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  • Benjamin de Waal

Bitcoin: Honest Money

Updated: Dec 27, 2020

Bitcoin is honest money. But what do I mean when I say that?

The problem stems from the fact that most people don’t actually understand what money is, how it came to exist, or how it is created in our modern world. Therefore before I can even begin to talk about bitcoin, I’m going to need to talk a bit about money itself. In fact, I’m not even going to mention Bitcoin for the next 30 paragraphs.

Money, at its most basic level is a representation of value. Money works best when it has little or no intrinsic value. Sure, you can burn a pile of dollar bills for heating purposes, but – at least for the moment – they’re probably more valuable as something you can trade for goods and services.

In this way, we see that money is a representation of value rather than being a thing of value itself. This extends to all forms of money. Gold may be used for jewellery, electronics, or similar but can also be used directly in trade and was frequently in the past minted in to coins that represented a far greater worth than the practical intrinsic worth of the metal itself.

A couple of times now, I’ve used a term that gets brought up a lot when talking about money: “intrinsic value“. Intrinsic value is the value something has in-and-of-itself. Food has intrinsic value because you can eat it. A shelter has intrinsic value because it protects you from the weather.

However my implication that money is something with more intrinsic value than that which is made of is somewhat of a lie. Or at least a misdirection. Money does indeed have intrinsic value – as a means of exchange, and store of value. This is in fact likely how it came to be in the first place. If you’re a hunter that kills mammoths and I’m a specialist in sewing warm clothes, we both have skills and specialisations where we can mutually benefit from each other. Between the two of us, trading meat for clothes might work. But what about the basket weaver? And the forest fruit gatherer? Maybe I don’t need a new basket right now and the basket weaver doesn’t want some new clothes.

So we create a token. A representation of the value that we can all agree on. Our village is far from the sea, but we’ve got some shells that a traveller brought back once and are hard to get again. These can be traded around so that whenever I create new clothes for someone, they can give me some shells. I can then use those shells for the things I need, whether it be forest berries, mammoth meat, or a basket.

And suddenly, money exists.

This form of money is fine and works well on a small scale. Once civilisation grows, we start realising that in the next village over, they use a different kind of token: some kind of bean from a special tree that grows in the village chief’s garden only. We need to determine an exchange rate between shells and beans.

Later still, more problems occur, when we find a trading route to a village near the sea. Suddenly, our shells are near worthless. It takes hundreds and thousands of shells to even buy a single meal now. We’ve experienced hyperinflation. We decide to stop using the shells and instead switch to the bean standard of our neighbours.

Beans seems fine… until one day one of our farmers plants one and grows his own bean trees. Of course, there’s a war between us and our neighbours because of it, but since we can finance more warriors (we have many beans trees, they only have one), we defeat them easily. Nevertheless, our hyperinflation problem is back. We’re growing too many beans and people have even started cultivating other plants with beans that look identical. Forgeries!

How do we solve this? We need something with some very specific properties that are globally recognised. As our society progresses, we find precious metals. They’re rare, hard to extract, and hard to fake. Since it’s soft and easy to melt down, we can shape it as we like and divide it in to agreed upon subdivisions.

Gold is pretty great really. It’s:

  1. Fungible (one bit of gold is essentially indistinguishable from another)

  2. Durable and Non-consumable (you don’t use it up, nor does it go bad)

  3. Reasonable portable (you can carry a lot of value on you easily)

  4. Reasonably divisible (anywhere from gold dust up to huge bars)

  5. Hard to counterfeit (especially since we know its density)

  6. Of a fixed supply (although we’re not totally sure how much exists on earth, we can make a reasonable guess; and the cost of extraction means that we won’t do so if/when it costs more to extract than the value of the gold itself)

Using gold (or other precious metals) as currency is a type of money called commodity money.

But precious metals do have some issues. Once you start getting in to large amounts, portability becomes an issue. Once you start getting in to very small amounts, divisibility also becomes an issue. And as we get better at chemistry and nuclear physics, both counterfeit and supply come more in to question as well.

