From Barter to Bitcoin: What is Money?

From Barter to Bitcoin: What is Money?

Welcome back to our continuing series on money, bitcoin, and cryptocurrency.  

The Evolution of Money

In our first post of the series, we learned that money evolves to meet the needs of market participants.  We saw that the earliest forms of money were simply tables of figures inscribed into clay tablets by centrally organized scribes.  Eventually, we noted that monetary commodities can be objectively compared along a spectrum of quality. Money must be durable, portable, divisible, easily verified, and extremely difficult to reproduce or copy.  

Now we will explore:

  • Where does the money we use today come from?
  • What does the future of money look like, and why?

The History of the Gold Standard

Precious metals, particularly gold, silver, and bronze, have been used as money for thousands of years(1). The precious metals have such a distinguished place in the history of money because of their nearly ideal monetary properties, which allowed them to easily displace primitive forms of money (e.g., shells, beads, barter/swap, etc.).  Ultimately, the dominant forms of precious metal commodity money became silver and gold. Gold came to be valued as the highest reserve asset across all markets it was traded in; in essence, all goods and services were now valued relative to gold issuing in the “Gold Standard” era.

Gold usage eventually evolved to adopt coinage, which allowed standardization of weight and simplified verification by the end recipients. Yet while the gold standard opened a new world of economic activity, some shortcomings emerged as trading activity scaled.  The primary issues with commodity money like gold are:

  1. Value to weight ratio: gold is heavy relative to its value, which makes large scale transactions difficult (e.g., how many tonnes of gold are required to trade for a ship loaded with spices from China?); and
  2. Threat of violence and loss: gold is a target of theft, and once stolen or lost, it is gone forever.

While these technical issues hindered the ability of gold to be used directly and efficiently in international trade, they led to a series of institutional innovations that first emerged in China and ultimately spread west via the vast trading networks of European, Mediterranean, and Islamic merchants.  The complete history of the emergence of paper money backed by gold and precious metals deposits is too extensive to detail here, but I will highlight some fundamental shifts.

A reproduction of a Chinese note from the Song Dynasty

The Chinese first used paper money as a substitute for the exchange of copper coins in large merchant transactions where the paper was redeemable directly for an amount of copper noted on the face.  Marco Polo’s accounts from the 13th-century detail that Genghis Khan’s empire was also supported by paper notes.  Centuries later in England, the modern banking system emerged from the ranks of goldsmiths who over time began to offer custody services for various clients where they would hold customer gold and grant deposit slips in return.  These goldsmiths ultimately layered additional entrepreneurial services on top of the custody aspect, and a new institution emerged: the bank.

Early banks facilitated international trade by accepting deposits and developing a network of banks across trade routes to provide banking services such as lines of credit and “bank money.”  Bank money was simply ledger entries held by a network of banks that certified various party’s purchasing power. Banks acted as centralized storehouses for precious metals, and the “bank money” issued as ledger entries soon evolved into paper notes redeemable for underlying precious metals.  The technological innovation of bank money, notes, and lines of credit based on warehoused precious metals immediately improved international trade.

What is Fiat Money?

While it is true that the invention of banking was an enormous step forward for the effective use of gold as money, it is also true that this invention brought along its own new set of challenges, especially for the internal markets of various nation-states.  

A banknote of the defunct Bank of East Tennessee

Rothbard’s “A History of Money and Banking in the United States” gives an outstanding account of the pressures that the existence of “free-market banking” puts onto an economy and market participants in the American context(2). We know that money is used as a third commodity to complete a trade. Yet, in a free market banking system, in which various banks issue their own notes that ostensibly represent gold reserves, an issue of trust and access began to emerge.  For example, some banks were smaller, had fewer gold deposits, and were more regional.  In a world that pre-dated instant communication, a farmer with gold deposit notes from a bank in Witchita, Kansas, would not expect their banknotes to have the same purchasing power in Lincoln, Nebraska as New York, New York. This was because the end recipient of the notes would have to travel to the home bank to retrieve the underlying gold. Due to the gold standard and unregulated banking came the challenges of regional exchange rates and acceptability issues with paper money.

Regional variation in the acceptance or value of money is a challenge for a nation's citizens. A nation-state is just a term to describe a singly controlled administrative area that corresponds to a particular land border where subjects of the state share a common language and culture, customs, and legal domain.  As central governments sought to consolidate the power to control trade, promote national self-defense, collect taxes and support an efficient economy, it became clear that simple commodity money and unregulated banking were hindrances to the consolidation of governmental power.  Some of the first attempts to consolidate the currency in America are the First Bank of the United States, the Second Bank of the United States, and ultimately the Federal Reserve itself. While these efforts managed to reduce the impacts of competing regional currencies, we see that the gold standard itself emerged as an obstacle to the government’s ability to control and regulate the economy more broadly.

