Birth of the Modern Economy

Birth of the Modern Economy

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First Settlements

The foundations of what we consider modern currency originated even before complex settlements took their form. In a time where nomadic lifestyles were the norm and provided the highest likelihood of survival, it was commonplace for different nomadic groups to interact with one another along their journeys across the globe. Eventually, these nomads transitioned into settled communities; they would use their survival skills to develop long-lasting homes where resources were bountiful and accessible. As early as 10,000 BCE, the beginning of agricultural farming systems and surplus food led to the first true form of trading: hunter-gatherer societies.

The basis of the hunter-gatherer society is simple: you trade what you can provide. It revolves around resource availability as well as artisan skills, where you acquire your own goods to trade for other goods that aren’t procurable for you. The first example was hunters trading their meat for the grains, herbs, and spices of gatherers – hence the name hunter-gatherer. We could think of this as simple bartering, a relationship where a certain amount of one item is traded for a certain amount of another item. As trading relationships became regular and settlements transitioned into sustainable areas, simple bartering expanded to resources and skills beyond basic survival needs. Professions including lumberers, fishers, blacksmiths, and carpenters offered an alternate option to the same basic principle, where traders had a greater variety of services and goods they could access through their own work. These professions also changed trading from good to good, to service to good, and service to service. This desire to sustain, survive, and obtain resources fueled the ancient settlers’ drives to continue working, trading, and building their own infrastructures.

Finding a Medium

Although this system was very effective in the sense that almost all resources were accessible through simple bartering, there were many flaws that influenced the balance and efficiency of these systems. The main flaw of the first renditions of simple bartering was the lack of a unit to value a particular good or service and in turn evaluate a “fair” trade. When your goods are no longer desirable for a count-to-count trade, you are left without an effective way to complete the trade for the good you desire.

For example, say fisherman John wants farmer Henry’s cow. John can only trade fish to Henry, but Henry is unwilling to trade for John’s fish because he already has fish from another fisherman, who gives him a better deal. The only way for John to acquire Henry’s cow was to provide him more fish for the same cow, which was not feasible for him. Through the example of John and Henry, we can understand that without a universal metric to determine the value of an item, bartering was an ineffective way to measure the value of a good.

This realization finally led to the birth of currency, which started out as valuable metals. Serving as the natural human desire for rarity and proving usefulness as a building block, metals became the most convenient and desirable form of currency. Through using metals as a quantifiable tool, there became a medium that could be used to put a value on products and make it easier to buy and trade whatever was needed with a standardized form of measuring value. We can now reanalyze how this affects the dynamics between John and Henry. To accommodate Henry’s disinterest in John’s fish, Henry priced his cow in the metal-based currency, so John would be able to purchase Henry’s cow while Henry could receive an agreeable value.

The benefits of centralized currency didn’t stop there: currency helped people to accumulate wealth, which led to stabilizing societies and their economy. This eventually led to social class based on economic “value”. By giving metal each their own sense of value, metal coins did not become a form of currency, but instead became a useful tool for society. The true value behind these metals – and even currencies in today’s world – revolves around the idea that their importance is shared. These currencies are so prominent in society and hold such value because every member of that community holds them in the same regard, and holds an implied status, security, and safety. Time and time again, we’ve seen great empires and societies reach this principle and embed this economic idea into their society.

Paper Currency

After centuries of using coins as a currency, the Tang Dynasty in China invented banknotes or paper currency in the 7th century. This was the first form of currency that did not hold its value for the actual material that it was made of. Paper currency rather gets its value from the belief that the people have towards the government or central authority. Belief in a government that issues paper currency as a medium to transfer goods is what gives currency its value.

As time passed, many other nations in other parts of the world started to follow along with China’s invention of paper currency. Paper currency started to become used all across the world as it proved to be far more efficient compared to carrying and using coins and metals of value for trade. During this time the Silk, Sea, and Sand Roads were still in use where traders carrying metal coins to barter would be far less efficient and more prone to attack from bandits and thieves of these trading paths. Paper currency was therefore preferred and became extremely useful.

