Benjamin de Waal
A Primer on Money
Updated: Jan 4, 2021
Money is a Communication Tool
It’s often very difficult to explain to people what Bitcoin is. The main reason for this is that the answer is deceptively simple but highlights a larger problem. The answer is that Bitcoin is money and the problem that it highlights is that most people have no idea what money is.
Fundamentally, money is a communication tool. It communicates value between people so that direct barter of goods and services is not necessary.
Talking about money as a communication tool for value, we also need to understand what value means. Value is “that which we want to have”. It is inherently individual and one person may value something more than a different individual does. Our reasons for value are tied to our individual positive feelings either directly, “this thing makes me happy” or indirectly, “this thing saves me time on something I don’t like so much, so I can spend more time on things I do like”.
In order to money to be an effective communication tool, it needs to be represented by something. In the modern world, we have physical and virtual representations of money. You can imagine for example a one-euro coin, a twenty-euro note, the value in your bank balance, and the number written on a small pad of paper representing your table’s current bar tab. The commonality with all of the above is that they’re represented in the same unit – in this example, euro. This brings us to a second concept: “currency”.
Currency is the metric we use for money. In other words, the way we measure “how much money”. There can be many different currencies, but not different metrics within a currency. One euro in one place or form is always equal to one euro in another place or form. Whether we have ten euro stored in a bank account, ten one-euro coins, or a ten-euro note, it’s considered the same amount of money. This brings us to the third concept: the representation of a currency, also called the “currency medium”.
The currency medium – whether physical or virtual – has properties that affect its suitability as a currency as well as how we use it in its role as a communication tool.
Unless a thing is ‘declared’ as a currency by a government or similar (we’ll discuss that later), it will usually go through several phases and hold aspects from these phases as it becomes a currency medium.
The first phase is as a collectible. Collectibles are things that people want to have and collect more of. In other words, collectibles are things that some people value.
The second phase is as a store of value. Once a thing is being collected by those who value it, it inherently becomes valuable to hold on to it whether you personally value it or not. Because of some specific properties of it that we’ll talk about soon, you expect its value to those other people to either stay the same or increase over time and thus you hold on to it for the future.
The third phase is as a medium of exchange. Once everyone around you is also holding these things, you can exchange them with each other for other goods and services. That they might one day be given to collectors is almost forgotten, as the currency now has value in and of itself for the purposes of conducting commerce rather than speculation.
The fourth and final phase is as a unit of account. The collectors are completely forgotten and now the value of goods and services is directly measured in units of this thing. Some currencies may at this point also lose their ability to be a store of value, however to understand how that comes to be, we need to cover a lot of other ground first.
Currencies therefore are things that often start off as collectibles and develop in to a medium of exchange for goods and services priced in these things (i.e. a unit of account). They are also usually – but not always – stores of value.
In order for currency to be a good metric, it needs to have properties regardless of its medium. The number and degree of these properties that a currency medium has, the better suited it is to representing the currency and the lack of properties may limit something’s ability to be used as a currency medium.
The commonly considered properties with some examples are:
Note that none of the examples for these properties is particularly useful as a currency medium, since even where they may be good in one or two properties they are often catastrophically bad in others. Facebook likes may be highly transactable, but they’re also not divisible, only weakly verifiable, and – most importantly – not scarce.
Hopefully we now have a better understanding of what “money” is, what a “currency” is, and what a “currency medium” is. To help keep it straight in your mind, we can sum it up with the following series of statements:
Money is the communication of value using a conceptual tool called a currency.
Euro, dollars, and Bitcoin are currencies.
A euro coin is a physical representation of the euro and thus coins are one currency medium employed by the euro.
A euro value stored in a bank account is a virtual representation of the euro and thus bank balances are another currency medium employed by the euro.
Types of Currencies and a History Lesson
In early money, currency was equivalent to its representation. The properties of currency were the same as the properties of the currency medium.
