Sudipta, a dear friend in the Silicon Valley, asked me to comment on a March 2013 article titled “Orphaned currency, the odd case of Somali shillings.” The piece is about how the Somali shilling continued to circulate even after the Somali central bank was literally destroyed in the civil war around 1991. The bank notes were “orphaned.”
When Somalia collapsed into civil war in January 1991, the doors of the Central Bank of Somalia were blown apart, its safes were blasted, and all cash and valuables were looted.* But something odd happened—Somali shilling banknotes continued to circulate among Somalians. To this day orphaned paper shillings are used in small transactions, despite the absence of any sort of central monetary authority.
I will leave you to read up that article before continuing here.
So here’s what I think. I take that case to be an illustration of a general principle I believe in: that people are inventive. Necessity, as the saying goes, is the mother of invention. So the state, and with it, the central bank collapsed. But that didn’t stop people from exchanging stuff. They continued to use the bank notes as before and life went on. Entrepreneurs, as they usually do, figured out some other ways of improving the situation — enriching themselves along the way.
Therefore it would appear that a central bank is not absolutely necessary for an economy to have some form of money. Hayek argued that, like other stuff that competitive markets produce, money should also be private. I am not competent enough to follow his argument on the matter of money. My understanding of money is limited but adequate for my purposes.
What’s money? It’s something that people find useful for a variety of reasons. The first and the most important use of money is that it allows people to participate in a non-primitive economy. A primitive economy is one in which consumption is very closely linked with production. A non-primitive economy is one in which consumption and production are de-coupled. Your consumption bundle is almost entirely different from what you produce. Without money, an exchange economy could not exist.
The second reason for the usefulness of money is related to the first: it is a common unit of value. Money functions as a numéraire — something that provides a common benchmark for measuring and comparing the value of different goods and services.
Then there’s another very useful function of money: it is a store of value. Money can be lent, borrowed, and saved. Of course, a commodity can also be lent, borrowed and saved. You can lend, borrow or save a cup of sugar. But it is easier to do that if you use money. Instead of borrowing sugar, I borrow the money to buy sugar. And when I repay the loan, you can buy sugar or whatever else. It’s just easier to use money. Money can be exchanged for anything that can be bought and sold. Money is fungible.
The previous bit was a functional definition of money — what money allows one to do. The implementation of money is a different matter. It can be bits of gold or silver, or even printed bits of paper (fiat money.) Regardless of all that, what matters is whether people consider something as money. It’s a matter of convention. If people consider something money, then that’s money.
There’s a nice little story that illustrates that point.
The Englishman’s Vacation
Once upon a time, an Englishman used to visit a certain little island for his annual vacations. The island was a little economy chugging along fine with a bit of domestic production, a little bit of foreign trade and a bit of this, that and the other. The Englishman would go there, stay at a hotel, enjoy the sun and sand, eat and drink, and return home refreshed.
One year he did not carry sufficient cash for his needs and ended up paying his hotel bills with a check from his checking account which he held at a bank in London. As he was a regular visitor with a reputation for honesty, the hotel accepted his check. But instead of encashing the check, the hotel management used the check as part payment for their grocery bill. The grocer, in turn, used the check to settle his shop rent. The landlord later used the check to pay for some renovations on his property. Months went by while the check circulated among the islanders, and the check was never presented to the London bank for settlement. The Englishman’s checking account balance was never debited by the amount on that check.
The question is: who paid for the Englishman’s hotel stay?
The answer, you might have guessed, is that potentially everybody on that island paid for it. The Englishman by writing that check simply added to the money supply of the island economy. Assuming that the Englishman’s vacation did not increase the total amount of goods and services produced in the economy–that is, he merely consumed a part of the total production which would have anyway occurred regardless of his presence–then his increasing the money supply in effect caused a bit of inflation in the economy. Which means that others’ money after the check went into circulation would buy a fractionally smaller amount of goods and services than before. The Englishman created money out of the blue.
Money is not real
The fact that money can be created out of the blue by simply scribbling something on a piece of paper is important in understanding that money is not a real thing. More accurately, fiat money is not a real thing at all, as opposed to commodity money which is. If you use say pieces of gold as money, it cannot be created or destroyed–it can only be transformed. Stuff is real but money that we normally use is not. It is either pieces of paper or simply digital bits in some computer memory.
Money is one of the most ingenious creations of human creativity. It is a way of keeping an account of who owns what. For that, first there have to be stuff that can be owned. So the stuff that you can own is the real stuff and money just keeps track of who has claims on that stuff. So if there is no stuff, money is worthless. On a deserted island with no stuff on it, sacks of money would be less useful than some stuff that you can use. [The above bit is reused from here.]
Banks Create Money
Just like the Englishman inadvertently did, banks create fiat money. They simply print the stuff. And the government then hands out the freshly printed money to whoever it favors. If the stock of money rises faster than the growth of commodities that the economy produces, you get inflation. Inflation is a form of theft: it’s theft by those who print money, from those who use money.
You too can create money
Just print some. Make sure that it looks nothing like the government created money — because you’d end up in jail for counterfeiting if it did. And convince a bunch of people to accept that printed stuff as money. Those people can use it as money among themselves.
“Money is an agreement within a community to use something as a medium of exchange.”
There are a variety of community currencies. Examples can be found here. That page lists
- Backed currencies
- Ithaca Hours
- Time Dollars
They are all very instructive if you’re interested in understanding what money is. It takes time to get a handle on what money is but is worth the effort.
Back to Somalia
The Somalia story is actually quite simple if you consider that there was a tacit understanding among the Somalis that they will use those pieces of paper printed by the erstwhile central bank as money. And based on that agreement within the community, the system continued to function even without a central bank.
Finally, I’d like to point to a very nice piece by Paul Krugman titled “Baby-Sitting the Economy“.published in Slate in Aug 1998. That was from when Krugman was a fine economist and not a partisan hack who opines in the NY Times. The truth is that Krugman is (was?) a brilliant economist who writes wonderfully. His Slate piece beings thusly:
Twenty years ago I read a story that changed my life. I think about that story often; it helps me to stay calm in the face of crisis, to remain hopeful in times of depression, and to resist the pull of fatalism and pessimism. At this gloomy moment, when Asia’s woes seem to threaten the world economy as a whole, the lessons of that inspirational tale are more important than ever.
The story is told in an article titled “Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis.” Joan and Richard Sweeney published it in the Journal of Money, Credit, and Banking in 1978. I’ve used their story in two of my books, Peddling Prosperity and The Accidental Theorist, but it bears retelling, this time with an Asian twist.
Go read that piece.