What is Money?

For something to be ‘money’, it must fulfill two basic requirements, be a medium of exchange and a store of value. By medium of exchange, we mean that at least two parties agree to trade x units of ‘money’ for y units of something else. By a store of value, we mean that x units of ‘money’ will more or less retain its original value over a useful period of time, because ‘money’ would not be very useful as a medium of exchange if its value fluctuated unpredictably.

In order to best meet these two main criteria, ‘money’ should have some other secondary characteristics.
Scarcity: If it can be obtained too easily, it won’t be perceived as valuable.
Non-perishable: Ripe bananas don’t make a good currency for long-term transactions...
Divisibility: You need to be able to make change.
Convenience: You don’t want to haul around tons of something.
Integrity: You need to at least have some idea of what you are being given and be able to easily identify and quantify it (not easily counterfeited).

Historically, certain commodities were used as mediums of exchange, salt being one of the oldest, which is where our word ‘salary’ comes from - salt in payment for work. Rare shells (as in a wampum necklace), cut stone ‘coins’ (some weighing tons!), and others have been used in local, relatively closed economies because everyone more or less agrees on their value. However, the first true ‘monies’ were most likely units of precious metals such as gold and silver.

Here, it would be useful to talk about valuation. Some monies, such as bullion and coins, are considered to have value equal to the value of the weight of precious metal they contain. Coins were minted to contain an exact weight of metal and stamped accordingly; one did not have to weigh and assay the coins every time a transaction was made, which made exchanges easier. However, even though a coin can be minted, this says nothing about their value.

It’s only worth what you think it is

The most important thing to understand is that, in all cases, the value of any money is solely determined by market forces at the time a transaction is made. With physical currencies, one may have a coin containing one ounce of gold (or silver, or copper…), but the value of that ounce is set solely by what someone else is willing to exchange it for. As a general rule, the value of the metal cannot much exceed the marginal cost of acquiring more of it. In practice, this means in a region where gold is very scarce, it will command a higher value than in locations where it can easily found, when you take into consideration the costs of transportation, etc.

Bulging pockets aren’t fashionable

Carrying around large amounts of specie (physical monies) is cumbersome, so paper money became a surrogate for it. The actual physical money was in someone’s vault or treasury, but a letter of credit or paper bill was transferred in place of the actual coin, which in turn could be redeemed for specie. Note that it was not just sovereign entities who could issue paper money; any trusted institution could do so, and in fact there were many private banks in this country issuing their own paper money up into the early 20th Century. The use of gold or silver-backed paper currencies worked very well, but there was a problem with the underlying asset – it was subject to supply and demand value fluctuations which were becoming destabilizing in the growing economies of the late 19th Century.

All physical monies suffer from this problem of continually varying scarcity, and therefore this affects their utility as a store of value, although long term changes in valuation do not affect a monies’ utility as a medium of exchange. Of all of them, gold has been remarkably constant in its purchasing power over the ages; an ounce of gold could purchase about the same services (free human labor or goods therefrom) in Roman times as it does now.

How much gold for this cow?

The supply of gold is not fixed, but the supply can only increase slowly (scarcity). Therefore, in a population there will be some ratio of gold to economic output, which defines the price (in gold) of goods and services. If the population (or net economic activity) increases and the quantity of gold does not, the relative value of the gold increases (or the value of the goods decreases), which is deflation. On the other hand, an increase in just the gold supply will have the opposite effect, inflation. A good historical example of this is 16th Century Spain, where the huge influx of gold from the New World caused tremendous inflation because the value of gold dropped as its marginal acquisition costs (it was stolen…) dropped.

Depending upon ones circumstances and time horizon, inflation (or deflation) can be a curse or a blessing. In a monetary deflation, wages have to drop as the prices of goods drop. If this happens over a long enough time period, there is no net effect, as living standards are not affected by this. However, it is difficult to convince workers that you have to pay them less because their money is worth more, which is why wages are considered ‘sticky’ - once they go up it is hard for them to come down. As economic activity accelerated at the end of the 19th Century, gold was literally in short supply so another approach to money was needed.

Fiat – Isn’t that some kind of car?

