In some way or another all of us assign value to things: books, knowledge, work, happiness, despair, solitude, friendship, … time. It bothers us not knowing what something is worth - how else do you know what’s important? Economists say the value of anything is measured by the happiness its possession brings to the owner. This unit of happiness, is called a util. However, reasoning about things in terms of utils can be hard, as it can get very abstract very quickly, therefore many of us use money as a more convenient proxy for value. It’s a terrible proxy. It fails to explain the variability in how we value things, and the inconsistencies that arise from that, but at least it’s something we see and measure easily. For the remainder of thist post, we look at the nature and evolution of money, our flawed proxy for happiness.
What if there was no money? It turns out money has always existed, and it used to grow in nature. Aristotle considered every object, living or not, to have two dimensions of value; the first being the original purpose for which it was designed or used, and the second as an object of exchange for something else [1].
Up until the 3rd millennium BC, people used to trade things they had for things they’d like to have. Livestock, particularly cattle, and plant products such as grain, came to be used as money [2].
This is called barter economy - the trading of goods directly for other goods. The barter economy is inefficient and cumbersome, because each transaction requires a double coincidence of want, the fancy way of saying that if you’re selling alcohol to buy books, you must find someone who has books and wants to buy alcohol. At this point you may be wondering: how does one give change back in the bartering economy? If whatever you have is not divisible, you’re in bad luck. The core problem is searching for transactions.
If there is anything you can think of, where the search for transactions is a problem, build an exchange for it - you may become rich.
To sum it up, in the barter economy, the goods themselves, were money. Some, like grain, were better forms of money, others, like donkeys, were not so good. Money in the barter economy was not optimal. If you’re wondering why, you’re guaranteed to like what’s coming next. If not, there are still many forms money took during its evolution – be patient. Now, it would be desirable that whatever is used as money, has certain attributes such that the functions money performs, are carried efficiently.
In the rest of this blog post, we’re going to focus on: Functions of Money, The Evolution of Money and Crypto Currencies.
1. Functions of money
Medium of Exchange. In economics, money is typically defined as any generally accepted medium of exchange. In order for money to serve as an efficient medium of exchange, it must be:
- easily recognizable
- readily acceptable
- easy to carry around - have a high value for its weight
- divisible
- reasonably durable
- hard (ideally impossible) to counterfeit
The double coincidence of want is unnecessary when a medium of exchange is used, therefore searching for transactions is easier. This kind of medium for exchange produces a most desired effect in economics - specialization, but let’s leave that for another time.
Store of Wealth (or value). Let’s go back to bartering. You are forced to exchange one good for another. How do you store wealth?
With money, storing wealth is easy, you just put it under the pillow. With time, someone, freed up from having to barter, will think of a smarter way of storage, say banks - more on this later.
But, for it to be a satisfactory store of wealth, it must have a stable value. Rapid fluctuations in its value, reduce the usefulness of money. You see, money is a convenient way of storing purchasing power. If the value of what you’re storing is fluctuating a lot, than your future purchasing power is fluctuating with it.
Unit of account. Money can also be used purely for accounting purposes. It does not even have to exist physically. Ragan and Lipsey have a good example of this [3]. Imagine a truly communist country that opens a store, and pre-allocates an amount of ‘virtual money’ only usable in that store. The money does not exist, yet you can buy stuff with it. When you do, the amount you possess is reduced.
2. Evolution of Money: from precious metals to fiat
Now that we’ve covered the functions money performs, you’re equipped to understand the evolution of money.
Metallic Money
Although almost anything has been used as money at some point, precious metals have held the historical throne. Throughout history, they have been in heavy and permanent demand for ornament and decoration. Precious metals also have two crucial supply related properties: they don’t easily wear off, and they have a pretty price-inelastic supply - meaning a higher price does not translate to a higher supply, because it’s hard to mine these metals. Furthermore, they are quite divisible into small unites. Ever heard about a grain of gold?
