What is money?

Hi, I am Joeri, and that is the question that one of the most intense debates in economics today centres around. In this debate there are basically two positions.

On the one hand, proponents of the commodity theory*** ***of money argue that only money that is made from a commodity like gold, silver or even cigarettes, is real money because these have intrinsic value. On the other side of the argument, proponents of the credit theory of money argue that it is pretty silly to tie economies to shiny rocks or other commodities and that credit money issued by, for example, central banks or private banks is not only the most efficient form of money but also the original form of money.

But, who is right?

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Well…. somewhat anticlimactically, I think both are correct given that there are clear examples of both commodities and credit tokens that have been used as stores of value, units of account, and mediums of exchange.

So, then the real question becomes, who is more correct?

One way to answer that question is by having a look at the history of money.

Commodity Money & Credit in Late Medieval Europe

Specifically, let’s go to late Medieval Europe where there were two emerging economic regions: Flanders and Northern Italy. At the time, both were dominated by rivalling princes, dukes and kings which each minted their own gold and silver coins….

There you have it … commodity money was important. But, hold on metal lovers… because much of the localized production and trade was done without money altogether.

The scene is a quaint village in Northern Italy. The actors are a farmer and a hunter. The problem is seasonality. After all, the farmer can only produce crops in the harvest season while the hunter can hunt all year round. Now, both the hunter and farmer like a balanced diet. What’s more, the farmer wants to eat some meat now so that he has the energy to harvest later.

The solution is obviously….. debt.

The hunter agrees to provide the farmer with meat now if the farmer promises the hunter plenty of crops after the harvest. This promise of future payment in crops is credit, or in other words…. debt.

Notice three key points about this local credit:

  1. First, it can be created ‘out of thin air’ and similarly will ‘disappear into thin air’ after the farmer has harvested his crops and given a share to the hunter. After all, this credit is a promise. No need to save money or metals first, people can just make and fulfil promises freely.
  2. Second, credit can be created exactly where it is needed …. to suit the local economic needs of the farmer and the hunter.
  3. Finally, this type of credit clearly promotes economic activity. It helps the farmer produce more crops and it helps both the farmer and the hunter to achieve a balance diet.

Now, where a barter system runs into trouble with dividing units and carrying around a lot of goods, a local credit system runs into trouble whenever economic activity expands beyond where people know each other and therefore know whether to trust each other.

And, with international trade expanding in late Medieval Europe, this was quickly turning a big problem.

International Trade, Money Changers, and Bills of Exchange

For example if an Italian merchant wanted to trade with Flanders, he faced two major problems. The first is that in Flanders they used different currencies than in Italy. Now you might think that, since these were all based on precious metals,… it should be easy to exchange them. However, in both economic areas there were many different types of coins in circulation of which the precious metal content was highly uncertain especially for foreign traders. The second problem was that, given the large distance, a substantial amount of coins would need to be transported between the two areas.

While a problem for most, some successful merchant families cleverly saw an opportunity to solve that first problem of different coins with uncertain quantities of metal in them.

So, besides their trading activities, they became money-changers that knew the exact value of multiple currencies and would be willing to change any coin into another…. for a price.

Now, big money changers also had the opportunity to solve the problem of transporting coins…. because they had the ability to set up an office in Bruges and in Florence. Then, they allowed small Italian merchants to purchase goods from them using a a bill of exchange denominated in silver Deniers rather than using actual silver Deniers.

So, in essence, by accepting this piece of paper called a bill of exchange, rather than coins, the money-changing merchant has provided credit to the smaller merchant.

These smaller Italian Merchants could then return home to Florence with only the imported goods and sell them there for gold Florins. The small merchant could then visit the money-changers family office in Florence and repay his bill of exchange denominated in Flemish Deniers using Florins,

at a very unfavourable exchange rate of course…..

After all, the merchant money-changer had provided two services: (1) currency conversion, and (2) the extension of credit both of which require work and are risky.

The added benefit of this construction to the Merchant money changer was that, while he was lending money…. he didn’t have to charge an interest rate,

therefore ‘technically’ he was in compliance with church’s decrees that prohibited interest rates, usury in other words…. even though he effectively earned an interest by charging an unfavourable exchange rate.

What is more, if we zoom in on the network over time… we can see that in effect the merchant banker and the smaller merchant are very similar to the farmer and hunter. Credit was first created in Bruges and later, ‘disappeared into thin air’, when it was re-paid, in Italy and all of this was done to suit the needs of trade where they occurred. Finally, this credit creation was economically beneficial for all parties involved and therefore the economy as a whole.

Having explored how big merchants started providing two key financial services: international money changing, and trade credit, you might now imagine that the step into ditching trade and becoming full time financial professionals was not that big.

Rise of the Bill Dealers

As it turned out, money changing, and providing credit was not only profitable, it was also less risky and provided higher social status than mere trading of goods.

