Why Does Money Have Value? Paper, Trust and the State
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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
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.