The Economic Implications of Hard Money in a World of Fiat
Fiat money is how the world generally transacts these days. This involves having a currency that is back by government promises and regulations that state that said currency can be used as legal tender. Hard money by contrast is how the world generally transacted throughout history until the past century or so. Hard money involves a currency that is backed by “specie” (a physical and valuable asset), typically gold or silver.
Is Crypto Hard Money?
This is a debatable question. Cryptocurrencies are not backed by any physical asset. They are typically not a representation of specie like gold or silver. They are backed by the promise of the project behind them that they have value and can be used (in their native networks at least) as legal tender. The project begins with a monetary policy created by the founders. These aspects lean towards a “soft money” label.
On the flip side, Cryptocurrencies are backed by a provable, immutable digital asset. This is not physical in the same way as gold or silver but it does have many of the same qualities. The digital asset cannot be created arbitrarily but rather must be mined or minted according to a transparent code. Even if the Digital Asset ceased to be accepted as currency in general, it still has value as a utility of the network it runs on. There is monetary policy involved but only at creation. After this, the currency continues according to the policies set at creation without tampering, changing, or regulating further. Control of the currency typically lies in the hands of the coin holders. The currency is also decentralized and not controlled by one entity. These aspects lean towards the label of “hard money”.
My verdict is that Cryptocurrencies in general are hard money. Each currency has different characteristics and some, Tether for example, would not fall in the hard money camp. Most however do. The key lies in fact that each unit of currency is an immutable Digital Asset that belongs to someone and can’t be changed, taken, or nullified by any other individual.
These Digital Assets are similar to some gold and silver coins that have been used in the past. A gold coin that is made of 10 grams of gold has the value of that gold and is that gold. A gold coin made of 1 gram of gold but is backed by another 9 grams at the bank has the value of 10 grams of gold but that value is split between the face value and the backed value. Cryptocurrencies follow the former example with each unit having the value of 1 unit and also being that 1 unit themselves.
Typically with physical hard money currencies, the coins would wear down, be shaved, or be adulterated in some other fashion over time. It was rare to have a coin actually consist of the amount of precious metal it represented without degradation over time. The specie reserve that have backed hard money currencies over the centuries has actually not always been on a 1 to 1 scale. Many banks have had 100% reserves but commonly those specie reserves were much less.
In America’s infancy there were times when “free banking” was in effect and banks acted as private entities. Some were prudent and kept ample specie reserves, thus keeping their currencies (in the form of bank notes) valuable. Many however printed and lent out more and more notes without increasing their specie reserves thus creating notes, essentially currencies, that were not backed by specie and would not be able to be exchanged for it on large scale because they would never have enough to satisfy a large demand. When holders of these notes realized that they wouldn’t be able to exchange their notes for specie on demand at these banks, a bank run generally ensued where holders all showed up demanding gold and handing in their notes. This would typically bankrupt the bank and render those notes worthless.
In general, the North East regions of America fared much better at this time in history. The key was that most of the northern banks kept a high specie reserve standard and did not overprint their notes. This prudence allowed many to remain in business through tumultuous times. By most standards, these notes, or currencies, that kept a firm line on hard money principals were successful. Those that fell into more soft money principles were not. The caveat is that these examples come from time periods of currency competition. There was not one government currency for the whole country that was successful not through merit but through law. By contrast, those days of free banking allowed free market principles to determine which currencies and business would succeed and fail and allowed this competition along with the consequences.
The reason gold and silver were used as currency were threefold. To begin with, metals are durable. They don’t degrade easily and don’t spoil. Corn would have made a much more useful currency but it can’t be stored indefinitely or transported as easily. Wood is nice but it breaks down as well. Durability must exist for saving and storing to even be possible as well as to avoid major degradation over time.
Second, metals can be divided into many parts and brought back together again. Currency necessarily needs to have this feature. Some transactions are large while some are small. I may have 1 pound of gold but want to buy a flower worth 1 gram. With metal I can do this. I can also take many grams together and combine them into a large bar for easy storage and transportation. This is not true of food, stone, wood, shells, or most other items used as currency at some point in history. Most could not be broken into specific and verifiable quantities not could most be brought back together into a larger whole afterwards.
The third and possible most important reason precious metals were used so commonly as currency was scarcity and attainment. People won’t just find these metals lying around. This would increase the supply a great deal and therefore greatly dilute the value. You also won’t completely run out, making your currency dwindle away to nothing. There is always more to mine, although it may be more and more expensive to do so. Attaining more inherently has a tangible cost associated with it. In order to find a precious metal deposit, mine said deposit, condition and transport said metal, and finally bring it to market, one must spend valuable resources through physical labor, transportation cost, initial start up expenses, etc. This serves the purpose of keeping the metals scarce but also of giving that metal an inherent value… that of the cost to attain it and bring it to market with the addition of ordinary profits.
How are cryptocurrencies the same as physical metal?
Cryptocurrencies fulfill the same qualities as the precious metals they are replacing. They are durable. In fact, Digital Assets never corrode, are never debased, nor do they diminish in size. As long as electricity is available in some form, cryptocurrencies can exist. They can be transfered via a print out on a piece of paper, a scan code, a string of numbers and letters, or a piece of hardware like a USB drive. As long as electricity is common and internet is available, they will likely remain mostly in digital form and transact usually in this form as well. Durability is never compromised with cryptocurrencies no matter the form of transaction or storage.
Cryptocurrencies can be split into parts and rejoin. In fact, Digital Assets can be split into smaller parts than can ever be necessary. They can all be collected back together again in a digital wallet at anytime in any amount. They can easily be used to purchase a house and just as easily purchase a single ordinary seed. One can store crypto currencies in whatever amounts they’d like as well. The options for division and reunification are nearly endless.
