The Nature of Cryptocurrencies Part 1: Understanding Money
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To better understand or appreciate cryptocurrencies, it’s important to get a good grasp on the nature of money. This is because cryptocurrencies are a form of money and by understanding the true nature of money, especially what important characteristics it should possess, you’ll be able to better appreciate and understand the nature of cryptocurrencies.
What is Money?
At the very core, Money is something that is used to represent the value of other things.
For example, you gave me money in exchange for receiving a banana, and that sum of money represents the value of this banana. The money I received from you and others who have bought these bananas from me, I’ll use them to purchase or acquire something of value from other vendors today or tomorrow.
If you study history, you’ll see that the values of things have been expressed in different forms and money, the primary way by which values have been expressed has come in different shapes and materials such as gold, shells, wheat and salt which have been used in the past to represent value and as a medium of exchange. But for something to be able to continue representing value, the people who are using it must continue trusting that the medium of exchange is indeed valuable and more importantly, its value will persist for a long time so that they will still be able to benefit from it in the future.
Origin & Evolution of Trust in Money
Only until one or two centuries ago, societies have always placed their trust in some medium of exchange when it comes to the value or representation of money.
However the way people trust in money has shifted from trusting something to trusting someone.
What am I referring to?
As mentioned earlier, in the past, people would use objects like gold, wheat, salt and even seashells as a medium of exchange or money.
But over time, people caught on to the fact that using such things as a measure of value and medium of exchange can be quite burdensome.
Imagine buying your groceries with salt?
What if inflation was very high the last couple of years and you want to buy a month’s worth of groceries?
Imagine bringing huge amounts of salt to the supermarket?
And if you’re the grocery owner,
Imagine having to weigh the salt being paid to you by your customers and needing a very large space and vehicle to store and transport all that salt?
What if it rains?
Can you see where I’m coming from?
Because of such inconveniences, people were forced to improvise and come up with a more practical value storage and payment solution — Paper Money.
So this was how things worked initially. When you take up a bank or the government’s offer to take physical possession of your gold bars for storage, they’d issue you certificates or bills for the amount or value of the gold you deposited with them.
If your gold bars were worth $500, the bank or the government taking possession of your gold bars would issue you a paper certificate or bills worth $500.
Now think about this.
Which is easier to carry around ?
Paper bills worth $500 or Solid Gold worth $500?
Another thing to think about is which is easier to break into smaller pieces or value for change, Paper bills or a Gold Bar?
If you want to buy a bag of potatoes for $10,
You’d only have to pay the recipient one $10 bill,
But if you’re carrying around $500 worth of gold, you’d have to cut it proportionately to an amount that closely or exactly represents $10.
Another point worth thinking about was that back in the day if you wanted your gold bars back, all you simply had to do was give $500 worth of bills or certificates back to the bank or government to redeem your gold bars.
Because of the convenience and practicality it brings, paper money has grown so much in popularity and has become the primary means by which goods and services are bought and sold all over the world today.
In the past, the value of the United States Dollar (USD) was linked or based on gold. The Paper Money of the United States of America was valued based on its gold holdings. This was referred to as the Gold Standard. Naturally over time, the macro economy changed and as a result, the link connecting the value of the United States dollar to the value of gold was cut. Thus, Americans as well as the rest of the world, considering the USD has become the world’s primary currency, had been conditioned to shift their trust from gold to the Federal government.
In other words, people have been conditioned to shift their trust when it comes to monetary value from something — gold, to someone who assumed responsibility for the value of the dollar - the Federal government.
The only reason this system continues to work is trust because there’s no real underlying asset of worth behind the value of USD or other currencies, other than the military capabilities of respective nations but let's not get political. This was how "Fiat" or paper money was born.
“Fiat”
The word “fiat” is a Latin word that’s best interpreted as “by decree.” This means that any fiat currency — paper money, only has value because their respective governments are backing them. As a result of such legal decrees of value, paper or fiat currencies are also called “legal tender” which means they have to be accepted for payment of goods and services in their respective countries.
That being said, you can now see that money as we know it today has value only because of it’s legal status, which is declared by governments.
As mentioned earlier, the trust in the value of money has shifted from Something (Gold) to Someone (The Government).
Now fiat money as we know it now has some pretty serious issues. These are centralized and are practically unlimited in quantity.
Being centralized means that there’s a central or lone authority that has the power to issue and control its supply, which in the case of the United States Dollar is the Federal Reserve. It’s also practically unlimited in quantity because the Federal Reserve has the power and capability to print or mint more units of the US dollar if it chooses to do so.
Now, why is this a serious concern?
The Reason?
One of the most basic principles of economics:
Supply and Demand.
Specifically, this means that when the supply of an object is increased, the value of that object will tend to decrease assuming demand for that thing remains constant.
Conversely, when the supply of an item is decreased, assuming constant demand, the value will increase.
Hence if the Federal Reserve or other monetary authorities decide to print more money, markets will be flooded with more of those currencies, which can make it worth less (buy less of goods and services with the same amount also known as inflation).
So when you see the prices of goods and services rising substantially over the long term, it’s not necessarily because they became more expensive but because the value of the currency has dropped due to the increased supply.
Centralized Digital Cash
The establishment of fiat money has made it easy for monetary authorities to create digital ones. With the advent of the Internet and the establishment of monetary authorities that control and issue money, the idea of digitizing money has become feasible and even necessary.
