Chapter 1
A Brief History of Financial Systems and the Birth of Money

Most of us know very little about our financial system and its history. Even though I had worked in the banking and finance industry for close to two decades, I knew very little about the financial system's history until I started doing my research. I was surprised to learn that our current financial system is only about 43 years old. I knew that the world had been using paper currencies for hundreds of years and that, before this, coins were used, mainly gold and silver. However, the circumstances for the shift from coin to paper as well as the shift to fiat currency were all new to me.

What I came to realize was that our financial system moves in cycles much like an economy does. It goes through periods of growth and expansion and then decline. There have always been crises in financial systems. No financial system has ever been perfect and free of flaws. Crises can be sparked by many factors-wars, speculation (bubbles), runaway government borrowing and spending, and government mismanagement of the economy or its currency.

To understand where we are and where we are heading, we must first understand where we have been, beginning with the history of money and financial systems. Literally hundreds of books have been written on early currencies and financial systems. This topic alone deserves time to explain in detail. However, to keep focused on the topic of this book, I will attempt to summarize the evolution of currencies and financial systems in this chapter.

Early Financial Systems and Currencies

Financial systems existed long before gold and silver were used as a medium of exchange. One of the earliest forms of money was cattle and other animals, which were used as a medium of exchange and a store of value as early as 9000 BCE.1 Animals were used as payment under Roman law, whereby fines were paid in oxen and sheep.2 Sacks of grain, salt, and even seashells have been used as a form of currency for trade at one point in time.3 Thus, trade, taxation, and payment of fines existed before metal coins and money as we know them today were used.

There is even some research supporting the idea that debt and credit existed before coins and other money came into existence.4 According to David Graber's research and his book, Debt: The First 5,000 Years, the first recorded credit and debt systems developed more than 5,000 years ago as means of accounting. Credit and debt existed in the Sumerian civilization around 3500 BCE. In this system of credit, farmers would often become so indebted that their children would be forced into slavery as a means to repay the debt. These debt slaves were periodically released by kings, who canceled all debts and granted them amnesty under what came to be known as the Law of Jubilee in ancient Israel. One of the conclusions of this research was that indebtedness throughout history often led to unrest, insurrections, and revolts.

Though barter was also used throughout ancient societies, it was never a complete system or means of account, as other social factors came into play. Social currencies (i.e., interaction among the community and mutual expectations and responsibilities among individuals) completed early financial systems. Social bonds were also created through gifts, marriages, and general sociability. This type of economy stood in contrast to the moral foundations of exchange, based on formal equality, reciprocity, and hierarchy. This system established the customs in a society, which also led to the development of caste systems (the "haves" and the "have nots").5

One of the first written codes of law mentioning money and debt was the Code of Hammurabi, enacted by the Babylonian king Hammurabi, who ruled from 1792 BCE to 1750 BCE.6 The code consisted of 282 laws dealing with a wide range of matters, from trade to family relationships. Nearly half of the code dealt with laws for contracts, the establishment of wages, interest rates on debt, inheritance, and property rights.7

The first mention of the use of money within the Bible is in the book of Genesis,8 which refers to the criteria of the circumcision of a bought slave. There are other early references to money going back as far as the twentieth century BCE, such as Abraham's reference to the purchase of the Cave of the Patriarchs.9

An example of an ancient currency is the shekel. It was an ancient unit of account used in Mesopotamia around 3000 BCE10 to define both a specific weight of barley and equivalent amounts of materials such as silver, bronze, and copper.

The use of coins later developed primarily as a means to pay soldiers in ever-expanding empires around the world. The rise of great empires in China, India, and the Mediterranean was marked by extreme violence as these empires grew and required more and more resources to pay for their expansion. In this way, coins developed to pay soldiers in far-off lands as well as to enforce the payment of taxes by the state's subjects to subsidize its growing armies. Around 1000 BCE, money in the shape of small knives and spades made of bronze were in use in China. The first manufactured coins appeared in India, China, and cities around the Aegean Sea between 700 and 500 BCE.11

Gold and Silver

Throughout history, gold and silver have been the most common form of money. In many languages, such as Spanish, French, and Italian, the word for silver is still directly related to the word for money. Although gold and silver were commonly used to mint coins, other metals were used, such as iron and copper.

The earliest known records of gold and silver being used for monetary exchange date back as far as the third millennium BCE, when gold, specifically, was used in Mesopotamia and ancient Egypt.12 The first gold coins were minted in Lydia (modern-day Turkey) during the Grecian age around the year 700 BCE.13 By the fourth century BCE, coins had become widely used in Greek cities. The coins were supported by the city-state authorities (the issuing authorities), who strived to ensure they retained their value regardless of fluctuations in the availability of whatever base precious metals they were made from.

Once well-established in Greece, the use of coins spread slowly westward throughout Europe and eastward to India. By the second century BCE, coin usage in India had become central to commercial transactions. Monetary systems that were developed in India were so successful that they spread through parts of Asia well into the Middle Ages. During the fourteenth century, much of Europe had converted from use of silver in currency to minting of gold.14

Metal-based coins had the advantage of carrying their value within the coins themselves. One disadvantage, however, was that they could be manipulated. The clipping of coins was a fairly frequent practice. The clippings were then traded and recycled. Governments, over time, also had the habit of diluting the precious metal content in coins, such as blending copper with gold or copper with silver. This, of course, caused inflation and, in some cases, loss of faith in the issuing authority. Governments did so because they were short on precious metals and had bills to pay.

A bigger problem was the use of coins made of different metals-copper, gold, and silver in Europe. Gold coins, for example, were valued more than silver coins, and silver coins were valued more than copper coins. In England in the 1670s and 1680s, the gold-based guinea coin began to rise against the English silver-based crown. The huge amounts of gold coming into Europe from discoveries in the New World shifted trade away from silver and into gold. In Asia, the situation was the opposite: Gold was leaving for Europe in favor of silver. Some prominent Europeans such as Isaac Newton, Master of the Royal Mint, were uneasy about these movements, as they created instability and made it difficult to value one metal over another.15

Soon thereafter, national banks were set up to bring stability to the system by guaranteeing to change money into gold at a promised rate. This, however, did not come without its own challenges. The Bank of England came close to a major financial crisis in the 1730s when customers demanded their money be changed into gold at a moment of crisis. The crisis was avoided only when London's merchants saved the national bank with financial guarantees.16

What's important to note about this period is that money evolved from being a unit of weight to being a unit of value. A distinction could be made between its commodity value (i.e., its weight in gold) and its specie value (its value in the market).17

Paper Money, Promissory Notes (Sukuk), and Bills of Exchange

Once money became a unit of value, it no longer needed to be held in commodity form. Paper money began to appear in China in the seventh century, under the Tang Dynasty.18 The development of banknotes (paper currency) was rooted in merchants' desire to avoid the weight and bulk of transporting coins to settle large commercial transactions. They developed a system whereby they would issue credit notes, which were for a limited duration and at a discount to the promised amount. This new paper currency did not replace coins until later, in the Song Dynasty, in the eleventh century. The banknotes were used alongside the coins until the central government noticed the economic advantages of printing banknotes...