The Making of Money
Money, as common as it is, is not an easy thing to understand. We all take it for granted and isn’t something to which most of us give much thought. The dollar bills in our pocket, checks that we write and bank balances instantaneously changed by credit and debit charges don’t demand much contemplation. But, Bitcoin, and the subsequent rise of cryptocurrencies, has forced many of us to reconsider our notions about money.
There wasn’t a whole lot of fanfare or press when Bitcoin was born. Someone simply built the Bitcoin system and, on January 3rd, 2009 at 6:15:05 P.M., Greenwich Mean Time, the first 50 bitcoins were created[1] — virtually. Six days later, on January 9th, just before 3:00 in the morning, the next 50 Bitcoin were created and over the next three days, after an additional 8,500 Bitcoins had been created, the first 10 Bitcoin were spent[2].
Thus, with the exchange of 10 bitcoins on January 12th, 2009 at 25 seconds past 3:30 in the morning, a cryptocurrency was born.
I suggest it is at this moment that Bitcoin became a cryptocurrency because, prior to this moment, the bitcoin that had been created were just electronic records on a few computers. No different than if I went into my excel spreadsheet, typed the word pickle and shared that spreadsheet with several of my friends.
It was not until someone exchanged bitcoins that Bitcoin served a core purpose of currency — it acted as a medium of exchange.
But understanding a cryptocurrency like bitcoin is impossible without understanding what makes something a currency in the first place. While most of us take currency for granted, truly understanding what makes something a currency is not intuitive. We all know that we can spend the dollar bills in our wallet or electronic equivalents in our bank accounts, but what makes the U.S. dollar a currency goes deeper than the simple fact that the U.S. government says it’s a currency.
To understand what makes something a currency is to understand what makes something money.
Bear with me while I tell you a short story. Hopefully, it will provide an example of how money can be formed. With that as a foundation, you may be able to more fully understand the cryptocurrency phenomenon.
The Village of Mone’
Welcome to the village of Mone’. It is isolated, but it’s pretty big as far as villages go.
It’s a prosperous village — a lot of trade between the many farmers, fisherman, blacksmiths, glaziers, and so on.
Every morning a market forms in the village square where everyone who has something to sell or needs to buy something turns up. But trade is cumbersome. There is no money so exchange is based on barter.
One day, a young, bright seamstress named Honora, frustrated by having to accept so many eggs in exchange for her dresses, is struck with a thought.
She decides to hold a lottery. In fact, she is going to hold one every week. The prize — a beautifully embroidered square of cloth that she will stitch. It wouldn’t take her long to make what she has in mind, but she also knows no one else in the village has the skill to make one quite like she does.
It will be unique, and all the villagers will know that she was the one who made it.
So, the following week Honora shows up at the town market. She stands up on a platform in the center of the square and tries to get the crowds attention — she can make one of those crazy, high pitched whistles that’ll call a dog from a mile away.
She lets a piercing whistle fly.
The crowd soon settles down and gives her their attention. She holds the patch up for the crowd and begins to describe the patch. She points out its attributes.
It’s a strong but finely milled piece of hemp cloth divided into eight squares by embroidered stitching. Within each square there is a beautiful pattern. One of the nice features of the stitching around each square is that it makes each of the eight squares strong and durable.
She hands the cloth to one of the villagers and asks that they pass the square around, so the villagers can see its fine detail. After a few minutes, the patch makes its way back to Honora.
Honora says that she would like to give the patch to one of the villagers. In fact, she’ll make a new one every week to give away.
To decide who will get the patch, she has come up with a riddle. Whoever can solve it will get the patch. The crowd buzzes while Honora states her riddle.
A few minutes of silence pass. The villagers are scratching their heads as no one seems brave enough to offer a solution to the riddle. Then, suddenly, Sally Sunbucket speaks up. She proudly announces what she thinks is the solution to the riddle. Honora beams. “Congratulations Sally, you won the first square patch!”
Weeks go by and the weekly giveaway turns into a much anticipated event. The villagers look forward to it and the winners cherish their prize. Also, some of the villagers have gotten pretty good at solving the riddles.
By now, Honora is also pretty good at making the patches. In fact, she is so good that she now makes six in the time it took her to make one. So, she decides to hold a giveaway every day.
A year goes by and, by this time, a lot of villagers have patches. Some even have several. They have begun referring to the patches as “Honor Eights.”
One morning, while at the market, Frank Baker is looking to buy some beer. He finds Bob Brewer, who makes a nice porter that Frank would like to buy.
Frank offers Bob some ciabatta rolls for a growler of porter but Bob, disappointingly, doesn’t need any bread though he would like some fresh mozzarella.
Frank sighs…
He now must track down a bread-wanting cheese maker and trade his bread for cheese so that he can turn around and trade cheese for Bob’s beer. This is a pretty typical situation and usually not too much trouble, but Honora’s giveaway is starting soon and he doesn’t want to miss it.
Then he’s struck by a thought.
