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Finance

The earliest economic interactions were direct barter: I’ll give you my goat for ten bushels of your wheat. Because such transactions are as explicit and direct as possible, they were easy to evaluate and police. One party examines the goat and the other party examines the wheat. They each see what they’re getting and there is no further cause for interaction after the exchange is made. Thus, the earliest forms of financial interaction were direct, explicit, and utterly devoid of abstraction.

This was sometimes clumsy: What if you were willing to sell only five bushels of wheat? I couldn’t sell you half a goat. This problem was solved by stepping up to a higher level of abstraction: the use of precious metals. I’ll sell you my goat for three shekels of silver. A shekel, by the way, was originally a unit of weight, not a coin.

Problems then arose when people cheated by trying to pass off these precursors to coins that really didn’t contain as much precious metal as they were supposed to contain. This required a new jump to a higher level of abstraction: the standardized coin. This was a chunk of precious metal that was manufactured by the state and guaranteed to be of pure metal and the correct weight. The proof of the value of the coin was the face of the king who issued it: “King So_And_So the Great guarantees that this coin is trustworthy.”

Note how coinage moved the economy to a higher level of abstraction. At that point, all fiscal accounts were kept in the otherwise arbitrary units of coinage. A rich man might be worth 10,000 sisterces. What does that mean? It’s an even more abstract concept.

Coinage worked well for a long time, until another new problem arose in the Middle Ages. Traders were traveling over longer distances, but the roads weren’t particularly safe. Traveling across Europe carrying a few pounds of gold was an open invitation to highway robbery. Merchants needed a safe way to handle their transactions. Thus was born a new and even higher level of abstraction: the bill of exchange.

This was nothing more than a note saying “Joe the Merchant authorizes Fred the Banker to transfer 50 ducats from Joe’s account to the account of Charlie the Merchant.” In other words, the bill of exchange was basically the same thing as an endorsed check. This meant that merchants could carry around pieces of paper rather than coins, making them robber-proof.

This was an immensely important leap in abstraction because, for the first time, the concept of value was divorced from a tangible object. Instead of transferring wealth through tangible intermediaries such as precious metals, wealth could now be transferred through a piece of paper. This represented a higher level of abstraction of the concept of wealth.

These bills of exchange stimulated the European economy and pretty soon they were flying all over Europe. Keeping track of them was becoming quite a hassle. If a bill of exchange bounced (due to insufficient funds), it was a huge hassle to track down the deadbeat and get your money.

Banks solved this problem by issuing generic bills of exchange. These were notes from a bank promising that the bank itself would pay the bearer a standard amount of coin. There were notes for one ducat, five ducats, ten ducats, and so forth. You gave your coins to the bank, and they gave you bank notes equivalent in value (after bank charges) to your coins. Then you paid other merchants with the bank notes. The merchants didn’t have to trust you; they had only to trust the bank that issued the note.

Of course, there was even more abstraction involved in this solution: Now the value existed in a bank that didn’t actually have the money. The prudent banker loaned out most of its money to get interest, and kept only a small amount in reserve to handle payments. So now you had to think in terms of value that resided in a bank and value that consisted of all the bank’s assets, most of which weren’t even coins.

This worked well, but there was still a problem: Sometimes banks would go bankrupt and the people holding all the banknotes from that bank lost their money. So then governments stepped in and established national banks, which were guaranteed not to go bankrupt. The banknotes issued by those national banks are what we now call paper currency. If you read your dollar bill carefully, you’ll see that it’s really a “Federal Reserve Note”—a banknote from the Federal Reserve Bank.

This idea of a national bank pushed the abstraction up another notch. As you might guess, a new problem arose: Those paper notes could be stolen just like the coins. So people learned to keep most of their money in banks and use banknotes only for “walking around money.” This pushed the abstraction even further: Now your wealth wasn’t measured by the banknotes in your possession, but by a number in the bank’s records for your account. You could have a million dollars in the bank but only a hundred dollars in your pocket. So now money had become really abstract—just a number stored in a book somewhere.

The next step in the process was the credit card. This is nothing more than a piece of plastic with your account number on it. You charge something to your credit card, and your signature constitutes a promise to pay that amount. The bank that issued your credit card pays the merchant and deducts that amount from your credit card account.

Let’s trace the levels of abstraction at work here: Your credit card points to your credit card account, which you pay off with money from your regular bank account. Your regular bank account contains a number that represents the amount of money that you have deposited with the bank. The money represents some amount of precious metal—well, it used to do that—which in turn represents a concept called wealth. Whew! That’s a lot of indirection!

Thus, as economies grew larger and more complex, the financial system underlying them grew more and more abstract.

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