That’s not to say that paper money was unavailable before then. Even as the U.S. government minted nothing but coins, private banks, often called “wildcats” [PDF], began issuing what in effect became thousands of currencies. Like the wartime continentals, these bank notes were in theory backed by gold, but it was hard to know whether a bank actually had enough gold to back up its notes, bank regulation being pretty much nonexistent at the time. Unsurprisingly, the wildcat era was fertile ground for fraud. What is surprising perhaps is that most banks did a reasonable job of keeping their currency and their gold reserves in balance, and the U.S. economy grew briskly.
The Bank of England, meanwhile, took a far more sober approach. In 1821, it adopted the gold standard, promising to redeem its notes for gold upon request. As other countries followed suit, the gold standard became the general rule for developed economies. The discovery of major new gold fields over the course of the 19th century ensured that the money supply kept growing.
The gold standard, as it was intended to do, brought stability to prices and was enormously beneficial to property holders and lenders. However, it also brought deflation—that is, prices generally fell—because as countries’ populations and economies grew, their governments had no easy way to increase the money supply short of mining more gold, and so money in effect became more scarce. Deflation was hard on farmers and borrowers, who longed for a little inflation to help them with their debts; when money gradually loses some of its value, so, too, do people’s debts.
The gold standard also didn’t prevent economies from falling into recession, and when they did—as during the worldwide slump known as the Long Depression, which lasted from 1873 to 1896—adherence to the standard made it difficult to do any of the things that might have quickly set things right, like cutting interest rates or pumping more money into the economy. As a result, economies took a long time to recover from downturns.
Of course, clever financial minds will always find an end run around the rules. Having a gold standard, it turns out, didn’t completely limit the growth of money. Banks could still make loans against their gold reserves, and they did so freely. Economic historians now believe that the amount of paper currency in circulation dwarfed the actual amount of gold and silver that banks had on hand. And so, while money was still tethered to gold in people’s minds, it had already begun to become unhooked.
What finally derailed the gold standard was World War I. Governments needed more money for their militaries than they had in gold, and so they simply began printing it. And though many countries tried to return to the gold standard after the war, the Great Depression ended that experiment for good.
The result? Currencies today are “fiat” currencies, meaning they’re backed by the authority of the issuing government, and nothing more. In the United States, for example, that means the government accepts only dollars as payment for taxes and requires its creditors to accept dollars in payment for debts. But if people were to lose faith in the dollar and stop accepting it in everyday transactions, it would eventually become worthless.
Many people find this situation unnerving, which is why there are perennial calls to return to the gold standard. The reliance on fiat money, we’re told, gives too much power to the government, which can recklessly print as much money as it wants. Yet the truth is that this has always been possible. Even with the gold standard, governments revalued their currencies from time to time, in effect dictating a new price for gold, or they ignored the standard when it proved too limiting, as during the First World War.
What’s more, the notion that gold is somehow more “real” than paper is, well, a mirage. Gold is valuable because we’ve collectively decided that it’s valuable and that we’ll accept goods and services in exchange for it. And that’s no different, ultimately, from our collective decision that colorful rectangles of paper are valuable and that we’ll accept goods and services in exchange for them.
The reality is that it’s a good thing that we’ve moved away from the gold standard and the idea that money needs to be tied to something else. In the first place, it’s honest: As soon as we left behind the habit of trading cattle for barley (both of which had intrinsic value), money became a social convention, and paper money just makes that convention obvious. These days, instead of worrying about where we’re going to find more gold and silver, we can focus on how to wisely manage the money supply for the greater good.
Second, and more important, abandoning the gold standard has given central banks much more flexibility in dealing with economic downturns. Recessions are downward spirals: Instead of spending and investing, people and businesses hold on to their cash, which shrinks overall demand, which forces businesses to cut back, which creates unemployment, which shrinks demand even more.
One solution is for governments to make up the difference by spending more. But it’s also important for interest rates to drop and for the money supply to increase, thereby making it easier for people to borrow money and helping overcome their reluctance to spend. Such actions are easier for the folks at the Federal Reserve and other central banks to pull off when they don’t have to worry about maintaining the gold standard. And recessions have been shorter and less painful since the gold standard was abandoned. Even the most recent global downturn, severe as it was, was minor compared to the Great Depression.
Of course, all this talk of central bankers tinkering with the money supply is precisely what critics of the fiat money system dread, because they believe it will inevitably lead to runaway inflation. And history does show that when a government massively and carelessly expands the money supply, it ends up with hyperinflation and a worthless currency, as happened in Weimar Germany in 1923 and in Zimbabwe just a few years ago.
But such episodes are rare. In the past 90 years, the United States and Europe have had just one sustained bout of high inflation—in the 1970s. That track record should engender some faith; on the whole, central bankers act responsibly, and healthy industrial economies aren’t prone to regular inflationary spirals. But that faith is apparently hard to muster; instead, it feels to many of us as if inflation is always about to soar out of control.
This irrational fear is ultimately a legacy of the way money evolved: We cling to the belief that money needs to be backed by something “solid.” In that sense, we’re just like Marco Polo—still a bit amazed by the thought that you can base an entire economy on little pieces of paper.
And yet we do. For more than 80 years, we’ve been living in a world in which money can be created, in effect, out of thin air. As we’ve already discussed, the central banks can create money, but so can ordinary banks. When a bank makes a loan, it typically just puts the money into the borrower’s bank account, whether or not it has that money on hand—banks are allowed to lend more money than they have in their reserves. And so with each home equity loan, car loan, and mortgage, banks add incrementally to the money supply.
There is, to be sure, something a bit eerie about all this, and periods like the recent housing bubble, when banks made an extraordinary number of bad loans, should remind us of the dangers of runaway credit. But it’s a mistake to yearn for a more “solid” foundation for the monetary system. Money is a social creation, just like language. It’s a tool that can be used well or poorly, and it’s preferable that we have more freedom to use that tool than less.
Over the course of history, the material substance of money has become less important, to the point that these days people talk easily about the possibility of a cashless society. The powerful combination of computers and telecommunications, of smartphones and social media, of cryptography and virtual economies, is what fuels such talk. And that progression makes sense because what matters most about money is not what it is, but what it does. Successful currencies, after all, are those that people use: They lubricate commerce, allow people to exchange goods and services, and thus encourage people to work and create. The German sociologist Georg Simmel described money as “pure interaction,” and that description seems apt—when money is working as it should, it is not so much a thing as it is a process.
This, perhaps, is what Kublai Khan understood seven centuries ago. It’s what we’re still trying to understand today.
About the Author
James Surowiecki writes The New Yorker’s popular business column “The Financial Page.” He is also the author of the best seller The Wisdom of Crowds (Doubleday, 2004). He found the task of condensing a few millennia’s worth of material into one magazine article challenging, but also incredibly compelling. “Money is one of those things that’s completely familiar and completely mysterious,” he says, “and that makes it a great subject.”