This is the first part of a three part series to introduce you to the world of cryptocurrencies. In order to understand Bitcoin, stablecoins and other cryptocurrencies it is necessary to analyze the history of money, its functions and how money evolves in a society, first.
Therefore, the first part covers the history and evolution of money in general and how Bitcoin is different from Facebook’s stablecoin. The second part covers Bitcoin in more detail and explains how Bitcoin works and what the advantages are. And the third part looks at different cryptocurrencies, especially blockchains with smart contract abilities.
The history of money
The simplest way to exchange value is known as the barter system. A process of direct exchange or peer-to-peer system, where valuable goods are exchanged directly with one another. Unfortunately, the larger the market grows, the bigger the problem of so-called coincidence of wants gets. There are three distinct dimensions to the problem.
First, the lack of coincidence in scales. Is the good divisible into smaller units?
Second, the lack of coincidence in time frames. Does it hold its value into the future?
And third, the lack of coincidence of locations. Is it easy to transport?
There is a great example of so called Rai Stones, where people of an Island wrote their wealth and the transactions on stones, which were very big and not moved around. This worked for some time but as more and more transactions were made these people ran into the problem of coincidence of wants. The stones may have been able to hold its value into the future, however they were not divisible and not easy to transport.
And why is it important to hold its value into the future? Just ask yourself, why gold and not copper has been used as money all throughout history. Copper is not able to hold its value because if it were used as money and became valuable for people to use, there will be an incentive to mine as much copper as possible, which would inflate the supply and decrease the value.
The only way around these problems is a form of indirect exchange. In other words, to use an intermediary good as a medium of exchange. This is the first function of money.
“Being a medium of exchange is the quintessential function that defines money — in other words, it is a good purchased not to be consumed, nor to be employed in the production of other goods, but primarily for the sake of being exchanged for other goods.” — Saifedean Ammous
According to Carl Menger, father of the Austrian school of economics, salability is the key property that leads to a good being adopted freely as money on the market. In other words: “the ease with which a good can be sold on the market whenever its holder desires, with the least loss in its price”. The relative salability of any good can be assessed in terms of how well they address the problem of the coincidence of wants:
Their salability across scales, across space and across time. The salability across time is the most crucial one and it is the second function of money: store of value. This refers to the ability to hold value into the future. In order for a good to maintain its value it is necessary that its supply does not increase too drastically. This relative difficulty of producing new monetary units determines the hardness of money. Goods, which are the hardest and costliest to produce, will, at the limit, always be used as money.
Another important aspect of the salability of a money is its acceptability by others. A wide acceptance of a medium of exchange means it can be used as a unit of account, which is the third function of money. Only with a uniform medium of exchange acting as a unit of account does complex economic calculation become possible. And with it, the possibility for specialization into complex tasks, capital accumulation and large markets.
Only if money is able to deliver the aforementioned functions, market actors can plan into the future. Their time preference lowers. Civilizations start to grow and families and traditions start to arise that can endure more than one generation, because the wealth can be preserved and passed on to the next generation. And international trade only functions because we have money we can use as a unit of account.
Sound money needs a high stock-to-flow ratio. In other words, new supply should be very difficult and costly to produce (the FEDs printing press disagrees), so that it becomes very small compared to the already existing supply and therefore cannot be easily inflated. Surrogates of money as well as money itself lose their value when their supply is inflated. The same is obviously true for FIAT money (Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it). Since President Nixon took the US Dollar off the gold standard in 1972, money supply of all major FIAT currencies increased dramatically and their value decreased.
M2 Money Supply Growth Switzerland
M2 Money Supply Growth USA
The gold standard was virtually the last form of “sound money”. Many of us have never experienced a monetary system with hard money and without someone having the ability to control its supply.
“I don’t believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can’t take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can’t stop.” — Friedrich Hayek
The quote from 1984 lacking knowledge about the actual form of that “something they can’t stop” looks like a prelude to Bitcoin. Why is Bitcoin so outstanding and possibly revolutionizing? Let us revisit the three distinct dimensions to the problem of coincidence of wants.
The coincidence in scales. Bitcoin can be divided into smaller units, called Satoshis. The coincidence of locations. Bitcoin can be sent around the world fast and relatively easily. All one needs in order to send or receive Bitcoin is an internet connection and a Bitcoin wallet. And thirdly, the coincidence of time. Does Bitcoin hold its value into the future? By looking at the fundamentals one could argue that it does. Bitcoin has a limited supply of 21 million units, meaning it cannot be inflated and therefore its value should not decrease because of a rising supply. On this basis Bitcoin could therefore be considered as hard or sound money, which could have large implications for the whole world, if successful.
