From an individual point of view, every trading transaction has two parts. In the first part I sell something, which I no longer want, in exchange for money. However, I really don't want money. I want something else that I can use. I use the money to buy the thing that I really want. The full transaction is not complete, until I have bought it. Buying is the second part of the transaction.

A transaction consists of two parts: selling and buying. After the transaction is complete, I am better off because I have replaced something that I did not want with something that I wanted more. Both the buyer and the seller are better off, because they end up with something they value more than what they gave up.

A link with the first part of the transaction that allows the second part of the transaction is essential. In the example above, money provides the link between the two parts. When I sell my goods, I accept money in return, because I expect that I can use the money to get what I want to complete the transaction.

I only hold the money for a short time. I start with something I did not want. I end up with something that I wanted more. The money is my security for the short time between the first part of the transaction and the second part. Money allows exchanges to to happen.

Holding money is quite risky. Once I have handed over my thing to the buyer, I cannot get it back, but I cannot be certain that I will be able to buy the thing that I want with the money. If no one will accept the money in exchange for what I want, I will be left with nothing useful (I did not want money). Once I have made my purchase, the risk is gone, because I have the thing I wanted. The risk has passed to the person who takes the money from me.

The possession of money is a sign to other people in the society that a seller has completed half of his transaction, by giving up something. It allows him to buy something from someone else to complete his transaction. Money is a record of a half-completed transaction.

The main risk during trade that my money will not be accepted. I don't want to get into a situation where I cannot complete the second part of my transaction. If I am unable to complete a transaction, I bear the cost. Therefore, I will only get involved in trading, if there a record of half-completed transactions, that is honoured by other members of society. Money is a widely recognised record of a half-completed transaction.

Trade

To understand how this can work, imagine eight people on an island. They have no money system, so they do all their trading by barter. They live a long way from each other, so barter is only practical with the person who lives on either side. For example, B can only have regular contact with A and C, so the opportunities for barter are very limited.

Each person has gone out and done what they do best, so each one has a surplus they can trade for other things. B wants what A has. C wants what B has, D has what C has, and so on round the circle. The problem faced by this small society is to come up with a way of trading with each other, so that each person ends up with what they want.

The blue arrows represent the direction that the surpluses need to move for each person to get what they want. This could be achieved by each person giving his surplus to the person on his right. However, there is no easy way for this to happen, as no one would be willing to give up their surplus, because they would have nothing left to barter with. They would have no way of getting back the things that they want. Something different will need to happen, or trade will not start. There are several possibilities.

Generosity

A may simply give his surplus to B. This might inspire B to give what he has to C. C might also give what he has to D. If this generosity went right round the circle, they might all end up with what they wanted. However, this level of generosity would be very unlikely. Even if A was generous, the chain of generosity would most likely break down somewhere. Then anybody further round the chain would still be left with the surplus they did not need.

The yellow blobs represent goods received. A would be worst off, having lost his surplus and receiving nothing back. The risk of this happening would be a strong incentive against generosity. Even if A tried it once, he would be unlikely try it again.

Popular Commodity

There might be some commodity that all eight people used regularly, eg bread or potatoes. If they all used this commodity, it would be of value to them all.

A might also have some surplus bread. He could trade this bread with H for some of the goods that he wanted. H might take the bread, because he would know that he could find someone who would trade their surplus for the bread. H could then trade with G to get what he wanted in exchange for the bread. This could proceed right round the circle. The blue arrow shows the movement of the surplus goods. The green arrow shows the movement of the bread. Each person would give up their surplus in return for the bread, knowing that they could trade it with someone else. Eventually, B would give the bread to Back to A, in exchange for A's surplus that he really wanted.

Everybody, would end up with what they wanted. A would end up with some well handled bread and would be lucky is someone had not taken a few bites on the way round. At least he would be able to get the goods that he wanted from H.

Gold

A might work extra hard and find a small nugget of gold, which would be of value to everyone on the island.

He could trade this gold with H, for some of the goods that he wanted. H would take the gold, because he would know that he could find someone who would trade their surplus for the gold. H could then trade with G to get what he wanted in exchange for the gold. This could proceed right round the circle. The orange arrows show the movement of the gold. Each person would give up their surplus in return for the gold, knowing that they could trade it with someone else. The yellow blobs represent goods received. Eventually, B would give the gold to Back to A, in exchange for A's surplus.

The goods would flow found the circle in one direction. The gold would move around the circle in the other direction. It would eventually get Back to A, who found it.

Everybody would end up with what they wanted. A would have get the goods that he wanted from H and would also get his gold back. Being a metal it would not be damaged, but there would be a risk that someone would file some gold off the nugget.