Mercantilism

During the 1600’s, mercantilism – a mixed economic system, having heavy government involvement – emerged as an economic theory that established how there is a fixed amount of wealth in the world, often measured through gold and silver. European powers were looking to obtain this wealth that was spread around across the Indian Ocean’s trade networks; however, they could never successfully take over territories with more established civilizations.

These European nations ended up implementing imperialism, a political and economic system that influences other nations through its own military force where a nation’s incentive is to colonize other territories and their people for their own benefit of wealth. They moved forward with imperialism and started to embark on setting upon colonies that took advantage of free labor from slaves that were transported in the Transatlantic slave trade. By having this new economic theory and mindset, European powers tried to gain as much wealth as possible. Here, the person with the most of this supposed wealth will be considered the wealthiest and most powerful.

New Capitalism vs Mercantilism

They often enforce having as much exports – outward trade – as possible while minimizing imports – inward trade – in order to maintain a favorable balance. This unfavorably benefited the wealthy connected to the government which usually takes the majority of the profits and wealth from this economic implementation. In order for the government to maintain the favorable balance of trade there were often taxes or tariffs on imported goods often incentivizing the use of making your own products and exporting goods in order to gain wealth.

In 1776, Scottish philosopher and prominent economist Adam Smith took a newfound, systematic approach to understanding how trading markets function: capitalism. Capitalism was a very unique economic system in its time, where it allowed the individual to employ their own services or goods for profit disassociated with the government. In capitalist systems, businesses and traders are encouraged to maximize profits while consumers remain free to purchase at will. The idea that individual businesses are free to determine price of a good or service instills reaction in consumers, where depending on their valuation, a business’ service becomes more and less desirable.

This model creates a very competitive, business driven economy, known as the free market. The free market resembles the idea that the value of a good or service relies on the consumer, not the producer. As the supply of this good or service increases and decreases, assuming all other external factors remain constant, the demand for it reacts inversely. As capitalism explains, consumers are free to observe alternate options to this service, justifying why the inverse holds true.

This idea of supply and demand, in turn, reflects the price at which the good or service holds. One such price change is a shortage, which occurs when the demand for a good exceeds its supply, which will raise this price. A surplus models the opposite effect: as the supply of a good exceeds the demand, the price will lower. As a service or good endures countless cycles of supply and demand, it will eventually reach a point known as market equilibrium. At market equilibrium, the supply and demand for a good are almost equal, where the price of a good reaches stagnancy at this point. Smith’s new thinking models most economic systems we see today.

Contrary to the centralized, government-heavy ideas of mercantilism, Smith’s capitalism empowered the idea and importance of self-driven economic growth and the free market. Fundamentally, mercantilism operates under the idea that wealth is a finite measure, whereas capitalism uses the production of services and entrepreneurship to increase wealth. Mercantilism’s emphasis on the import-export culture of the economy allows for almost total governmental influence over the economy.

Through the complex trade networks that mercantilism generates, governments hope to use tariffs – or trade related taxations – to maximize local export; capitalism in this context is independent of government motives, where trade barriers are avoided to maximize individual trade efficiency. In societies where innovation and entrepreneurship are growing in popularity and applicability, capitalism’s freedom accommodates the future. Finite wealth is an idea of the past, leaving capitalism in the favor of many newer societies over the last centuries.

Smith’s Ideas

Smith explained his ideas behind capitalism throughout his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, which  heavily influenced European society as a whole. In England, uplifting a policy known as “The Corn Laws” (which secured the price of grain during the 19th century) was the first of many acts to promote capitalism and led to them becoming a dominating economic power in Europe. Like England, many other nations across Europe took interest in Smith’s exhaustive research and developed their economies to highlight the benefits of divisions of labor, industrial competition, and the internal-external trade systems throughout his book. The book pounced on the flaws of government intervention and effectively provided a step-by-step plan to achieve his capitalism.

