A prerequisite to understanding Bitcoin is having a fundamental understanding of money. Most people haven’t thought much about what money actually is, why we have it, or the properties that might make one form of money better than another. That being the case, it is difficult for most people to see why Bitcoin is a superior form of money to anything we have ever used before, and why it is and will continue to be superior to anything that has been invented since. Indeed, why it will very likely maintain superiority over anything that might be invented in the future.
Life Without Money
Perhaps the best way to begin to understand what money, and why society is much better off when it has some form of money, is to imagine what your life would be like without money at all. You have basic needs for food, shelter, water, and clothing, and you have essentially two options: 1. You can try to be entirely self-sufficient, providing for your own needs with your own two hands, or 2. You can become proficient enough at one particular skill that you can trade that skill with others who have different skills to get everything else you need.
In the first scenario, the vast majority of your time will be spent simply acquiring and maintaining the things you need to survive, and you will have little time for other pursuits at all. A portion of each day will be dedicated to collecting water and making it drinkable, another portion will be dedicated to hunting and gathering, and another portion dedicated to replacing worn and damaged clothing, or maintaining whatever you built for your shelter. If you have a spouse, you can divide some of this labor between each other, so as to be more efficient. However, this still proves to be a full-time job just to make sure you maintain an absolute minimum standard of living. 100% self-sufficiency is nothing more or less than 100% poverty.
In the second scenario, things can be vastly improved. You can live in a small community with people that each specialize in skills that can benefit one another. You might become an exceptionally good hunter, while another becomes a proficient fisherman, and another a builder of sturdy and leak-proof homes, and so on. When you grow tired of always eating venison, and want some fish to add variety to your diet, you can go to the fisherman and offer to trade him some of your venison in exchange for some fish. And when you want to upgrade your home, you may go to the builder and offer to supply him with venison for a month in exchange for the work. Because each person is specializing in a particular pursuit, they have the time investment necessary to become vastly more efficient at that one skill than they otherwise could have ever been, so they can produce much more of it than they need, and trade the surplus with others in the community.
Barter
This is how a barter economy works, and it is a significant upgrade compared with trying to provide for all of your own needs with your own hands. However, it still has some serious limitations, particularly if you try to extend it beyond a very small and localized community. For instance, if you are a hunter and you want to trade your venison in exchange for a builder upgrading your home, but the builder has no need for venison, because his son is also a hunter, then you need to find a different builder who will take your venison as payment, or you need to find out what the builder will take for trade, let’s say apples, and then go find someone who will take your venison in exchange for the apples, so you can trade the apples to the builder to do the work on your home.
This is a non-trivial amount of friction already, but that’s not where it ends. You see, the work you want done on your home is probably worth a great deal more than a bushel or two of apples, and since apples spoil quickly, you will have to make an agreement with the builder that you will get him apples every week for a period of a few months until the amount of apples he has received is deemed of equivalent value with the amount of work he performed. This means you will also need to keep trading your venison for apples just to give them to the builder, regardless of whether you want to eat the apples yourself. If, during that time, the apple grower also wants to have work done on his home, he will find that the builder is unwilling to trade his work for apples, because he is already receiving a steady supply of apples from you. Now the apple grower has two options: 1. Find something else that the builder is willing to take as payment, and hope they can find someone who wants to take their apples in exchange for it, or 2. Stop trading apples for venison with you, so that the builder will be willing to accept apples as payment again, leaving you high and dry with no means of repaying the builder what you owe.
This problem with the barter system is called the non-coincidence of wants, and as difficult as it can be to deal with in a small community, it becomes even more difficult as communities expand in number. Moreover, the need to find trading partners who have what you want and want what you have in exchange cuts into the amount of time you can dedicate to honing your skills and producing the goods you want to sell. To answer this problem, communities began to use some form of money that made trade much more efficient. The exact form that money took varied widely in history, from salt, to seashells, to glass beads, to blocks of dried tea leaves, among many other types of goods. Indeed, the use of paper bills, though ubiquitous today, is a very recent development, and is already being phased out in favor of digital versions of fiat currency. Over 90% of US Dollars do not exist as physical coins or bills at all, but only exist as numbers in digital bank ledgers. Regardless of what form money took in history, though, having something to use as money made trade far less cumbersome than the barter system.
As a hunter in a community that uses money, you can sell your venison to anyone who wants it in exchange for money, and then you can go purchase anything else you want or need using that money. You are no longer restricted to only trading with people who will accept your venison as payment, or else forced to find something else they will accept as payment, and trade your venison for that. Instead, you can trade with any other person in the community, even if they have no interest in your venison at all, because they are all willing to accept money as payment instead. This frees up more of your time for you to dedicate to becoming more proficient at your chosen skill.
The Ideal Properties of Money
How each various society in history eventually agreed on something to use as money can be easily understood when we consider the role that money would be used to fill. Some things make more ideal forms of money than others, and so a society tends to converge on whatever has the most ideal mixture of characteristics. Let’s look at what people would want money to do, and discern what monetary characteristics would be most ideal to accomplish that goal.
The most basic thing people would want to use money for is to purchase goods and services from others, without having to figure out what their trading partner’s individual wants and needs are in advance. Already, this gives us some ideas of characteristics money ideally ought to have.
Divisibility
Since you are likely to want to purchase some goods that are of low value, and other goods that are of high value, whatever you use as money should be able to be divided into small enough units to facilitate the smallest feasible transactions, or combined into large enough sums to facilitate the largest feasible transactions. We call this characteristic “divisibility”. All else being equal, a good that is more divisible will be more ideally suited to being used as money than a less divisible good.