Fiat currency (from the Latin, “let it be done”) is money because a particular government says it is – and if you don’t agree they will throw you in jail or shoot you… If you look on a US federal note, you will find the words “This note is legal tender for all debts, public and private”, which means it MUST be accepted as a valid form of payment for any dollar-denominated transaction, even though the note itself has no value backing. The neat trick here is that the government can create all the money it needs to keep the economy moving (or for fighting wars) just by printing it. Initially, the fiat dollar was notionally redeemable for gold or silver (Silver Certificate dollars), but since few people ever did, the dollar supply began to exceed the gold supply. Up until 1933, paper currency could be redeemed for a set weight in gold, and until 1964 for dollars made from silver. A gold standard was retained for sovereign transactions until 1971, when the USA officially went off it and completely un-anchored the dollar. The result of this was, unsurprisingly, increasing devaluation of the dollar; in fact, since the formation of the Federal Reserve in 1913, the purchasing power of a dollar has dropped about 95%.

Crypto-currency – Money for ghosts?

Cryptocurrencies (CCs), the most well known being Bitcoin (BTC) are, in effect private monies, much like the bank-issued notes of the 19th Century, and like all monies, their denomination (one dollar, one BTC, etc) can be specified but their purchasing value must be determined by market forces. A problem with all monies is ownership and integrity. Ownership is simple with physical money – either you have it or you don’t. Integrity means it isn’t counterfeit. Money in a bank exists as only (now all digital) entries and notionally belongs to the depositor, but in reality, it belongs to the bank and/or the government if they so choose. CCs act to provide a money which is (theoretically) beyond the reach of any institution and belongs only to the owner. It does this basically by two mechanisms.

Ownership is established by the possession of an encryption key (a string of digits) which unlocks the money and allows its transfer (in whole or in part) to another owner. For all practical purposes, the key is unguessable, so if you forget it, the CC effectively disappears forever, but this also means only you can access it. So, how does one ‘own’ an intangible thing? Think of it like the ‘dollar’ in a dollar bill; the bill only represents a record that one dollar was ‘created’ by the Federal Reserve Bank and the bill is your claim on that dollar. In a cryptocurrency, a ‘coin’ is created by the software, and its ownership can be passed to you through a digital token so that only you can ‘spend’ it. This token is an encryption key (which can be represented by a QR code readable by a smart phone camera). Just like the physical dollar, the owner of the bill (or token) has exclusive control over it. However, unlike a physical bill, if someone copies your token key, now both of you can access it, but the first one who does so can claim ownership and lock the other person out.

Integrity is provided by a mechanism which makes sure you can’t cheat by selling the same CC several times. This is usually done through a software mechanism called the ‘blockchain’, which is a non-falsifiable public record of all transactions. The blockchain record is not housed in any particular location but is widely distributed across the internet, which makes it fairly immune to hacking or government meddling. Unlike cash, it is not totally anonymous but is close to it. So, you can now have a private, inviolable certificate of ownership, but to what?

These tulip bulbs are sure expensive!

The problem with all of the 1000+ CCs now is that there needs to be a somewhat stable market to establish their valuation. Their value, like all monies, will be determined by the perception of their utility, and one of the biggest hurdles to their acceptance is the difficulty of ‘cashing them out’ into currencies in current use. If most transactions were denominated in BTC (or whatever CC), this would not be an issue, but until they come into common use, they must be converted into local currency to be useful, and this is where governments will want to insert their sticky little fingers. So far, CCs seem to mainly be vessels for speculation as people ‘bet’ on which one(s) may succeed, and it is likely that most will fail.

It is not my intention to get into the technical hurdles CCs currently encounter, but there are quite a few problems which threaten their long-term utility, at least in their present form. One positive thing that can be said for CCs is that their quantity can be limited by algorithms impervious to government (or other) meddling, which can slow or prevent monetary inflation. Only the market can decide their ultimate value, but some of the underlying technology may be applied to other monies.

Crypto-physicals – Checking the ghost’s health?

As said above, the technology underlying the CCs is one that can absolutely ensure ownership (and transfer) of an asset. A suggestion has been put forth in the CC community that some CCs should be backed by a physical asset, such as gold, where one CC unit would be worth some fixed amount of the asset. Therefore, the anonymity and ease of asset transfers enabled by CCs would be paired with a relatively stable valuation. The problem here is, of course, who holds the gold and does one trust them not to run off with it. My guess is the Swiss could pull this off very nicely.

The future of CCs

I have no idea, but it has already been demonstrated that the underlying technology (encryption key identity and blockchain transaction storage) will have a huge impact on how property transaction are done in the future.