In order to understand how Facebook’s cryptocurrency Diem works, a comparison with Bitcoin is due.
Difference between Bitcoin and Facebook’s Diem
In its whitepaper (an informational document usually issued by a company or not-for-profit organization to promote or highlight the features of a solution, product, or service), Bitcoin is a “…purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” Bitcoin seeks to create a payment system without trusted intermediaries. It is also based on economic scarcity with transactions recorded on a censorship-resistant ledger that anyone can both access (read data from) and append to (write data to). In other words, the Bitcoin ledger is public and permissionless.
In Diem’s whitepaper “…the goal of the Diem Blockchain is to serve as a solid foundation for financial services, including a new global currency, which could meet the daily financial needs of billions of people.” Diem is all about scale and access and it is money based on trust in an issuer. Transactions are recorded on a ledger that anyone can access and view, but only an authorized set of corporations can amend. In other words, the ledger is public and permissioned. Bitcoin, therefore, is censorship-resistant and functions like gold coins or any other valuable commodity. Diem transactions can be censored and the coin functions like a banknote or stock certificate. Summarizing, Diem is a cryptocurrency built by Facebook but overseen by an independent, nonprofit organization called the Diem Association, based in Switzerland. Cryptocurrencies were originally being created to use a form of money without needing a trusted, centralized intermediary.
“The sound money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system.” — Ludwig von Mises
What is Diem good for and how does it work?
Diem is not designed to serve these functions which does not necessarily indicate Diem being bad. If anything, Diem could support the crypto and blockchain industry by generating attention and speeding up the adoption process. Because Diem is designed and functions more like a banknote than anything else it is in competition with traditional FIAT currencies and in particular the U.S. Dollar. There are therefore two important implications:
First, The U.S. dollar is the world’s ‘reserve-currency’ and is held by other governments in their reserves as it is a relatively stable currency. Second, the money used to buy Diem is not just retained in a bank. It is also used to buy debt obligations that are issued by states. If Diem is successful, it makes sense for countries to hold Diem in its reserves. This is because it is backed by the most important and most stable currencies of the world. Currently, the way the U.S. dollar functions as the world’s reserve-currency is as follows: Foreign governments usually don’t choose to hold dollars directly. Instead, they buy U.S. Treasuries (which is U.S. debt). This is incredibly important for the U.S. as it helps the government fund its budget. A total of $28 trillion of such U.S. Treasuries is outstanding. This is about 4 times the total amount of cash that’s circulating. And foreign governments hold about 22% of this debt. Foreign governments are of crucial importance to the U.S. and they have to keep buying U.S. government debt, or the U.S. deficit will spin out of control. If they don’t, the interest rates the U.S. government has to pay to borrow money will go up, making it more expensive to get loans and making the government’s budget deficit increasingly worse. Keep that in mind while expecting what the US Government will decide if they will allow Facebook to create and utilize Diem.
To conclude, money should serve three important functions in order to be used in a society. It should be divisible, transferable and hold its value into the future. FIAT money, such as the US Dollar or the Swiss Franc, are very good to transfer and divide into smaller amounts, however as we have seen in the past few decades, they lost most of their value.
Facebook’s stablecoin Diem, has technological advantages over FIAT money in the sense that it can help the unbanked people and reduce transaction costs, however since this stablecoin is backed by FIAT money it has the same problems.
Bitcoin on the other hand, is arguably the best option that has ever existed to serve the function of money. It is divisible into smaller units (called satoshis), it is very easy to transfer (much easier than FIAT money) and time will tell if Bitcoin is able to hold its value into the future. Since the total amount ever issued is fixed and coded into the source code of Bitcoin it can not be manipulated or changed in any way. This makes it very attractive as money and resilient for a long time. You may ask but the price of Bitcoin is very volatile so it is not very useful as money. This is true at the moment, however the market for Bitcoin is very small and therefore by definition more volatile than other currencies, if the market grows to the same size as other currencies the volatility should decrease as well. Another argument is that, despite the volatility of Bitcoin it has at least not lost its value over a longer time period (>1 year) compared to other FIAT currencies, which all lost value over time.