The Next Chapter of Monetary History
The History of Money
What is money? I think the most honest answer is that nobody knows. Although there is a historic trail that money is somehow linked to keeping track of debt and/or assets, it's also true that the history of money is something that is closely linked to the context of that particular time and region. When I study monetary history it's easy to get hooked on a specific concept; every author of a book is very keen on conveying his view of what money is ought to be. I don’t think there’s a single unified concept. Money is constantly being invented and reinvented to fit the historical context. As shall be seen, bitcoin is going to open a new chapter in the book of monetary history.
Let’s quickly review the history of private money in Europe during the 16th century. In the 16th century of Europe wealthy families formed a network which became the monetary base of private banking. ”Bills of exchange” were circulated as a way of transferring wealth between parties. Because these families were trusted with their wealth, the bills of exchange started to circulate without being redeemed. Sometimes, redeeming a bill of exchange turned out to be useless and the issuer defaulted on its obligations.
Public currencies did also exist as part of the sovereign. The King/queen/prince of the region minted coins to pay his/her soldiers. The good news with public currencies is that they don’t default. A coin is always a coin and by enforcing it having the character of ”legal tender,” it could always be redeemed for goods and services. However, that non-defaultness comes with a different price, namely when people stop in believing in it all together. Then the entire currency defaults. It required careful balancing to issue as much money as possible while keeping the trust of the public.
Wars were common and costly. The King compensated by minting more coins and depleting the silver content in order to keep the operation running. This was just a clever way of expanding the money supply. At the time there was a philosophical debate whether sovereign coins represented money abstractly or whether the coin itself should be worth its own weight in silver. Regardless, some people were not too amused at the time, and started differentiate coins depending on their silver content. For example, when paying taxes they did so with the depleted coins. Finally people would lose their faith in sovereign money and switch back to private money with the possible flaws of defaulting. Remember that private money couldn’t enforce the ”legal tender” so the bills of exchange had to be exchangeable into something tangible (like gold) which again could default.
At the end of the 17th century, the King of England, William III, was financially broke. Costly wars have made the sovereign poor, and he knew that it wouldn’t be possible to create money ex nihilo (from nothing) to fund his operations. The fleet had to be rebuilt to pursuit France, England’s adversary at the time. The King understood that private money had become victorious and the sovereign had to take a loan. The problem was that no one was willing to lend.
So a sinister deal was struck. The King says: ”Give me your trust and I’ll give you my authority.” As known, the problem with private banks is that they could default and did; debased sovereign money however made people flee to private money. So let’s join forces. The year is 1694 and the King says “Let’s create the Bank of England where you, the wealthy families of England, become stakeholders. You grant me a loan of £1,200,000 and in return I’ll give you the power of issuing money which cannot default.” You may recognize that something similar happened to the U.S. Federal Reserve. The template of central banking is older than you think. The road to regulatory capture begins with central banks.
Derivatives and the Abstract Money Supply
Today’s modern money is typically rated in terms of maturity and risk. Imagine a piece of paper where it says ”this piece of paper can be redeemed for 100 USD” (it’s not a 100 USD note, because that’s sovereign money which cannot default.) That paper, depending on the issuer could default at the time of being redeemed. So the paper itself represents a contract with the intended value of 100 USD. This financial instrument is called a derivative, because it is being denominated/derived in something that has value.
I think most people can grasp the derivative market for simple financial instruments, e.g. a bond, but I don’t think many people realize that your standard checking account at your local bank is a derivative too. Your checking account tells how much your bank owes you, but this is just a ”promise to pay.” If the bank goes bankrupt, then this ”promise to pay” no longer applies. Therefore, ”bank credit” (in this case your checking account) is a derivative on ”sovereign money.” In fact, that’s what the conspiracy founded in 1694 is all about. Banks can issue credit that later can be redeemed as sovereign money.
The fusion of private and public money in 1694 carries a problem. If banks behave badly and issue credit that defaults too easily, then the loss is socialized through the sovereign money. This is why the government tries to put a limit on how much bank credit can be swapped to sovereign money. In Europe, this is set to 100,000€ per person. That sounds a lot for a regular middle class person, but it’s actually a very small amount. For example, for small businesses, if a bank would default, the government would only cover 100,000€ which is nothing; think about all the salaries that have to be paid each month. Running a business with just 10-15 employees and you’re exceeding the limit for the staff alone.
The 100,000€ limit is just an illusion though. There have been many occasions where the government just bail out the banks if they are determined to be systemic. This has occurred in Sweden, U.S., U.K., Ireland, and the list goes on. Because of this unfair socialization of loss and privatization of profit, we’ve heard a stronger dissent with requests to reform.
The Chicago Plan
The depression around 1930’s due to the bank crash at the time brought a push of real monetary reform named the Chicago Plan whose strongest proponent was Irwin Fisher at the University of Chicago (hence the name.) Although unsuccessful in implementation the monetary reform requests unwinding the sinister agreement between private and public money in 1694.
To avoid the systemic problems with banks going bankrupt the plan proposed a complete separation between private and sovereign money. Money that is needed to get commerce going, paying out salaries, paying merchants, would be separated from credit issuance. Only the former would be fully backed by sovereign money with a separate bank network where fractional banking was strictly forbidden.
