In the previous article, you learned the definition and basic characteristics of a cryptocurrency - including the distinction between the money and the money system, and the role of cryptography.
You also had a brief intro to the history and evolution of money up until Bitcoin. This should have given you a grasp on how cryptocurrencies - despite being entirely digital - can have value, the origins of the term “gold standard”, and the basic properties of what makes for sound money: durability, divisibility, fungibility, portability, recognisability and scarcity.
While all forms of digital currency satisfy the first five reasonably well, it turns out it’s surprisingly hard to impose scarcity on any digital thing. This is crucially important because value comes from scarcity. Imagine if gold was as common as sand, or Da Vinci had produced 1 million exact copies of the Mona Lisa.
The absence of digital scarcity is the biggest weakness of existing money; achieving it was arguably the biggest challenge for cryptocurrency. Explaining both, is our challenge here, and it begins by talking about the importance of money holding value.
Money is a metre/yardstick for measuring value. This aspect of money is taken for granted by everyone who participates in the economy by using it as a medium of exchange. All trade and economic activity relies on it - it’s like a universal language. And just like when we speak our own language, we don’t often stop and consider it; we just take it for granted.
Can you imagine a world where a metre kept constantly changing? Science, engineering and almost all commerce would be impossible.
The same goes for economic activity in a world where the value of money doesn’t hold. Even just buying a coffee would require both a lot of maths and a huge amount of risk, let alone more complex stuff like mortgages or insurance. The complexities of modern commerce would be impossible and we'd revert back to the simple credit system mentioned in the first article.
Unlike the metre, however, which is a fixed, objective and universally agreed measurement that will never change, money’s value - its measurement - is subjective and therefore changes.
That change is the result of money’s relative scarcity; the impact on money’s value of the increase in its supply is called inflation.
That’s exactly what happens in countries suffering from inflation, and why sound money is so important and shouldn’t be taken for granted. Extreme instability of money is hard to imagine, but Germany between the wars gives good illustrations.
Before the First World War (1913) the German Mark, British Shilling, French Franc and Italian Lira were all worth about the same. At the end of 1923 this was the exchange rate for the Mark.
. Mark to Pound exchange rate at the end of 1923
If Germany of the 1920’s seems distant, similar - if slightly less extreme - examples have played out in Venezuela, Zimbabwe and Argentina, while lower, but consistent, rates of inflation erode the spending power of every fiat currency.
So if the key to money holding value is scarcity, how does cryptocurrency achieve digital scarcity?
A scarce commodity is something that has a limited supply; it isn’t easy to create, copy, or otherwise access.
Physical stuff can be scarce (like we’ve seen with gold), but digital things are an entirely different matter. A byte is very easy and cheap to copy, as the music and film industries have painfully discovered in the early days of the internet.
That’s why digital money, such as cryptocurrency, isn’t a file you keep on your hard drive; that would be impractical as anyone with a computer would then be able to just infinitely copy it around.
Instead, all forms of digital currency - both fiat and crypto - rely on an accounting system based on digital ledgers. A ledger being an organised record of debits and credits against account holders, providing a running balance.
You may be surprised to hear that 97% of all fiat money only exists digitally. So all the money in your bank account, for example, are just entries on your bank’s accounting system. Even the 3% physical banknotes and coins are accounted for as entries on a central bank’s digital books.
Bitcoin is also based on a digital ledger. The crucial difference between Bitcoin and Fiat is the way rules are created to govern if/when/how much new money is added to the system and how the ledger is maintained.
And it just so happens that these differences change everything.
Money can only be useful (and sound) if the ledgers can be trusted to be accurate and honest, and if its supply is kept under control. This means unreasonable amounts of money won’t suddenly be created or destroyed, with consequential impact on its spending power.
So how do fiat currencies solve this today? Simple: the government manages money the ledger for its currency either directly, by controlling .physical money creation (minting) and managing and allowing the creation of credit/debit relationships between itself, banks and people.
To do this the central bank licences a few select institutions (like banks and building societies) to keep ledgers of their own. The sum of the credit of all the records from the ledgers of all the banks of a country (including the central bank) is the total supply of that currency.
We then collectively agree that the only books which are to be trusted are those kept by these institutions, and that they will keep the books properly. This consensus comes from trust that they’ll keep their obligations, as well as in the rule of law.
This authority-based trust system is what holds the traditional money systems together. The reason we can use our money online is because we trust that banks won’t let people cheat and spend more money than they have.
We even trust them to ‘create’ money, lending out more than the deposits they hold, and assuming risks for complex investment strategies (more on this below).
Though the system in practice is far more complicated, the general principle relies on trust. We must trust that institutions will behave in everyone’s best interest, and by doing so we grant them the authority and control over the money system.
Even if this centralised system works most of the time, it still has a few noticeable weaknesses. For example, while your money is legally yours, it’s never really under your custody.
Every time you pay for a €2 coffee with your card, you are effectively asking your bank to subtract €2 from your account, and for the vendor’s bank to add €2 to the shop’s account.
A single central point of failure is more vulnerable to corruption, manipulation, or plain old external pressure. This leaves the door open to abuse, mismanagement, and economic exclusion (e.g. “the unbanked” - we’ll talk about this in another lesson).
However, sticking to our central theme, the most worrying side effect of fiat money - money based only on institutional trust - is how it undermines scarcity.
As more value is created via economic activity, new money must be introduced in the system so that the economy can continue to flow.
Grossly oversimplifying, new fiat money is created by Commercial Banks. The extent to which they create new money is rationed by the Central Bank. These are common ways:
This rationing is a delicate balance. On the one hand, if too little money is created, spending slows down and the economy may grind to a halt. In practice, this almost never happens.
On the other hand, if too much money is created, then the value of the entire supply is diluted, prices rise, and everyone loses purchasing power. This is called inflation, and in extreme cases turns to hyperinflation, which may lead to a whole country going bankrupt. Historically, this tends to happen rather often with national currencies.
Either way, human institutions are ultimately in charge of the levers to the money supply, meaning there’s no real scarcity. This is why fiat currencies, by definition, can’t be considered sound money.
As we’ve just seen, centralised systems can be vulnerable. However, up until 2009, it was arguably the only way to make a secure digital money (but not a sound one).
Bitcoin breaks with this approach from the very beginning and we'll explore exactly how in the next lesson.
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