Proof of this is the evolution of alternative modes of payment to the point that they have become the main methods for transactions today.
For example, Credit Cards, Fund Transfers and PayPal have become standard forms of payment these days. And in the United States, in particular, paying in cash is looked upon as unconventional or even suspicious in some cases. The ramifications of this evolution are huge. One of them is the ever shrinking amount of physical money circulating in many of the world’s biggest economies and financial systems.
In the Era of Digitalization,
How does money in its digital form work?
What systems are in place to prevent double-spending of money?
What’s to stop me from digitally reproducing my money so that I’d have so much more than what I actually have?
In the same way you can create duplicate copies of your favorite songs for listening on different devices.
Most financial institutions today address this issue with centralization.
This means is there’s only one party responsible for keeping records of financial transactions under a particular system, keeping track of who owns what and how much.
Everyone who transacts under such systems has an account, which has a specific ledger under which all transactions and balances are recorded and maintained.
Everyone, including you and I, trust the systems of financial institutions to keep accurate records of our balances and these institutions, in turn, trust their computer systems.
Basically, the solution of centralization of records is based on a ledger that’s stored in a huge single computer system or network. Prior to the creation of the blockchain, there have been many attempts to create alternative digital forms of payment that have failed because of one major issue — preventing double-spending without a central authority.
That’s why the centralized record keeping solution has persisted until this day — it works in general.
Challenges
Whenever we give someone or a group of people total authority over something, there will be serious challenges that will need to be addressed.
When it comes to the monetary system, there are three specific challenges that need to be addressed:
- Corruption
- Mismanagement
- Control
Corruption
There’s a proverb that goes “absolute power corrupts absolutely”.
Central banks or monetary authorities such as the Federal Reserve, who have the legal mandates to print money and create value in the process, practically have the ability to control how value is created and destroyed in their respective countries and in the case of the Federal Reserve, the whole world.
Such legal mandates are akin to unlimited or absolute financial power. One instance of this is the debacle at Wells Fargo where it’s employees were ordered to clandestinely open fictitious bank and credit card accounts in an attempt to puff up the company’s revenues and consequently, its net profits, for several years. Although compared to monetary authorities, Wells Fargo isn’t even an authority.
Mismanagement
Mismanagement is simply when a manager or a steward acts in a way that is not consistent with how his or her boss wants him or her to act.
In the case of monetary authorities, it can happen when governments act against the interest of the people they govern. A very good example of this is the way the United States monetary authorities allowed major financial institutions to issue credit-linked notes or financial derivatives with mortgages that have very high default risks, which corrupt credit ratings agencies have rated as “investment grade.” This has resulted in the near collapse of the United States financial system, which the Federal Reserve rescued by acting against the interest of the public by using public money, which the public has objected to, to save the biggest financial institutions from collapsing in 2008.
Another issue of mismanagement is printing of new money without proper consideration of the deflationary effects of such an action. As mentioned earlier, printing more money floods the financial system with too much money, which in turn can cause a specific currency’s value to plunge or drop (law of supply and demand, remember?). A very good case of this is the Venezuelan government, who mismanaged the country’s financial system and official currency by printing too much money. The Venezuelan currency has become practically worthless to the point that people started to measure its value by weight instead of amount.
Control
Finally, a central monetary authority means surrendering all control over the people’s money to the government.
Because governments have the legal mandate to control the money supply, they also have the authority to control your money in ways that can prove to be very unfavorable or unjust to you, such as freezing your bank accounts and keeping you from accessing your money.
Keeping physical cash on hand doesn’t mean the government can’t keep you from beneficially using your money. Governments can still keep you from using your money for your benefit simply by revoking its legal tender status so you won’t be able to use it for transactions, such as what India did in the past.
Silver & Gold
Let’s talk about gold and silver.
Why?
Because of its connection to money.
To be more specific, gold and silver aren’t just investments
They’re money!
You might say “No, money is the US dollar or the British Pound!”
Sorry to burst your bubble but those are merely currencies, as is the case with all fiat currencies in the world.
But currency is different from money.
Firstly, currency is just a legal tender status, the value of which isn’t determined by the people but by governments.
Secondly, legitimate money has important characteristics that make it so and the United States Dollar doesn’t have all of them
Here are the Seven characteristics of legitimate money:
- Durability, The reason why wheat and salt are no longer used as money;
- Divisibility, The reason why paintings and other pieces of art aren’t used as money;
- Convenience of use, The reason why copper or lead isn’t used as money;
- Consistency in value, The reason why real estate is hardly used — if ever — to pay for goods or services;
- Intrinsic value or value, The reason why paper isn’t really money;
- Limited in available quantity, The reason for not using iron or rocks as money
- Long track record of acceptability.
Upon close evaluation, you’ll find that only gold and silver actually meet these characteristics.
If you look at financial assets like stocks, bonds, or even real estate, they don’t pass the consistency test because their prices tend to fluctuate. For others likes stocks, chances are that stocks of companies from 100 years ago — save for a few big and strong ones — have either deteriorated in value or are no longer worth anything because the companies whose ownerships such stocks represent no longer exist.
The only items whose purchasing powers have not only been maintained but have also increased over the long-term are gold and silver. If only for this characteristic alone, gold and silver have decimated of many currencies that have failed over the last 5,000 years. And if you factor in the fact that gold and silver are the only items that continue to have high value since the early days of all civilizations on Earth, you’ll see why fiat currencies aren’t really money.
