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Ledgers are the foundation of money.
Throughout human history, ledgers have taken many different forms: clay tablets, shells, informal notes, and beads just to name a few. All of these ledgers are designed to keep track of past work between people.
Ledgers are useful whenever humans trade, but they are especially important in complex economies where buyers and sellers do not always have the items the other one needs.
For example, if I grow apples that I want to trade for firewood, I need to find someone who has firewood and also wants apples in return. If I do find that person, we have a “coincidence of wants” and we may be able to trade with each other directly. However, the most likely outcome in a complex economy with many participants and a vast array of available products is that I won’t always be able to trade my apples directly for the products I need.
This is where ledgers become important. They are intermediary tools we can use to keep track of the goods each of us has produced and consumed.
Ledgers can either exist as formal or informal systems that act as a “financial battery” for storing one’s past work or status in society.
In the past, formal ledgers like clay tablets, shells, and beads were typically used in complex economies when one might not trust or know the person they are trading with. Informal ledgers are typical for trading between close friends and family.
Formal ledgers tend to use commodities that are scarce, portable, and durable to make trade more efficient and ensure nobody can cheat the system. This is why gold, beads, scarce stones, and shells have been chosen as money in the past.
Naturally-occurring commodities also have the benefit that no one person or entity controls or has visibility into the global state of the ledger. Nobody knows exactly how many shells exist, or who used gold to make a trade. These commodities act as “nature’s decentralized ledger”.
Commodity money works well as long as all participants have similar technology or productive capacity. However, when advanced civilizations trade with primitive civilizations , a problem emerges.
Advanced civilizations can easily out-produce their primitive counterparts, flood the market with new money, damage everyone’s trust in the scarcity of the commodity, and corrupt the ledger.
Informal ledgers can be written on paper, spoken aloud, or even maintained by memory.
For example, a group of friends that regularly goes out to dinner may take turns with the bill and keep mental note of who has paid for past dinners. A family may keep a list of chores on their fridge to remind each member of their daily tasks. A friend or colleague may ask you for some cash if they are in a pinch.
These are all examples of informal ledgers where social credit within one’s tribe is the “currency” being traded, rather than the commodity money of formal ledgers used in low-trust settings.
These informal ledgers can become corrupted if the “tribe” expands beyond a trusted group, and are therefore not suitable for large-scale economic trade between strangers.
Families and close friends don’t need money to cooperate. Money is only needed for trading beyond small groups of trusted people.
Throughout history, societies have all chosen to develop money because having a standardized, credible tool for exchanging and storing value makes all economic transactions more efficient.
Allowing anyone to easily trade any goods with anyone allows an economy to flourish.
However, societies don’t just choose any commodity to be their money. The job of money has always been served by commodities that have a few important properties.
Good money is divisible, portable, durable, verifiable, fungible, and scarce. All natural resources have various strengths and weaknesses across this scoring criteria, but societies only choose the best available commodities for their money.
With high scores on the properties above, good money is able to transmit value effectively across both space and time. People can depend on it to withstand long journeys, daily activity, and the test of time.
As the intermediary connecting all the goods people produce and consume, money is the most salable good in a society - the item that can be most easily sold.
Good money must be able to defend it’s scarcity from the strong incentives to create more supply. Historically, gold has done this better than all other forms of commodity money.
Annual gold production has consistently remained between 1-2% of total gold supply, despite the strong incentive to create more. In other words, it’s incredibly hard to find more gold, and that helps it retain it’s value.
While scarcity is an important property of good money, a commodity must not be so scarce that there isn’t enough of it to easily divide and distribute among people in an economy, or it will not be able to serve as money.
The purchasing power of commodity money can be broken down into two components: the utility value of the commodity and the monetary premium.
All commodities have some utility value, whether for industrial, agricultural, or decorative purposes. However, only the ones with the properties of good money earn a lasting monetary premium.
Early isolated societies chose their local money based on the natural resources available to them. Some chose shells, tobacco, cocoa, stones, feathers, beads, and grain. However, once these societies came into contact with each other and the world became more connected, most early forms of local money lost their monetary premiums to gold and silver.