Before coins, merchants used to go around carrying sacks of gold and a sensitive sets of scales. However weighing coins is cumbersome and slow. Ideally the coin could be accepted at “face value”, but this required a trusted authority whose face (or seal of approval) on the coin would guarantee its weight. So rulers started doing exactly that. It was not long before people started clipping slices of precious metal off the edge of the coin, and as a consequence it became hard to accept coins at face value - given the value had changed.
Power corrupts; absolute power corrupts absolutely - Lord Acton.
A few corrupted rulers in power, ran a pretty profitable fraud. Here’s what they did: In cases of marriages, anniversaries or alliances they would order their constituents to take their coins (some clipped, some regular) to the royal mint. Then the old coins would be melted down and new coins with a fresh stamp following the occasion would be issued. Between the melting down and the recoining, however, the rulers had only to toss some further inexpensive base metal in with the molten gold. This debasing of the coinage allowed the ruler to earn a handsome profit by minting more new coins than the number of old ones collected and putting the extras in the royal vault. Through debasement, the amount of money in the economy (but not the amount of gold) had increased [3:1]. This is the equivalent of the central bank printing money. If you’re a Keynesian and the time is right, this may be ok, but in most other cases this practice causes inflation.
Anyway, it later became common practice for coins to have a rough round edge, to prevent fraudsters from clipping slices of precious metal off the edge. So if you’ve ever wondered why coins are round, now you know.
Paper Money
As much else in life, the concept of money evolved with the needs for using it. People had gold, and whenever not being used to purchase things, the gold had to be stored somewhere safe. Say hello to goldsmiths.
Goldsmiths, for a fee, started keeping other people’s gold in their secure safes. When people deposited the coins, the goldsmith would issue to them a receipt promising the return of the gold on demand. If you wanted to buy land, you’d go to the goldsmith, get the gold, and pay for the land. Given the large quantity of gold, it was likely the person selling the land, would take the gold back to a goldsmith. With time, as some goldsmiths gained a reputation for being reliable, people stopped taking the gold out, and started paying with goldsmith receipts. This way the transaction happened without the gold ever leaving the secure safe.
This transferring of paper receipts rather than gold was essentially the invention of paper money. Goldsmiths became banks. Paper money was a promise to pay a denoted amount in gold. In the 19th century, banks started issuing paper money they called bank notes. These bank notes were fully backed by and convertible into gold at the bank where they were issued at any time. It was typical for one to have several types of currencies in their possession.
Fiat Money
At any point in time, some clients would be depositing gold, others withdrawing it, and most would be trading the bank notes without going to the bank at all. Banks realized that in the process, they could issue more bank notes than the amount of gold they held in their vaults. This was good business because the money could be invested profitably in interest-earning loans. The money issued was now only fractionally backed by gold.
If, for whatever reason, people lost confidence in the bank and headed to the vaults to have their gold back, known as a run on the bank, they’d find themselves left with worthless pieces of paper. The 19th and 20th century were full of such events [3:2].
So comes the governmental goldsmith, or as it’s commonly known these days, the central bank. Central banks quickly became the only institutions allowed to issue paper money. Initially, they’d issue currency that was fully convertible in gold. The practice of backing the currency with gold was known as the gold standard.
Central banks too, however, realized that most of the time, they could issue more currency than they had in gold. Unlike common commercial banks, the central bank, however, had enough discretionary power to control the amount of money in the economy. So a run on the central bank was less likely, or so they thought.
Between the two world wars, almost every central bank abandoned the gold standard. The money they were issuing was not convertible by law into anything valuable. This kind of money, derived its value from its acceptability in exchanges and such acceptance was decreed by the government. If you’ve heard the expression fiat lux, latin for “let there be light”, as if by some authoritative decree, then you’ll understand why this type of money is called fiat.
Fiat money: Paper money or coinage that is neither backed by nor convertible into anything else but is decreed by the government to be accepted as legal tender [3:3].
I hope you’re not disappointed to learn that the money you have, are just pieces of paper generally accepted in transactions due the confidence that it will continue to be accepted in the future.