One way to become a full time financial professional was to offer the service of buying bills from traders without actually trading with them.

A promise to pay currency by a trader without it being coupled to a specific transaction became known as a bill of finance,

rather than a bill of exchange.

And the merchants that were in the business of both buying and selling these bills of finance came to be known as bill dealers.

To see the logic of this, let’s go back to our previous example.

But, now assume that the merchant money-changer had gone all-in on buying and selling bills in different currencies. What would happen now is that small merchant traders could go to the specialised bill dealer with offices in multiple cities to solve both the foreign currency and coin transportation problems. Furthermore, the bill dealer is specialised enough to check if the small merchant is credit worthy.

So, now, the small Italian merchant issues a bill of finance which he sells for Flemish Deniers at the bill-dealers office in Bruges. The small Italian merchant then uses these Deniers to buy goods from a small Flemish merchant. After returning home, the small Italian merchant then sells these goods to another small local merchant and then uses a large part of his earnings to repay his bill of finance at the local office of the bill dealer, at an unfavourable exchange rate. Effectively paying an interest rate to the bill dealer to compensate it for the risk of foreign exchange movements and the default risk that it takes in trusting the merchant.

When comparing this to the previous examples, we can see that in effect the same happens… credit is created when the Italian merchant buys goods in Bruges and destroyed when he pays them back in Italy.

So, here again, credit or debt or promises to pay in the future enables economic activity.

The big difference is that this now happens through a third party, rather than with a big international trader.

However, this is not yet banking as we know it because there banks receive deposits and make loans…. and, sure, while bill dealers do effectively make loans by buying bills of finance from small merchants, they do so with their own money… they do not have deposit accounts.

Rise of the Merchant bankers

Next, in our final step of the evolution towards banking in Europe, the Bill Dealer wanted to expand its own lending capacity. And One way to do this is by allowing traders to open a deposit account.

If we then go back to our example, we see that, instead of offering hard currency to the Italian merchant, the bill-dealer turned banker proposes to open a new deposit account in exchange for the merchant’s bill of finance.

In effect, this comes down to the same thing as saying, let me keep the coins that I should give you, and you can come and get them anytime you want.

Here is a promise that you can, and this written promise is ‘your money in the bank’ so to speak. In other words, it is your deposit account.

Because the merchant banker is well known, and respected in Bruges, the Flemish merchant also has a deposit account with the Merchant banker and therefore is quite willing to give good to the Italian Banker and for the Banker to increase its deposit account while decreasing that of the Italian merchant. Then, the Italian merchant can travel back home with its new goods as always and repay the banker’s office in gold coins back home.

Did you notice that during this last evolutionary step of European finance something extraordinary happened?

The part of the debt issued by the banker is now acceptable as means of payment.

Money creation in action.

In fact, it could very well be that the Flemish merchant also travels to Italy from time to time and uses his bank account for payments there. If that is the case, these newly created deposits might start circulating along the merchants…..

It’s quite complex. I can see therefore, why it would be tempting to move back to the relatively simplicity of commodity money transactions or even to thinking that credit money creation is somehow unnatural or even fraudulent.

Of course, we have now seen that the emergence of credit money is a natural of evolution of credit itself, which in turn is a natural evolution of trade itself. So in fact, credit-money is not unnatural but deeply linked to the core of the economic process.

Furthermore, the example shows that debt, while something we might want to avoid as an individual, can be good from the perspective of the broader economy because it helps trade.

In fact, once you rephrase it such that there is an increased number of promises in the economy, it becomes clear that this can be good for the economy.

But, where does that leave commodity money? Did silver and gold coins disappear?

The Hierarchy of Money

Well, no…. after all silver and gold coins were still used extensively in late-medieval Europe.

Debt and commodity money existed side by side because they served different purposes.

As we have seen, debt money was great for international trade. Credit relationships great for activities with those close to you, and coins…. for everything in-between.

Another thing that insured coins would always be needed were the local prince or kings who demanded that payments of taxes would be in coins.

Furthermore, in times of economic crisis and uncertainty, a bank run might even occur where all people wanted to exchange their bank deposits for coins….

Therefore, you could say that in this period there was a hierarchy of money in which metal coins were at the top, and on which the credit money structure was built.


And that was the story of how credit money emerged in Europe and facilitated economic activity across the continent.

But, as some of you might have noticed, this was not the first time credit money emerged in Europe. In fact, credit money and banking was already widespread in Ancient Greece and Rome. If you want to know more about that, check out my video on the monetary economics of Ancient Athens.

Besides that, you might now think, if credit creation can spring people into action to produce and trade more, could it perhaps be used for economic development? Well, that question will be answered in my next video, so make sure to subscribe.

Finally, if you would like to enable me to produce these videos more quickly, consider supporting me on Patreon or buying me a ‘coffee’ using the links in the description.

Main Sources:

  • Chapter 3 of A Financial History of Western Europe
  • Money Changes Everything, by William Goetzman