Easy Money

1. Money emerged organically to overcome barter's limitations.

The strangest part is that no single person or society, as has been the case with almost every other invention, came up with the concept of money.

Barter's inherent problems. Early human societies relied on barter, exchanging goods directly. This system faced significant challenges, primarily the "mutual coincidence of wants" – needing to find someone who had what you wanted and wanted what you had. Indivisibility of goods also posed problems.

Evolution of a medium. Gradually, societies adopted standardized items as a medium of exchange. These items were chosen based on their marketability, durability, and inherent use. Examples include:

• Almonds in ancient India
• Coconuts in the Nicobar Islands
• Salt in Western Africa (source of "salary")
• Cowry shells in China, India, and Africa
• Tobacco in parts of the United States
• Dried cod in Norway
• Even cigarettes in POW camps

Facilitating specialization. The emergence of money allowed individuals to specialize in producing goods or services they were best at, confident they could exchange their output for anything else they needed. This specialization was crucial for increasing productivity and societal progress, as demonstrated by the complexity of making even a simple toaster today.

2. Metals, especially gold, became the preferred form of money.

Ergo, gold became useful because it was useless.

Metals' advantages. As societies advanced, metals like gold and silver emerged as superior forms of money. They were durable, divisible, portable (high value in small volume), and relatively scarce. Unlike perishable goods or fragile shells, metals retained their value over time and could be easily weighed and assayed for quality.

Gold's unique properties. Gold eventually became the universal money due to its chemical inertness (it doesn't tarnish), stable supply growth, and high density. Its limited practical uses meant that hoarding it for monetary purposes didn't significantly detract from other essential economic activities. This "uselessness" paradoxically made it ideal as a store of value.

From bars to coins. Initially, metals were used in the form of bars, requiring weighing and testing for each transaction. The invention of coins, first in Lydia around 700 BC, standardized weight and quality, guaranteed by the ruler's stamp. This innovation greatly simplified trade and facilitated the growth of markets.

3. Governments throughout history have consistently debased or printed money.

Debasement was used by rulers, time and again, to ‘create money’ to meet their whims, fancies, political considerations and even to wage wars.

Debasement of coins. Once coins became the standard, rulers discovered they could increase their wealth by reducing the precious metal content while maintaining the face value. This practice, known as debasement, allowed them to mint more coins from the same amount of metal. Roman emperors like Nero systematically debased the denarius to finance expenditures, leading to its eventual worthlessness.

Printing paper money. With the advent of paper money, governments found an even easier way to create money: simply printing more of it. This was often done to finance wars or cover budget deficits when taxation or borrowing was difficult. Examples include:

• Mongol-ruled China under Kublai Khan
• French Assignats during the Revolution
• American Continentals during the War of Independence
• German Reichsmarks during hyperinflation after WWI

Consequences of abuse. Excessive debasement or printing inevitably leads to inflation, where money loses its purchasing power. This destroys savings, disrupts trade, and can contribute to economic collapse, as seen in the decline of the Roman Empire and the hyperinflation in post-WWI Germany. Despite these historical lessons, governments repeatedly resort to this method for easy finance.

4. Paper money originated in China and evolved from deposit receipts.

The start of paper money as we can see was based partly on pure fraud.

Chinese innovation. Paper money was first invented in China, where paper, ink, and printing originated. Initially, it developed privately as deposit receipts issued by shops that held valuables for a fee. These receipts, representing deposited wealth, began to circulate as a convenient medium of exchange.

State adoption and abuse. Chinese emperors later adopted paper money, initially backed by metals or commodities. However, they soon realized they could issue notes not fully backed by anything, simply decreeing them legal tender. This led to massive overprinting and hyperinflation, eventually causing the collapse of the Mongol currency system and a return to silver.

European evolution. In Europe, paper money also emerged from deposit banking. Merchants deposited coins with reputable banks (like the Bank of Venice or Bank of Amsterdam) or goldsmiths in London, receiving receipts. These receipts, easier to transfer than heavy coins, began to circulate as money.

Fractional reserve banking. Bankers soon discovered that depositors rarely withdrew all their money simultaneously. They could lend out a portion of the deposited metal or, more profitably, issue new paper receipts (loans) not backed by any physical deposit. This practice, the foundation of fractional reserve banking, allowed banks to create money and credit, often leading to instability when depositors demanded their metal back.

5. Early banking profits stemmed from lending paper money not fully backed by metal.

The main source of profitableness of established banking is the smallness of requisite capital.

Leveraging deposits. Early bankers, initially custodians of deposited gold and silver, realized they could lend out a portion of these deposits for interest. This was the first step towards generating profit beyond simple storage fees.

Issuing unbacked notes. The true profit revolution came with the issuance of paper notes (deposit receipts) that exceeded the physical metal held in reserve. A banker could lend out notes representing far more value than the gold in their vault, earning interest on the entire amount. This fractional reserve system allowed banks to multiply the money supply and their profits.