Even more problematic for supply is the continuing approach of the asteroid mining, where we might soon be able to flood the precious metals market with metals pulled from rocks outside of our atmosphere.

Even aside from literally producing precious metals through chemical/physical means or pulling them from space rocks, it also remains a fact that there is a lot of each of them in the earth. The supply of gold for example isn’t actually practically limited by the amount that exists, but rather by the economic costs of extracting it. That is, if gold increases in value, the incentive to spend more energy on extracting it will also increase and thus the supply will increase. Although there is a real limit on how much could be extracted, for all practical purposes this quantity is so large that it “may as well be” unlimited. If the total supply of gold were suddenly available to everyone on the open market, it would – as a money – be worth less than belly-button lint.

Metals (and other commodity money) actually even has another problem that many people mistake for a benefit. It has a non-monetary intrinsic value. It can be used in electronics and other such endeavours. The reason that this is a problem is that it dilutes the fixed supply by a fluctuating amount and equally sets a lower limit to the value that also fluctuates accordingly. The fluctuation is based on our technical capability and desire to use it for its non-monetary purposes (currently growing significantly).

Despite the problems, commodity money based on precious metals worked for a long time. One of the inventions to help with some of the problems was the creation of banks. Banks were a place you can take your gold or other metals where they look after it for you and give you a receipt for the value of the commodity you’ve stored with them. Since these receipts were “as good as gold”, it even became easy practice to simply trade these receipts around, knowing that at any time you could walk in to the bank and claim the commodity that the receipt represented. And thus paper money was born.

Although it was paper money, it wasn’t yet fiat. Fiat derives from the Latin word fiere – “be done or made” – and can be best translated directly as let it be done. The general usage of the word in English is something done or created by decree rather than by a natural order. Fiat money is therefore money that useful as money because a government or other authoritative body decides it to be so.

The paper money I’ve described isn’t fiat because it is backed by a commodity. That is, although the paper (or other token) is simply declared as a promise of money, the monetary it represents is a tangible, known thing. You couldn’t just create new promises out of thin air without having the commodity to back it up (well you could, but that would be fraud). This is called a representative currency since the token represents the value of the commodity held and exists solely as a promise of access to that valuable commodity.

Around 1000AD, China created the first fiat currency. The jiaozi was originally a representative currency backed by copper, however once copper supplies ran out, the emperor declared that the paper money itself can be considered to have value without requiring any copper reserves backing it up. After all, no one ever claims the copper, so why have it at all?

The jiaozi fiat currency was a disaster. Inflation became quickly uncontrollable as more and more ‘notes’ flooded the market, making each worth less and less. The ruling class had given itself the ability to create value out of nothing and expected to be able to use it to pay for goods and services, but soon found that it would take more and more each day just to buy the same things as the supply of money increased.

This failure has been repeated throughout history including (but by no means limited to) the German Weimar Republic in the early 1920s, the Zimbabwean Dollar in the late 2000s, and the Venezuelan Bolivar in the late 2010s.

Until 1971, the US Dollar was also a representative currency. On the 15th of August that year, Richard Nixon declared the US Dollar to no longer be tied to the price of gold. Its value would be declared directly with nothing to back it aside the promise of the government and the strength of the country. In effect, the gold-backed US Dollar ended that day and a new fiat currency was introduced with the same name using the same paper and coins that were previously representative of gold.

Wanting to avoid the mistakes of the past, the US (and soon after, many other nations) were much more careful in their implementation of fiat currencies. To avoid hyperinflation, they set rules on monetary creation and/or created independent or semi-independent bodies outside of the government tasked with controlling it.

This has been appearing to work more or less well for nearly 50 years. Countries with fiat currencies have grown their economies well and other than a few “hiccups”, most people seem to be doing pretty well under this system.

The key words in the paragraph above are: “seem to“. Those hiccups aren’t little things. They’re indicative of an underlying problem with the controls put in place to try to hide the problems inherent in fiat currency. This is where money starts to become dishonest.

