Why paper money systems all fail

"You can't blame the king of Persia for printing up money no one could trust. His neighbours in China were doing the same, after all, and with the same inevitable consequences, too..."

Creating money from nothing to try and keep the economy stoked is far from a modern invention. Mistaking extra money for value is a common enough event throughout history, in fact, right from the 99% debasement of Roman coins in the second and third centuries AD to the paper hyper-inflation of Weimar Germany in the 1920s.

The horrors which excessive money then spawns are a regular feature as well. Yet politicians and potentates still believe they can out-do the ancients... somehow plucking wealth from thin air with better success than everyone else. Most often in history, this futile attempt meant inking a state-decreed value onto the pulp of dead trees.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Seven hundred and fourteen years ago, for instance, the kingdom of Persia suffered just such a government-made surfeit of money after the harsh winter of AD 1294. Thousands of cattle and sheep had died in what's now Kazakhstan. So many thousands, in fact, it emptied the king's treasury of much-needed tax revenues.

The king responded by printing great quantities of "chao" - a Chinese word for the paper money first invented almost three centuries before. And "on 13th August 1294," says a mid-20th century history, "a proclamation imposed the death penalty on all who refused to accept the new currency.

"Considerable quantities of chao were then prepared and put into circulation on 12th September." The experiment lasted scarcely two months, as Glyn Davies explains in his magisterial History of Money. "[It] turned out to be a complete disaster, with the bazaars deserted and trade at a standstill."

You can order people to accept money on pain of death, in other words, but you can't then make them buy and sell with it - if only because they might choose instead simply to stop buying and selling altogether!

But making money from nothing looked such a great trick at the time, who can blame the Persians for trying?

"In this city of Kanbula is the mint of the grand Khan, who may truly be said to possess the secret of the alchemists, as he has the art of producing paper money..."

So wrote Marco Polo in his famous Travels

(1275-1292), reporting on the magic of Mongol currency in China - a magic which the kingdom of Persia merely sought to repeat. And to his readers back in Venice, Polo's story of making real money from paper must have seemed just as fantastic as his stories of three-headed monsters and eight-legged gods.

"When ready for use, [the Khan] has this paper cut into pieces of money of different sizes...[and] the coinage of this paper money is authenticated with as much form and ceremony as if it were actually of pure gold or silver."

Gold and silver were of course money back then. Limited by metal-mining supplies, people trusted their value - both as a means of exchange and a store of purchasing power for the future. But provided the Great Khan didn't issue more paper than he had gold and silver to back it, all would go swimmingly. So long as he restricted any excess of paper, in fact, he might hope to prevent it collapsing in value when the rice-paddy peasants caught onto his wheeze.

"This paper currency is circulated in every part of the grand Khan's dominions," the Italian traveller went on, "nor dares any person - at the peril of his life - refuse to accept it in payment... With it, in short, every article may be procured... All his majesty's armies are paid with this currency, which is to them of the same value as if it were gold or silver.

"Upon these grounds, it may certainly be affirmed that the grand Khan has a more extensive command of treasure than any other sovereign in the universe."

Alas! These great riches sunk under their own weight again - just as they had three times or more since being invented sometime around 1032. They needed repeated re-valuation and fresh paper issues right through to the final collapse in the late-15th century, by which time the 1448 Ming note was worth just 0.3% of its apparent face value.

Still, after some 400 hundred years of trying and failing, at least the Chinese emperors finally latched on. Paper money and the inflation it brought wasn't used in the Middle Kingdom again until the early 20th century.

This article was written by Adrian Ash for Whiskey and Gunpowder.