Blockchain Fundamentals

What is money?

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Understand cryptos means understand moneys, so what is money?

Money is the most marketable good.

How long has money, as we know it, been around? We don’t know. Or rather, there is no history of human kind that doesn’t also include the concept of “arithmetic” in its most rudimentary forms. We could argue that money is as old as language or writing, so we can say that it’s at least 5,000 years old. But what is money exactly?

Friedrich August von Hayek once said that money is “a medium of exchange for people who want to hold it until they wish to buy an equivalent for what they have supplied to others”. In this sense, money is whatever good is the most marketable. It is the best commodity available as a store of value.

Humans have always been very interested in money, and have been trying to improve it for centuries. Technologies have varied over the course of history though, and it hasn’t always been easy to obtain good results.

To understand if Bitcoin really is the new money, we must understand what money is. Let’s cover some basic history on money, or rather on commercial trade, and see how money has solved a number of problems. This is will be an extreme synthesis. A 5,000-year journey in just 10 minutes! Let’s start from the beginning, with barter.

Barter

In antiquity, the first form of exchange was barter. I had something you needed, and you had something I needed. The double coincidence of matching needs. We would reach an agreement on the exchange and voilà… It sounds easy enough, but it was actually quite difficult to find someone who had something I needed, and at the same time also have something that they happened to need. Then there was the problem of “giving change”. If I have extra goods, or if the value of my goods resulted in some left over credit, how much credit is it exactly? A sheep’s worth? 2 hens? The accounting involved was a nightmare. Then there’s the fact that the debt wasn’t always paid.

Debt is as old as money, even older, and it has always been difficult to collect on.

Obviously, a barter-based economy had severe limitations. Mostly people were forced to trade with a little of everything and do a bit of everything. Procuring food, building homes, defending the community, etc…

Then there was the problem of preserving the goods for future exchanges. Some products had to be consumed immediately or they quickly lost value.

There was no specialization of labor. Calculating value in trade was difficult because there was no common medium (money), and people couldn’t afford to concentrate on just the one thing they did best. Work was generalized instead of specialized, “value” was unclear, debts were difficult to collect, and it was therefore difficult to create wealth. Later though, someone realized that certain goods were more in demand than others: salt (where the word “salary” comes from), wheat, coffee, and other types of assets that transformed “direct” barter into “indirect”, or “mediated”, exchange. This was the birth of what economists call commodity money.

Commodity money

This particular type of good had to have at least three characteristics:

  • It had to be convenient from a logistical point of view, and therefore had to be nonperishable and easy to transport
  • It had to be widely distributed
  • Verifying its value had to be simple, i.e. quantity had to trump quality (for example, one gram of salt is pretty much the same as any other gram of salt, whereas different diamonds can have vastly different values).

The necessity of exchanging goods required a widespread, easily requested commodity that could be saved for later use, for a future exchange.

After a long period of using commodity money, natural selection took over (I’m summarizing thousands of years of trade), and some goods turned out to be more suitable than others as a medium of exchange. Metals, especially precious metals, proved to be particularly effective.

They had excellent characteristics, such as their durability through time, their portability, their exceptional interchangeability (one gram of gold can be replaceable any other gram of gold), the ease of assigning a value, etc…

Precious metals thus ended up being elected as a true currency for trading, and soon after people began minting coins out of precious metals.

Using something as currency obviously assumes that the good itself (in this case metal) has a higher value used in exchange than if it were simply used as a material (such as being used to make a metal sword or other object). We’re not talking about intrinsic value because humans are the ones who assign a value to things. Nothing, not even gold, has “value” in and of itself. If gold were only used to make jewelry, it would have a lower value than if it were used as a bargaining chip. This is a concept that evades most economists, but it is critical in order to understand the value that cryptocurrency could have.

With the passage of time, these precious metals, along with other “precious” goods, were usually taken to a deposit bank. This provided a service of security, which could then be guaranteed by a “note of deposit”, and which soon lead to the birth of the banknote.

Paper money

Paper money is more or less the modern day banknote that we all know and still use (at least for now). It has changed radically over time, but it has always had these three characteristics:

  • It expressed a value (money was already being used as a unit of value by that time)
  • It could be used as a method of payment, as a medium of exchange
  • It was a “store of value”, though this function has been jeopardized in recent times (previous banknotes were better at retaining their purchasing power).

It is important to note that, in its first phase of life, paper money was an expression of a deposited value. In the modern period, this function was carried out by gold. This means that 10 dollars (or pounds, or marks, etc…) expressed a bill of deposit, an equivalent value in gold, in the coffers of a central bank. At least, that’s how it worked until the end of World War II (again, I’m synthesizing hundreds of years of history). The 1929 crisis had already devalued various currencies, which in turn jeopardized the gold standard; so in 1946, after the Allies defeated the Nazis, it was decided that the world monetary system needed a change. With the Bretton Woods agreements, allies surrendered their gold standard, which used gold as the equivalent to all of the money out on the market, and instead chose the dollar as the value against which all currencies would be compared. This meant that each national currency could be converted into dollars, and the dollar (and only the dollar) could be converted into gold. At this stage, much of the world’s gold ended up in the American coffers (and a large part of it disappeared, but that’s another story). We had moved from the era of the “gold standard” to that of the “dollar standard”. But it didn’t end there.

