If you were to take a £5 note to the Bank of England today, and ask for its equivalence in worth, you would receive nothing more than that same £5 (and perhaps a courteous smile). The reason why this would happen is because modern money is nothing more than the cotton it is made of (or plastic, which will be used from 2016 onwards) 1. The monetary world we live in is a world of Fiat Currency, where the value of money is not tied to any commodity, but is rather determined by government regulation and law. The tale of what money was, to what it is now is a winding story. This article will detail this transition, from the humble beginnings of Barter and Gold money. Thereafter, the evolution to the Gold Standard and paper money will be examined, followed by the final leap to Fiat Currency. Throughout these sections, the ever-prudent insights of Islam will be provided.
Barter and the Conceptual Emergence of Money
In ancient times, humanity used what can be considered the polar opposite to Fiat Currency; barter, the exchange of goods and services without money as an intermediary. But barter was certainly not used in isolation. In many ancient societies money existed (in a conceptual sense, rather than as we know it) in tandem with barter, often existing not specifically as a precious metal. It could exist as any commodity that was valuable to a society, divisible and storable. Examples of this can be the use of livestock as money between 9000-6000bc. As societies grew, a more common and more mutual representative of value was needed. This was what led to the usage of precious metals (as well as its durability and storability).
In terms of objectivity, this is all that can be said regarding the emergence of money. As regards to when and why money emerged, social theorists and philosopher’s hold differing opinions. To paraphrase Aristotle, money necessarily came into existence as inhabitants of different countries became increasingly interdependent on one another with respect to trade; thus precious metals were used as a common representative of value and something that boasted greater portability than physical goods. 2
Barter is an entirely legitimate form of exchange in Islam; ibn Rushid (1996) recognises it as one of three forms of sales that can emerge wherever money and goods exist. The Noble Prophet (pbuh) is also known to have engaged in barter. Commodity Money can be considered the ‘most Islamic’ iteration of money. Unsurprisingly, there are a myriad of pertinent reasons why Islam holds this view that are particularly relevant in modern times. However this is a point which warrants a discussion on its own. Some of these reasons will become apparent in the following sections. 3
From Commodity Money to the Gold Standard
If there is anything that will fuel the current bash-the-banker culture, it is the story of the rise of the Gold Standard. Please note that this section will narrow the discussion to England, and details have been omitted in an attempt to sustain simplicity. Please see The Problem of Interest, by Tarek El Diwany for the thorough and detailed account.
As England moved away from barter and adopted precious metals as Commodity Money, it only took a few shrewd individuals to transform the monetary system – the Gold Smiths, or the ‘Original Bankers’. In the mid-17th Century, the Gold Smiths had only one role, to act as a safe house for storing precious metals. Individuals would store their gold with the Gold Smiths, in exchange for a Bearer Receipt, a receipt which would confirm the amount stored. Carrying a receipt is obviously preferable to heaving a sack of gold, so it is no wonder why people decided to leave most of their gold with the Gold Smiths, and dually that merchants began accepting Bearer Receipts as a means of payment.
With Bearer Receipts in full circulation, the Gold Smiths – whom we may now refer to as Bankers – realised that the gold they had could be used for a lucrative venture. They decided to lend out not gold itself, but Bearer Receipts, at interest. Then came the issue of Reserve Ratios. How much gold would the Bankers have to hold against the receipts they lent out, to ensure that if individuals want to cash in their receipts for gold, they would not have to be turned down? Anything less than 100% created the risk that the Bankers would not be able to pay back everyone who deposited gold with them. The Bankers settled for less than 100%, in the knowledge that they could very cheaply manufacture Bearer Receipts. In essence, the Bankers were given the license to print money.
Let us take a moment to understand how this worked. Say the Bankers had £100 (of gold coins) in storage, with a reserve ratio of 20%. This would mean that the Bank could manufacture and lend £500 at interest, and would only have to keep £100 against that. When the Bank would be paid back, they could destroy the extra £400 manufactured, but keep the interest as a profit. If the interest rate was, say 10%, then the profit for the Bankers would be £50. In total then, the Bankers would have £150 in storage, £50 more than what they started with. (Example sourced from The Problem With Interest, by Tarek El Diwany).
