A brief history of money

The following is an extract from the unpublished book:

Peoplons, Charmons and the Strange One: the uncertain science of economics

by C. S. Adams, Illustrated by Cohenbaum.

Tokens of exchange:

In the economist’s book of myths and legends, money was invented to solve the “double coincidence-of-wants” problem in a pair-wise economic exchange. Paul the baker wants a beer, but Mary the brewer already has a loaf of bread. Instead Paul gives Mary some gold coins or tokens which are exchangeable for something else later on. Problem solved.

The key property of a coin is not its intrinsic value – over time, gold was replaced by cheaper metals or pieces of paper. The key property is that the token is likely to be accepted as a unit of exchange for subsequent transactions. As Adam Smith writes in the Wealth of Nations, Book I, Chapter 4, Of the origin and use of money:

 … every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in a such a manner as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry.

Smith goes on to explain why metals are a convenient substance for this exchangeable commodity:

Metals can not only be kept with as little loss as any other commodity, scarce anything being less perishable that they are, but they can likewise, without any loss, be divided into any number of parts, as by fusion those parts can easily be reunited again; a quality which no other equally durable commodities possess, and which more than any other quality renders them fit to be the instruments of commerce and circulation.

Although metals are a ‘convenient’ representation of the unit of exchange they are not necessary. In fact, it makes no sense to limit economic activity to the availability of a particular metal whose supply is limited. The double-coincidence-of-wants problem could just as easily be solved using any accepted token (see e.g. David Graeber‘s brilliant Debt: the first five thousand years). In the medieval era, when Paul the baker is served a beer and does not have anything to offer in exchange, he signed Mary’s book of accounts, or made a mark on a tally stick. After the beer is brewed and consumed, all that remains is a mark on a stick which records who made the beer and who drank it – a collective memory of credit and debt. The stick is split in two – a stock and a foil – such that both Paul and Mary have matching records. As they are a record of a debt, they acquire a value and may be accepted in exchange by a third party if everyone believes that one day Paul will pay. At the end of the year, Paul and Mary and everyone else tally up their stocks. By storing information about an unbalanced exchange, the tally sticks – something readily available with no prior value – become valuable, they become money.

A sculptural tribute to the historical significant of tally sticks can be found on the gates of the UK National Archive in Kew, near London. The tally stick model illustrates how money functions as information about an unbalanced pair-wise exchange where a good only went one way.  Money is simply a collective memory recording the fact that the balance of the origin pair-wise remains to be restored – it is a collective memory of a credit-debt relationship. Although this simple model can function at the level of a village where everyone knows Paul, scaling up to a whole country requires some additional structure. Fiat money is the modern equivalent of tally sticks – based on computers rather than pieces of wood and with an extra layer of institutional organisation. But just like tally sticks, fiat money has no intrinsic value – it’s utility is based on belief.

From tally sticks to Sovereign money:

At various points in history, the Sovereign took a particular interest in money in order to further their goals such as the conquest of new lands.

With assistance from the smartest guys in the room, the Sovereign concocted a money circuit to finance overseas adventures. In its simplest form the story goes like this: First, the Sovereign mints metal coins – Sovereign money – with the King or Queens head embossed on one side. This Sovereign money is used to pay soldiers that participate in the military campaign. In return for protecting citizens from foreign invaders, the Sovereign demands a tax to be paid in Sovereign money. The soldiers are the key link in the circuit. Someone in the family or community has to go and fight to ensure that the community has enough Sovereign money – effectively a tax credit – to pay the Sovereign’s man. When a soldier returns from war and offers a Sovereign coin in exchange for Mary’s beer or Paul’s bread they are more than pleased to accept, knowing that one day the tax man will call.

The invention of Sovereign money – the government’s spend and tax circuit – sold itself on the basis of security. It is not that different today. For the Sovereign’s spend and tax circuit to work, it needs to be carefully controlled –  alternative circuits break the loop and could undermine the value of Sovereign money. To function effectively there needs to be monopoly control of the money system. Although, the Sovereign’s Exchequer initially accepted payment in the form of tally sticks this creates complications – if taxes are paid in tally sticks there is no incentive to join the army and the primary money circuit is undermined. Their use was eventually banned in 1826. As part of Pitt the Younger‘s reforms of the money system, the office of the Exchequer was abolished on October 10th, 1834. Six days later government officials, decided to burn their stock of tally sticks and set fire to the Houses of Parliament. This event is recorded in two paintings by Joseph Mallord William Turner (London 1775–London 1851) that epitomise the Turner style. If you happen to be in Cleveland or Philadelphia you can see the originals.