If there’s one thing we learn from the history of money, it is that anyone who manages money on behalf of others, or who operates a monopoly, simply ends up taking advantage of it. It happened in the past with the deposit bank, and it still happens today with hedge funds. It also happened in the era of the dollar standard.

Americans ended up injecting an excessive amount of dollars into the system, even more than the gold in the central banks could cover, creating inflation. This was back in the ’70s, and when the situation could no longer be “hidden”, the United States unilaterally decided to terminate the so-called dollar to gold “equivalent”.

On August 14, 1971, President Nixon, a man who had the “guts” to do difficult things, announced that, due to a poorly understood speculation, the United States could no longer ensure the exchange of dollars into gold. And that was that.

Other countries had actually been concerned for quite some time about the loose management of the “dollar standard” and, starting with the French, began to demand their gold back. This, in turn, threatened to undermine the entire system.

Since then, virtually every country and every central bank has been allowed to print as much currency as they want, because it is no longer fixed according to either dollars or gold.

Thus “fiat money” was born, i.e. a currency that exists simply because we say so. With no equivalent.

Fiat money

Fiat money is the medium of exchange that we use today. It has a face value, which determines the purchasing power. This means that if the piece of paper says 10 dollars, then it can be exchanged for ten dollars’ worth of merchandise. This is because the people who printed it decided to write that number on it. If they had written 100 instead, then that piece of paper would be worth one hundred US dollars on the market. Fiat money is, essentially, “forced” money. If you’re planning to open a store, you will be forced to accept the currency that is used in the country at that time. You cannot accept gold in exchange for your goods and services. In some countries, it is forbidden to even own gold.

Some say that fiat money is based on trust, but it is actually based on coercion. We are forced to use it because we have no choice.

The central bank can’t give me anything else in exchange for fiat currency. I can only trust that someone else, who is forced to use it just like me, will continue to give me goods or services in exchange.

This transition, from a currency that expresses a gold reserve to one that is fiat, radically changed the rules of the game. Without a fixed quantity of gold as an equivalent for the money supply in circulation, certain policies of convenience could then be put into practice.

Before, if a government had irresponsibly squandered its funds or resorted to cronyism, their budget would have been in the red and they would have to try to save money where they could or increase taxes. After all, they couldn’t just print more money out of thin air… Now that money can be infinitely printed from nothing though, all kinds of fraudulent and convenient policies can be cheerfully implemented, and they still are on a regular basis.

Governments began to continually print money, either directly or through central banks, to cover up inefficiencies, cronyism, corruption, and social policies, in order to gain favor. This has always had, and will always have, a serious consequence: inflation.

Prices are determined by supply and demand, but also by the amount of money circulating in the market. When you increase the money supply, you also increase prices. You can prove this just by thinking of how much cheaper everything was when you were a kid: how much did a house cost? A bicycle? An ice cream? Prices have risen dramatically, even though production techniques have improved tremendously and given us the ability to produce more and more with fewer resources. For further discussion about price trends, inflation, and currency devaluation, I suggest you read my book, Matrix Economy.

The transition from currency as an expression of a value in gold, to fiat currency (an expression of purely face value), has radically changed the market and our society. A change, without us even realizing it, from a currency based on trust to a currency based on coercion.

Things are always manipulated and corrupted in the same way. First, society creates something according to its own needs, something that works and has a recognized value, but then that thing is taken, changed, and distorted. Fiat currency didn’t just pop up out of nowhere. If that’s how it had happened then no one would ever have trusted a simple piece of paper with a number written on it. Manipulation must involve something you trusted at first before it was distorted. This is always how it works.

To make matters worse, new technology arrived, which, as we know, can be used for either good or evil. We’ll talk about this more when we get back to cryptocurrency.

Now, in recent history, we have witnessed the transformation from paper money to digital money. Don’t forget that it is still all fiat currency though…

Digital money

The concept of fiat money has been expanded and enhanced by computer science. No more need to “print” money, just type a few keys on a computer and that’s it.

That is how it’s done, and now more than ever. It is estimated that 98% of the money in circulation is in digital form, not paper. However, it is still always the same “old” fiat money, infinitely created out of thin air, and it is being produced faster and faster. It costs virtually nothing; it’s just bits on a computer. These bits are radically different from Bitcoin though. We’ll talk more about this later.

The consequences of all this money being injected into the system are there for all to see. Prices constantly rising, government debts reaching unimaginable levels, making those debts technically non-refundable (unless you print even more money out of thin air), and finally, the latest surprise our crippled economy has for us: negative interest!

Negative interest is a recent aberration of the economy. It’s a contradiction of terms: I shouldn’t have to pay someone in order to lend them my own money. By lending out money, I not only give up my ability to use that value, I take the risk that it might be worth less when it is finally returned to me, and there is also the risk that I will simply never be repaid. I shouldn’t have to pay for the privilege of taking such a risk. The whole point of taking that kind of risk is if there’s a potential for future gain.

