In order to understand the nature of money, let us begin with a little economic fable. This fable is not meant to recount the actual historical process by which money developed, but is designed to bring out certain essential features of what money is. This is a logical, not historical, account of the origin and development of money.
The first sorts of exchanges would have been barter. One person had wheat, another shoes, another was a carpenter, another a miller. If the farmer needed shoes and the shoemaker wheat, then an exchange was easy. But it surely must happen that the shoemaker needed wheat at a time when the farmer did not need shoes. Perhaps then the shoemaker had something else to trade. But if not, he could give the farmer a slip, good for a certain amount of shoes, redeemable whenever the farmer needed shoes. A slip would be an IOU. Yet these slips or scrip could be exchanged with third parties too. Suppose the farmer mentioned above needed some carpentry work done, yet the carpenter did not need any wheat at that time. The farmer could give the carpenter the scrip from the shoemaker as payment, and similarly, this scrip could be traded by the carpenter with someone else, and so on. It is an item of value because it represents a claim on a product, namely the shoes.
It would soon be convenient for all the producers to issue this scrip to avoid the necessity of immediate product exchange (barter) when no product was needed by one of the parties to a transaction.
Concomitantly, a process of standardization of value would necessarily be going on. There would emerge a rough consensus as to how much wheat was worth so many shoes, so much carpentry work, etc. Even though individuals might differ in their estimate of the value of some items, at least for necessities and other things of general use the community would gradually form a rough common estimation of comparative value. (Of course this would be based on other factors as well, including scarcity and the cost of production. The important thing to note is that this common estimation is not based on one factor alone.) So as the use of these slips became general, many of them would circulate around the community, each one good for a certain product or service, yet standing in some quantitative relation one to another. For example, if someone bought a pair of shoes he would expect to pay for it with scrip of equivalent worth, say, a scrip worth one bushel of wheat. Or if he had a house built, he would pay for it with scrip for shoes, clothes, wheat or what have you, yet standing in some more or less fixed quantitative relationship with the worth of the building work.
The next step would be for each producer no longer to indicate a particular product on his scrip, but simply some unit of value. If, for example, it had become the practice for a pair of shoes to equal one bushel of wheat, then the shoemaker might begin marking his scrip simply with the notation One Unit, and the farmer likewise. Other producers who made more costly items could indicate larger values on their scrip, and so on. So the shoemaker would produce scrip which in a sense represented a claim on a future pair of shoes, but since they named no particular product or service, could be spent on any product or service. With this you now have a complete system of money.
Some points need to be noted. What “backs” this pure paper money? In one sense it is backed by the faith of the particular community that their scrip money will be accepted for the goods they need. In another sense of “back,” the money is backed by the economic power of the community, the ability of the community to produce the goods and services its people need to live. The money in fact is a claim on some economically valuable good or service, a kind of IOU. Does the money itself represent an addition to the wealth of the community? No. If it did, each producer could leave his trade and begin writing money-slips all day long instead. The only things of economic value are products, services or land. The scrip just enables these items to change hands more easily, aids in standardizing their relative worth and in allowing economic values to be stored for future use, since it is easier to keep an amount of scrip than of some actual product.
The money system is now set up. Previously, before the slips of paper had become divorced from a particular product or service, they were made by each economic producer, whenever he needed to buy something for which he could not barter; and they stood in some relation to his stock of goods, for if the shoemaker, for example, instead of making shoes, made slips of paper supposedly redeemable for shoes, soon people would find this out, and not accept his slips. So he could not make more slips than he had shoes in stock, or could produce within a reasonable time. But when the slips no longer represent a particular product and simply state an economic unit of value, redeemable for anything costing that much, who is to issue the money, and how much are they to issue?
First, how much? The answer is implied in what I said above. If the money is in units of economic value, and this economic value is in reference to certain products or services, then the amount of money must keep pace with the amount of goods and services available, unless the value of the money is to change. Money is simply a surrogate for real economic goods and services. As the amount of economic activity increases or decreases, the money supply should roughly keep pace with that increase or decrease.
Who is to issue the money? There is more than one possible answer to that. One obvious choice is the guardian of the temporal common good, that is, the government. Another possible candidate would be the federation of all guilds (occupational groups). But whoever undertakes this function must adjust the money supply as the total of goods and services produced grows or decreases. How is he to do this? When more money is needed, it can be paid out in salaries, wages, and as payment for purchases by whatever entity is charged with supplying money. If the money supply needed to be reduced, money in possession of the issuing authority could simply be destroyed. But in any case, the creation of money must be strictly limited by statute and other means so as not to cause inflation by issuing too much money. The money supply must roughly keep pace with the economic activity of the society.
Note that commercial banks play no role in money creation in this hypothetical society, for there is no reason for them to do so. The money-creating role of banks is economically unnecessary, and in fact a kind of tax and blight on the community, since all the money created by the banking system comes into being as debt and must be repaid with interest.
Note also that there is no logical role for gold or any other commodity as money. The desire for commodity money often represents a confusion about the nature of money, as if money itself were to have value, and not simply be a claim on real economic goods and services.
The purpose of this little fable is to illustrate that money is logically neither some object of value itself (as gold or silver) or the creation of the private banking system, but is simply an expression of the sum total of the society’s economic activity. Money is the tool and servant of the community, to accomplish the community’s goals of facilitating exchange and supplying the public’s needs.