From gold to fiat:

Throughout history there was a feeling that money should be linked to something substantial and durable, for example, a precious metal. At various times, a gold exchange standard was adopted and then abandoned.* After the second world war, the Bretton Woods system pegged most major currencies to the dollar which in turn was exchangeable for a particular quantity of gold – 35 US dollars per ounce. The gold standard locks national economies to a fixed exchange rate which can become too restrictive as their economic paths diverge. The gold standard was temporarily suspended by Nixon in 1971 and collapsed completely in 1973. Over the longer term it makes no sense to link the quantity of money to the quantity of any particular metal, or to tie different economies to a fixed exchange rate. After 1973, all money became fiat (let it be) money, whose value is based on confidence alone. Modern fiat money is like tally sticks except now the state has monopoly control over the creation of new money.

There is no particular evidence that either commodity money or fiat money has a particularly strong influence on trend growth, however, the switch from a gold standard to fiat money is fundamental, and part of the turmoil of the 1970s was a coming to terms with this. In the post Bretton Wood era, there is nothing to limit money creation apart from maintaining confidence in the unit of exchange – the belief that money is as ‘good as gold’. Even though the world changed dramatically in 1973, the perception of money remained the same, and at the microscopic level nothing appeared to change. Both gold and ‘let it be’ money only have the value we believe them to have, but whereas we cannot create unlimited amounts of gold we could create unlimited amounts of fiat money. To prevent this happening all money is created in the form of  debt, such that the amount of money is linked to future activity. However, a debt-based system of money is also not without problems but that’s another story.

*  For a history of the gold standard era between 1919 and 1937, see End of an Epoch: Britain’s Withdrawal from the Gold Standard, Michael Kitson, June 2012. pdf

Lower tax equals a worse life

Let’s be clear, lower tax means lower prosperity, worse public services, worse health and worse education.

The evidence is in the data. The graph below (updated 2017-06-08 following suggestions in the comments) shows outcome measured using the UN’s inequality-adjusted human development index (IHDI) as a function of input measured using tax as a percentage of national income (GDP) using data collated by the Heritage Foundation. IHDI is a number that measures income, life expectancy and years in education.* The higher the score the better. Top of the IHDI league table (see here) is Norway (which despite its oil wealth also has high taxes), bottom is the Central Africa Republic. The UK (in colour) is currently 13th, better than the US, but not as good as Germany, Australia or any of the Scandinavian countries. Included are all countries where data is available which includes more than 95% of global population.

The line assumes a diminishing return with increasing tax. However the exact form of this line is a bit arbitrary as we do not know what kind of correlation to expect. We could argue that countries above the line are getting relatively good value for money whereas those below the line could do better although there is a large country-by-country variation that depends on individual circumstances, such as Norway has oil as well as high taxes.

A simple linear fit gives a Pearson correlation coefficient r = 0.77. This tells us that prosperity outcome is roughly proportional to government input – the size of the governments spend and tax circuit. The more you spend and tax, the better the quality of life, the better your life expectancy and the better your education.

The conclusion is clear. A vote for a tax party of low tax is a vote for a worse life, worse health and worse education. On Thursday, why not vote for prosperity instead?

* IHDI also includes a correction for inequality but in most cases there is not much difference between the HDI and IHDI.

The best of times, the worst of times – back to the ’70s?

Regardless of the power cuts, stagflation, the IMF loan, the sick man of Europe, the question, Do you want to go back to ’70s? is as ridiculous now, as asking someone in the ’70s if they want to go back to the ’30s. Even if we wanted to, we cannot turn back time – ignoring all the medical and scientific advances that have improved our lives since. The consistent story of economic history is that thanks to advances in knowledge, we have been getting gradually richer and richer as the graph below shows.