Despite having many properties of good money, gold isn’t easy to divide for small payments. The smallest gold coins are typically too valuable for small purchases, so silver has historically served as a complement.a
In fact, many societies relied on two forms of money at the same time - one for storing their wealth or for large payments, and one for making small daily payments.
Silver has similar properties to gold and is reasonably scarce, but where silver where silver outperforms gold is as a tool for making small payments.
When advanced societies discover primitive societies, they use their superior technology to produce the money of the primitive society at a much faster rate than ever before, exploiting the primitive society until their money loses its value.
As the world became more connected, the vast collection of commodities that once served as money were consolidated down to just gold and silver.
Despite improvements in technology that made mining gold and silver easier, their scarcity made it hard for even the most advanced societies to rapidly expand supply.
The role of gold and silver as money was further enhanced when authorities began issuing gold and silver stamped coins. Having standardized coins issued by a government enabled more efficient trading, but also created a temptation for governments to devalue their own money.
The value of legal tender coinage can be broken down into 3 components:
Governments have consistently abused their role as the monetary authority for thousands of years, frequently by melting and re-issuing coins with filler metals added in the place of precious metals.
This caused people to hoard old coins and spend new ones, hurting the fungibility of the government-issued coins.
Improvements in communication technology in the last 200 years made it possible to settle long-distance payments much faster than ever before. As a result, banks began issuing paper bills redeemable for gold coins. This relieved people of the burden of carrying around gold coins to trade, but also ushered in the era of fractional-reserve banking.
Rather than trading gold directly, the gold standard era of the late 1800s was defined by backing paper currencies and financial communication systems with gold.
By trading with gold-backed paper rather than gold itself, gold was no longer a true medium of exchange and gold’s divisibility problem was solved. Since gold could now be divided by issuing paper notes in small denominations, silver lost much of its monetary premium.
The relationship between silver and gold shows that when the best money has a limitation, like gold’s divisibility problem, a secondary money can co-exist by offering a solution. However, when the limitation disappears, the need for the secondary money does too.
There are two primary schools of thought for explaining the foundation of money: the commodity theory and the credit theory.
The commodity theory of money believes that barter is inefficient, and a commodity money that is difficult to debase and easy to trade emerges naturally to solve the coincidence of wants between people.
The credit theory of money believes that all payments for goods and services are transfers of credit, and that the value of credit doesn’t depend on the value of any commodity, but on the obligation of the debtor to pay his debt.
On the surface these theories seem to be at odds with each other, but they both contribute elements to a holistic understanding of the foundations of money.
The commodity theory of money believes that money emerges naturally in a society and the commodities that are scarce, divisible, fungible, verifiable, durable, and portable are the ones that tend to become money.
However, the commodity theory also incorrectly believes that barter pre-dated money, and that money was the solution to the coincidence of wants problem introduced by bartering for goods and services.
The credit theory of money correctly believes that credit pre-dated commodity money and is foundational to the origin of money. Humans have always relied on various forms of informal social credit to keep track of past work.
However, the credit theory requires high trust between individuals, which doesn’t scale well to trading within large groups of strangers or migrating between communities.
Proponents of the credit theory assume that authorities will always act in the best interests of their people over long periods, and that no unforeseen events will necessitate the debasement of money.
However, history has shown that every government that has ever issued fiat credit in replacement of commodity money has seen their fiat money devalued against gold, destroying the wealth of their citizens in the process.
Centralized, human-controlled ledgers have some parallels with the second law of thermodynamics, which states that entropy (or chaos) only increases over time. Just as all closed physical systems have some inevitable energy or heat loss which increases entropy, all credit-based monetary systems have some unexpected events or bad decisions that lead to debasement over time.
In fact, just by having the ability to produce new credit units at will, authorities are able to cause or amplify bad decisions like entering wars that otherwise wouldn’t have been affordable on a commodity money standard.
Since no human authority can debase commodity money with the stroke of a pen, commodity money retains its value much better over long periods of time.
Therefore, the universal and trust-minimized nature of commodity money makes it ideal for trade among strangers or storing wealth over long periods of time, while the trust-based nature of credit money is more efficient among small groups of highly-trusted individuals.