A unique principle that the book prompted was the idea of laissez faire, a French term which generally translates to “leave untouched” or “left alone”. The premise of this idea was that even though government regulations, control, and balance may provide security for certain industries, the ideas of free market and supply and demand will naturally resolve any imbalances within the economy over time, where no external interference is necessary to preserve the stability of a nation’s economy. Altogether, the work of Adam Smith in fathering modern capitalism had an immense impact on the structure of world’s economies and changed the way economics is viewed today.

Capitalist Empires

Before Adam Smith’s introduction of capitalism, the Dutch East India Company and the British East India Company were created in the early 1600’s. These were the first privately owned joint-stock companies which were companies that allowed people to buy shares of the companies worth and be able to own a part of the company which also meant they would profit a small percentage of the companies earnings. This topic will be elaborated further in the Stocks section. Both of these companies were significant due to their historical significance and its close connectedness towards both mercantilism and capitalism. The Dutch East India company acquired a 21 year monopoly over the trade in the East Indies where they were incentivized to colonize territories, establish trading posts, and control trade.

Their main accomplishment was controlling the spice trade in modern day Indonesia where these valuable commodities were easy to grow. The Dutch East India Company was able to monopolize on the growing of these valuable spices and ended up controlling the prices of these spices. Trading posts all across Asia were set up as well including factories to control the trade of these commodities for easier transportation and access to higher profit margins. They also ended up trading other commodities, exploring the banking industry and shipbuilding as well. Overall, they were able to generate the majority of their wealth due to their monopoly over the trade industry in Southeast Asia that allowed them to capitalize on getting supplied with commodities and valuables for far less prices that could be sold for far more in other parts of the world. They were able to take advantage of the high demand for these commodities in Europe and were able to supply for far less in Asia which benefitted them the spread of profit from each trade.

Influence of World Events

Different economic systems have provided varying performances in different societies, but it’s often world-level events that influence a nation’s economy the most. The aftermath of World War 1 exemplifies how war shatters economies in extremely short timespans, where in this example, both Germany and Russia were under effect. After their defeat in World War 1, Germany faced heavy reparations detailed in the Treaty of Versailles in 1919.

Their already weak economy was put under even more stress by these reparations, and led to a hasty decision to increase the money supply by printing money to deal with missing funds. With a greater amount of money in circulation but the same amount of goods available, people become willing to pay more for the same amount of goods available. As a result of new money that had not existed before the war, the prices of goods across the country skyrocketed. The same dollar that could buy a loaf of German bread became a fraction of what was necessary to buy the same bread after the war. As these prices continued to grow, German citizens demanded greater wages to keep up with the growing cost of living. German officials at the time were unable to cope with these dire circumstances with little backing by the German people and the rise of extremist German political parties muddling their ability to aid the situation. These extremist German ideals transitioned into the birth of the second world war, but the effect of external circumstances on the economy remains evident.

When Germany was facing heavy consequences set forth by the Treaty of Versailles and the government printing more money in order to pay up for the expenses of World War 1, the German mark became almost worthless. With the printing of so much of the currency there was too much money in circulation causing the currency to lose most of its value. This instance of the same currency being able to purchase less with the same amount from earlier is known as inflation. In the peak from 1921 to 1923 when the German mark started losing its value, people would need barrels of cash in order to buy a loaf of bread, which obviously signified the major consequence of printing too much money to compensate for bringing the economy back up. This scenario is known as hyperinflation, or when inflation gets out of control.

Inflation can be defined as the way the general price of a good service changes in an economy, defined by the CPI and PPI indexes. CPI is an average measure of how much a consumer pays for a service compared to previous years. Similar to CPI, PPI is the average measure of how much providing a service costs compared to previous years. These values are so important because they influence how prices change and fluctuate. Based on CPI and PPI, general prices of goods and services inflate over time. Severe inflation is often caused by decrease in supply, change in taxation policy, and in this instance, increase in money supply. This German situation can be deemed as hyperinflation because of the rapid increase of German money supply, which led to a sharp increase in CPI with the supply of German goods constant.