Finally, cryptocurrencies are scarce with valuable attainment. These Digital Assets cannot be found arbitrarily nor can they be created thus. On the contrary, they are scarce by nature with the foundations of their creation stipulating their scarcity and rules for existence. More units of currency will only be created if certain criteria are accomplished, which are necessarily costly to do. In order to create a Bitcoin, one must “mine” it by using their computer to solve complex algorithms and process a block. This has a cost of hardware and energy as well as any cost associated with storage and transactions afterward. With proof of stake coins such as Ether, the cost to create a new Ether lies in an initial investment of that asset and the hardware and energy cost to process transactions on the Ethereum network as well as storage and transaction costs. With proof of work coins, the cost lies mostly in the hardware and energy usage whereas with proof of stake coins the cost lies mostly in the original investment of that currency with cheaper hardware and energy costs. Transaction and storage costs are minimal with either.
Supply and demand
A key aspect of money is supply and demand. With fiat, more money can be created whenever demand outweighs supply and money can be taken out of the market when the opposite is true. This is all controlled by the government as is usually done through the use of bonds, interest rates, issuing debt, etc. Theoretically, the currency can continue on forever without ever being backed by anything of value so long as the government in charge handles the monetary policy skillfully and the public never tries to redeem the value of the currency in any other form in mass. The problems with this system usually are derived from greed and short term thinking and end in a worthless currency.
Another misconception is the stability of fiat systems. Cryptocurrencies have been extremely volatile due to them currently being in the investment and speculation phase, not in widespread use as currencies. Fiat systems are very well established but are still not very stable in the long run. If one looks with any depth at inflation rates, both in monetary supply and in monetary value, it becomes obvious that fiat currencies aren’t nearly as stable as they seem at first glance.
The purchasing power of a US dollar from 50 years ago was the equivalent of anywhere from $4.50 to $15.20 depending on the measurements you look at. This mean that over the course of the last 50 years, every dollar you had has decreased in value by a minimum of 78% with high estimates being closer to 94%. Even in the cryptocurrency markets, an 80% drop in value is significant and is much more so when the currency in question is a government backed “stable coin” that has no other practical competition. This problem not only deincentivizes saving but it actually punishes the en devour by drastically decreasing the value of your savings more and more as time goes on.
America is a good example of soft money principles currently. The country has a fiat system and has been using monetary policy to raise money for government expenses while giving out more money to spur economic growth. The country’s debt is upwards of 21 trillion dollars. At the same time, they are issuing more money to banks to filter down to businesses and individuals to increase economic activity. In addition, the US has lowered it’s tax rates thus bringing in less revenue. Even with all these aspects, the country is accruing more and more debt each year and raising government spending at the same time.
This example is only possible under a fiat system and could potentially continue indefinitely. The problem would come if public faith in the currency diminished or if debts were called in that the country couldn’t pay. For example, if Americans decided they didn’t believe the dollar was worth what the government said it was worth, they could exchange those dollars for physical items, gold, cryptocurrencies, foreign currencies, etc. The affect would be that eventually, the government would have to raise even more debt or print even more money to pay the individuals pulling out of USD thus devaluing the currency further and fueling the flight from USD even more.
What if other countries lost faith in USD? They would call in the USD denominated debt they are owed which would cause a similar run on the USD market and flight from the currency. Even worse, in this scenario, the government couldn’t attain more debt because no other country would give it to them. Currently the global reserve currency is USD which has the affect of bringing in large amounts of foreign capitol into USD through bonds, stocks, debt, and currency stockpiles. This is very good for the stability of the currency but a horrendous situation to be in should the currency loose it’s value.
Let’s look at supply and demand dynamics in regards to Bitcoin to contrast the USD example. According to my assessment, BTC (Bitcoin) is a hard money currency. BTC is also completely open to a free market system and is not controlled by any country or government. BTC can never get into a similar situation as USD because no one entity can manipulate the supply or the demand in a large enough way to make the currency risk failure. There will never be a situation of debts above and beyond what is backed by the Digital Asset because of these dynamics. If such a situation ever occurred, the market would be heavily incentavized to fork the asset and nullify any issuance that is not an actual verifiable Bitcoin Digital Asset.
With the free market, decentralized system that Bitcoin is a part of, supply and demand dynamics are free to operate without constraint or control. If individuals or entities are more uncertain about the currency, they sell and the price reflects that sentiment. If faith is strong, the number and value of buyers increases thus raising the price. The amount of currency in circulation will always hold true to a specified standard and can’t be changed to accommodate outside factors. If faith and thus the value of BTC is in decline, no one can hinder that through monetary policy. If the demand spikes, so will the value and nothing can stop it. The value will always reflect the value placed on the asset according to worldwide consensus. Anytime this is not the case, the value will adjust until it is. Investors and market makers will always be incentivized to do so to make money off the return to the mean or the arbitrage opportunity.
Hopefully, the fact that the Bitcoin Network and protocols are so transparent will keep the value from ever being too far from it’s natural state. If the market price is too high, more people will invest in mining the currency, thus increasing supply, lowering the value, and stabilizing the price. If the price is too low, miners will spend less resources on mining in order to keep from loosing money or opportunity costs thus decreasing supply, raising the value, and stabilizing the price. Bitcoin is unique in the fact that it has a capped supply which brings in a slew of other factors but we won’t delve into that aspect here.
Even with these dynamics, Bitcoin could still fail. If a currency is not viewed as valuable, it will not have value. The key is that this is much less likely to occur with hard money than it is with fiat currencies. There is a strong view by many that the unstoppable free market currency competition offered by cryptocurrencies will force a battle between traditional fiat systems and these new Digital Assets.
originally published on https://www.thedigitalassetguide.com/