According to archaeological evidence, one of the first currencies used was likely seashells. Far from the ocean in central Africa, seashells are relatively rare to find naturally and at the time – tens of thousands or maybe even hundreds of thousands of years ago – the technology to counterfeit them didn’t exist. Looking at the other properties that make something a good currency media, we can see quite quickly that shells aren’t a bad choice for a tribe of early humans in central Africa. They’re quite good in terms of being fungible, non-consumable, portable, verifiable, transactable, and scarce. They really aren’t so durability or divisible, but six out of eight is a pretty good start.
Seashells of course aren’t something someone actually wants to have under normal circumstances. They have to be understood as a representation of value – that is, money – before their properties as a currency even come in to play.
There are two main ways that a currency can come in to being: by consensus and by decree.
Consensus currency is usable as money because everyone agrees that it is. That is, there is no individual or group that demanded it be considered usable as money, it simply became adopted as such because its properties were sufficient for it be a usable currency and the people using it agreed for that to be the case.
Currency by decree comes in to being because an authority claims it to be so and the society that follows that authority accepts it as the case. Currency by decree is often called fiat, but this is actually slightly incorrect. The word fiat comes from the Latin verb fiere – to be done – and is best translated as the command “let it be done”, however applied to currency, it doesn’t relate to the initial decree for its existence, but rather the power over the creation of more of it.
No one can simply declare more gold, air, water, corn, or frogs in to existence, no matter how much political power they wield. These things can be created – some more easily than others – but all require energy to be put in to their creation and thus they have a strict upper limit based on the available supply of energy. Generally, these things are referred to as commodities. A commodity is defined as a basic good that is interchangeable with other goods of the same kind. Or, put in the terms we’ve already used, it’s a good that is fungible. Currencies based around commodities are commodity currencies.
Fiat currencies on the other hand have potentially unlimited supply at no fixed energy cost per unit. The creation of a thousand new words in a language doesn’t require a thousand times the energy of one new word. Equally the creation of a million new dollars in a bank database doesn’t require any more energy than the creation of a single cent.
Inherently, this is the only difference between commodity currency and fiat currency, however as we will soon see, this is significant enough on its own.
Initially, all currencies were commodity currencies. This is even true for early national coins such as the Roman Denarius. Being made of nearly pure silver, the Denarius was worth exactly as much as its weight in equivalent purity silver. The “coin” was simply an easy way to identify how much silver it was without the necessity to weigh it. Thus, the true currency was the silver and the Denarius coin was the common medium for it.
In the first century, Emperor Nero realised that debasing the Denarius with cheaper metals would allow for the creation of wealth “at no cost” and allow him to pay off his debts more easily while still remaining wealthy. The Denarius had become so standard as a currency in its own right, no one even paid attention anymore to its relationship to the silver it was made of.
For a while this worked, however more so in Rome where money could be treated more abstractly without too much attention being paid. As the outlying parts of the empire began to understand the deception, they – still considering the silver to be the true currency – began to charge more for their goods in order to get the silver that they wanted. The Denarius, without ever being formally redefined, had shifted from a commodity currency to a fiat currency.
Two centuries later, the Denarius was 0.02% percent silver, and considered worthless outside of Rome. The Roman empire collapsed soon after.
In the thirteenth century, Kublai Khan brought China under Mongolian control. He bought vast amounts of goods and hired many soldiers for wars. He even traded significantly with Europe through contact with the Venetian explorer Marco Polo. How did he finance these many purchases? He simply printed new currency at essentially no cost to himself; or in other words, he used fiat. Kublai Khan had learned this trick from his grandfather Genghis Khan’s contact with the Jurchen people in the late twelfth century.
The Jurchens had used copper coins, similar to the Roman silver Denarius. They had however learned to overcome the problem of carrying large amounts of heavy coins around by the invention of proxy currency. Proxy currency is the first instance where a distinction needed to be made clearly between a currency and the currency medium. In the case of the Jurchens, it was a printed paper note called a Jiaochao, and can be considered the world’s first banknote.
