Why Does Money Have Value? Paper, Trust and the State
By the BrainSnail editorial team. How these articles are written and checked, and how to tell us when one is wrong.
A twenty-pound note is a piece of polymer that costs a few pence to make. It is worth twenty pounds because the next person will take it for twenty pounds' worth of goods, and they will take it because the person after them will. That circle of expectation is not a flaw in the system. It is the system, and it has held for most of history using materials that were never valuable in themselves.
Three jobs money does
Economists define money by function rather than substance. It is a medium of exchange, something everyone will accept in trade so that a farmer does not have to find a shoemaker who happens to want wheat. It is a unit of account, a common measure that lets the price of a haircut and the price of a house be compared. And it is a store of value, a way of carrying purchasing power from this week to next year.
Anything that does those three jobs is money, and a remarkable range of things have: cattle, salt, cowrie shells, giant stone discs on the island of Yap, cigarettes in prisoner-of-war camps, and mobile phone credit in parts of East Africa. The best candidates are durable, divisible, portable, hard to counterfeit and scarce, which is why metals won for two and a half thousand years.
From metal to paper
Coins of standard weight appeared in Lydia, in modern Turkey, around 600 BCE, and their value was the metal in them, with the stamp merely certifying it. Paper began as a receipt. Chinese merchants in the Tang dynasty deposited heavy coin with trusted agents and traded the receipts instead; by the eleventh century the Song government was issuing paper notes directly, the first state paper money. In Europe goldsmiths' receipts for deposited gold became the first banknotes in the seventeenth century, and the Bank of England's notes were a promise to pay the bearer in gold on demand.
That promise defined money for two centuries under the gold standard: a note was a claim on a fixed weight of metal. The arrangement broke down in the twentieth century because it tied the money supply to the amount of gold in the vaults regardless of what the economy needed, and it ended for good in 1971 when the United States stopped converting dollars to gold. The words 'promise to pay the bearer' are still printed on Bank of England notes, and the promise now means only that the Bank will replace the note with another note.
Fiat money and why it works
Modern money is fiat money, from the Latin for let it be done: it is money because the state declares it so and backs the declaration in two practical ways. It accepts the currency, and only the currency, in payment of taxes, which guarantees that every citizen needs some. And its courts enforce contracts denominated in it, making it legal tender that a creditor must accept in settlement of a debt. Those two facts give the paper an anchor that the paper itself lacks.
The rest is confidence, and confidence is not the same as faith. People accept pounds or yen because they can see that everyone else does and because the institution controlling the supply has a record of not printing too many. Where that record breaks, the money fails quickly. Germany in 1923, Zimbabwe in 2008 and Venezuela after 2016 all printed money to cover government spending until prices doubled in days and people abandoned the currency for dollars, cigarettes or barter. Money is valuable precisely as long as it is not created without limit.
Who creates it
The state creates the notes and coins, but they are a small fraction of the money in circulation, around 3 percent in most rich countries. The rest is bank deposits, numbers in accounts, and those are created by commercial banks when they lend. A bank that grants a mortgage does not hand over someone else's savings; it credits the borrower's account with new money and holds the loan as an asset. When the loan is repaid the money disappears again.
Central banks steer this process rather than perform it. By setting the interest rate at which banks borrow from them, and by buying or selling government bonds, they make lending more or less attractive and so expand or shrink the amount of money the banking system creates. Their job, in the end, is to keep the promise on the banknote credible: to allow enough money for the economy to work and not so much that it loses its value. The ingredients of a working currency:
- •General acceptance: everyone expects everyone else to take it
- •A tax anchor: the state demands it, so everyone needs it
- •Legal tender: courts will enforce debts settled in it
- •Controlled supply: an institution that does not print without limit
- •Stable prices: a track record that makes it worth holding overnight
A prison camp that reinvented money
One of the clearest case studies of money was written by an economist who was a prisoner of war during the Second World War. R. A. Radford described how, in his camp, prisoners received Red Cross parcels with tea, chocolate, tinned food and cigarettes, and traded them. Within a short time cigarettes had become the currency. They were durable, easy to count, came in standard units and were wanted by nearly everyone, so goods came to be priced in cigarettes even by people who did not smoke. Nobody decreed it. The camp settled on a money because barter was too awkward.
The camp then displayed, on a tiny scale, the problems of a national economy. When a large delivery of parcels arrived, cigarettes became plentiful and prices measured in cigarettes rose, which is inflation. When supplies ran low, or heavy smoking burned up the currency, prices fell, which is deflation. Less popular brands tended to be spent while the prized ones were smoked, an example of the old observation that bad money drives out good. Radford's account is still taught because it shows, without any central bank or law, how money emerges from trust and how its value depends on how much of it there is.
What a steady two percent does to a banknote
Most central banks in rich countries aim for inflation of about two percent a year, which sounds negligible but adds up. A quick way to see its effect is the rule of 70: divide 70 by the annual inflation rate to find roughly how many years it takes prices to double. At two percent, prices double in about 35 years, so a twenty-pound note left in a drawer for that long will buy about half as much as it did. At five percent they double in 14 years, and at ten percent in about 7, which is why savers notice even moderate inflation.
Central banks do not aim for zero, for three main reasons. Official price measures tend to overstate inflation slightly, because they struggle to allow for goods that get better at the same price. Falling prices can be damaging: people and firms may put off spending if things will be cheaper later, and the real burden of existing debts grows as wages and prices fall. And because interest rates cannot easily be cut far below zero, a little inflation leaves a central bank room to lower rates in a downturn. The two percent target is a compromise between those risks and the steady loss of value.
Stone money that never moved
On the island of Yap in the western Pacific, people used large carved stone discs, called rai, as a form of money. Some are taller than a person and weigh several tonnes. They were quarried on islands hundreds of kilometres away and brought back by canoe at great risk, and the effort and danger involved were part of what gave each stone its value.
Because the biggest stones were too heavy to move, ownership could change without the stone itself going anywhere: everyone simply agreed that it now belonged to someone else. One account describes a stone that sank in the sea during transport yet was still treated as wealth, since everyone knew it existed. Economists, including Milton Friedman, have used Yap to show that money rests on shared agreement about who owns what.
The takeaway
Money has value because people accept it, and they accept it because the state demands it for taxes, enforces debts in it and keeps its supply limited through a central bank. The metal or paper never mattered as much as the promise, and the promise holds only as long as the institution behind it resists the temptation to print its way out of trouble.