Bitcoin and the story of money
Before we begin — this article, and its second Part (link at the end of the article) have been written in collaboration with Billy Cundiff, Cofounder of CryptoFizz.
And now… let’s dig in.
We don’t know how you got to this article or even why you are interested in this topic. And we don’t even want to know because we believe in a future where complete privacy and anonymity are the norm thanks to internet and cryptography. What we do know is that if you keep on reading you will find out what money is, how it acquires value, and how centralized monetary systems are at the root of that value. Or… are they? Read on to discover what actually makes money… money. And what alternatives there are for us to live in a world where we are fully in control of our finances.
What is money?
Before we get into what kind of money Bitcoin is, let’s first wrap our minds around the notion of money. What is money and what is it that makes paper notes (or plastic notes for some currencies) so valuable? The textbook definition of money is that it represents a unit of measurement, a storage of value and a medium of exchange. To this we must add that for money to function, a fourth element is needed — scarcity. These notions might seem self-explanatory, but in order to understand how money gets its value, we need to dig in a little bit into the history of money. And we mean really dig in since most of this information came from excavating ancient archaeological sites. So let’s take each idea one by one.
Money as a Unit of Measurement — or the Third Item
Before we had money, people had to rely on something that is quite uncommon nowadays, especially in the Western world — barter. When there is no money, you exchange goods for… well, other goods. This works all fine and dandy but only up to a certain point. And that point is reached when you have something really valuable that cannot be divided without losing its value. One such simple example is livestock.
If you have a cow for sale, that cow is worth a lot of other products. Unfortunately for you, your needs are varied. As such, you do not need the cow’s worth in oranges. You actually need oranges, coffee, cheese, potatoes, soap and a couple of other things. But how can you get them if you can’t find one single other trader that has everything that you need and is also in need of a cow? The short answer is, you don’t. While some might be very lucky once in a blue moon, most of the time your only option is dividing the cow. But meat is not the same as a live cow and you might lose value. Moreover, if you don’t have freezers, meat is perishable and if you can’t find people to buy it right away, you might lose even more value. Wouldn’t it be great if you had something else that you could get for your cow that you could then reuse to obtain all the things that you need? Something like a 3rd item that serves as a unit of measurement. Something like… money?
Money as a Storage of Value
If barter is the only form of trade, then another problem you might run into is storing value. Some goods are perishable and obtaining non-perishable goods in exchange might prove tricky. It might also be a bad investment because when it comes to commodities values tend to change. Let’s say you want to buy lots of corn in exchange for all your cheese, since corn stores better. But the value of corn might drop next year when corn will be plentiful as a result of good crops. Not a good deal. Wouldn’t it be great if you had something that stores value without as many risks? Something like… money?
Money as a Medium of Exchange
And the problems of barter don’t end there. Let’s imagine another simple scenario — three traders with three different products — a laptop, oranges, coffee. Now, trader A has loads of oranges but is desperate for a cup of coffee. In order to obtain that coffee, he visits trader B who owns large amounts of coffee beans. The problem is, trader B doesn’t want any oranges — he wants a laptop. Now, trader A is in luck as trader C has a laptop for sale AND is also in need of oranges. But in order for him to obtain his coffee, he has to first exchange goods with trader C and then go back to trader B to offer him a laptop. When you have only 3 traders that each want something that the other has, the situation is only mildly complicated. But imagine having 20 traders and 3, 4, or 5 of them wanting a laptop, but only one of them having one laptop for sale. Not so smooth. In fact, some of them might end up without the things they desire. If only they had a medium of exchange to help them obtain a universally desirable third item with which they could then obtain the goods they need.
But even when barter is no longer the trading mechanism and you have that third item, you might still run into some problems — for something to function as a medium of exchange it has to be transferable. Archaeological discoveries have shed light on various ways in which people have been trading in the past. For example, in Mesopotamia, silver was used as a form of currency for trade. Silver was a great commodity to use for exchanges since people valued it in itself — silver was valuable because people thought it was valuable. But it is unlikely that people carried silver with them when they went to the market to buy products. More likely, they recorded their payments in accounts or ledgers and paid later for what they had bought. But this kind of system only works in small communities where people can be trusted to repay the merchant because the merchant knows them and their rap sheet well. When larger communities start trading between themselves, this is no longer possible.
