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Understanding Money

Paper Money

The earliest records of paper money date to China during the T'ang dynasty (618-906 AD), a golden age of Chinese culture. For hundreds of years, there was no paper money outside of China. Indeed, when the Venetian traveler Marco Polo traveled to Asia (from 1271-1295), he was astonished at the power of the Mongol emperor Kublai Khan, who was able to compel his subjects to use money made of paper.

The Chinese emperors, however, did not use money to expand the economy in a way that benefited the general population. Rather, they confiscated all the gold and silver and then forced their citizens to use paper money. They did so for two reasons. First, they wanted all the gold and silver for themselves. Second, by eliminating the need to transport large amounts of coins from one place to another, the emperors were able to simplify the administration of the largest empire in the history of the world. Collecting taxes, for example, became a lot easier once everyone used paper money.

In the West, paper was not even invented until 1150 (in Spain), and the debut of paper money had to wait until the German printer Johann Gutenberg invented the first printing press with moveable type around 1436. Once money could be printed, it proved to have important advantages over coins: it was cheaper to produce and a lot more convenient.

Sweden, for example, had very little silver or gold from which they could make coins. The Swedes did, however, have a great deal of copper so, in the 1640s, they began to make copper money. Because copper is less valuable than silver and gold, these "coins" were actually large metal plates that weighed about 4 pounds each. In 1644, the government wanted to produce more valuable coins, so they minted copper plates that were worth ten times as much and weighed over 43 pounds apiece.

Clearly, this system was unworkable, and in 1661, the Stockholm Bank became the first European bank to issue paper bank notes. The bank notes were accepted readily, because a single note could take the place of 500 pounds of copper. Merchants liked the new system because it meant that they did not have to move stacks of heavy copper plates from one place to another.

A little reflection will show you that paper money also has a significant disadvantage compared to coins. Because paper money is so cheap to produce — compared to what it is worth — there is a constant temptation for the people with the keys to the mint to print as much money as they possibly can. When that happens, the money quickly loses its value, inflation strikes like the hot kiss at the end of a wet fist, and the entire system collapses. The first particularly egregious example was in France, and involved a Scotsman who came to be known as the Duke of Arkansas. Here is the story.

By the early 18th century, the idea of paper money was generally accepted in Europe, and various banks and governments had already issued their own money. None, however, had been successful. In 1715, a young King Louis XV became ruler of France. At the time, France was virtually bankrupt, and because Louis was still a minor, the monarchy was controlled by a regent named the Duke of Orléans.

In an attempt to solve the country's financial problems, the Duke, in 1716, arranged for the monarchy to start its own bank under the direction of John Law, a Scotsman of ill repute. The Duke was particularly attracted to Law's promise that the bank would be able to issue as much paper money as it wanted.

At first, Law only issued money that was backed by the gold reserves of the bank. The money was accepted, the new bank was a success, and Law was given the title of the Duke of Arkansas. Within a short time, however, the two dukes began to print more and more money, and before long, the bank had issued more than twice the amount of money that it had in real gold.

Meanwhile, in 1717, Law helped found a company to exploit the riches of Louisiana (which was, at the time, a French colony in the New World). Using his influence at the bank, Law created a pyramid scheme to attract investors to the new company. The bank would print money to loan to investors who would use it to buy shares in the company. The company would then use the money from the new investors to pay out huge, bogus dividends to existing shareholders. Before long, the pyramid collapsed, leaving a long trail of worthless money and impoverished investors.

The phenomenon of printed money becoming worthless has happened many times. To me, the most interesting example occurred during the American Revolution. The printing of money was an experiment that was not only a terrible failure, but a spectacular success.

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