There would be four problems with this situation

    1. Trade would only start if A wanted to trade. If A did not want to trade nobody else would be able to trade. This would give too much power to A.

    2. Trade could break down at any point on the circle. If D decided the gold was worth more to him than what he wanted from C. He might keep the gold, and not trade with C. This would give him the power that A previously had. However, C and B would be left in a position where they could not trade.

    3. The trade round the circle might be too slow. It might take too long for the gold to move round the circle. B and C would get very frustrated, because they could not trade when they wanted to. (The velocity of the gold might be too slow.)

    4. If A found sufficient gold, he might go to each of the other people and buy their surplus. This would leave A in better position. The other people would not get the goods they wanted, but they would have some gold.

Everyone has some Gold

When the other people see that owning some gold gives some advantages, they might all want some gold. They might go and find some gold for themselves. If A was the only one who knew where to find the gold, the others might have to barter with A to get some gold. Once half of the people had some gold, the trading situation would change.

A C E and G could go and exchange their gold for the surplus goods with B D F and H, respectively. B D F and H would then hold the gold.

They could then exchange their gold for surplus goods with C E G and A.

Everyone would then have the goods that they wanted. A C E and G would have received back their gold.

The benefit of this solution is that trading is sped up, so that people will be able to do more than one exchange in a day. This increase in trade, will make the society more efficient.

There are some problems with this solution.

  1. People will put a lot of effort into searching for gold. While they are looking for gold, they will stop producing the surpluses that other people want. Time wasted searching for gold may reduce the overall welfare of the society, because less goods will be produced.

  2. Unless people are willing to give up their ability to buy goods, the gold always ends up with the person who had it at the beginning of the round of trading. Like the bread it ends up where it started. Apart from enabling them to trade, the gold does not add to their welfare. The society would be better off, if they could find a way of trading without gold.

  3. The system would be vulnerable to theft. People might debase the gold by mixing it with other minerals. Society would need a legal process for punishing people who committed theft in this way. (The most common method has been to give the king a monopoly on issuing coins. This has not worked well, because throughout history kings have been the worst offenders at this crime.)

  4. People would have to put security systems in place for protecting their gold from theft. They would be particularly at risk when moving away from their home base to do trade. This risk could be reduced by people placing all their gold into a security store and exchanging gold receipts when they are trading. (This is the origin of the modern banking system).

  5. Some days only one or two people may want to trade goods. On those days most of the gold will be sitting idle. On some days people may want to do a lot of trading. On those days their may not be enough gold to facilitate all the required trade. In general the optimum amount of gold will not be available.

The amount of gold in circulation in society (the supply of money) will become a significant issue. If there is not enough gold, trade may be slowed down. Apart from the slowing of trade, a shortage of gold will not be a serious problem. If there is too much gold, several people may want to buy the same surplus goods. A situation could develop, where all eight men want to buy the entire surplus of the other seven. If there is two much gold the price of the surplus goods will increase. Prices will generally rise until the value of the goods available matches the amount of gold.

Recording Transactions

An independent clerk might arrive on the island and set up system for recording trading balances, like that described in the parable (Beeble). The pattern of trade would work like this.

All previous exchange had been by barter, so each person would start with a balance of zero. A C E and G could go and buy surplus goods from B D F and H, respectively. The clerk would record positive balances for B D F and H.

B D F and H could then go and purchase some surplus goods from C E G and A. Their positive balances would be the proof that would entitle them to purchase from C E G and A.

The clerk would subtract from the positive balances of B D F and H. He would add to the negative balances of C E G and A. All balances would return to zero. Everyone would then have the goods that they wanted.

The clerk may make a charge for this service. However, an efficient computerised recording system would reduce the cost of any transaction to almost zero. The price for the service would be very low. It would likely be cheaper than searching for gold.

This approach achieves the same result as using gold.

This system has just three limitations, but they are easily overcome.

  1. A dishonest person might allow their balance to go negative by buying some goods and then refuse to sell anything to anyone else. They have effectively stolen from someone. This crime is easy to deal with, because their theft has been recorded. There would be a strong incentive preventing people from doing this. They would not be able to trade again, as the clerk would refuse to deal with them until they sold something that would return their balance to zero or positive (plus any penalty for theft). They would be outlawing themselves from society. Very few people would risk doing this.