Deposit Money. You may have also heard this term. Even though only central banks can issue currency, commercial banks of today, just like goldsmiths, can still create money. After all it’s commercial banks we go to, when we need to get some cash, or deposit money, or take a loan. By taking deposits and giving out loans commercial banks create was is called deposit money, and it comes exclusively from being able to give more loans than what they have in deposits. They only need to keep some minimum amount of reserves, specified by central banks.
3. Crypto currencies
Before delving in this new type of money, there is an important clarification to make. Money and currency are not quite the same. The only function of money currencies perform, is that of a medium of exchange. So here’s how you can think about it:
- If fiat money is generally acceptable, it is a medium of exchange (currency).
- If its purchasing power remains stable, it is a satisfactory store of value.
- If both of these things are true, it serves as a good unit of account.
A crypto currency is a digital asset designed to work as a medium of exchange that uses cryptography to secure its transactions, to control the creation of additional units, and to verify the transfer of assets [4]. Not all crypto currencies are alike. In coinmarketcap.com there are about 1500 different different ‘coins’ listed.
If you think about it, the financial system we have is pretty inefficient in the context of transferability and leads to a lot of issues in terms of governance (at the very least, let’s say we’ve had quite a fair share of financial crises). It’s also not very fast, bound to errors, fraud and it gives way too much power to central institutions controlling its supply.
The appeal of a decentralized digital currency is clear. It has a stable, limited supply, operating in a system where transactions happen in a peer-to-peer network without the need for institutions. Rather than bureaucrats, they are backed by mathematics.
So why not do the switch, this sounds great, … right? There are two main reasons, first related to the nature of distributed ledger technologies, like the blockchain which powers most crypto currencies, and second related to their promise to redefine the way economies are organized.
Technology and governance of crypto currencies
Vili Lehdonvirta of the Oxford Internet Institute gives a good overview of these challenges [5], which I highly recommend you read. From a purely technological perspective, truly distributed crypto currencies, have still to prove they can compete with the transaction capacity of more centralized approaches. At present the bitcoin blockchain currently handles around 3-4 transactions per second, while the etherum one around 20. Meanwhile, the visa payment network has a peak capacity of 56 000 transactions per second. However, the transaction capacity limitation is one I am sure will be solved as the blockchain technology matures. The real issue is the governance model of crypto currencies. Let’s dive in:
When we talk about protocol, we’re typically referring to two things: the making of the rules and the enforcing of these rules. The rules are made by the core developers of the protocol behind crypto currencies. When the technology is open source, forking is not enough to guarantee democratic governance. Competition is not enough of a solution when there are strong network effects. Regardless of the number of forks, everyone would want to be in the network with most users.
At this point, we’re at the same state we were when banks were issuing their own notes fractionally-backed by gold, except crypto currencies are not backed by anything at all, rather then the promise of future value.
Crypto Currencies and the new economy
More than the technology, many are excited about the promise these crypto currencies make - namely redefining the way economies are organized. But let’s apply what we learned about money so far, to make sense of how crypto currencies stand to the test.
Crypto currencies have thus far been very volatile, so using them as a store of value, and unit of account, is risky to say the least. As a medium of exchange, they have yet to gain acceptability. As of yet, they manifest attributes that seem less like money and more like an investment asset for the less risk-averse amongst us.
There is more to the economy than money. Institutions matter. In the past, regulators have sometimes been slow and ineffective at designing rules that tame the greed of the banks. Yet, I think we still need them. The fuzziness and non-deterministic nature of regulatory legislation as it stands today is not always a bug. A programmatic, smart-contract does not benefit from such fuzziness. An economy powered by crypto currencies and crypto-finance will have its own institutions.
I am generally optimistic about distributed ledger technologies. I think we have yet to see the full spectrum of applications they may have. Using them as the backbone of crypto currencies makes sense. I do however think that at present, crypto currencies fail to perform any of the functions of money reliably. Some of their properties will be adopted by more conventional forms of money, backed by more conventional institutions, like central banks. I don’t see a scenario where the decentralised fully displaces the centralised. Time will tell.
History of Money - by Glyn Davies ↩︎
Cryptocurrency - Wikipedia ↩︎