As a merchant you have to obtain your pay then and there, otherwise you have no guarantee of ever seeing the buyer again and getting repaid. Silver works well enough for trading in larger communities since it is transferable. Shells are also great because they’re tiny and light.
One of the first proofs of money-use in China are the cowrie shells found in the tomb of Chinese empress Fu Hao. What archaeological evidence suggests is that cowrie shells were used as some form of money system. This is the first evidence of moving toward a symbolic system of exchange since the shells weren’t particularly valuable, but people mutually agreed that they could be used as a form of currency for trade. Both cowrie shells and silver were great items to use as money since they filled all the categories mentioned above and they were also scarce.
Scarcity is essential for currency to function. If we use pebbles as currency, anyone will be able to obtain them so no one will have an incentive to accept them as payment. Why would you want to obtain as payment for your valuable product something that you can easily obtain anywhere? This is why cowrie shells and silver are great. But scarcity is a double-edged blade. If you have a growing economy, a currency that is too scarce can also pose problems. When you have more value, you also need more currency to represent that value. And if you cannot get more currency, you cannot grow your economy. Cowrie shells were unfortunately too scarce. They worked fine to start with, but at one point you just couldn’t get more to keep up with the growing economy.
It is the same with precious metals since mining cannot move as fast as the need for currency when you get an economic boost. But the Chinese came up with something GREAT, AMAZING, and WORLD-CHANGING — paper money. The great thing about paper money was not that they were paper, but that they were an abstraction that was easy to produce and easy to carry around. But THE MOST IMPORTANT thing about paper money was that it first functioned as an IOU. And if there’s anything you take out of this paper, this should be it since it represents the foundation of modern economy.
A Bit of Chinese History
At one point in its history, China had been engaged in various wars. As a result, it did not want its precious reserve of metals to leave the country through trading, so the currency people used was created out of iron. But iron is heavy and not so valuable — so people found it hard to use it as currency. Instead they created one of the first forms of IOUs — documents that acknowledge debt. These IOUs were made of paper and they started circulating between people as a form of currency.
Let’s see how this could function. Mr. Ang buys tea from Mr. Bang and offers him an IOU, now Mr. Bang wants to buy rice so he gives Mr. Chang Mr. Ang’s IOU in exchange for rice. And now Mr. Ang’s IOU continues to function as money being exchanged between people with a good chance of never tracing its way back to Mr. Ang for repayment in iron. Mr. Ang is happier for this matter, but he in turn might buy someone else’s IOU, which he can then resell. And now it is easy to see how the first paper money came about. This is the same way in which money functions nowadays with one deceivingly small difference. Let’s look at China again.
When the Emperor saw people like Mr. Ang benefitting from this form of currency, he decided to centralize everything so that the state can benefit from this interest-free loan that it might not be asked to repay. So the Emperor started issuing paper money that had his seal of approval. This became the only approved currency and one of the first forms of fiat money. And this small difference created money as we know it nowadays. But do not be deceived; what might seem like a small difference is actually a HUGE one.
“Fiat” comes from Latin and means “Let it be done”. Fiat money is money that the Emperor or the head of the state guarantees via a “Let it be done” and people know he will back it up with value. THIS is how money functions nowadays. THIS is how money acquires value. The state says “Let it be done” and money continues to circulate because people have TRUST in their government and the value of the money they use. Can anyone spot the problem with this system? No? Well, let’s see how things can go wrong when you have a central authority issuing money.
When Things Go Wrong
Let’s go back to the cowrie shells. Remember we said that for something to function as money it has to be scarce, but that if that item is too scarce, you might also run into problems. This notion is called deflation — when too little money is chasing a large quantity of goods. Deflation causes prices to drop as money becomes more and more valuable and hard to come by. You’re probably not that familiar with this concept as the phenomenon of deflation is not that widely spread. Its opposite however, inflation, is something you most surely heard about as it usually is the hot topic of the day in many countries. But what is inflation?