If you ask people who creates money, the vast majority will likely say it’s created by the government. That’s incorrect. Others – slightly more informed – might point to a central bank such as the United States Federal Reserve (which is one of those private non-governmental institutions I mentioned above). This is actually also mostly incorrect. Central banks do in some cases directly create money, but many do not at all. Most money is actually created by commercial banks under policies and frameworks defined by central banks.

One of these frameworks is fractional reserve banking. Fractional Reserve Banking is a system that allows a bank to loan out more money than it has. The amount allowed is determined by the central bank, but the process of doing it is entirely under the control of the commercial bank. The term fractional reserve refers to the fact that only a defined fraction of the total amount lent is required to be held in reserve by the bank.

When you borrow money from a bank – for example for a mortgage or a car loan – the bank creates the majority of that money out of thin air. The amount of physical currency is irrelevant since only a tiny fraction of money exists as physical tokens, the rest is just entries in a computer database. When the bank borrows money from you – which is exactly what they’re doing when you have an account with them – they can use the full amount of this to create new loans to others (or even back to you!) multiplied many times over.

Where the real problem comes in – and hopefully it should be clear by now – is that loans from a bank to an individual will almost always generate new deposits, which are nothing more than a loan from an individual back to a bank under unequal rules.

Breaking it down more clearly (note that this is an oversimplification, but the principle holds true):

  1. We imagine a simple fractional reserve requirement of 10%.

  2. Bank A loans Alice $1000 so that she can buy a car. This is backed by a reserve of $100 held in their vaults.

  3. Alice buys the car from Bob, who deposits it in Bank B.

  4. Bank B loans Carol $10000 for a family holiday. This is backed by the reserve of $1000 that came from Bob.

  5. Dave’s Holidays – the travel agent – that Carol uses banks with Bank A. Dave deposits Carol’s $10000 in his account.

  6. Carol owes Bank B $10000. Alice owes Bank A $1000. But these debts were both just made up by the banks from an initial reserve of only $100. The total money supply has increased $10900 in just a couple of short transactions.

These events are happening every moment of every day and is clearly hyperinflating the total money supply.

So why don’t we see it? The purchasing power of the US Dollar is declining – a McDonalds hamburger in 1970 was much cheaper than 1980, which was cheaper than 1990 and so on; but why don’t we see hyperinflation like that in Zimbabwe in 2008, where the value of money halved on a daily basis?

Quite simply: Because it’s being hidden. This incredible inflation is masked in debts and loans… the exact same debts and loans that fractional reserve banking works on. In other words, if even a fraction of people and businesses actually paid off a significant portion of their debts, the entire economy would come crumbling down. The only thing that is capable of keeping it afloat is the flow of money in to those debts without completely covering them. This money is representative of the value produced by work, and thus many economists claim that this monetary system stimulates the economy to action and increases useful/valuable production.

This is absolutely true on the short term, but dangerously false on the long term. And we have now actually seen the problem happen, without most people realising what they were seeing. The financial crisis of 2008 was exactly this problem playing out. Because of the fractional reserve system, being unable to pay back a debt and defaulting on it provides the same pressure as completely paying it back since the incoming flow of debt payments goes to zero in both cases.

So, how was the problem solved? How did we recover from 2008? We printed more money and gave it to the banks!

Because of the way this system works, that solution “worked”. Or more precisely, it delayed the problem a while longer. However it should be clear to anyone reasonable that the only possible result of this is a continuing cycle of even greater and greater crashes with increasing frequency until such time as fiat currencies experience near infinite hyperinflation and are declared worthless.

In late October 2008, a person or persons going by the pseudonym “Satoshi Nakamoto” published a whitepaper on an internet mailing list of interest to cryptographers and cypherpunks, describing a digital electronic peer to peer cash system. He called it Bitcoin.

On the 3rd of January 2009, the Bitcoin network went live. Satoshi embedded a message in to the first block on the Bitcoin blockchain. It was a headline from The Times newspaper on that day:

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.

And thus, bitcoin was born.

