equivalent stone tools’ somebody owes them. These reed rods then, essentially, become currency.
Effectively you start with buying things on credit. This quickly gets complex — thus, currency is created to keep track of IOUs. This is where the concept of debt emerges. Debt is a specific quantification of credit. Currency allows very precise measures of debt to occur. Also, more than simply being an IOU, currency must have a ‘standard’ value. To say that a piece of bread is 10 ‘coins,’ and to say that a sword is 15 ‘coins,’ one must have a stable notion of what one coin is ‘worth.’ A currency can have an abstract notion of ‘worth,’ as long as that abstract notion is largely the same across the board. It does not have to be ‘worth’ anything in gold, silver, etc. See below picture for a visual representation of the above paragraphs.
How, then, do we explain QE & Money Creation?
If we accept the notion that currency is fundamentally just an accounting system for IOUs, printing money under a fiat currency system is a tough concept to understand. What is the government ‘owing’ to the people who accept its IOUs (i.e. dollars, yen, etc.)? The IOU is not backed up by gold or silver, it is fiat currency — i.e. ‘faith’ currency. Thus, the government does not necessarily ‘owe’ anybody anything. In a fiat currency system, I think it’s better to think about the bank notes as ‘votes of confidence’ rather than ‘IOUs.’ When people use/accept fiat currency, they are implicitly acknowledging they have faith in the government’s power to tax real economic activity — such as labor, transportation, consumer goods, etc. If the government did not have the power to tax real economic activity, then the currency would be in a philosophically weak position. This has nothing to do with a currency’s ability to be redeemed in gold/silver.
Sal Khan proposed a very convincing argument for fiat currency vs. commodity backed currency: Gold is completely useless, except for the psychological perception that it is intrinsically valuable. Thus, your choice in his example is this: would you rather have 1) a currency backed by a useless metal whose value is psychological (i.e. gold), or, 2) a currency backed by an entity (i.e. the government) which has the ability to tax real economic activity such as labor, trade, transportation, etc. This distinction by Sal is very relevant to the discussion of printing money (i.e. printing IOUs) in a fiat currency system.
As a more minute distinction, the Fed creates money — not the government, per se. The Fed creates money by literally creating it out of thin air. On the liability side of its balance sheet, it creates outstanding bank notes (i.e. IOUs). On the asset side, the money is booked as a loan — primarily through the purchase of Treasury bonds. Here, there is still the fundamental question of, “What exactly are the bank notes good for? Why are they ‘liabilities’ and what exactly is owed by the Fed?” Nothing is really owed, per se. It is probably best to think of the IOU more as a vote of confidence. The Fed/Treasury simply ‘owes’ future stability to those which hold the currency. It’s tough to conceptualize in anything but an abstract, amorphous sense.
Note: Much credit to David Graeber’s book, “Debt: The First 5,000 Years” for exposing me to these arguments and making me think quite deeply about the topic.