Money

The role of money

Note for readers: the following section is an introduction into cryptocurrencies. If you are already familiar with the concept of cryptocurrencies and blockchain, you can skip ahead to the section titled “Tezos”.

Cryptocurrencies are form of money. To understand how cryptocurrencies operate, we must take a brief historical and theoretical perspective on money.

Modern economic theory identifies three roles of money:

1) A store of value.

Money maintains value over time. You want to be able to save your money for future consumption. Imagine that you have money now and you don't want to spend it right away, you want to spend it next year and next year you still want it to have value. Unlike, say, produce or meat, money does not deteriorate rapidly and serves well as a store of value.

2) A means of exchange

Money should be exchangeable for other items. You have a can of tomato soup and I have some money. When I give you money, you give me the can. You want to be able to spend money to buy goods regardless of when you choose to.

3) A unit of account

Money is divisible and can be used to put a numerical price on various items. Values of money can be entered into contracts, you can create wages, prices and so on. It's a convenient way of expressing prices in shop inventories and restaurant menus. You want to be able to tell people what kind of money they will have to spend in exchange for these goods. It also enables economic calculation: if you say well it's gonna cost me this much to do this and that much to do that, then you can compare these numbers and deduce what is best for you. By using money as a unit of account, we create a single scale on which anyone can compare their options to make everything easier.

Maximizing optionality

Why do we need money? Typically it's because we want to maximize optionality. Let's say I have a bunch of fish and I don't know what I want to do with them. I have fish today, but in the future, maybe I will want to trade my fish for something else: maybe a couple of bananas, or perhaps a steak.

I don't know exactly what will I want in the future, but if I just keep my fish, they are going to spoil and become rotten, thus losing value for me. The solution is to exchange my fish for money. Since the money does not spoil, I will be able to exchange the money for a banana or a steak whenever I want to. Everyone wants to have money, regardless of whether they have a banana, a steak or fish.

You might ask: “why not just exchange my fish for a banana and then I can always exchange the banana for a steak or a fish at a later point if I change my mind?”. The idea behind maximizing optionality is that you want to get the item that is going to be easiest to exchange for everything else.

Money is one such item. It is the obvious choice because it is easier to buy your bananas with money and it is equally easy to buy your steak with money so you don’t need a coincidence of needs like you’d need in a barter.

Before we had money, we had the barter system. You have fish and you can trade the fish for bananas or for a steak. In theory, you can trade anything for anything, thus you may ask, why use money (an intermediary) if you can just barter your items for other items?

The problem with that is you need a coincidence of needs. If I have fish and I want a steak and the person who has a steak doesn't actually want fish, perhaps they want a banana, then I can't get my steak directly in exchange for my fish. What we need to do is go and find a third person who has bananas and perform a triangular trade. The trade gets more complicated as we now have a 3rd party that is necessary to conduct an exchange between two individuals.

The ancient solution to that problem was the introduction of commodity money. For instance, many societies regarded iron as a useful and valuable commodity, and therefore pieces of iron were a popular choice as a commodity money.

Let’s say you exchanged your fish for 3 pieces of iron and with those 3 pieces of iron you can buy 6 bananas. You can therefore deduce that 1 fish is worth 6 bananas.

What happens is that you avoid having to have an intermediary (3rd person) because the money itself serves as an intermediary. Money is the perfect intermediary because everyone wants money and therefore everyone can trust in its value. You don’t have to include additional people in your transactions, as long as you and your trading partner both agree to use the same sort of money.

The benefit is that everyone who uses money can efficiently trade with one another. As long as you have money (regardless whether its commodity money or fiat), you no longer have the issue of having to find a coincidence of needs. By creating money, we can now route our trade in a very efficient way with each other. Money is a truly universal language that everyone can understand and use.

Banking and Credits

Advantages

  • Credit reduces need for money.
  • Faster safer long-distance trade

Disadvantages

  • Reputation doesn’t scale
  • Enforcement favors large power structures

The idea of banking and credits is to reduce the need for physical money.

Let's say for example that you have a steak and I have fish and neither of us has money right now, but we both know the price of your steak and my fish. I want your steak, but I don’t have any money. Since neither of us has money, we have to work with credit. Paying with credit is a claim: “I'll pay you (for the steak) in the future”, but then maybe we do another trade in the future, with me giving you fish in return for your credit, and then if we both owe the same credit, then the debt is annulled.

It's a method of facilitating trade without needing money. However, the caveat is that for it to work you need to already have money in the system, so you can expand the money supply by using credits.

The benefit of credit is that it reduces the need for money. It's faster, you don't need to actually physically exchange the money, it's safer because adversaries can’t come in and steal the money, the credit is in your name and it facilitates long distance trade.

Say you lived as a merchant in 15th century Portugal and you wanted to buy spices in India. You would normally have to purchase boats, fill them with bullion (a form of money) and hire a crew. However, now you would have to deal with pirates, storms and other risk factors. Whereas if you have something like a banking system where you put your money in your local bank in Portugal and then retrieve the money from another branch of the bank located in Portugese-controlled India, you can send money through very long distances without actually having to physically move the bullion. This reduces the cost of trade as well as removing many trade-related risks such as piracy and foul weather.

There are problems with it: a credit system is often based on reputation, so you have a reputation of being a good creditor only when you regularly pay back your debts.

However, a reputation system doesn’t really scale well. It works in a small village, but does it work in a very large economy? If someone doesn't have any reputation and they don't have access to credits, then they will have trouble conducting trade. They can't prove that they would pay back their creditors and if you end up lending money only to people that you've lent money before, then you create a feedback loop that can leave certain disadvantaged people out of the economic system.