Similar to Germany, Russia also faced economic uncertainty after the first world war, but used a very different method to recover from their losses. Known today as the Russian Revolution, Russia went through a swift transition into different ways of organizing the country. The new Russian government administered a series of economic and political policies known as NEP, which allowed for a limited market-oriented economy in the form of private businesses. These policies were very influential in providing a period of stability and recovery in the Russian economy. During the 1920s and 1930s, Russia went through a rapid period of industrialization. Industry projects such as dams, railroads, and resource harvesting increased exports dramatically. The most important of the harvested resources was the agriculture industry, which utilized collective farming for an extreme surplus of products. These resources were sold throughout Europe and allowed for Russia to return to a stable economic state. Although the means of Russia’s success were indeed unethical and led to the Soviet Union’s collapse in 1991, we can see a clear difference in the ways in which these two nations recovered from economic despair.

The Great Depression

On the other side of the world, one of the greatest economic failures of the 20th century began. The Great Depression began in the United States in 1929, and marked a time of unprecedented unemployment (reaching peaks of 25%) and international economic instability. Millions of Americans were left jobless until 1939 and consumer spending rapidly declined due to many being unable to afford basic needs. Similarly, the GDP (Gross Domestic Product) of the United States during this period decreased by almost 30%, as businesses could no longer support themselves.

The heart of this depression was the infamous stock market crash of 1929, known as “Black Tuesday.” This crash, where stocks rapidly lost value, was a result of corrupt trading and insecure trading. Certain people were informed of private information to make more informed trades while investors traded stocks with borrowed money, which in turn overvalued stocks. Along with this crash, industrial overproduction and surpluses of inventory massively decreased consumer demand. This was particularly prevalent in agriculture, where crops were sold at an extremely slow rate compared to previous years. This left the agriculture industry in a very weak state. During this period, thousands of American banks collapsed, leading to consumer wariness and a need for new financial government regulations.

Monetary Policies

After the Great Depression, nations enacted monetary policies in order to regulate money supply and stop future financial crises from happening. In 1907 there was a financial panic after many bank runs and citizens and businesses closed down due to these banks going under. During the early 20th century there was also high fluctuation risk in the US economy with no regulation which left no last resort for a failed bank to give back money. This caused Congress to issue the Federal Reserve Act, creating the Federal Reserve system in 1913 to primarily prevent these bank runs as such in the 1907 panic.

Starting in the 1990’s the Federal Reserve started coming up with monetary policies to tackle inflation. Many other banks in other countries including the European Central Bank have used interest rates to slow down inflation. By raising interest rates, borrowing becomes much more expensive for the everyday person, making people not want to spend that much of their income on expenses. This then affects businesses who have less customers and in turn raises prices which then affects their employees who will need a higher wage in order to live in the more expensive times. This circle keeps spiraling out of control which all eventually decreases inflation; however, there also comes a high chance of risking a recession at the same time if a sector of the economy crashes. For example, the banks which struggle in a higher interest rate economy (needing to loan out at higher interest rates to be profitable) sometimes have a chance of going out of business.

Recently

During the Financial Crisis of 2008, the Federal Reserve introduced a new sort of monetary policy known as quantitative easing. This was an unconventional way that the central bank used in order to push the economy into an uptrend once again. The central bank resorts to quantitative easing when lowering interest rates doesn’t bring the economy up during the bottom of a recession. Rather they tend to look towards increasing the money circulation for people to then have incentive to spend money again and eventually move the economy back on an uptrend. They start by printing more money and buying back bonds and securities from banks in order to lower long-term interest rates.

Today’s economy is an ever-changing system built on a culture of imports and exports. The desire for goods, services, and information fuels the world today, comprising various systems of banking, trading, and technology. New markets and advances in understanding the financial markets make the economy so dynamic. Taking away beginnings of the financial systems of the world we live in, we establish a better foundation of how the world’s economy functions today.

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