Plotted in the top graph is the average UK weekly income since 1765 adjusted for inflation based on data from the Bank of England.* The dark shaded areas indicate the World Wars, the light shaded regions financial crises. Unsurprisingly, the graph shows that – despite a few bumps along the way – we are richer now than in the ’70s, just like we were richer in the ’70s than we were in the ’30s or the 1870s! More importantly, and what matters in terms of policy, is the rate at which we get richer, i.e., where is the steepest part of the graph?

To find out, below the main graph I have plotted the slope or rate of wages growth per year (grey dots). This fluctuates wildly from year to year so I have added a decadal average (large black squares with a vertical bar to represent the scale of the fluctuations). Each of the black squares is centred on the turn of decade from 1770 to 2010. Some things of note are that in terms of income growth:

1. The best decade was 1965-75.

2. The worst decade was 1785-95. **

3. The second worst was 2005-15.

In terms of recent history, the interesting question is why was 1965-75 so good and 2005-15 so bad? Let’s consider 1965-75 first. Was it just that we were paying ourselves too much. No! This would show up as a hangover, and 1975-85 was pretty good too. The reason that income growth was so high around  1970 is because this era coincided with peak productivity growth and as any economist will tell you:

prosperity = productivity

The economist Paul Krugman – winner of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2008 – put it like this in 1994:

Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

The Bank of England data set also includes productivity so below I plot income growth (top graph) together with productivity growth (bottom graph).

The wage growth plot is the same as before but for productivity growth (which is very volatile) I have used a moving average. Roughly the ups and downs in the income growth and productivity growth match just as Krugman said they should. In particular, it is clear that peak income growth around 1970 correlates with peak productivity growth also in 1970.

A puzzle is why productivity growth started to decline after 1980, dropped off a cliff in 2008, and has not recovered since causing the stagnation in wages that we see now.*** One argument is that all the easy gains had been made, another is that financialisation has crowded out real production as I discussed previously.

Yes we are richer now, but if we want to get back to the productivity gains of the past we should look at what worked well in the ’70s – e.g. the higher income share of labour (see Chart 15 in this speech by the Chief Economist of the Bank of England) – and what is not working now – e.g. lack of investment.

And while we are on the subject of the best of times, have a listen to this!

*  For those that care about such things I have used a logarithmic scale on the vertical axis such that each factor of ten takes up the same amount of space. If I use a linear scale, the graph hovers around bottom until 1950 and then shoots up.

** Adam Smith died in 1790. A tale of two cities was set around 1780.

*** The situation in the US since 1970 is even worse because average growth has not kept pace with productivity growth.

Graph of the day

The Institute of Fiscal Studies has helpfully done an analysis of the manifesto proposals of the main parties (see here). The graph below is their analysis of how current Conservative plans will influence the income of people in different parts of the income distribution. It shows, the richest 10% just about managing, while the poorest 10% loose 9% of their income.

The manifesto does nothing to address this – not what you might expect from the claim on page 9 to “abhor social division, injustice, unfairness, and inequality.” But then, what politicians say is one thing, what they do is another.

In the interest of balance, I should add that the next page of the IFS report shows that Labour is better but could have gone much further (see here). The case for a progressive spend and tax policy is strong. For evidence, have a look at Sweden.

Follow the money

There is one simple rule that most economists agree on:

prosperity = productivity

The Chancellor understands this – productivity was mentioned 10 times in his recent Spring Budget speech. He said:

Simply put, higher productivity means higher pay.

and went on to say that Britain’s problem is a productivity problem

We are 35% behind Germany and 18% behind the G7 average. And the gap is not closing.

So what is going wrong and who is to blame? Is it the 99% or the 0.1%? I would say the latter. Let me explain why.

Continue reading “Follow the money”

What is the deficit?

In my previous post on government spending (How are we going to pay for it?), I wrote that unless people choose to save it, then extra government spending all comes back as extra tax. If this were true, then what does not come back, the deficit, must be equal to private sector savings? We can test this by plotting data available in the Quarterly National Accounts provided by the ONS. Continue reading “What is the deficit?”

How are we going to pay for it?

When you listen to all the discussion about balancing the budget, about how any increase in spending needs to be matched by an increase in tax, why does no one mention that an increase in spending automatically generates extra tax?
There is no need to raise tax rates!

Continue reading “How are we going to pay for it?”