The other problem is that one of the ways creditors enforce their debts is through force, so if you don't pay your debts, you may go to prison or have your assets seized. This type of enforcement is going to favor very large power structures, like national governments, who can actually enforce these rules.

Fiat money

In the 11th century, the Chinese Song dynasty monopolized the issuance of paper money and created the world’s first government-backed fiat money. Unlike other money used at that time (gold, silver and copper coins, for instance), the Jiaozi was not a commodity in itself. It was basically a piece of paper and its value was guaranteed by the Chinese imperial government. To protect against counterfeiters, the Jiaozi was marked with several banknote seals.

With fiat money, we can keep track of what kind of value we theoretically can exchange for if we spend our money. There's no reason that your money in itself needs to be worth anything, you only need people to trust it and an institution or group that backs its claim to value. The world has been running on fiat money since 1971, the year when the US decided to ‘float’ the Dollar, severing the link between gold and their national currency.

What makes fiat money valuable?

A government has legal tender laws that recognize fiat currency as an accepted form of payment for financial obligations (purchases and debts). This means that the fiat currency is the standard, and sometimes the only, method of paying back creditors, unless the creditors are willing to accept something else in return.

Taxation (chartalism)

Fiat money is the only financial medium that is accepted as a tax payment by almost all national governments. You need to pay your taxes in money, therefore it is important to have money. Even a food independent farmer who lives off of his land and has no need for money will eventually have to sell some of his crop or livestock in order to pay taxes.

Common knowledge (convention)

Perhaps the most important reason: it is simply common knowledge that money is useful. This is more a result of other reasons rather than a reason in itself. We know money has value because we know that it is accepted as a form of payment, it is necessary to pay taxes and it doesn’t lose value the way fish or meat do. If enough people assume that money is valuable, then others will too and the entire concept of money becomes a positive feedback loop.

The case of the Iraqi Swiss Dinar

The Iraqi Swiss Dinar is an interesting historical case study that demonstrates how non-commodity money works. Saddam Hussein used to have his Dinars printed in Britain using printing plates from a Swiss company. After the 1990 Gulf War, the United Nations authorised financial sanctions on the Iraqi government and Saddam Hussein could no longer import the Dinars from Britain, so he created a new currency which became known among the Iraqi population as the Saddam Dinar, which was printed in Iraq and issued in the post-war period.

As political scientist Sultan Barakat writes, “the story of Iraq from 1991 until 2003 is of a country suffering a profound macroeconomic shock”. Coalition bombers had destroyed much of the country’s infrastructure while economic sanctions severely limited international trade. The economy stagnated, but this didn’t stop the Iraqi government from printing more Saddam Dinars to pay out government salaries and handle other expenses, causing high inflation (price loss over time) for the new Saddam Dinars.

However, in northern Iraq, in the politically isolated region of Kurdistan, the Kurds had refused to accept the Saddam Dinar and decided to keep using the remaining Swiss Dinar as the standard method of payment. Since no new Swiss Dinars were being printed (and some banknotes were even taken out circulation as they were damaged or lost), the Swiss Dinar appreciated against the Saddam Dinar and the Kurds managed to avoid the massive inflation that plagued the rest of the country.

In this historical example, we see that when a large enough group of people agrees to the value of a currency, it does not require any kind of additional economic backing as the trust itself grants it value.

When the first cryptocurrencies emerged, a lot of people said: “how can this thing have any value? it's not a commodity like gold, it's not issued by any government, therefore it cannot have any value”. To those I would say, take a look at the Iraqi Swiss Dinar. If there is a social consensus (collective agreement) on an item’s value, then it does become valuable, regardless of whether it has commodity value or government backing.

Electronic money

Electronic money is fiat money that is represented on a digital ledger. It is a rather inconclusive vague term that describes a wide variety of financial actions: digital transactions, bank deposits, debts, balances and so on. The European central bank defines it as:

“money which exists in banking computer systems and is available for transactions through electronic systems. Its value is backed by fiat currency and it can be exchanged into physical form however its uses are often more convenient electronically.”

A majority (over 90%) of the world’s money is electronic money. For most people, having most of their money in electronic form is more practical; it reduces the risk of the money being stolen, it is more practical when sending large sums and they can easily keep track of it.

Ecash

  • There is no trusted intermediary (third party)
  • The electronic money isn’t based on credit
  • Ecash is more private than electronic money

The idea of ecash was formed back in 1983 by cryptographer and computer scientist David Chaum. It started becoming popular in the 90s as computers became a standard item for most adult Americans. The difference between electronic money and ecash was that while electronic money (credit/debit cards) was dependent on an online connection between the retailer’s terminal and the customer’s bank, ecash was secured offline on the customer’s PC. A bank would use RSA cryptography to ‘seal’ the user’s balance on his PC.

The user of ecash was be able to spend their money without having to contact the bank every time they made a purchase. RSA cryptography ensured that transactions were unlinkable. These aspects made ecash a better option than standard electronic money as it was more private, didn’t require regular communication with banks and wasn’t based on credit. True to its name, ecash combined the advantages of physical cash and electronic money.

Despite the initial excitement and promise of e-cash, the system did not flourish as Chaum had hoped for, and by 1998 Chaum’s company had gone out of business. Chaum explained the failure of ecash in the following statement: “as the Web grew, the average level of sophistication of users dropped. It was hard to explain the importance of privacy to them”.

A decade after ecash had fallen apart due to a lack of customers, concerns regarding privacy and a distrust of central banks once again reignited the desire for a more private and independent form of digital money. This desire was a factor in the creation of the first cryptocurrencies.