  2. A dishonest clerk would be a serious problem. He could change some of the records in his favour, or accept a bribe to change another person's record. A legal process for punishing a clerk stealing in this way would be essential. However, the best protection would be competition amongst clerks. This would make stealing a risky business. A clerk, who was dishonest, would destroy his business, once he was exposed. People could be switch to another clerk, with a better reputation. Each clerk would need to guard his reputation carefully. One way to build a reputation would be to keep the books open to scrutiny by other clerical experts. This scrutiny and the risk of being caught being dishonest would tend to keep the clerk honest. This competition among clerks with respect to honesty would be very important. If the king gave one clerk monopoly rights, this protection would break down.

  3. Trade could only occur in places that were connected to the clerk's recording system. With modern communications networks linking computers, this is not a serious limitation.

With this system there is no concern about the supply of money. Every transaction involves two people. One person's account has the price added to it. The other person's account will have been debited by the same amount. The total balances will at all times sum to zero.

I have just shown the transactions that occur on one day. At the end of round of trade, every person has a balance of zero. (The money supply would be zero). The same pattern could be repeated on subsequent days. In reality, a full round of the transactions may not be completed in a day. At the end of the day some people might be positive and others would be negative.

Some times, if a lot of people have not completed all their trading, the value of positive accounts will be quite high. This does not matter, as they will be balanced by other negative accounts. At other times they may go down close to zero, if most people have completed both their selling and buying. However, at all times total balances would still sum to zero. (The so-called money supply does not matter).

Note

I have assumed in each option above that all exchanges are equal value. In practice, this would not be the case. People would want to make exchanges of different value. In a gold system, the gold would need to be in coins of different denominations to allow exchanges of different value to take place. With the transaction recording system, the clerk would just record the appropriate value for each sale. The only limitation would be on the number of decimal places the clerk's system could store.

(For simplicity I have ignored saving, but this can also be dealt with be adding a timestamp to the clerk's records. This is explained in my article on money).

Credit

The clerk will allow all eight people who live on the island to go negative when buying goods provided they have a reputation for honesty. However, they will have to get Back to zero or positive within a few days. Every one who is honest will have this privilege. The value by which they can go negative will be determined by a formula based on their trading history and record of payments. If they do not get Back to zero as required, they are effectively stealing from someone. They would have to go positive before they could trade again or they would have lose the privilege of going negative. Foreigners would not have this privilege as their reputation would not be known.

The privilege of going negative is a form of credit. The clerk is not giving or creating credit, as credit is something that an honest person already has. The clerk just acknowledges their honesty and reliability (credit). The person allowed to go negative must have a reputation for honest dealing in trade. They are creditable so they have credit. The clerk just recognises their reputation (credit). If they do not go Back to positive, they will quickly lose their reputation. Their credit will disappear. They will become a discredited person and will lose the privilege of being able to trade by going negative first.

The clerk would have to be careful about allowing people who are not creditable to go negative, as it would destroy his business. The business is dependent on honesty being maintained. The clerk will have a role in assessing the credit of people who are trading, as if he allows people to be dishonest the consequence will be worse for him than for he fraud. To protect their business they would have to be very cautious in recognising credit.

Credit card companies already carry out this function. They give new clients a small credit limit. They allow these clients to go negative. As clients prove to be creditworthy, they increase their credit limit. This allows them to go negative further.

We often say that the bank has given us credit. This is incorrect. Banks do not give us credit, they recognise the credit that we already have established for ourselves through honest and creditable behaviour.

Each honest person on the island will have credit that will be evident to the clerk. They will all be wanting to increase their credit as much as possible by practicing honest and reliable behaviour. They will not be interested in living in debt, but will only go negative to facilitate trade. Their reputation for honesty will always far outweigh the value of their temporary negative balances.

The total value of the credit available will not matter, because most people will never use all the credit. The volume of trade will not be determined by the total credit of the people, but by there ability to pay for their purchases. People will have to limit their total purchases to what they can sell, so that they do not lose their credit. A person who loses their credit, will be limited to selling before they can buy. Those who have credit will have the option of buying before they sell. This will enable them to get better bargains, so their credit will be something they value highly. People who have the great credit will guard it more carefully, because they have the most to lose.

This system will benefit those who have proved they are honest, because they will have greater choice and opportunity to make the best deals.

This system does not need everyone to have credit. In the example above, on half of the population went negative. An even smaller proportion of honest people will be sufficient to get trade started.

Those who are dishonest will be able to survive. They can still buy and sell, but they will always have to go positive before they can make any purchases. Dishonest people will still be able to participate in trade, but they will be forced to sell (or work) before they can buy. They will forced to trust others.

If a modern banking system was transformed to work on these principles, most people would start with positive balances in their accounts. Therefore, allowing people to go negative would not be such an important issue. It might be required as trade expanded and the population grew, but generally it would be taken care care of by declining prices.

To see a detailed study of Money.