Back in time before there were governments, before there was currency, one system that worked for acquiring goods was barter. Let’s say Alice wants a tool and Bob wants medicine. If each of them happen to have what the other person needs, then they can swap and both satisfy their needs.
On the other hand, let’s say Alice has food that she’s willing to trade for a tool, while Bob, who has a tool, doesn’t have any need for food. He wants medicine instead. Alice and Bob can’t trade with each other, but if there’s a third person, Carol, who has medicine that she’s willing to trade for food, then it becomes possible to arrange a three-way swap where everyone gets what they need.
The drawback, of course, is coordination — arranging a group of people, whose needs and wants align, in the same place at the same time. Two systems emerged to solve coordination: credit and cash. Historians, anthropologists, and economists debate which of the two developed first, but that’s immaterial for our purposes.
In a credit-based system, in the example above, Alice and Bob would be able to trade with each other. Bob would give Alice the tool and Bob gets a favor that’s owed to him. In other words, Alice has a debt that she needs to settle with Bob some time in the future. Alice’s material needs are now satisfied,
but she has a debt that she’d like to cancel, so that’s her new “want”. If Alice encounters Carol in the future, Alice can trade her food for Carol’s medicine, then go back to Bob with the medicine and cancel the debt.
On the other hand, in a cash-based system, Alice would buy the tool from Bob. Later, she might sell her food to Carol, and Carol can sell her medicine to Bob, completing the cycle. These trades can happen in any order, provided that the buyer in each transaction has cash on hand. In the end, of course, it’s as if no money ever changed hands.
Neither system is clearly superior. A cash-based system needs to be “bootstrapped” with some initial allocation of cash, without which no trades can occur. A credit-based system doesn’t need bootstrapping, but the drawback is that anyone who’s owed a debt is taking on some risk. There’s a chance that the other person never comes back to settle the debt.
Cash also allows us to be precise about how much something is worth. If you’re bartering, it’s hard to say if a tool is worth more than medicine or medicine is worth more than food. Cash lets us use numbers to talk about value. That’s why we use a blended system today — even when we’re using credit, we measure debt in the amount of cash it would take to settle it.
These ideas come up in many contexts, especially online systems where users trade virtual goods of some kind. For example, peer-to-peer file-sharing networks must deal with the problem of “freeloaders,” that is, users who download files without sharing in turn. While swapping files might work, there is also the issue of coordination: finding the perfect person who has exactly the file you want and wants exactly the file you have. In projects like MojoNation and academic proposals like Karma, users get some initial allocation of virtual cash that they must spend to receive a file and earn when they send a copy of a file to another user. In both cases, one or more central servers help keep track of users’ balances and may offer exchange services between their internal currency and traditional currency. While MojoNation did not survive long enough to implement such an exchange, it became the intellectual ancestor of some protocols used today: BitTorrent and Tahoe-LAFS.