Purely electronic money wasn’t a new idea, but it had a problem. It was always fiat. If I give you a gold coin, you now have it and I don’t. But if I give you a computer file, we both now have it and I could also give it to someone else. Digital scarcity couldn’t exist. So the only way to stop someone “double-spending” (giving the same money to more than one recipient) was to have a central authority monitoring transactions. In the case of legal money like the US Dollar, this is the job of the banks and there are laws in place for how they do so. In the case of money that someone wants to create themselves, it’s a single point of failure should the government decide to stamp it out, and a single point of trust should the creator decide he’d like to “give himself a bit extra”.

Satoshi solved this problem through the invention of bitcoin with a Proof-of-Work based decentralised blockchain. I won’t go in to the technical details in this article, but I certainly will in another.

When we look at Bitcoin as a currency, we can think back to what we know about different kinds of currency and ask ourselves: is it fiat money? is it representative money? is it a commodity money?

We can best answer this by looking at its properties:

  1. Fungible (one bitcoin is functionally indistinguishable from another – only their history is unique)

  2. Durable and Non-consumable (you don’t use bitcoins up, nor do they go bad)

  3. Extremely portable (being digital, you can carry any amount of them on you without trouble)

  4. Extremely divisible (each bitcoin is divisible up to 100 million units (called “satoshi” in honour of the creator) and can be subdivided further if needed through technological means)

  5. Extremely hard to counterfeit (that’s what the Proof-of-Work system ensures)

  6. Of a fixed supply (there is a defined rate of creation that reduces over time and will eventually hit zero just below 21 million bitcoin; after which there can never be more created)

These properties should hopefully remind you of something earlier in the article. These are the same properties that we described for precious metals (although significantly better). Bitcoin is a commodity money.

As we recall, commodity money is a good system, but it had its drawbacks. If we examine Bitcoin as a digital commodity money with regards to the drawbacks of physical commodity money, we see:

  1. Non-monetary intrinsic value: I claimed earlier that metals’ use in electronics and other similar endeavours means that the non-monetary use competes against the monetary use. Bitcoin does actually have a non-monetary intrinsic use: it’s a global ledger that can be used for time-stamping, proof-of-existence, and other similar activities. These activities are inherently valuable and can be built upon for functions like decentralised identity and more. However, Bitcoin’s non-monetary intrinsic value doesn’t use it up. That is, by using these functions of Bitcoin, we don’t reduce its ability to be used as money. Essentially, we’re using the Bitcoin fundamental technologies (blockchain, proof-of-work, etc) for these tasks without actually using up the Bitcoin itself. This is in contrast to metals that can not be used for monetary purposes while they are used for non-monetary purposes.

  2. Ease of transfer: Metals are bulky. While they are somewhat portable, it is still quite difficult to transfer large amounts from one location to another. Bitcoin – being digital – can be transferred anywhere in the world instantaneously with near zero effort.

  3. Security: Protecting large reserves of precious metals requires significant physical security. Bitcoin is protected by private keys that are mathematically next-to-impossible to guess (guessing one ‘at random’ would take longer than the age of the universe even if you expended all of the energy of a large star to do so). Securing a private key is easier than securing gold, since it can be represented in a number of different ways and can take up an arbitrarily small amount of space. It’s even possible to memorise a list of words that represent a private key, meaning you are holding your bitcoin entirely in your head! (I don’t recommend this… forgetting the words means losing your money; a piece of paper in a locked safe is generally more reasonable).

  4. Scarcity / Fixed-Supply: Although I said earlier that precious metals have a fixed supply, the reality that I pointed out after that is that this isn’t necessarily true. We may find more elsewhere in the universe and we also don’t actually know how much is still undiscovered under the earth. Even aside from the amount that exists, it’s also not easy to predict with any accuracy the rate at which we find and extract them. The costs for extracting them also varies to an extent based on luck aside from the more controllable factors. By comparison, Bitcoin is strictly limited to just under 2.1*10^15 (2.1 quadrillion) satoshi / 21 million bitcoin and the rate of generation is fixed to average at one block per 10 minutes, with a defined halving of the generation every 21000 blocks (approximately four years). This means the supply is extremely predictable, removing potential for problems caused by supply disruption (in either direction).

Clearly, as far as being a commodity money goes, Bitcoin doesn’t suffer the same drawbacks as commodity moneys of the past.

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