3.3 hunting The Monster: a Brief (Partially Fictional) History of Money
To hunt down th eInflation Monster, and to understand how it evolved, it is necessary to know a little about te history of money. Unfortunately most histories of money get distracted n the details of Pacific islanders swapping seasels, prisoners-of-war trading cigarettes, or the artistic merit of ancient Persiann coinage, these histories are interesting as histories but are of litle help in understanding how today's financial system works. For this reason, in the following section I have made up a fictional history of money to convey something of how we arrived at our current monetary system, the key elements of the system, and how the Inflation Monster came into being.
3.3.1 barter exchange
Long, long ago, the first trade was coducted ia barter. All goods were exchanged directly for all other goods. It wasn't great system; if you wanted to swap your chieken for a loaf of bread,
but the baker happened to want firewood, you were stuck with the task of traipsing around the market square until you could find someone wih firewood who just happened to want a chiken. Despite its drawbacks we muddled along with barter exchange for a few hundred thousand years. Unsurprisingl, this period was not one of rapid economic growth.
Growth may have been lacking but at least financial instability was ot a problem. All goods were exchanged for each other n real time; no finance means o financial instability. In the barter exchange economy there is no sign of an Inflation Monster; no one would scatter valuable chickens around a arketplace for free.
3.3.2 Gold exchange
The first big breakthrough in finance came when everyone agreed that bartwer exchange was just taking too long. under the new system everyone agreed to acept gold in return for whatever they were selling. this transition allowed the swappig of chickens for gold and then gold for ayhing else - the baker could jolly well find his own firewood.
Once gold took on the role of a recognised means of exchange it also inadvertently became a store of value. If i one season ou happened to have a lot of chickens, you ould swap all of the chickens for gold, spend oly part of the gold on bread, and keep a few nuggets for a rainy day.
Money becoing a store of value was the start of monetary inflation cycles and a prototype of financial instability. If you happened to have too many chickens this season, the chances were so would all the other chicken sellers. If everyone tried to sell at the same timek, there would be too many chickens chasing too litle gold and pretty soon you'd have chicken deflation, or gold inflation deending on our perspective.
The emergence of gold's secondayr function as a store of value allowed demand to be transfered through time. Under a gold exchange system sometimes wihin specific oods and sometimes more generaly, most likely linked to harvests, wars, disease and the like. However, thewse would have been cycles, that is to say prices would hae gone up and then down, but on average staed more or less the same over very long periods.
At this stage we could get price cycles but there is no systematic trend toward higher prices, and there is certainly no sign of any Inflation Monster randomly scattering nuggets across the marketplace.
3.3.3 Gold money (coins)
Economically speaking, the step from gold exchange to gold coins was evolutionary rather than revolutionary. the main breakthrough was the agreement to divide the gold up ito uniform manageable lumps of equal weight and equal purity.
The invention of coins made trade easier, and encouraged economic so carrying and securing the cons became more troublesome. an annoying habit of coin cliping also emerged, where people would shave gold from the edes of the coins, and turn these clippings into more coins. this was the start of monetary debasement, It took the genius of none other than Isaac Newton to come up with the idea of millng fine lines onto the edges of the coins, making it easier to detect if the coins had been clipped.
while coincliping was practiced within the private sector, in the state sector monetary debasement took on an industrial scale. governments, especially when in financial trouble, would recall their coinage, melt it down and reform the metal into more coins with a lower gold content. Private sector coin clipping was a crime punishable by death; public sector coin clipping (recoinage) was considered monetary policy; both caused an increase int he number of coins relative to goods and therefore inflation.
Needless to say the process of recoinage, whereby the government demanded its population turn over their coins and hve the replaced by new worth-less coins, was not a popular procedure. For government, however, it enerated a nice new pile of gold for conersion into extra coins for their own coffers.
Recoinage, or debasement, the process of progressively reducing the gold content of coins, represents the conception point for a prototype Inflation Monster. But recoinage was a difficult time-consuming process, which was conducted only occasionally. When it happened there would be a sudden flood of extra money into the system, met by a burst of inflation. However, once the prices had adjusted to the new coinage inflation would stop once more.
Even with recoinage there is still absolutely no sign of the ECb's Inflation Monster throwing away coins in the market square. Recoinage was orchestrated for the purpose of generating extra coins to be thrown in the direction of the government - not given out for free in the market square. The inflationary recoinage engaged in by Newton had much to do with England's budget deficit as a result of it being at war with europe at the time; the conection between inflation and war financing remains with us to this day. The key point to take away from this is the close connection between taxation and inflation. The two are almost synonymous, with inflation representing a retrospective taxation.
3.3.4 Gold certificates
The next big leap in the development of money was revolutionary and came with the inventio of certificates of gold deposts. Debasement, coin clipping and the larger monetary transactions, due to economic expansion, meant that gold coins became difficult to deal with. Each transaction required that the coins be counted, weighed and checked for purity and athenticity. In addition to which there was the costant problem of security; it is presumably quite difficult to conceal a thousand gold sovereigns about your person.
These problems lead to the develoment of gold depositor banks. Groups of merhcants got together to form merchant banks tha twould hold their gold securely at a central location. The quality of the coinage was checked as it was deposited, and the depositor was issued with a paper certificate of deposit. The certificate of deposit represented his holdings of gold within the bank and the holder of this certificate was entitled to present the certificate back to the bank, who would, on demand, exchange it for the same amount of gold coins originally deposited.
On the face of it the development of gold depositorybanks and the use of gold ceritificates of deposit, for trade, looked like merely a technical change in how gold was moved between merchants. But this technical change was to lead to an entirely new financial system, and the emergence of modern day financial instability.
The depository banks soon worked out that the merchants who had depositd their gold very rarely came back to collect it. What's more, the small inflows and outflows of gold that did occur tended, on most days, to cancel one another out. As a result the baners found themseves sitting on a large pile of gold coins, which were mostly idle.
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