Barter to Billions - An Economic Odyssey

If there is one thing without which an economy cannot exist, it is a 'surplus'. This is a story about how the modern economy came to be and why things are the way they are. Only by understanding the past can we explain the present and plan for the future.

'Once Upon a Time'

Hunter-gatherers / foragers relied on their immediate environment and would hunt, fish, and harvest naturally occurring fruits and vegetables to meet their needs. The challenge of this lifestyle was that the natural resources it relied upon would spoil rapidly, and the people of that era had only fire as a means to cook food, without the ability to preserve or store it. As such, productivity mattered only to the extent you weren't foraging enough to meet your short term needs as anything beyond that would simply go to waste.

Since foragers were largely focused on finding and consuming what they needed on a daily basis, there were few goods left over to exchange. There was no concept of money (a generally accepted store of value / medium of exchange; for example US Dollar, cigarettes in prison), and goods were generally just exchanged for each other (barter). In some cases, however, goods were given with an assumption of reciprocity down the road. This assumption of reciprocity was essentially a form of debt.

Humans remained hunters-gatherers for tens of thousands of years, but eventually consumption pressure from a growing population and climate change started putting a strain on environmental resources. Humans in many parts of the world were forced to find new ways of obtaining food, and this led to the agricultural revolution. It is noteworthy that the strain on the environment was so pervasive that agriculture was invented in multiple parts of the world entirely independently. In parts of the world where the environment remained rich in resources (Australia, South America), humans continued to forage. (Need really is the mother of invention!)

Who's Going to Take Care of This?

Agriculture made it possible for humans to produce more than they were consuming, presenting an unprecedented challenge of figuring out what to do with the excess. As Yanis Varoufakis writes in his book Talking to My Daughter about the Economy: A Brief History of Capitalism, agricultural surplus is what gave rise to writing, money, and government.

Agricultural surplus was stored in common granaries, and writing was invented to keep a record of how much each person deposited. The granaries had rulers and were overseen by guards to protect against theft. Eventually rulers started paying workers with engraved shells depicting pounds of grain they could collect once they had been harvested - thereby making it a form of debt. People routinely exchanged these shells for goods, and as such were using them as money.

For this system to work, people had to have a great deal of trust in the ability of granaries to honor the shells. The granaries as such came to be backed by central authorities (rulers, royal families, government). The concentration of power in the hands of the few (central authorities and their official representatives) gave rise to inequality. While farmers toiled in the fields, the elites of society became powerful and wealthy, free from the concerns of foraging. Agricultural surplus thus necessitated its management, giving rise to the word 'economy,' derived from the Greek word 'Oikonomia,' which means 'household management.

Agricultural surplus caused an increasing number of people to consolidate in one area, and this led to the formation of villages, towns, and ultimately cities. Kingdoms and dynasties soon emerged to exert control over the newly formed cities, and this also contributed towards an increase in use of money as a medium of exchange. Farming families continued to produce their own food, and as such for the masses the motive of production remained personal consumption. As the years went by people started focusing on producing whatever they were most efficient in (comparative advantage) and in combination with technological advances this gave rise to global trade.

Bon Voyage

Technological advances in shipbuilding and invention of a compass made it possible for Europeans to explore trade beyond traditional borders. This gave rise to merchants who soon became some of the wealthiest people in society. Merchants took advantage of a global trade web consisting of wool from England and Scotland, silk from China, swords from Japan, and spices from India.

The flourishing global trade partly led to the 'enclosures' in Britain - landowners (envious of the wealth merchants were accumulating) built fences around their estates and replaced peasants / serfs (agricultural laborers) with flocks of sheep to produce wool for international trade. The serfs were thus displaced from lands their ancestors had lived on for generations and forced to find new ways of making a living. Serfs, without any property of their own, had no choice but to go around town offering to work in order to afford food and shelter. This is what created the labor market.

Landowners came up with a structure whereby they rented out their land (often to serfs) based on the prevailing market value of wool. A serf renting land for production was essentially an entrepreneur, and had to borrow money (credit) to cover rent and the upfront costs of production before any goods were even produced / sold. Credit thus became an essential part of the production process and the motive of production shifted from consumption to profit.