Inflation happens when money isn’t scarce. If cowrie shells were much easier to come by, then you would obtain inflation as a result of too much money chasing too few goods. This type of inflation is also called demand-pull inflation, as there is a high demand for goods as a result of an increase in the money supply. The result of inflation is higher prices, since inside a state prices are determined by dividing the quantity of money existent to the quantity of goods. This is a simplification of the pricing mechanism, but it helps better understand how things work in practice. Now, when people have too much money, the value that money holds becomes smaller. In other words, the purchasing power of money drops. When a country goes from having 1000 bills to having 2000 bills, an apple that once cost 1 bill, now costs 2 since the quantity of the existing money gets divided by the quantity of goods to determine prices.
The reason why inflation is the hot topic of the day so often is our centralized monetary system. Because money is essentially created by the state and backed up in its value by the state, printing new money in order to keep the economy of a state under control is quite tempting for the centralized power. Bad governing decisions lead to economic troubles. If the state cannot repay its debts to its citizens, it prints more money. And therein lies the problem. Some governments manage to keep the inflation rate low. But others are not so adept — and the temptation to cover up corruption and incompetence with printing more money to make ends meet as a state and be able to pay back your citizens is high. Some fail to resist it and we end up with situations such as the current one in Venezuela.
Venezuela saw a boom in value as its oil reserves became increasingly valuable with the rise in prices for oil at the beginning of 2000s. The Chavez presidency, through its government, increased spending considerably in order to initiate a number of social reforms that will have great success in boosting the standard of living in Venezuela. But as prices for oil started to drop again towards the late 2010s, the Chavez government was confronted with a serious problem. The overspending had been so bad that there was no way to pay back the government debts. Simply put, Venezuela printed more money than it could account value for. This led to one of the worst inflation crises in human history — with inflation values soaring as high as 4000% in 2017. The consequences were disastrous. Venezuela’s economy plummeted and people were faced with poverty never before known as the country’s currency suddenly lost value. The Venezuela disaster was a consequence of irrational government spending in the face of unlimited power over the monetary system. Printing money without anything to back up their value created inflation and Venezuela’s government ended up starving its own people who lost trust in the currency’s value.
But this isn’t the first time inflation rates were terribly high. Right after the First World War Germany was faced with the worst devaluation of currency ever known by them. This period is known as the hyperinflation crisis during the Weimar Republic. What created this crisis? While Germany didn’t have oil reserves, it had a war. And since wars are expensive, Germany borrowed money extensively to fund its growing war expenses. When Germany lost the war, it had to pay back its debts, plus the war reparations that had to be paid back in gold and foreign currency. What Germany did was rapidly print large quantities of paper Marks (Germany’s currency at the time) and buy foreign currency with it in order to pay its war debts and reparations. As in Venezuela, this created soaring inflation rates which quickly devalued the mark. When people received money they quickly had to spend it, as the devaluation rate was so fast that by the end of the day, the same sum could buy far less. And this wasn’t even the worst case of national currency devaluation. Hungary’s pengő in the aftermath of World War II reached such horrible devaluation that it was better to pay for your coffee when you entered the coffee shop rather than when leaving.
Inflation is one consequence of the government being able to print its own money. But what other problems are there when you have a centralized monetary system that cannot print money and as a consequence cannot create inflation? The answer is Cyprus. Back in 2013, Cyprus was a Eurozone member with loads of debt. Since negotiating further loans with EU officials wasn’t possible and printing money was also out of the question as Cyprus gave up its national currency in favor of the Euro, the government decided to get liquidity by confiscating its citizens’ bank deposits. No, we didn’t make this up. Cyprus actually took money from people’s bank accounts to pay back state debts. Imagine leaving work on a Friday evening with a bank account full of savings and then waking up on Monday morning with only 60% of what you own in your bank account because the state confiscated your money. So, when centralized powers control the monetary system, they can steal your money and there’s no way to stop them.