The Jiaochao was redeemable at the official printer for the coins that it represented and so was much more convenient to carry and use in trade as if it were the coins that it represented. In modern terms, we refer to this as a currency that is backed by something else. As long as the currency medium truly is backed by the commodity as promised (and this can be proved, as we’ll discuss later), this is still a commodity currency, as the currency itself hasn’t changed, simply a new medium has been added.
Of course, it didn’t take long for the Jurchens to realise that if people treat the Jiaochao as if it is currency itself rather than just a currency medium, then there’s really no need to actually own all of the coins that it represents. Very few people claim them anyway, since the paper is “just as good”. Just as happened with the Denarius in the Roman Empire, the Jiaochao suffered severe inflation as more and more were printed and they became worth less and less. Eventually, they were not accepted at all and the public only accepted copper and silver for trade.
Kublai Khan knew this history from his grandfather, but didn’t care. His goal wasn’t financial stability but instead to finance his empire-building at no personal cost. His notes – declared as backed by silver, where there really was little to none – also suffered severe hyperinflation and by the mid-fourteenth century (after his death) were rejected entirely.
Throughout the centuries that followed, many more attempts were made at creating proxy currencies and the inevitable fate of all was to lose their commodity backing followed by hyperinflation.
In the early eighteenth century, the French enlightenment philosopher Voltaire observed that:
“Paper money eventually returns to its intrinsic value: zero.”
This was shortly after the “livre tournois” – France’s first attempt at a paper money – had suffered hyperinflation and become worthless in less than twenty years from its creation; something Voltaire had witnessed and experienced first-hand through his adolescent and formative years. As a response, the government had created monetary stability again by precisely fixing an exchange rate between gold and silver and then declaring the exchange rates of coins minted using these metals.
Unfortunately, those who fail to learn from history are condemned to repeat it (Winston Churchill). Only one generation later, the French government again tried to create a fiat paper currency – the “assignat”. 13000% inflation and a rather well-known revolution later, Napoleon Bonaparte restored France to a gold standard with the introduction of the gold-backed “franc”. This remained stable – and the basis of a solid monetary union with other nations – until the franc was removed from its gold-backing at the start of the twentieth century, after which it lost 99% of its value in the space of a single decade.
Since then, the world has seen countless fiat currencies be declared and fail. The Papiermark of the Weimar Republic in the 1920s, the Greek Drachma in the 1940s, the Bolivian Peso in the 1980s, the Zimbabwe Dollar in the 2000s, and the Venezuelan Bolivar in the 2010s, just to name a few.
The US dollar was originally a gold-backed currency, but began to be decoupled from gold in the 1930s, finally being completely decoupled in 1971. In the 48 years since then, the dollar has lost over 82% of its purchasing power ($2.50 in 1971 went about as far as $20.00 now on equivalent goods and services).
The economic theories of John Maynard Keynes described in his many writings – most notably his 1936 “The General Theory of Employment, Interest & Money” – are often used as a justification for why this is somehow different to all of the failures of unbacked currencies of the past. To Keynes’s credit, the dollar hasn’t collapsed quite as quickly after having its backing removed as other currencies in the past, but it is worth keeping the size of the US economy in mind as well. As you will recall, the Roman Denarius took nearly two centuries to fail completely and it was only slowly debased rather than having its silver removed entirely.
The euro was created as an unbacked fiat currency from conception and has decreased in value following a similar pattern to the US dollar in its twenty-year history with the only differences being visible when comparing the two directly instead of against purchasing power.
Another Look at the Properties of Currency
Why honestly (rather than deceptively, like Kublai Khan) move away from commodity currency to begin with?
To answer this question, we need to go back and take another look at the properties of a currency and see how a typical commodity currency – gold – compares to a typical modern fiat currency – US dollars.
The properties where we see the largest differences between gold and US dollars are: portability, transactability, and scarcity. US dollars are far more portable and transactable than gold; but gold is much scarcer than dollars.
Gold worked well when the majority of commerce was local and the prices of anything would typically fall in a range of not more than around 104 (the most expensive item typically bought and sold in daily transactions isn’t more than ten thousand times the price of the cheapest item).
In our modern world however, we have significant non-local commerce and our typical price range for daily commerce is closer to 106. These aspects make gold – and every other traditional commodity currency – highly unsuitable for use as money.