Chasing Green

Technological advances and particularly the development of the steam engine led to the Industrial Revolution. The resulting increase in production / manufacturing / transportation capabilities led to the creation of factories and businesses with a profit motive. All these business ventures required significant upfront investment, but anyone could become an entrepreneur as long as they were willing to take on the debt required to do so. Debt is a double-edged sword, and while it was the catalyst for wealth creation for some it left others deep in poverty (Note that it wasn't until 1977 that the first Limited Liability Company / LLC was setup and as such entrepreneurs were personally responsible for their debts even if it meant selling all their belongings). The greater role of debt / credit in society allowed the banking system to flourish.

Similar to the granaries discussed earlier, banks allowed people to deposit whatever surplus money they had. Unlike granaries though, banks also let entrepreneurs borrow money (credit). Moreover, banks only had to hold in reserve a fraction of the loans they made (~10%), and till date banking follows a 'fractional-reserve' model. A few key things were happening here - 1) Money was essentially being created out of thin air, 2) Banks were assuming not every depositor would demand their money at the same time and the fractional reserves would be enough to meet withdrawals, and 3) Entrepreneurs were relying on investments generating enough return to at least pay off the loan / debt.

Banks were incentivized to keep lending as their profits were tied to the interest payable on loans, but there was a delicate balance to be struck as excessive lending could in theory be detrimental to everyone involved. This theory became a reality when the credit fueled excesses of the 'Roaring Twenties' partly led to the Great Depression that started in 1929 and lasted for more than a decade.

A Delicate Foundation

All debts come due. The overenthusiastic lending / borrowing eventually led to the debt burden becoming higher than the investment returns, and as a result entrepreneurs fell behind on their payments (default) and went bankrupt. As businesses started to fail and factories shuttered, workers found themselves unemployed. These workers and business owners, left with no source of income, cut back on their spending.

One person's expense is another's revenue - those relying on someone's spending were in turn out of income. Thus an increasing number of people defaulted on their bank loans. People then started questioning the banks' financial position given the widespread defaults, and an increasing number started taking their deposits out (bank run). Given banks only held fractional reserves, many were unable to cope with the increasing withdrawals and failed. People who had money left in these failed banks lost every penny. This led to further misery and even people who had money put away cut back on their spending. The trust upon which the economy was built thus fell apart, and it was caught in a self-perpetuating downward spiral.

Desperate, people sold whatever assets they could which led to a further decline in asset prices. Facing an uncertain future, banks were unwilling to lend and entrepreneurs were afraid to borrow / invest, and this created a vicious cycle that led to a prolonged period of downturn (slump). Governments and central banks had to intervene. In the United States the Federal Deposit Insurance Corporation (FDIC) was established in 1933 and insured up to $2,500 per account. While the Federal Reserve's (US Central Bank / the Fed) initial approach of raising interest rates was a grave misstep that exacerbated the downturn by stifling borrowing and causing the economy to stagnate, in the mid-1930s, interest rates were lowered. This policy shift revitalized the economy.

The most significant lesson from the Great Depression is that restoring public faith in a better future is key to stimulating the economy. It's this faith in the future that drives entrepreneurs to borrow money and invest, factories to reopen and hire workers, and people to resume spending knowing they'll still have a job and a paycheck the next day.

Capitalism doesn't work if money is hoarded as wealth, it only works if it is reinvested as capital.

Here We Are

Lessons from the Great Depression continue to be relevant today and were instrumental in navigating the Global Financial Crisis (2007-2008) when the US made a swift recovery as expansionary policies ensured credit did not dry up (Note that expansionary policies can have unintended consequences such as high inflation but that's a topic for another day). The internet and social media have added another layer of complexity to how various players in the economy interact, and this was evident in March 2023 when there was an 'X' (formerly Twitter) fueled collapse in trust in the banking system that resulted in bank runs and forced the FDIC to intervene. Governments and central banks all over the world continue to play a critical role in holding together today's economy.

What started with a local farmer's leftovers has transformed into a global phenomenon that continues to evolve.

That, in a nutshell, is how the economy came to be.

This essay was inspired by Yanis Varoufakis' book 'Talking to My Daughter About the Economy'.

Disclaimer: All content is for informational purposes only and should not be construed as legal, tax, investment, or financial advice. All opinions expressed are strictly my own and do not represent those of any company or third party.