Profit vs. Risk. The less capital (physical metal) a bank held relative to the paper money it issued, the higher its potential profit. However, this also dramatically increased the risk of a bank run – if too many note holders demanded conversion to gold simultaneously, the bank would fail, as seen with early goldsmith-bankers in London and the Bank of Stockholm.

Incentive for expansion. This inherent profitability of lending unbacked paper created a powerful incentive for banks to expand credit and issue more notes, often beyond prudent limits, contributing to financial instability and panics throughout history.

6. Financial bubbles and panics are a recurring feature of monetary history.

I can calculate the motions of the heavenly bodies, but not the madness of people.

Speculative manias. Periods of easy money or new financial innovations often fuel speculative bubbles, where asset prices rise rapidly based on irrational exuberance rather than fundamental value. Investors, seeing others get rich, pile in, believing they can sell to a "greater fool."

Historical examples:

• The Mississippi Scheme in France (1719-1720), driven by John Law's paper money and monopoly company stock.
• The South Sea Bubble in Britain (1720), involving a company taking on government debt amidst rumors of immense wealth and rampant speculation in various dubious ventures.
• The US real estate boom of the 1830s, fueled by wildcat bank paper money.
• The Argentine debt crisis of the 1880s, financed by British investors.

The inevitable crash. Bubbles eventually burst when confidence erodes, new money stops flowing in, or a triggering event occurs. Prices collapse, leading to panics, bank runs, and widespread bankruptcies. The South Sea Bubble, for instance, ruined many investors, including Isaac Newton.

Human nature persists. Despite repeated historical examples, speculative manias and panics continue to occur, suggesting that the psychological drivers of greed and fear are deeply ingrained in human behavior, often overriding rational judgment in financial markets.

7. The Bank of England evolved into a central bank through state finance and crisis management.

This cosy relationship between the political establishment and the Bank of England ensured that the government kept getting enough money and in return, the bank got a more or less monopoly power to issue paper money...

Origins in government debt. The Bank of England was founded in 1694 primarily to raise funds for King William III's war efforts against France. It lent its initial capital to the government and, in return, received the right to issue paper money (banknotes) up to that amount. This established a symbiotic relationship between the state and the bank.

Gaining monopoly power. Over time, the Bank of England secured concessions from the government, notably a legal prohibition in 1708 preventing banking associations of more than six individuals from issuing paper money. This effectively gave the Bank a monopoly over joint-stock banknote issuance, limiting competition to smaller country banks.

Crisis response and evolution. The Bank's role expanded during financial crises. During the Napoleonic Wars, it suspended gold convertibility and financed much of the government's expenditure by printing money. Later panics, like the one in 1825, highlighted the fragility of the country banking system and led to reforms that strengthened the Bank of England's position, including making its notes legal tender and allowing joint-stock banks further from London.

Formalizing the role. The Peel Act of 1844 further formalized the Bank's central role by separating its issuing and banking departments and linking banknote issuance beyond a certain limit directly to gold reserves. These steps solidified its position as the central bank responsible for managing the nation's money supply and acting as a lender of last resort during panics.

8. The United States struggled with currency stability and central banking for decades.

Senator Nelson Aldrich summed up the situation best when he said, ‘Something has got to be done. We may not always have Pierpont Morgan with us to meet a banking crisis.’

Early currency chaos. The newly formed United States faced persistent currency problems. A shortage of coins led states to use various commodities as legal tender. Early attempts at government paper money (Continentals) during the Revolution resulted in hyperinflation. The bimetallic standard (gold and silver) was unstable due to fluctuating market ratios, causing one metal to disappear from circulation.

First and Second Banks. Attempts to establish central banks (the First Bank of the US, 1791-1811, and the Second Bank of the US, 1816-1836) faced political opposition, concerns about foreign ownership, and debates over constitutionality. While they provided some stability and acted as government bankers, they were ultimately shut down.

Wildcat banking era. The absence of a central bank led to the "wildcat banking" era, where numerous state-chartered banks issued their own paper money, often with insufficient reserves or located in remote areas to discourage redemption. This resulted in a chaotic and unstable currency system prone to bank failures.

Recurring panics. The fragmented and under-regulated banking system led to frequent financial panics throughout the 19th and early 20th centuries (e.g., 1837, 1857, 1873, 1893, 1907). These crises often required intervention from powerful private financiers like J.P. Morgan to prevent total collapse, highlighting the urgent need for a more robust and centralized system.

9. Recurring financial panics spurred the creation of the Federal Reserve System.

The eventual Federal Reserve Act … was similar to the earlier plan launched by Senator Aldrich.