“Hey Bob”, Frank says, “I happen to have an Honor Eight on me. How about I trade you one of those for a growler of porter.”
Bob’s face screws up. Why would he make that trade? He never really got into the whole giveaway thing and sees the daily ordeal as silly — a useless distraction. After all, Honor Eights have no inherent value since they can’t be used for anything.
Then Bob is struck by a thought. Even though he doesn’t value an Honor Eight, it sure seems like everyone else does. So much so that he’s pretty sure he could trade the square with almost anyone for whatever he needs. Especially that flamboyant Fran Fromage for some mozzarella — she loves those dang things.
Besides, even if she doesn’t want it, he can just hold onto it and trade it for something else he might need down the line.
His expression eases and he responds “Sure Frank. Good idea. Happy to make that trade.”
Bob grabs a growler from his cart, turns and fills it from his cask of porter, corks it and hands it to Frank.
Frank reaches into his vest pocket, pulls out his Honor Eight and hands it over to Bob.
Bob thanks him and suggests they head over to the giveaway. It will be starting soon.
Thus…a currency is born.
By later that year, many Mone’ites have gotten into the act. Bob can no longer trade a growler of porter for a whole Honor Eight but, since the villagers began cutting patches into pieces of eight along the seams between the stitching that bordered each of the eight small squares, he can accept two Squares of Eight for a growler. One square of eight will now buy a pound of fresh mozzarella.
And, to Honora’s delight, she sold one of her dresses for two Honor Eights.
The Character of Money
Bitcoin is a form of currency. It’s referred to as a cryptocurrency but it’s a currency all the same. Why? Because it is now exchanged for goods and services all around the world.
People accept it in exchange for what they want to sell because they are confident that, when they need something down the road, they can exchange the bitcoins they have for what they will need. Worst case, they can exchange bitcoins for dollars, euros or most any traditional currency to get what they need. Also, given the predictable increase in the supply of bitcoins, the Law of Supply and Demand suggests each bitcoin can be expected to buy more stuff in the future as it seems more people are willing to accept bitcoins for what they have.
It seems to be the case that demand for bitcoin is increasing faster than the supply. That is because there is a networking effect at play. Each person that begins to transact in bitcoin grows the network exponentially.
This networking effect is true for any currency. When a deal was struck with the Saudi’s to sell their oil for U.S. dollars, the network for U.S. dollars grew significantly. As other oil producers began selling their oil for dollars — some willing, some not — the demand for dollars grew even more. It wasn’t long before trade for most goods around the world was conducted in dollars. That’s when demand for dollars really exploded.
That more villagers accepted Honor Eights in exchange for goods and services also created a networking effect. More villagers accepting Honor Eights increased the number of people accepting Honor Eights. Growth in the network became a self-reinforcing cycle with demand growing exponentially. The Bitcoin network is now a very large network, with over 12,000 nodes[3].
That fact that so much trade was conducted in U.S. dollars increased everyone’s confidence that dollars would be a viable medium-of-exchange for a long time. Indeed, it is this simple principle, confidence that many people will except one thing in exchange for almost any other thing, that makes a currency.
But currency doesn’t have to come from a central bank. Honora didn’t get permission from the town hall to stitch the patches just like the creators of the Bitcoin program didn’t ask permission. They just did it.
Also, a central bank doesn’t have to distribute the currency they printed by auctioning U.S. dollars for bonds (or stock, which is now the case in some parts of the world). Honora decided that a patch would go to anyone who solved a riddle. Bitcoin effectively makes the computers on the network solve a riddle. The first to solve it gets allocated freshly mined Bitcoin. The work to solve the riddle represents a scarce resource and, thus, contributes to Bitcoin’s value.
No village bureaucrat proclaimed from on high that Honor Eights were legal tender. Honor Eights were initially valued in their own right. They were valued for their beauty, their intricacy and their specialness. It was the villagers, on their own, that arrived at the conclusion that Honor Eights could be used as a currency just like the market has now validated bitcoin as currency.
The Mone’ites soon realized each Honor Eight would last. They were durable. Bitcoin are exceptionally durable. So long as we can run computers, there will be Bitcoin.
It occurred to the villagers that an Honor Eight could be divided into eight pieces. It was divisible — each eighth of an Honor Eight itself being durable. Each bitcoin is divisible into 100,000,000 pieces and each piece is called a Satoshi.
They knew that only one Honor Eight was auctioned each day. This made the increase in supply predictable. New Bitcoin are mined at a predictable rate. This rate is controlled by the riddle. Moreover, there will never be more than 21 million Bitcoin mined.
Regardless of how Bitcoin came to be, the fact that people accept them in exchange makes it a currency.
[1] https://blockchain.info/block/000000000019d6689c085ae165831e934ff763ae46a2a6c172b3f1b60a8ce26f
[2] https://blockchain.info/block/00000000d1145790a8694403d4063f323d499e655c83426834d4ce2f8dd4a2ee