The 2008 Housing Bubble
Economic bubbles arise when people make irrational decisions that drive rapid price increases. But economic bubbles are only possible because of centralized entities that act as guarantors for debt. You know these entities by another name — banks. When interest rates for bank loans started to drop back in the 2000s, people became more and more interested in buying houses as investment opportunities. Banks also saw this as an opportunity of getting more and more money from people getting loans. And in time, they started issuing loans without even checking the ability of the creditee to pay back the loan. Basically, what this created was debt — both for the bank and for the public. If banks issue loans to people who cannot pay them back, then people will eventually default on their payments. And that is exactly what happened. More and more people could not afford paying back their house loans and the banks were suddenly in possession of a great number of houses that they couldn’t sell as no one wanted to buy them. The situation was as serious as it gets, but even though the bubble was on the brim of bursting, it hadn’t done so yet. Right now all we have is many, MANY people who have defaulted on their credit and MANY banks with MANY houses on the market for sale.
Since the market is oversaturated with houses, the number of buyers is much smaller, thus driving the value of the houses down. Now, if the houses are not worth much at all, the bank LOSES money, REAL money. And when people need to take money out of their bank deposits, the bank has no way of repaying them. That is when the bank goes bankrupt and people lose their lifetime savings. THAT is when the bubble bursts. And when that bubble burst, it drove the stock market down and with it the world economy went into recession. Now, if only we didn’t have a centralized monetary system in which banks control our money and create debt that they cannot back up by real value.
A Better Future or What Is Bitcoin?
Bitcoin appeared on the scene right after the 2008 housing bubble that led to the global economic recession. With people growing more and more unhappy with the way governments handled economic matters, a decentralized currency system independent from inflation seemed like an impossible wish. After all, how could you have SAFE and SECURE money transactions without a central authority guaranteeing that? But someone came up with an ingenious solution.
What is Bitcoin?
Bitcoin is an open-source digital decentralized currency first created in 2010 by someone using the pseudonym of Satoshi Nakamoto. Bitcoins exist as computer code that no one, including banks or state governments, can control. But, wait a minute? If no one controls the Bitcoin, then how come it has any value? Anyone can create something and call it money, but for money to work it has to be a storage of value. The short answer lies in looking back to what we’ve discussed so far. Remember the Chinese emperor? What gave value to fiat paper money issued by him? Let us quote ourselves: “The state says “Let it be done” and money continues to circulate because people have TRUST in their government and the value of the money they use.” Fiat paper money value is created by TRUST. People THINK that a piece of paper has value and they ALL agree it has value. When ALL people thought that Bitcoin had value and TRUSTED it, Bitcoin suddenly acquired value and became a storage of value.
But the real potential of Bitcoin lies in its monetary architecture — the technology it is based on, the blockchain. At the moment, if you want to send money across the globe to someone, your money has to pass through one or two banks or a money transfer service. This takes up a lot of time because banks have to verify that transaction. Not to mention the fees they would collect from you for transferring the money. With Bitcoin this should happen much faster, thanks to the Blockchain technology. Bitcoin transactions are also less expensive (especially for large sums of money). What this means is that Bitcoin works much better as a medium of exchange — digital money are incredibly easy to transfer and thanks to its monetary architecture it take less time and money to make an exchange.
What is the Blockchain?
Blockchain technology is basically a digital ledger that records every Bitcoin transaction ever made. It derives its name from the fact that transactions are grouped in blocks and then validated in decentralized manner via a peer-to-peer validation system. For this technology to work, Bitcoin relies on cryptography. Cryptography is, by Wikipedia’s definition, “the practice and study of techniques for secure communication in the presence of third parties called adversaries”. Basically, encoding information so that people cannot read it or tamper with it in any way.
Another thing Bitcoin relies on are miners. When Bitcoin was created, only a limited number of Bitcoins were put into circulation. The rest had to be mined and anyone with enough computer power could become a miner. But how does mining work? Remember those transactions?
Transaction validation happens through miners. Each miner competes with other miners in solving a complicated mathematical function created by Bitcoin’s algorithm. The one that solves the function first, is able to validate the transaction and obtain a Bitcoin reward. But how can we be sure that the miner or a hacker does not tamper with the information? The secret lies in the algorithm itself.
Bitcoin’s algorithm is based on a so-called hash function. Let’s use another handy definition by BlockGeeks: “In simple terms, hashing means taking an input string of any length and giving out an output of a fixed length. In the context of cryptocurrencies like Bitcoin, the transactions are taken as an input and run through a hashing algorithm which gives an output of a fixed length.” Everyone runs their transactions through the same hashing algorithm, if anyone tampers with the information, the result will be different. Since other miners are also competing for a reward as a result of a correctly validated transaction, they will also obtain their own outputs. If one or two of these outputs differs from the majority of the outputs of all the other miners, then it is incredibly easy to spot a cheater. This system creates a powerful tool that prevents cheating through incentives for correctness.