Fiat currencies on the other hand – primarily by virtue of their ability to be represented non-physically – are much more suitable as they can be represented in many forms including digitally and thus don’t suffer the same portability and transactability issues. They initially seem like a great solution to these problems and in many ways are even a naturally developing solution as we learned from our history lesson.
A Closer Look at Scarcity
We learned in our history lesson that many fiat currencies of the past “hyperinflated” and we also see that ‘moderate inflation’ is generally defined in Keynesian economic systems as being a positive thing.
That leads us to ask: Does unbacked fiat always lead to the problem of hyperinflation? And if so, why? And when will the US Dollar and Euro suffer this fate?
Sometime after the first massive financial crisis of the 20th century, a story was created that it was caused by “too much scarcity” of commodity backed currency, rephrased in terms of liquidity. Liquidity is simply how quickly and easily currency can be accessed, moved around, and converted to other forms. Liquidity can also be local: Pokémon trading cards are highly liquid in many comic shops and schoolyards, but not very liquid at all elsewhere. It correlates closely with – but is not identical to – the currency property transactability. While aspects may be tangentially related to scarcity, conflating the two is most certainly a fallacy and sadly one that is taught in many economics classes even today.
A lack of scarcity is the simple – and obvious – reason that fiat currencies generally suffer this fate. It is possible to imagine a scenario where a benevolent dictator declares a fiat currency and institutes monetary policies of strict scarcity but it’s a hypothetical only and could only last as long as the people in charge continued to decide it to be so. In reality, no fiat currency has true scarcity and never can because even if it does not get inflated, it can be inflated.
Here, we need to side-track to a small lesson about markets. A market is the entire economic activity of a specific group, a specific area, a specific set of goods and services, or so on. When used with the definite article, “the market”, it is simply the aggregate of all markets; that is, the entire economic activity of the world as a whole.
All markets are constantly in flux. As new people are born, they tend to grow. As people die, they tend to shrink. As new technologies create new value for less energy input, markets grow. As wars disrupt the free flow of money, they shrink.
The monetary value of a currency can be summed up as the size of the market they address divided by the total amount of it that exists (known as the currency’s supply). That is, if the market consists of a hundred widgets (and no other goods or services) and there are two hundred units of the funbucks currency that can be used for these widgets, the natural value of funbucks is such that one widget costs two funbucks.
No one can truly calculate the total size of any complex market as there are simply too many factors to address. That doesn’t mean it can’t be modelled more generally though and we can use simplified cases as thought experiments to provide us with a generalised understanding of the more complex reality.
If the supply of funbucks is increased 5% yearly, then over a little over 14 years there’ll be twice as many funbucks as there were before. If the total market is the same (still one hundred widgets), then the effect is that funbucks aren’t as valuable as they were before. I used to be able to get two widgets for four funbucks, but now I can only get one.
The apparent increase in supply in relation to the size of the economy is called inflation. It’s important to note that this not the same as the real increase in supply. The inflation that occurs with a doubling of the money supply is identical to the inflation that occurs with a fifty percent decrease in the total market.
Keynesian economics fundamentally argues for an increase in the currency supply in order to stimulate economic activity. If I want widgets and I know that my funbucks will get less of them in the future than they do now, I’m encouraged to spend my funbucks instead of saving them. This keeps the widget manufacturer in business, who can pay his staff, who also buy widgets. Everyone is happy.
Except they’re not… this is another myth taught in economics classes around the world. In reality, this is a masked variant of the well-known broken window fallacy. A glazier who pays a boy to break windows in the village may certainly be drumming up business for the glazier who then spends his earnings at the baker, the butcher, and the tailor but what’s forgotten is that the money they paid to the glazier to fix their broken windows could have been used directly and without the cut taken by the glazier and the boy.