The Panic of 1907. The severe financial crisis of 1907, triggered by a failed copper corner and subsequent runs on trust companies, demonstrated the fragility of the US banking system and the lack of an effective lender of last resort. J.P. Morgan's private intervention, while successful in stemming the panic, underscored the reliance on individual financiers rather than a public institution.

Calls for reform. The panic intensified calls for a central bank to provide currency elasticity, act as a reserve holder for banks, and lend during crises. However, there was significant public and political distrust of concentrated financial power, particularly associated with Wall Street and powerful figures like Morgan and Rockefeller.

The Aldrich Plan. Senator Nelson Aldrich, head of the National Monetary Commission formed after the 1907 panic, drafted a plan for a National Reserve Association. While presented as a decentralized system, its perceived ties to Wall Street led to its rejection in Congress.

The Federal Reserve Act. Building on elements of the Aldrich Plan but with greater government oversight, the Federal Reserve Act was passed in 1913. It created a system of twelve regional Federal Reserve Banks supervised by a government-appointed Federal Reserve Board. This structure aimed to balance the need for centralized control with concerns about regional representation and preventing dominance by New York finance.

10. The gold standard provided stability but was often abandoned during crises.

The glory of the classical gold standard was that it demonstrated, for the last time so far, how a worldwide monetary system could emerge without political scheming and red tape between national governments.

A self-regulating system. The classical gold standard (roughly 1870-1914) linked currencies to a fixed weight of gold, providing stable exchange rates and, over the long term, relatively stable price levels. The "price-specie flow mechanism" theoretically ensured that trade imbalances would self-correct as gold flows affected money supply and prices.

Limitations and pressures. Despite its theoretical elegance, the gold standard faced challenges. Gold discoveries or shortages could cause inflation or deflation. Central banks didn't always strictly adhere to the rules, and administered prices or trade barriers could impede the self-correcting mechanism.

Abandonment during war. The immense financial demands of World War I forced most belligerent nations to suspend gold convertibility and print money to finance expenditures, effectively abandoning the gold standard. This led to currency depreciation and inflation.

Post-war attempts to return. After the war, countries attempted to return to gold, but often at unrealistic pre-war parities (like Britain in 1925). This created economic difficulties, particularly for export industries, and contributed to instability in the international monetary system, ultimately leading to the collapse of the gold standard during the Great Depression.

11. Financial crises reveal the moral hazard of government and central bank rescues.

The moment a rescue is arranged, chances were that the next panic would be even bigger because the market would get back to work with the assumption that if trouble comes, a rescue would be arranged.

Intervention during panics. Throughout history, when major banks or financial institutions faced collapse during panics, authorities (governments or emerging central banks) often intervened to arrange rescues. Examples include:

• The Bank of England's rescue of Barings Bank in 1890.
• J.P. Morgan's private interventions during US panics like 1907.
• International cooperation to rescue Austrian and German banks in 1931.

The moral hazard problem. Rescuing troubled firms, while potentially preventing wider contagion, creates "moral hazard." Financial institutions learn that they may be bailed out if their risky ventures fail, reducing their incentive to act prudently in the future. This encourages excessive risk-taking, potentially leading to larger crises down the line.

Political and systemic pressures. Decisions to rescue are often driven by immediate concerns about containing panic, preventing economic collapse, and political pressure from connected firms. The long-term consequences of encouraging moral hazard are often overlooked in the urgency of the moment.

A recurring pattern. Despite the clear historical lesson about moral hazard, the pattern of rescuing financial institutions deemed "too big to fail" has persisted, contributing to the cycle of boom, bust, and bailout seen repeatedly in financial history.

12. History shows a pattern of money abuse and crisis that continues today.

What experience and history teach is this – that nations and governments have never learned anything from history, or acted on principles deduced from it.

Consistent themes. The history of money reveals recurring patterns: governments' tendency to abuse their control over currency for easy finance, the inherent instability of fractional reserve banking, the cyclical nature of speculative bubbles and panics, and the repeated need for intervention during crises.

The shift from commodity to fiat. The evolution from commodity money (gold/silver) to paper money and eventually to pure fiat currency (not backed by anything physical) has concentrated power over money creation in the hands of governments and central banks. While this offers flexibility, it removes the natural constraints of commodity money and increases the potential for abuse through excessive printing.

Modern parallels. Many historical dynamics are visible in the modern financial system. Central banks are engaged in unprecedented money printing ("Quantitative Easing"). Banks operate with relatively low capital reserves, incentivized by profitability. Financial crises still occur and are met with large-scale government and central bank rescues, raising ongoing concerns about moral hazard and the socialization of risk.

Ignoring the past. Despite centuries of evidence demonstrating the dangers of currency debasement, excessive credit expansion, and unchecked speculation, policymakers and markets often seem to repeat the mistakes of the past. The historical record serves as a stark warning, but one that is frequently unheeded.

Last updated: May 4, 2025