Fundamentals of Crypto — Part 2
This is part 2 in an ongoing series. To start at the beginning, visit our Intro to the series.
In Part 1, the color of money, we established a basic understanding of the difference between money and currency. In Part 2 we’ll take a deeper dive into the characteristics and attributes of currency, and try to build some context for the emergence of crypto.
“Thou shall not confuse currency with money.” Imagine those words written in a bloody chicken scratch on your arm, like the scene in the 5th Harry Potter when Umbridge, with a quill that painfully inscribes whatever you write with it into your own flesh, forces Harry to do penance for telling inconvenient truths.
For our purposes, and to avoid transgressing our laws on cruel and unusual punishment, a simple reminder will probably do:
- Money is the underlying system of accounts (eg. the ongoing record of the credits and debts of individuals, institutions, nations, et al.)
- Currency is the abstract unit that denominates and represents value.
In this post we set out to discuss the different types of currency — from the ancient to the brand spanking new. Through examination of their attributes, we’ll then try to figure out what makes an effective currency. But it’s not as simple as separating the good from the lousy. Currencies, like people or tools, have different strengths and weaknesses. Their merits are context dependent. They can be superior in one domain, and ill-suited in another. A hammer is great for banging in nails, but good luck eating soup with it.
This is all to say that when evaluating the efficacy of one currency vs. another we should know whether we’re trying to frame a wall or have lunch — whether we need to send money to our family across the border, or protect our wealth from inflation. For the purposes of our discussion we can separate currency into three main categories:
First there’s Commodity Currencies, sometimes called hard currencies due to their physical or material nature. Think sacks of wheat, livestock, or coins of real gold and silver. Generally these materials have some perceived “intrinsic” value which makes the thing itself useful and desirable and establishes a kind of baseline raw value that can then be used as a benchmark for valuing other things.
Then there’s Fiat Currency, like the US Dollar, a non-commodity currency deriving its value from some central authority — like a government. There is nothing material (such as gold) underpinning the value of fiat currency, only the faith and trust in the body from which it has been issued. Basically, it’s legal tender because someone powerful says it is.
Lastly, we have Digital Currency, claims to funds that are represented electronically, typically in the form of balances via banks and various financial institutions. In this way digital currencies can, and sometimes are, nothing more than electronic versions of fiat or commodity currencies, but they are also capable of a lot more. Cryptocurrencies are one such example, demonstrating that the technology of the internet has created unprecedented possibilities for how a currency can function (more on this later later)
Accepted economic dogma states that all forms of currency share three basic functions.
- They are a unit of account — a measurement used to assign and express value. This establishes a common language in which people are able to negotiate the costs of goods and services, especially of things that are unrelated (eg. a house vs. a haircut)
- They are a medium of exchange — A fancy way of saying that people are willing to accept it as payment, that it has purchasing power.
- They are a store of value — that their worth as a means for payment is relatively stable and trustworthy. Basically, that what you can buy today with your currency will be more or less the same a week, month, or even a year from now. This last point, however, is more wishful thinking than an inherent truth about how currencies actually function. History has demonstrated repeatedly that currencies, particularly fiat, are susceptible to sudden and catastrophic losses in value.
The viability of any currency is directly correlated to how well it performs these critical functions. But what makes a good unit of account? Or a good medium of exchange? What makes one bad? Over the course of history many different materials have been used as currency, but certain patterns do seem evident. The existing literature around currency points to several common properties and attributes that a material, if it is to lend itself well to usage as currency, ought to have. They are:
- Durability. They’re tough. They won’t fall apart or melt in your pocket.
- Portability. They’re easy to transport and easy to exchange.
- Divisibility. You can break them down into smaller parts, or add them together to equal more. You can make exact change.
- Fungibility. They’re all the same. One unit is as good as another. There’s no first edition that’s more valuable than any other edition. They’re interchangeable.
- Credibility. People will readily accept them as payment, and have trust or faith that they will be useful and valuable in the future.
- Liquidity. They’re desirable. There’s a big market for them. You can transfer them between people easily and rapidly.
- Scarcity. There is a limited supply, or some means for controlling their replication. They are not so easily duplicated.
When looking at the above list it’s easy to see why precious metals, where available, quickly established themselves as the dominant form of currency. They are extremely durable. They’re resistant to the wear and tear of everyday usage and they’ve got a seemingly infinite shelf-life. This made them an obvious improvement over other commodities such as cattle or grains which, beyond being subject to spoil or die, were difficult to store, transport, divide and make uniform. Imagine trying to pay your barber for a haircut in cattle. Perhaps after slaughtering you could supply him a steak, but while it’s alive there’s no way to give him a small portion to pay him for his humble service. In order to be a functional unit of account, the currency has to scale both up and down. Precious metals on the other hand were imbued with properties that allowed them to be worked and shaped to suit many of the varying needs of a diverse market economy. With the right tools they could be smelted down, pressed into pocket size coins of equal consistency, weight and measure. These qualities made them easy to swap for goods and services, both large and small, satisfying the conditions for a good unit of account and a good medium of exchange. The limited supply of precious metals and the considerable effort that’s required to extract them from the ground also gives them a defacto scarcity. It’s not so easy to mine precious metals, to get them into usable form, or to counterfeit them. This has had a stabilizing anti-inflationary effect. With a relatively controlled supply (or at least one that naturally resists rampant proliferation) credibility and liquidity have on the whole remained very high. People generally trust that gold and silver are safe bets, that people, now and in the future, will accept them as payment. This form a positive feedback loop. Confidence in the shelf life of a currency, and historical evidence to support it, boosts confidence in the present, and ultimately makes for a good store of value.