Of course, the system can be overridden by creating a majority, but for that to happen someone would have to hack the computers of 50% +1 of the miners, which would require too much computer power and money to be feasible.
But what happens to the transaction once it has been validated? It becomes part of the chain of validated transactions — hence block chain. Now, this blockchain or ledger is stored on the computers of all the miners, making it nearly impossible to tamper with. This is not the case with centralized monetary systems like banks, where all the information is stored on a single server and can be easily hacked and stolen.
And… that’s it, really. Open-source, decentralized money that is nearly impossible to steal, hack, or trace. No one can reverse your transactions, no one can spy on them and your privacy is ensured. Moreover, you don’t have to pay any fees for transactions and there is no danger of inflation or deflation as is the case with fiat currency. That is because Bitcoin is also scarce, but not TOO scarce. When Nakamoto created the Bitcoin algorithm, he made it so that there will only ever be X Bitcoin in circulation. This way, inflation is not possible with Bitcoin. No one can create MORE Bitcoin. Wait a minute? What about the cowrie shells, if no one can create MORE Bitcoin how can you avoid deflation? The answer is simple, as digital cash, Bitcoin is infinitely divisible. So even when 1 Bitcoin is worth 1 million dollars, you can still send someone 0.0001 Bitcoins. No deflation with Bitcoin either.
Infinite divisibility also means that Bitcoin can be used as the ideal unit of measurement. No more problems with dividing that cow. You can easily divide Bitcoin and divide Bitcoin and divide Bitcoin to measure whatever you want to sell.
There you have it! Bitcoin is a storage of value, a medium of exchange, a unit of measurement, aaaand it is also scarce. Everything you need to have something function as money.
So, let’s wrap this up in a few sentences. Fiat paper money that is widely used as currency all over the world is centralized money. A centralized monetary system is open to abuse of power from the state (the universal centralizer). This is easily seen in situations in which the state creates debt through poor monetary management and then inflation by having the power to create more currency. Moreover, when monetary systems are centralized in banks, the state can also confiscate your money, as we have seen happening in Cyprus. Centralized control over money also leads to economic bubbles as the Housing bubble of 2008 in the US which led to stock markets crashing and world economy entering a period of recession.
But how can we have any other type of currency other than a centralized one? Money has to have value and we all know money gets its value by being backed up by the government. Well, as we have seen in this document, money actually has value because someone BELIEVES it does. Now, you might say “No, no, money has value because the government or the emperor backs it up by saying “Let it be done”.” But try doing the same thing with a bunch of pebbles. Do they automatically acquire value? No. Why? Because other people have to also BELIEVE they have value and TRUST that value. That is how money acquires its value — people see it as something worth having, as something valuable. So, the fiat really doesn’t matter because if enough people agree that something has value that thing will have value and will have the potential of becoming a currency. And, as we have seen, this is exactly what happened with Bitcoin.
But why should you care? For the last 8 years, Bitcoin’s value has managed to skyrocket and become one of the most valuable assets to invest in. People have gone from being poor to being millionaires as a result of investing in Bitcoin. This is why Bitcoin holds great financial potential. As more and more people use it as a transaction currency, it will become more and more valuable. As such, Bitcoin, like many other cryptocurrencies now on the market, represents a tremendous lifetime investment opportunity. Moreover, by more and more people investing in Bitcoin we can all become more and more free.
Less centralization guarantees a free world, where governments no longer control your money and are not able to gamble their financial and governing incompetence with your lifetime savings. At the end of the day, a free market means a free world. But how free can a free market be when our monetary system is centralized and controlled by a small number of people who, through their decisions, mould our lives according to their wants? Bitcoin is not just an investment opportunity, Bitcoin is the promise of a truly free world. And a truly free world, is a fairer world.
Now, we know this is long — but there’s more. There are myths and critiques regarding Bitcoin. You can read all about that in part II.