This will essentially take us back to the time before 1694, but with the exception that the government is much stronger. Lately, Michael Kumhof at the IMF has revived the Chicago Plan called Chicago Plan Revisited. I recommend watching some of the YouTube videos where he lays out the foundation of his monetary reform. For example,
National Currencies and International Trade
I would argue that the system with national currencies breaks down with international trade. When two countries involve in trade, importing and/or exporting, there’s an immediate question which currency to use. As U.S. has been able to establish USD as a world reserve currency reserve, it is a tremendous benefit if U.S. can import goods and pay in its own currency, USD. The seller in a different country could then choose to swap these USD to its own currency on the currency exchange market, or hold the USD. The ”hold” strategy is very good for U.S. because it keeps USD its purchasing power.
To avoid these caveats it would be much better to use an international currency that is completely detached from any nation. The problem then becomes, how should this international currency’s supply be regulated? Some majority decision in the United Nations? It’s most likely that any such strategy would fail miserably. At some point in time gold did actually serve as the international trade currency, but moving gold is incredibly complicated. And gold derivatives can default, so that path is not a good one when it comes to international settlements.
Bitcoin, a new Kind of Money
All this history brings us to the next chapter of monetary history. The implications to our society would be enormous if bitcoin becomes a widely accepted currency. It will turn the financial system upside down and reintroduce base capitalism. In my opinion for the better.
The first interesting aspect is that bitcoin is neither private nor public money. For both private and public money, the supply can change by authority. In the case of private money, changing the supply too fast may increase the risk of defaults. As for public money, because of the legal tender status, the same action may result in hyperinflation or that people will abandon the currency. For both a careful balancing act is required to ensure that trust is not lost.
Bitcoin has the same property as sovereign money; it can’t default unless everybody stops believing in it. Although, anyone can invent that kind of money, what makes bitcoin different is that trust becomes intrinsic because of its mathematically regulated supply. I would argue that there are three reasons why bitcoin has market value: 1) bitcoin balance can never default 2) the supply is mathematically regulated with a finite supply 3) New money is distributed fairly.
Gold was rarely used as money, because it was too cumbersome to carry around and transfer. Therefore, certificates were created to make it easier. But certificates are gold derivatives and like all derivatives they can default. Or can they?
There’s plenty of examples of problematic bitcoin derivatives. The most infamous example would be the former defunct bitcoin exchange MtGox, where the balance of acquired bitcoin is just a ”promise to pay,” but MtGox has gone bankrupt and they did what they’re not supposed to, namely acting as a bank with fractional reserves, or like private money the supply of bitcoin derivatives (the sum of account balances) exceeded the supply of bitcoin. You could imagine other bitcoin derivatives that would suffer from the same behavior. In some sense bitcoin would be seen as ”hard money” and all the derivatives would be money at risk. This would be very similar on how modern money works today.
But bitcoin is different. In early 2015 two bitcoin researchers, Joseph Poon and Thaddeus Dryja, showed using the built-in scripting language that it is in fact possible to create bitcoin derivatives whose supply is directly matched by its underlying assets. That is, it wouldn’t be possible to expand the supply of bitcoin derivatives so it exceeds the bitcoin it refers. They can be transferred between parties without using the bitcoin blockchain. That network is named the lightning network:
It yet has to be implemented, but it sounds promising and most likely be part of bitcoin’s future.
Bitcoin derivatives whose supply cannot exceed the underlying balance has far reaching consequences. It means that these instruments would be classified as ”hard money.” This is something that is not possible to accomplish in the standard (fiat) currency world where there’s no mathematical control over the supply.
I’m not ruling out bitcoin derivatives that are not fully backed by the underlying asset, but it will not be used a currency. End users will always prefer bitcoin derivatives used for currency which cannot default. In essence, this becomes the Chicago Plan on steroids. The ”real” economy (in terms of businesses and people doing commerce) is shielded from the ”speculative” economy where you create financial instruments that can default.
The difference from the Chicago Plan is that the governments themselves are included in the equation. Governments cannot create money ex nihilo to fund themselves; it needs to raise taxes (or whatever) to ensure its revenue stream. With this comes political accountability. If a government is spending on unproductive things they will be held accountable. They wouldn’t be able to stealth tax the population masked with inflation.
Another interesting aspect is that in a bitcoin only world there’ll be no credit. This means that to borrow money you must be able to find someone to lend. Bitcoin banks would only act as intermediaries. That’s a very good thing, because it means that someone is forced to take risk when funding a project. This will minimize capital misallocation and reintroduce capitalism to its fundamentals; no risk, no reward.
Some economists would be terrified over such an economic system. They would scream ”deflationary spiral of death!” Don’t listen to them; they are all wrong. Deflation as such is a non-issue. The reason why they are wrong is that they don’t separate deflation from the cause of deflation. Deflation can be due to a real slowdown in the economy (bad), or because of higher productivity (good) or because of a fixed money supply (neutral.) All our financial contracts of today are compensated for inflation. There’s nothing that stops you from doing the same for neutral deflation.
So there it is. Standard (or fiat) money won’t be able to compete with bitcoin because the fixed money supply is required to build the mathematical trust which is the base of smart contracts. The future monetary history is already written. Sit back and relax and contemplate. What remains is whether you’d like to do that from within the system or from the outside. That is, have you acquired any bitcoin yet?