Given the above, admittedly oversimplified analysis of precious metals (as commodity currencies), one has to ask why other forms of currency emerged at all. What was it about gold, for instance, that was found insufficient? One could argue that in many instances gold is quite cumbersome. That although it’s divisible, shaving it down or smelting it isn’t exactly easy to do, especially on the fly. And when dealing with large amounts, gold is difficult to transport (aka heavy af). You could also argue that in order to verify the legitimacy of gold it required access to accurate weights and measures — something that was not always available or accessible to the common person in pre-modern times. But those things seem more like minor inconveniences, and hardly enough to warrant abandoning a seemingly tried and true currency.
One reasonable answer for the shift to fiat currencies is that they provided a new source of political power and control for the ruling authorities. Historically, fiat currencies have often been the levers of kings and governments, a tool used to exert economic control as a means of solidifying authority and self-servicing their own financial needs. How? By controlling the money supply, governments and monarchs had the ability to manipulate value. Rulers could increase the supply to relieve debt, or decrease the supply to boost their own coffers. Stamping their seal onto a coin was also a way to signal their legitimacy and entwine their position on top with the economic interests of the people. If all the currency you hold has King Louie’s face on it, you might consider it a risk to your personal wealth if he were to be suddenly dethroned.
The above is a more sinister interpretation of the emergence of Fiat currencies, but it’s obviously not the whole truth. Reality is always more nuanced. If we use our above list of the properties that make a good currency, we can try to construct a more balanced examination. Take US dollars for example. They are reasonably durable — though nothing compared to metals — just add fire, water, or enough time and see what you get. But their decreased durability gave them a definite edge in portability — they’re far lighter and a hell of a lot more compact and inconspicuous. Untethered to any hard asset, fiat currencies can be printed or minted in any denominations with precision, rapidity and relative ease. Their flexibility gives them superiority as a unit of account as they can easily be adapted to suit the needs of the market.
So far so good right? But things get a little sticky as we get towards the bottom of the list. Earlier we briefly mentioned that the natural scarcity of precious metals has a defacto scarcity effect that helps in maintaining value. Fiat currencies are quite the opposite. There is no limit, other than a self imposed one, to the amount that can be produced. This can be a real boon to economic activity as it created a way to counter cyclical and recurring contractions of credit — times when people are reluctant to spend and more apt to hold and save. During these times things naturally slow down and the economy experiences a tightening. Introducing new money supplies (making credit and currency more readily available) gave rulers an artificial mechanism by which a slow economy could be propped up or spurred on.
But the ability to create currency, out of thin air as it were, is double-edged. On the one hand it can stimulate economic activity. On the other hand, it can lead to devastating inflation and the ultimate devaluing of a currency. As there are no tangible assets behind fiat currencies their credibility, liquidity, and scarcity remain stable only as long as the issuer stays in power and can be trusted to refrain from any egregious manipulation of the money supply. We can see what shaky ground this is in our contemporary world. Just ask the Argentines or the Venezuelens, who in recent years have experienced hyperinflation to the point where their fiat currencies have lost most of their purchasing power, and nearly all of their desirability. Or consider the US, where the bailouts of banking and lending institutions after the 2008 housing crisis led to “quantitative easing,” financial speak for the rampant printing of massive amounts of currency (to the tune of 4 trillion dollars!). Change in political power, corruption, or irresponsible fiscal and monetary policies can wreak havoc on the value of fiat currencies, exposing them to gradual or sudden collapse. According to a study by dollardaze.org, the average life span of a fiat currency is only something like 27 years! The oldest fiat in existence, the British Sterling, comes in at only 317 years old, but even there the currency has lost 99.5% of its original value. It’s difficult to defend the notion that fiat currencies can be a decent store of value in the face of their seemingly obvious susceptibility to misuse and abuse.
So why not go back to gold? Easy…ish. One answer is that we now have, arguably, something that could be better — something that can be shaped to combine the advantages, and avoid the disadvantages of its predecessors.
Enter Cryptocurrency — and the moment it’s taken us several thousand meandering words to get to…
In Part 3 we’ll take a good hard look at cryptocurrencies and try to make sense of the what, the why, and the how as it relates to this new technology.
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