This is because the government is restrained in its spending to the extent that a national bank has enough physical money to base its paper banknotes. The American Civil War and World War I were two major conflicts where the central authorities ran into issues raising enough physical gold to finance war efforts. They were forced to issue new banknotes while suspending the ability to convert these notes back to gold. Central administrators both at the national banks and in national governments soon realized that people still used the paper notes even without being able to convert them back to gold. There appeared to be more economic activity since there was more paper circulating in trade.

Bob verifying that Alice indeed created the message she sent him using a public key cryptography scheme

The late 19th to the early 20th century birthed the next evolution in money: fiat money.  Fiat money is simply money controlled entirely by a central authority printed and circulated with no underlying basis other than the decree of the nation-state issuer.  President Richard Nixon in 1971 birthed modern fiat money in a press conference denying gold convertibility of US dollars in direct defiance of the Bretton Woods agreement reached barely two decades earlier.  With this global statement that the US dollar was no longer backed by gold, the world entered a new experimental phase of using fiat money: money valued by the power of a nation rather than the value assigned by market participants.

The Internet of Money

The financial evolution to fiat money coincided with another substantial change in the function of society: the rise of digital technologies and personal computation. The new era of cheap fiat money fueled global trade and innovation to new heights, creating deeply intertwined financial markets.  Simultaneously, military research institutions, particularly the Defense Advanced Research Projects Agency (DARPA), developed a novel process of networking geographically separated computers together and defining various standards of computer communication protocols.  This work effort and breakthroughs in transistor and computer hardware ushered in a new global phenomenon: the Internet and its web of connected computers(3).

With the rise of globally connected computers, there came a need to securely share and protect information. This provided a fertile ground for previously mathematical domains like cryptography to apply themselves to Internet applications(4). For the first time in human history, people across continents were connecting to like-minded individuals in anonymous and secure ways. This was the age of the rise of email, private mail servers, anonymous chat rooms, and the growth of the “hacker” ethos to extend the freedoms of the Internet to all realms of society(5).

One thing is clear for all of the conveniences of fiat money: it is not based on an open standard of participation and communication like the fledgling Internet. Money was global, yet financial control still remained in the hands of various power brokers, banks, politicians, and privileged elite with the ability to transact internationally.  While the power hegemony of fiat spurred massive economic growth, it also produced a sequence of devastating mal-investments that peaked during the collapse of the American housing market in 2008. An extensive system of weak loans for homes of questionable value was packaged into a series of equities and sold throughout the global economy. Once it became clear that the underlying loans in many of these products were not worth the paper they were printed on, a massive global financial shock ensued.  What followed was a series of coordinated efforts by politicians and central banks across the globe to inject large amounts of new fiat cash into the system to stem the tide of losses(6).

It seems that the 2008 financial collapse, the fiscal response, and subsequent aftermath were the final straw for Satoshi Nakomoto, an anonymous hacker or group of hackers acting behind a pseudonym. They dedicated themselves to releasing the world’s first global, non-governmental, purely digital, provably scarce, unforgeable, peer-to-peer system of cash known as Bitcoin.

What's Next?

Yes, this post was a bit longer than the last, and we’ve barely been able to scratch the surface on several important topics and concepts. The key points I want to leave you all with are:

  1. Money and its forms are continually evolving. Market participants create new technology to best meet their needs, and money will change as the needs of the marketplace change.
  2. One of the most important evolutions in the history of money was the introduction of trusted institutions such as banks and other intermediaries to allow trade between disparate parties.  The introduction of banks led to more freely available capital than in a purely metal standard, created the notion of paper currency, and introduced society to leverage (i.e., the increase of purchasing power by the extension of credit).
  3. The Internet enabled instantaneous communication yet lacked a native means of transferring value.  The lack of an open protocol for money meant that the ability to trade and participate in physical economies was controlled by nation-states.  National control of money through monetary policy and regulatory choices impacts the ability of individuals to store their wealth and even express their financial desires by limiting potential partners of exchange.

I’ve included some additional resources below for you to look over that further explain what I've shared here. In the next post, we’ll dive headfirst into exploring the first native currency of the Internet: Bitcoin.  We’ll examine its foundations, its journey over the last decade and compare it objectively to the national fiat currencies that currently exist as the latest stage of money.

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  1. https://cdn.mises.org/On%20the%20Origins%20of%20Money_5.pdf
  2. https://mises.org/library/history-money-and-banking-united-states-colonial-era-world-war-ii
  3. https://www.darpa.mil/about-us/timeline/modern-internet
  4. https://www.ics.uci.edu/~ics54/doc/security/pkhistory.html
  5. https://bitcoinmagazine.com/technical/what-happened-when-bitcoin-creator-satoshi-nakamoto-disappeared
  6. https://www.youtube.com/watch?v=GPOv72Awo68

Stay tuned for our next installment on the continuing evolution of money and how to make sense of it. Before you go check out our pieces on cuts, cars and coins, and please, share with your networks!