After forty years of this monetary system, our economy is in shambles. There are no other words to explain the current situation. Economists (always be wary of economists!) will tell you that the macro economy is a complex thing, that it is difficult to understand, that it requires experts. But of all the people who don’t understand the economy, they themselves are right at the top of the list. Mainly because these “experts” lack any practical experience, they only know theory. If we asked them to put their theories into practice, all of their shortcomings would quickly become obvious. Then there is bad faith. The monopoly of money, and therefore the ability to infinitely print from nothing, is very convenient for those who have established power. Obviously!

This money monopoly has created paradoxical situations. Once again we have proof that when someone manages the money of others, they just end up taking advantage of it. It is a tailor-made economy for debtors, who continually take new money, using it to buy at the old prices, and thus inflating it. It is a world where those who work for money are poor, and those who make money work for them (by borrowing it) are rich. The world has turned upside down.

But (there’s always a “but”) people are resourceful. They fall and then get right back up again. They make mistakes and learn from them. When all seems lost, they redeem themselves. So more and more people, tired of this situation, started thinking of a solution. If there is a problem, there is always a solution. After several attempts with new technology, just a few years ago someone invented something that would change our society forever. Just like electricity, the telephone, and the internet. You probably think I’m exaggerating, but as you’ll see by the end of this book: I’m not. This invention was cryptocurrency.

Cryptocurrency

In 2008, a scientist (or a team of them, we don’t know) under the pseudonym Satoshi Nakamoto, invented an algorithm to solve a need. Namely, the need for a value of exchange that we can trust. Decentralized, secure, and with no intermediaries. A new type of money that people can use to exchange value. That can be used to benefit everyone, and not simply managed by a powerful few. That cannot be manipulated, devalued, or falsified, and cannot be turned into a monopoly. One that is transnational, and yet also retains the classic features of money. That can act as a unit of value, to give a price to things, to serve as a medium of exchange, and as a store of value (a trait that has now been distorted by fiat currencies). Is this too much to ask for? Is it too good to be true?… Believe it or not, they made it. It happened. Such a thing was invented. These days there is no longer any doubt, and that’s why I wrote this book.

The technology that underlies cryptocurrency is called Blockchain. The first cryptocurrency ever created, the founder of a new era and by far the most popular, is called Bitcoin.

Blockchain technology isn’t just about transferring money; its main function is actually its ability to designate the ownership of each individual digital coin (each string or sequence of bits), unequivocally and verifiably, in a large archive that cannot be falsified. This sequence of bits can express not only money but also the ownership of a house, a car, a purely digital or legal entity. It is more of a service than a currency. A service can indeed be money, but it can also be the ability to handle a land registry, the public registration of a car, or the delivery of digital music. Some cryptocurrencies (also known as “tokens” in computer jargon) can also be issued exclusively for a specific service, like Spotify, eBay, or Uber. That is, to use that particular service platform, or to listen to music in that particular database, you will need that particular currency. And I can buy that particular coin by exchanging it with another currency like the bitcoin.

Later we will discuss this new technology in more detail, and all the social and economic implications that it brings with it. But the theory I want to establish from the very start of this book, and I believe I am also the first to do so, is that we are entering the new age of service-money. After commodity money and fiat money, there is service-money. A currency linked to a particular service.

Service-money

Obviously, the most requested services are those that function like money itself, but first it’s best to clearly understand a new concept about the Crypto Economy: the technologies are all open source. All of the programs are written in clear code that you can study and copy! This means that it isn’t possible to demand payment for the service, instead you have to issue money. Allow me to explain. The developers of these services don’t sell their software (which is free and can be copied); they simply make it so that it requires a special token (i.e. cryptocurrency) in order to use it. So the programmers issue the token (money), and the more the service is requested, the more money (in the form of tokens) is needed to use it, causing it to appreciate relative to other currencies, and consequentially increasing the spending power of the token holders. It becomes more and more rewarding to participate in that service and more and more people will want to contribute.

Let’s use an example with the Bitcoin system, which we will then elaborate on later in the book.

Bitcoin money is a cryptocurrency. It is a certificate of value. Those who work to support this service (meaning that they make their computing power available to support the network) receive some money (a few bitcoins) in exchange. If these bitcoins are in high demand from the market, their value with respect to other currencies (such as the dollar) increases (as has been the case so far). So the value of a bitcoin in dollars will rise, and my remuneration in bitcoin will have greater and greater purchasing power. In other words, I contribute through my work (programming, the computing power of my computer, or making memory space available) the provision of a service that requires a particular money (cryptocurrency) in order to be used. The more this money is requested, the more it is worth, and the better paid my work is.

If you’re having trouble understanding, don’t worry. Things will make more sense later on!

For now, suffice it to say that you can have and use one or more currencies, which are not issued by any central body, but which you can trust because their functionality is transparent, decentralized, and disinter-mediated.

The result of all this is an efficient, cheap, and reliable currency. It may sound like a fantasy, but it’s true: all this was invented just a short time ago. Welcome to the world of cryptocurrency.

Welcome to the Crypto Economy!

Extract form the book “Crypto Economy” 2017 — www.robertogorini.com

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