Inflation by artificially increasing the currency supply is the same thing, only that the “glazier” and the “boy” are more hidden and thus overlooked by many economists. Inflation certainly does encourage spending, but money doesn’t enter the economy evenly. When new euro are created by the European Central Bank, you don’t find you suddenly have more in your pocket or your bank account. But they do. They create the money and then spend it on goods and services. These goods and services are available at the price established by the currency supply prior to the new creation act. Over time and several transactions, this new supply is naturally incorporated in to the market and prices adjust. You even get an increase in your salary to keep up with inflation and may not think much of it. Sure, things used to cost less, but you used to earn less, so it’s the same. Except somehow, it doesn’t balance out. The price of things has increased more than salaries have. The extra value has been taken. Looking back to the broken window fallacy, it’s now clear where the money went: the creators of the currency supply – doing so at no cost to themselves – are taking the role of the “glazier” and their employees, contractors, suppliers and more are the “boy”. They are taking their ‘cut’ out of the market for free and pointing at the increased market activity as if it’s a good thing.
As new technologies are constantly being developed and populations grow, it’s easy to understand why most markets also appear to be in a constant state of growth. If a market grows, then to maintain a state of inflation, the currency supply has to grow faster. Most controlled currencies are targeted at two percent total inflation, which means an increase in the money supply of larger than that during market growth.
However, nothing grows forever. Even with new technologies, markets must eventually stop growing or shrink. It should be expected that there will times of growth, times of a level size, and times that it shrinks. In a perfectly controlled currency supply targeting a specific rate of inflation, this could theoretically be managed through the destruction of currency. This however is where the system breaks down – very, very painfully.
The creation of money financially benefits those who are empowered to create it. Likewise, the destruction of money financially detriments those who are empowered to destroy it. The US Federal Reserve, European Central Bank, and other central banks have costs – the “boy” in the broken window fallacy comparison – and simply can’t afford to destroy money. They’d be unable to continue operations because their entire business model has become “breaking windows”.
What this means is that Keynesian systems – like the one we currently find ourselves in – is completely incapable of dealing with any market state other than growth. The only way to even try to stave off economic downturns is through even greater inflation. Since currency creation is typically implemented in the form of new debts (e.g. the bank loans a million dollars that did not previously exist, thereby creating a million dollars), this is often dressed up in the form of low (or even negative) interest rates to stimulate lending.
It is hopefully obvious to the reader that even when successful on the short term, the only possible long-term result of this is eventual hyperinflation. As for the final question at the start of this section, no one can reasonably calculate with any accuracy when it will happen to the dollar and the euro, only that it will happen and over the last two to three decades have arguably already seen the first clear signs of the end.
The Properties of Bitcoin
Now we know more about the properties of currencies and how traditional commodity currencies compare to fiat currencies, it’s finally time to look at Bitcoin and see how it stacks up.
Bitcoin has perfect or near-perfect scores on every property. Notably, it avoids the problems of commodity currencies by being perfectly portable and perfectly transactable. It also avoids the primary problem of fiat currencies by being perfectly scarce.
So far, we’ve been using these properties without considering if there are further properties that make something valuable. Bitcoin has some significant differences to other currencies that are also worth considering when deciding on its value as a currency.
Sovereignty is currently a clear win for the US dollar over gold or Bitcoin, however it may not be enough to make up for the other shortcomings of the currency and may even cause a reduction in the power of the nation directly if they choose to remain inflexible as while the strength of the currency is backed by the force of the nation, it’s also true that the force of the nation is – at least in part – backed by the strength of the currency.
In terms of Decentralisation and Programmability, Bitcoin is the clear winner as neither dollars nor gold have any significant aspects of these properties at all.
A Bitcoin Economy
A person’s desire for goods and services now is different to their desire for those goods and services later. This is called Time Preference and plays an important role in the discussion around markets that was introduced earlier when discussing the scarcity issue of fiat currencies.
If I’m out in the city late at night and really need to sleep, then I will have a high time preference for a hotel room or a taxi home. I don’t need one later, I need it now.
Similarly, people don’t have to buy the latest mobile phone – one from the previous generation will work fine and can still do everything it could do when it was new only a year or so ago – but many people are still more than willing to pay more for the new features and capabilities now instead of waiting until the latest device is cheaper when the following generation comes out. Other people however might have a lower time preference and consider instead to get the previous generation of device.