Without the sale of any good or service £50 was made. Imagine a shopkeeper telling you that they would make £50 profit without selling any goods. Surely one would suspect them of fraud. But astonishingly, society sits and watches the Banks do this. A person is arrested if they are caught counterfeiting money at home, but Bankers did and still do, print money from nothing on mass proportions. Yet the Banking industry remains one of the highest paid industries in the world. And what gives bankers this power? Two things: a low reserve ratio and interest rates. It is no wonder why Islam prohibits interest. 4
This practice also brings to light one of the reasons why Islam favours Commodity Money; you cannot create gold out of thin air. Thus the treacherous consequences of printing money, inflation (and possibly hyperinflation) are avoided to a large extent. The Institute of Economic Affairs reports that since 1946, the Pound has lost 98% of its purchasing power as a consequence of inflation. Under Commodity Money this would have been avoided.
So the Bankers could print money. Yet the money they printed was still backed by Gold. In the background of bitter relations with the French, the Bank of England (BoE) emerged in 1694 to fund a war against France. BoE’s power included being able to print money, similar to the Goldsmiths. However at this point, BoE was required to hold gold reserves against the money they printed. However in February 1797, an act was passed by Parliament which granted BoE to print money that was not backed by gold for a period of time, which amounted to heavy profits for BoE. For a number of reasons, including intellectual pressure from BoE, in 1825 a substantial number of Banks ceased payments in gold – yet currency was still backed by Gold.
Gold coins remained in circulation, as well as paper money. Gradually, paper money gained popular backing, as they were deemed to be more reliable. Slowly but surely, Commodity Money i.e. gold coins were phased out, to be replaced paper money backed by gold – the Gold Standard.
Bretton Woods Exchange Regime: A vestige of the Gold Standard
The Gold Standard continued in England until it was suspended in light of World War 1 in 1914. England flirted with the Gold Standard with pseudo iterations of it, but eventually abandoned it in September 1931. Thus Fiat Currency came to be.
Fiat Currency was initially short lived; the Bretton Woods Exchange Regime that was introduced in 1940s promised a monetary system that would stabilise the World Economy, in light of the cataclysmic impacts of the Great Depression and both World Wars. It was said that the subscribers to this regime (namely the Allied Forces among others) would never have to see insane inflation that the Weimer Republic (Germany) experienced. The way this was to be achieved was to peg every currency to the US Dollar, which was held to be the most stable currency. The US Dollar itself was then pegged to gold. This system persisted, until President Nixon announced in 1971 that there would be a temporary suspension of the dollar to gold. This was done in light of a weak Dollar throughout the 1960s. Attempts to revive it failed, and in 1973, currencies became free floating (i.e. that their value is determined by the free market mechanism). 5
Today we find that not all currencies are free floating, some are pegged to other currencies. Argentina pegged the Peso to the US Dollar in the 1990s. But in this year, 2014, no currency is backed by gold – we live in a world of Fiat Currency.
Concluding Remarks: the elephant in the room
The history of money is a topic better addressed in a book rather than an article. This article has sparingly discussed how money emerged as a concept, and how the existence of commodity money was necessitated by increasing trade. It was then found that by the shrewdness of a few people, receipts representing gold was mass produced which was the initial step to the Gold Standard. History then played its hand, with the BoE emerging to legitimise printing money. With the advent of World War 1, the Gold Standard was abandoned, with the Bretton Woods Exchange Regime acting as a successor of sorts. However this too was dropped; since then we have had Fiat Currency.
Fiat Currency provides a larger economic toolkit to the Government in exchange for perpetuating debt. With the best-selling UK financial magazine Money Week issuing an ominous prediction that in the next few years Britain will be crushed by debt, the dangers of Fiat Currency may be trumpeted to the world. Details of the drawbacks of Fiat Currency deserve an article on its own, and these dangers very well interchange into the strengths of Commodity Money.
On the issue of Commodity Money, arguing the world should return to it would indeed be a bold statement to make, and would likely result in scoff. But rest assured there are perfectly valid reasons in favour of Commodity Money, whether or not the world is ready to accept it.
With the advent of the Bitcoin, and the danger signs of coming debt crises, perhaps currency reform will be pushed forward in the economic agenda. Right now, it remains an elephant in the room.
2Paragraphs based on:
Pack, S. J. (2010). Aristotle, Adam Smith and Karl Marx. Massachusetts: Edward Elgar Publishing. p3-11.
3 Paragraph based on:
Diwany, T. (2001). A Debate on Money. Available: http://www.islamic-finance.com/item104_f.htm. Last accessed 27th Aug 2014.
4 Story of the Goldsmiths and example sourced from:
Diwany, T (2010). The Problem With Interest. 3rd ed. London: Kreatoc Ltd. p39-47.
5 Sourced from: https://www.imf.org/external/about/histend.htm