Once upon various times, pretty much everything was used as money. People just needed to have faith that it could be used as a medium of exchange. Oxen, dried tobacco, salt, shells, cocoa beans, precious stones even feathers have been in use as mediums of exchange before.
However, preference was assigned to precious metals above every other commodity.
Different metals have been used by different nations for this purpose.
Iron was the common instrument of commerce among the ancient Spartans, copper among the ancient Romans, and gold and silver among all rich and commercial nations.
The metals had a special quality; that without any loss, they could be divided into any number of parts, and by fusion those segments could easily be reunited again.
Gold remained the symbol of financial and commercial power and became the centrepiece of trade, hence the goldsmith’s tale. To facilitate commercial transactions, goldsmiths made business easier by casting coins into standardised units whose weights and purity were certified by entities called the Mint. But to protect his gold, the goldsmith stored the gems in a vault.
Soon afterwards, his fellow rich townsmen were knocking on his door to rent space to store their gold. Not long after, the vault was full of tenants’ gold, earning him some rental income.
As years rolled on, the goldsmith made a very astute observation. His depositors rarely came back to remove their physical gold; and even if they did, they never came all at once. This is because the claim checks, which he gave his tenants as paper receipts for the gold were traded in the marketplace as if they were gold itself.
In fact, this paper gold was far more convenient than the actual gold coins and amounts could just be written instead of laboriously counting gold coins one by one for every transaction.
This was the birth of paper money. The goldsmith would eventually be replaced by banks. And every gold paper issued by a bank in favour of the depositor would be backed by gold in the bank’s vault.
This introduced some form of parity, which became the famous gold standard. The paper gold represented a promise by the gold depositor to make payment (to a seller of goods or services) at a future date (or an I-owe-you).
They were also a liability to the bank because they represented a claim to the gold. The bank merely issued the paper to guarantee the seller that his/her money would be paid, but the bank itself had no commercial interest in the transactions.
Fast forward to the 20th century. The gold parity was abolished and central banks took over the role of issuing currency, but without the backing of gold in the vault.
The banknote today, which remains a liability to the issuer, represents an IOU without any corresponding physical asset backing it.
The only backing it has is the trust citizens have in the issuer (the government) and the law declaring it as the only legal tender.
Consequently, if the Central Bank of Kenya, the issuer on behalf of the government, withdraws the legal tender of existing banknotes (demonetises them) and asks holders to return them in exchange for a new legal tender, it has basically reissued the promises.
However, since there were no assets in its vault backing any of its previous promises, it cannot claim, as windfall, any banknotes that have not been returned.
Conceptually, the old promises have simply lapsed. And if it goes ahead to claim the windfall, as it did last week to the extent of 7,386,000 pieces of Sh1,000 banknotes, then it has printed money outright. This is an action whose (de) merits can be debated in the face of the coronavirus pandemic.