Busting money's creation myths

Here again Kumhof breaks new ground for a neoclassical economist. Since the vast majority of neoclassical economists ignore banks, debt and money completely when they model the macroeconomy, they also completely ignore the historical question "where did money come from?”

This is in sharp contrast to the blogosphere, where the origin of money is as hot a topic as the origin of species was in biology two centuries ago. The reaction to US financial program Keiser Report, hosted by broadcaster Maxwell Keiser, illustrates this. My answer to Max's "Is gold money?” question in last week's Keiser Report was indicative here, evoking over 500 comments in just two days. Keiser was adamant that gold is money; I was equally adamant that it's not.

As in all such debates, I prefer to resolve them by the empirical record. In a marked departure from neoclassical norms – where armchair theorising is almost compulsory – so does Kumhof. Here's his opening sortie in the paper on the conventional belief about the origin of money:

"The monetary historian Alexander Del Mar (1895) writes: 'As a rule political economists do not take the trouble to study the history of money; it is much easier to imagine it and to deduce the principles of this imaginary knowledge.' Del Mar wrote more than a century ago, but this statement still applies today.

"An excellent example is the textbook explanation for the origins of money, which holds that money arose in private trading transactions, to overcome the 'double coincidence of wants' problem of barter. As shown by Graeber (2011), on the basis of extensive anthropological and historical evidence that goes back millennia, there is not a shred of evidence to support this story.

"Barter was virtually non-existent in primitive and ancient societies, and instead the first commercial transactions took place on the basis of elaborate credit systems whose denomination was typically in agricultural commodities, including cattle, grain by weight, and tools.

From that record (developed by anthropologists examining late Cro-Magnon and early Sumerian society, where the first writing originated) it's clear that the statement 'money developed out of barter' is one of the two great Creation Myths of economics – the other being that 'gold is money'.

The barter myth was a core concept in Adam Smith's Wealth of Nations, in which he argued that barter was an innate characteristic of the human species. It's worth citing Smith (who is often referred to as the father of economics) at length here because it turns out – as Benes and Kumhof assert in their paper – that despite its persuasive feel, Smith's 'armchair theorising' about reality is almost the opposite of what the historical record reveals:

"This division of labour… is the necessary, though very slow and gradual consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another… It is common to all men, and to be found in no other race of animals…," he says.

"Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog… When an animal wants to obtain something … it has no other means of persuasion but to gain the favour of those whose service it requires. A puppy fawns upon its dam…

"Man sometimes uses the same arts with his brethren… But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them…

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of his fellow-citizens…

"In fact, it appears that human society began as what we would today call a gift-exchange system. Humans did not 'make a fair and deliberate exchange' in the early tribal groups, but bonded with each other via reciprocal gifts. In the small (generally less than 150) hunter-gatherer groups that preceded the agricultural revolution, everyone knew everyone else and was aware of what they had given to others, and what they had received in return. Debts were interpersonal obligations that bound those early societies together." (Jean Auel's historical novel Clan of the Cave Bear gives a well-researched rendition of this personal basis of exchange.)

The sheer scale of agricultural society made this informal system of credit impossible. The act of keeping record of who was obligated to whom in these newly sedentary societies spurred the development of writing, and the keeping of those records was undertaken by the most trusted members of society – the religious leaders. This first record-keeping (one couldn't yet call it writing) involved clay pots that contained symbolic representations of grain, animals and so on. By 3300 BC, these had evolved into the clay tablets of the Sumerian civilization: the origin of writing (Jane Gleeson-White's book Double Entry covers this history nicely).

Therefore neither gold nor barter featured in the actual origins of money: instead, credit did. It transformed over time from personal obligations to recorded and socially enforced ones, and ultimately led to fiat money: debts and credits recorded and enforced by the state, and coins whose values were state-determined.

Figure 1: A cunieform tablet recording debts in commodities

This message comes through strongly in University of London anthropologist David Graeber's book Debt: the first 5000 years: barter as a defining feature of human existence is a myth.

"No example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money; all available ethnography suggests that there never has been such a thing,” he says.

The same is true, it transpires, of the view that gold or silver was money. As Kumhof puts it, most of the times when gold played a major role in currency, it was because it had been nominated as the form of money by the sovereign. In an irony for critics of fiat money, gold became money because of fiat:

"There is another issue that tends to get confused with the much more fundamental debate concerning the control over the issuance of money, namely the debate over "real” precious-metals-backed money versus fiat money. As documented in Zarlenga (2002), this debate is mostly a diversion, because even during historical regimes based on precious metals the main reason for the high relative value of precious metals was precisely their role as money, which derives from government fiat and not from the intrinsic qualities of the metals.

"These matters are especially confused in Smith (1776), who takes a primitive commodity view of money despite the fact that at his time the then private Bank of England had long since started to issue a fiat currency whose value was essentially unrelated to the production cost of precious metals. Furthermore, as Smith certainly knew, both the Bank of England and private banks were creating checkable book credits in accounts for borrowing customers who had not made any deposits of coin (or even of bank notes)."

There were periods when gold was used in customary exchange, but these coincided not with commercial societies but ones based on plunder, where the rule of law – even the law of a local despot – had broken down. One can of course draw parallels with today, and argue that we are witnessing one of those periods where the established order is collapsing, and gold and silver will rule in those circumstances. But when this period is resolved, historical precedent suggests that a system of credit will supplant it.

Firstly, one hopes that future society – and ours today for that matter – will be characterised by peaceful relations rather than conflict and plunder. If so, we are likely to evolve a system based on credit rather than gold:

"While credit systems tend to dominate in periods of relative social peace, or across networks of trust (whether created by states or, in most periods, transnational institutions like merchant guilds or communities of faith), in periods characterised by widespread war and plunder, they tend to be replaced by precious metal. What's more, while predatory lending goes on in every period of human history, the resulting debt crises appear to have the most damaging effects at times when money is most easily convertible into cash."

Secondly, the weight of history is on the side of credit and fiat money systems, rather than a "commodity money” like gold. As Graeber points out, in a broad sweep view of money, credit money systems have dominated human history:

"The cycle begins with the Age of the First Agrarian Empires (3500–800 BC), dominated by virtual credit money. This is followed by the Axial Age (800 BC to 600 AD) … which saw the rise of coinage and a general shift to metal bullion. The Middle Ages (600–1450 AD), … saw a return to virtual credit money… [T]he next turn of the cycle, the Age of Capitalist Empires, … began around 1450 with a massive planetary switch back to gold and silver bullion, and … could only really be said to have ended in 1971, when Richard Nixon announced that the US dollar would no longer be redeemable in gold."

Figure 2: A debt denominated in silver, with independent witnesses

Thus far, this IMF working paper gets big ticks from me on two fronts where I normally castigate neoclassical economists: the analysis explicitly includes money and is based on a realistic model of how money creation works today; and the historical knowledge of money and credit is accurate. In a future article I'll consider the next issue: their analysis of the Chicago Plan to replace credit-based money with something rather different.

Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch.