Whether you are scrolling through Facebook feeds or reading your local newspaper, headlines about Bitcoin, money printing, and inflation are everywhere. Yet to a person with no economic or software engineering background, these may be difficult to understand. The purpose of this article is to provide a brief insight into these economic concepts in the context of how the current monetary system works and why blockchain technology could be in the process of introducing an arguably viable alternative. This write-up focuses on basic macroeconomic and programming definitions to explain these concepts without engaging in any in-depth analysis.
Can cryptocurrencies play the role of money?
To answer this question, we need to address the economic problems cryptocurrencies are trying to solve. Cryptocurrencies seek to challenge the profound control enjoyed by central and commercial banks with regard to money creation. They also want to get rid of the intermediary role played by commercial banks by replacing them with a fully decentralized system built on the Blockchain.
I will start by defining money and the monetary system, explain how money is supplied in our modern-day economy and how this causes inflation.
So, what is Money?
Money is a self-belief system that makes people transact. It needs to be scalable, varies with different levels of demand, and must have these three fundamental features:
- Unit of account [ can be used to determine prices of goods]
- Medium of exchange [ works as a means of payment]
- Store of value [ keeps its purchasing power over time]
Throughout history, there have been many cases where currencies have failed to live up to their basic requirement of maintaining stability (store of value), eventually losing their value over time.
Now think of money as a car, the fuel that makes it run is the monetary system:
Monetary system is a set of instruments and policies set by central authorities and governments to provide money to stimulate an economy. Since its inception, money has developed through three different phases:
- Commodity money (salt, seashells, and metals) -was used as early as 3000 BC and up until approx. 19th century.
- Commodity-backed money (gold standard)- was used between the 18th — 20th centuries approx. For example, in the late 1950s, the US dollar was pegged at $35 per ounce of gold.
- Fiat money, backed by governments and trust of the people- started to dominate after 1971 with the collapse of the Bretton Woods agreement (under Bretton Woods system, the US dollar was pegged to gold, and other currencies were pegged to US dollar).
Fiat money has no intrinsic value, it’s a currency issued by a government or more precisely a central authority (bank). It was created because using commodity (scarce resource) as a currency became unsustainable due to increased demand, as a result of population growth and rapidly expanding economies.
We have now defined money and the system it follows, let’s see how money is pumped into the economy:
Currently, most fiat currencies are in the form of bank balances and records of credit or debit (digital money). So, how’s money created?
Fiat money is created by a trusted authority that runs the monetary system; this authority is widely known as the central bank. They, in conjunction with commercial banks, provide liquidity for an economy. Central banks use two tools to influence monetary policy.
First, by using interest rates, central banks can influence economic activity especially in the short run by decreasing or increasing interest rates.
The second tool central banks usually use is quantitative easing, also known as money printing (think of it as expanding the money supply). This basically involves creating new money in the form of debt by purchasing government securities.
The central bank can print money but cannot increase real GDP or create wealth in the long term. It can however stimulate demand in the economy in the short term by collaborating with the central government to transfer money into the hands of people. This is usually executed through a stimulus plan (hence, think of the 1.9 trillion dollars that were announced by the American government as part of the Covid-19 relief plan), purchasing goods/services, or more commonly engaging in massive infrastructural projects which include investing in education, etc.
This monetary system is mainly based on the trust people have in governments, especially central banks to act in their best interest and not abuse the authority vested in them to print money. If these authorities abuse this power and print money to a level that exceeds real economic growth, high inflation, and currency devaluation would be a problem.
Blockchain as an alternative monetary system
So far, we have established what money is, explained the monetary system and the process of money supply to the economy. We have also explained how fiat currency is mainly based on trust reposed in a central authority by citizens of a state to control the monetary policy.
The DLT (Distributed ledger technology):
In 2009, and for what it looked like a response to the central government’s excess money printing to bail out the banks during the global financial crises, an anonymous person or a group of people identified by the name of “Satoshi Nakamoto” introduced a new peer-to-peer electronic payment system that is based on cryptographic proof (basically computers try to solve complex mathematical formulas to validate transactions) instead of trust. This means that instead of having one centralized entity (bank) that acts as an intermediary to issue and facilitate all transactions, we will have a decentralized network of a payment system (Blockchain).
These systems use consensus (simply means general agreement) algorithms to validate transactions and record them on a distributed ledger. Think of this ledger as a file (spreadsheet) that starts with an initial distribution of cryptocurrencies and records the history of all subsequent transactions. An up-to-date copy of the entire ledger is stored by each node (this is what makes it “distributed”).
Although the fundamental idea behind cryptocurrencies depends on them being recorded on a distributed ledger, they differ in terms of how this ledger would be updated. One type of cryptocurrency uses a permissioned ledger, which is a central entity guaranteeing access to new nodes (participants) entering the network. Whilst the other type uses a permissionless ledger in which all nodes can participate, like in the case of Bitcoin.
The flower of taxonomy of money
Blockchain-based permissionless cryptocurrencies such as Bitcoin have two groups of participants: “miners” who act as bookkeepers and “users” who make transactions in cryptocurrencies. The idea underlying these cryptocurrencies is simple: instead of a bank centrally recording transactions, the ledger is updated by a distributed consensus system called mining and the update is subsequently stored by all participants.
In a traditional payment system, a buyer purchases goods from a seller and the payment takes place via bank accounts — i.e. via a centralized ledger. The buyer sends his payment instruction to their bank, which then adjusts account balances by debiting the amount from the buyer’s account and debiting it to the seller’s one.
In contrast, if payment takes place via a permissionless cryptocurrency, the buyer first publicly announces a payment instruction stating that the cryptocurrency holdings of the buyer are reduced by one, while those of the seller are increased by one. After a delay, a miner includes this payment information in a ledger update. The updated ledger is subsequently shared with other miners and users, each verifying that the newly added payment instruction is not a double-spend attempt and is authorized by the buyer. The seller then observes that the ledger including the payment instruction emerges as the one commonly used by the network of miners and users. Source: Adapted from R Auer, “The mechanics of decentralized trust in Bitcoin and the blockchain”, BIS Working Papers, forthcoming.
This distributed ledger is updated in groups of transactions called blocks. These blocks are chained sequentially using cryptography to form the Blockchain. This concept was first used in the creation of Bitcoin but was later adopted by several other cryptocurrencies.
So, back to our question, will cryptocurrencies be able to play the role of money?
Blockchain and the decentralized ledger technology seem to offer a good alternative that can be used to complete, and not replace our current monetary system. As mentioned above, one of the essential features of money is to be a store of value and maintain its purchasing power over time. Permissionless cryptocurrencies such as Bitcoin and many others have been extremely volatile during their existence and failed to deliver on this fundamental quality. In addition, and because of that volatility, they have not functioned as a unit of account and almost no one quotes the prices of their products as in terms of bitcoins.
One can argue that due to its characteristic of being deflationary in nature, Bitcoin must be treated more as a commodity than money. This can be seen in the way how it’s currently being rebranded as digital gold that would appreciate in value over time.
In other words, permissionless cryptocurrencies do not satisfy two of the three key functions of money and thus its use as money is likely to be quite limited.
What about permissioned cryptocurrencies then? specifically if backed by governments or central entities?
Well, according to recent surveys, the majority of central banks around the world are actively researching the potential for a CBDC (central bank digital currency), while the central bank of Bahamas had already launched its digital currency under the name sand dollar.
A central bank digital currency (CBDC) is a “centralized” digital currency in the form of central bank money for general purpose users. It is a direct claim on the central bank’, in the same way, that banknotes and coins are today. By comparison, bank deposits are claims on private banks.
One important player that is expected to disrupt the crypto universe is the Libra Association, originally proposed by Facebook to launch their own blockchain-powered cryptocurrency (Diem). It will be backed by a basket of fiat currencies, and aim to offer financial inclusion for people remaining outside of the financial system.
The Libra Blockchain will be launched using a permissioned ledger before converting fully to a permissionless one at a later point in the future. It will be designed to support a low-volatility cryptocurrency that will have the ability to serve as a medium of exchange to billions of people around the world.
In summary, cryptocurrencies currently serve only as a medium of exchange, and if in the future they will be considered a good store of value, then the Monetary Policy will be marginally challenged. The world has entered a total digital disruptive era and money is no exception. Blockchain technology seems to have gotten the attention of central banks, and it is expected that 2021 will be a huge year for government regulations.