Time preference for specific goods and services isn’t another thing that can be calculated precisely but certainly can be clearly illustrated.
In the first example, a taxi home now might be something I’m willing to pay fifty euro for. If waiting an hour for a taxi at a cheaper price were an option, how much cheaper would it need to be? Maybe I might feel that twenty euro would be worth that wait. What about a week from now? Well, that’s worthless to me. It has no value.
In the second example, how much cheaper would the previous generation have to be for the person with the higher time preference to buy it instead? How much more expensive would the previous generation have to be for the person with the lower time preference to select the new model instead? I don’t know, but I can guarantee you that Apple and Samsung have calculated this as an aggregate across their customer bases in their sales planning.
Currencies themselves also have time preference and this is what is being manipulated by the artificial control over currency supply and ultimately the rate of inflation. As the money devalues, it pushes my time preference for goods and services up. I want to spend my money sooner and experience the value of goods and services that are paid for later as being higher than it would have been with no inflation.
In an economy with a fixed currency supply like Bitcoin, time preferences for each good and service are allowed to sit at their ‘natural’ levels for each person.
As already described, markets sometimes grow, are sometimes steady, and sometimes shrink. We’ve also learned that bitcoin can become unavailable through deliberate or accidental loss. That means that it should be reasonable to expect that in an economy based on Bitcoin, the currency should experience periods of inflation, stability, and deflation.
This is often cited as a concern with Bitcoin since Keynesian economics teaches that deflation is inherently a problem by causing people to ‘hoard’ (better called ‘saving’) their money instead of spending it, which – through lower spending – further shrinks the market, and ends up in a “deflationary spiral” until everything collapses. Despite this theory being cited as an inevitability, history has never actually seen it happen and many economists argue that it’s an unrealistic myth.
The general expectation with a fixed supply economy is that when the market experiences growth, the currency will appear deflationary and thus discourage unnecessary spending through lowering people’s time preference for luxury items. Their time preference for basic requirements of course remains unaffected; no one will stop eating for months with the expectation that they can buy more food later. People with very high time preferences for specific luxury goods – such as in the mobile phone example – may still not have their time preference pushed to the point that they delay spending and the companies that produce these goods will also adjust their prices accordingly in longer periods of deflation.
Of course, the preference for saving over spending will put some pressure on the market against growth. That may lead it to stop growing if the growth is not sustainable. At that point, the market is stable, and deflation stops.
At some point, for any number of possible reasons, the market may shrink. When this happens, the currency will appear inflationary and thus encourage spending through increasing people’s time preference for luxury items. This is the opposite case from deflation and equally applies an opposite pressure against the shrinkage of the economy.
Unlike in systems where the currency supply is manipulated, a fixed supply economy is self-stabilising and will not experience runaway inflationary or deflationary effects due to the opposite pressures that each of these causes puts on the people interacting with the market.
This primer was primarily written about “money” more generally and not specifically about Bitcoin since the latter can’t be truly understood without understanding the former. Bitcoin was created because of the failings of the current economic systems and offers the chance of a better one.
The economic principles and ideas described in this primer are largely from the Austrian school of economic thought and so further reading on these concepts and ideas is advised, despite that many thinkers and authors of this school lived and died well before Bitcoin ever existed and thus couldn’t foresee or predict everything that might be possible with the invention of this technology. Specifically recommended are:
The Bitcoin Standard by Saifedean Ammous: https://saifedean.com/the-book/
The Mises Institute: https://mises.org/
The works of Ludwig von Mises, Friedrich Hayek, Milton Friedman, and Murray Rothbard
Note that although I – the author of this piece – generally agree with these writers on matters of economics, I often disagree with them on other political matters. In a future piece, I intend to address the differences between right-wing libertarianism (including anarcho-capitalism, to which many Austrian economists ascribe) and left-wing libertarianism (including anarcho-socialism, to which I personally ascribe) and how Bitcoin’s economic model fits differently to these models.