Bitcoin from the Perspective of Good Money Pt. 1

Is Bitcoin Sound Money? Can you Trust it?

There are a few reasons why Bitcoin is not an easy concept to grasp. Most of us do not understand what money actually is. Bitcoin is intangible, many people are put off by bitcoins just being data running on computers. It can take a little understanding of math, economics, and computer science to ‘trust’ and really ‘get’ it. That is a turn off for others. However, we’re dealing with the exchange of value in a world where the limits of trade are now endless. We owe it to ourselves to know what this ‘thing’ is we work almost every day of our most productive years for. I’ll discuss what money is, a brief history of it, what the current issues are, and finally how Bitcoin fits in.

What is Money?

At its core, money is an accounting system to keep track of and facilitate the exchange of value in a community. This is understood more easily by looking back at the history of money, which is the history of credit. In almost every economics textbook, beginning with Adam Smith’s Wealth of the Nations, the story of money begins in a fictional town needing to develop an efficiency to barter. It follows that, Alice is a shoemaker and Bob’s a butcher, and well, Alice is going to have a pretty hard time convincing Bob to cop a pair kicks every week so she can get some good meat. The problem of coincidence of wants was apparently solved with money serving as the unit of account and medium of exchange between the parties.

In reality there is little to no evidence of this actually happening. We do however have evidence of “gift giving” economies in some of our earliest civilizations which transformed into informal credit systems. This is to say that, using the example above, Alice would receive meat on credit from Bob and vice-versa. This practice would extend to the community at large, and at some interval, the community would come together, balance the credit system, and whoever still owed someone would settle their debt, likely with a goat or some quantity of barley.

You’re probably wondering why this perspective of money inception matters. Motive. If it was just an efficiency to solving a problem of barter (ie. double coincidence), we’d miss the motive of trust. As ancient civilizations got vastly larger, with wars and colonization, the practice of communistic societies eroded. New, untrustworthy individuals would readily accept gifts from the community, but could not be trusted to reciprocate in-kind. Coinage therefore, helped solve a bigger problem than just efficiency of exchange, it allowed complete strangers to engage in commerce without much trust. Rulers would mint coins of precious metals, typically, gold or silver with marks symbolizing they’d be guaranteed and accepted as payment for taxes, fines, and fees. (For more on this, David Graeber’s Debt: The First 5000 Years, offers a unique look into the history of debt, credit, and money).

Still with me? So we know money is a medium of exchange, it creates a significant efficiency in helping strangers trade without needing to trust each other. Good money serves as a unit of account, that is, it’s stable enough to assign prices for items marked for sale. This leads to the third characteristic of a good money; store of value. It makes sense that if you are to hold this money over a period of time that you should expect it to retain its value. Milk for example would be a terrible store of value.

Sound & Ideal Money

There are now two concepts of money I want to briefly discuss. Sound Money, and Ideal Money. The former is the idea of stable money, one that is determined by the market rather than a government or central authority. The best example of this is gold, or 100% gold-backed paper money. Ideal money is more of an abstract concept of money, something we should aim towards. John F. Nash Jr, the American mathematician, (and yes, also the character who A Beautiful Mind was based on), wrote a paper in 1994 describing what Ideal money is. The idea is that it would serve as a stable international reserve currency, helping to solve the potential conflict of interests between the short-term domestic and long-term international objectives when a currency used in a country is also serving as world reserve currency. A key to establishing this is having a stable and predictable inflation rate.

Gold as Money

Gold has many great features that led to its use as money and a reserve currency over civilization’s history. Scarcity is, and was, its most valuable trait. It was a rare metal that it took effort and time to find and extract. This meant that inflation was more or less stable, as it wasn’t easy to get more of it in a short time. Of course if a large deposit was discovered, the price (as well as a currency it may have been pegged to), would fall temporarily. Gold also had utility as jewelry, if all else failed, you’d still look pretty. Being malleable allowed it to be easily broken down into smaller pieces, making it greatly divisible and practical for coinage.

Aristotle developed a framework of characteristics defining good money:

1.) It must be durable. Money must stand the test of time and the elements. It must not fade, corrode, or change through time.
2.) It must be portable. Money hold a high amount of ‘worth’ relative to its weight and size.
3.) It must be divisible. Money should be relatively easy to separate and re-combine without affecting its fundamental characteristics.
4.) It must have intrinsic value. This value of money should be independent of any other object and contained in the money itself.

Without much effort, we can see gold checks all the boxes above. To elaborate on divisibility is important. F or something to be divisible with respect to money it also needs to be fungible. Fungibility is the concept that each unit would be indistinguishable from others. This means that you can’t taint, or discriminate against certain pieces. In gold’s case the remains true as you can always melt it down and remove rubbish metals or a mark of a certain (now perhaps unfavourable) authority or leader. This is why gold has been so prevalent as a money and more recently a hedge against financial and economic uncertainty.

Fiat Money

Now that we have a background of what money is, and specifically what good money is, we can look at current money and its current state. Fiat money is any money backed by decree or law. This generally refers to government-backed money that is reinforced through it’s geopolitical and/or military power. Prior to Fiat, modern currencies that were backed by gold were referred to as using the Gold Standard. This meant that the currency in circulation could not be increased without increasing gold reserves. The attraction to this was in theory, as global gold supply grows slowly, government spending and inflation would stay in check.

Eventually the Gold Standard was removed by most governments to allow for economic stimulus (the printing and injection of new money supply into an economy) during difficult times like the Great Depression in the US. Now that currency is debased, it can be printed at will. This has happened several times since the Great Depression, most notably in recent times when money was effectively printed by the Fed to purchase government bonds and bad securities to bail out banks via open market operations and quantitative easing, respectively.

This is important for two reasons. First, when money is added to the supply it causes inflation, this erodes your purchasing power. Your money isn’t worth as much as it was before *all things held equal*. Second, this sets precedent. The government has looked at this as a success, even though other measures (ie. letting banks fail or bailing out the end-individuals), weren’t tried. What’s even more dangerous, is that banks, insurance companies, and the like now know if the problem is big enough, they’ll be bailed out. This creates a time bomb of a moral hazard. These are problems that sound and ideal money mitigate or completely extinguish. Shouldn’t money be more accountable? Fairer? Less corruptible?

I’m going to leave it here as that’s a lot to mull over before getting into Bitcoin. Click here if you’re ready for part 2.

Twitter: @tavishgilmour