Portability
Since you may want to buy something from someone who is some distance away from where you live, such as across town, or in a neighboring village, whatever you use for money should be easy to carry with you in the quantities that you will commonly need for spending. We call this characteristic “portability”, and it is also an important security feature for money to possess, because it allows people to more easily hide it away from would-be thieves. All else being equal, a good that is more portable will be more ideally suited to being used as money.
Verifiability
Since you want to be confident that the person you are buying from will accept your money as payment, you will want to use something that they will immediately be able to recognize as genuine, or else be able to verify quickly via some sort of test. If you use a rare metal, then they can verify it by weight. If you use a paper bill, they can verify it using hard to replicate security features, like watermarks, micro printing, etc. If you want them to honor it as payment, they have to be certain it isn’t fake. There’s a reason we have the term “fool’s gold” to refer to iron pyrite, after all. Only a fool would not be able to tell the difference between it and genuine gold. We call this characteristic “verifiability”, and goods that are more verifiable will tend to be more ideally suited to being used as money.
Fungibility
Another thing that may stand in the way of having your money accepted as payment is if the person you are trying to pay can tell where you got the money from. For instance, if they are a vegetarian, and your money is stamped with a mark that says you received it from working at a butcher shop, they may not want to accept your money as payment due to their moral principles. For this reason, one unit of anything being used as money should be indistinguishable from another unit of the same value, so that whoever is receiving it as payment has no reason to reject it based on its history. We call this characteristic “fungibility”, and a good that is more fungible will tend to be more ideally suited to being used as money.
Fungibility is also important for maintaining a standard valuation for each unit of the money. If every unit of a good is unique, then it is hard to know the value you have, and it’s also hard to know how to price what you want to sell. For instance, if you want to use small stones as your money, you can’t just say that you will work for 5 stones an hour, because one stone might be slightly larger than the others, another might be more round, and another might be a more rare and interesting shape or color. So, a money with units that are each identical will work much better than a money with widely varying units that are difficult to measure.
Durability
Since you may have a period of time between when you receive money as payment and when you want to spend it to purchase something else, and then the next person may have a period of time before they want to spend the same money, and on and on with each person who accepts it as payment thereafter, whatever you use as money should not be easily damaged or deteriorate over time. We call this characteristic “durability”, and once again, all else being equal, a good that is more durable will be more ideally suited to being used as money.
Part of the reason you want money to be durable is so that it maintains its value over time, as well. You don’t want to use a form of money that will buy you less goods tomorrow than it will today, and significantly less goods in a month, due to the damage or deterioration of the money itself. This is why perishable goods like apples or beans never really caught on as money. Without specific actions to preserve them, they tend to rot away very quickly, and no one will value an apple that is even just beginning to rot anywhere near how they would value a fresh apple, so the lifespan of an apple being used as money would only work for one or two consecutive transactions, and only if those transactions happened in a short period of time, while a more durable good could be used for years and years while retaining its value.
Money must retain value over time, not just so it can be used in multiple consecutive transactions, but because some things you want to purchase may take more time to save up for. Therefore, you will need to be able to set money aside with confidence that once you have saved the amount you need, the price will not have gone up significantly, requiring you to save up even longer. When you originally look at the price of an item, you instinctively consider how much of your labor and time it will take to pay for it based on the posted price. If the price goes up over time, due to the money you are using dropping in value, it means that the cost over time to save up for that item is much higher than at first appears, skewing your perspective on whether it is worth saving up for.
Scarcity
There are other characteristics besides durability that can have an effect on a good’s value over time, which will therefore also come into play for deciding whether it would make a good form of money. This ability to retain value over time is sometimes referred to as “hardness” or “salability across time”, and durability is only a portion of what contributes to a good’s hardness. If a good that is being used as money is not sufficiently hard, then people will be less and less willing to accept it as payment over time, since its value is always decreasing in relation to other goods, or else, they will require larger and larger quantities of it as payment for the same goods.
A major contributing factor to a good’s hardness is how much work is required to manufacture or otherwise acquire the good, outside of receiving it as a form of payment. If a form of money is too easy to acquire in quantity, then people will cease to do other forms of productive work to sell for that money, and instead will simply work to acquire the money directly, whether by mining it, gathering it, growing it, or manufacturing it, which will result in an ever increasing supply of the money, and a decreasing supply of all other goods. This will make the value of the money go down significantly over time, reflected in the price of all other goods going up. So, all other things being equal, the harder it is to acquire a good directly, the more likely that it will retain its value over time, and the more ideally suited it is to being used as money. We call this characteristic “scarcity”, and when various forms of money have failed throughout history, it has generally been due to them losing this characteristic.
How a Money Dies
Glass beads were once used as money in Africa, because they were difficult to make with the technology available, so they tended to retain their value over time. They could be used for purchasing very inexpensive items for just a few beads, or very expensive items for bags full of beads, so they were very divisible. Small glass beads were relatively durable, so they didn’t rot or break often, unlike larger items made out of glass, and they were also easily portable for most daily spending. They weren’t the most fungible goods, though, since each bead was unique and therefore some beads were valued higher than others, and some people preferred different shapes or colors of beads, while other people preferred completely different beads. However, it was not due to this lack of fungibility that glass beads ceased to be used as currency. It was because Europeans with superior technology, which allowed them to very cheaply manufacture large amounts of glass beads, came along and inflated the supply of the money.
The same is true for many other forms of money that could not maintain their value over time due to large increases to the money supply. At first, everyone thinks they are getting rich, because their sales are going through the roof, and they have more money than they have ever seen before, but after a time, they realize that everything they want to buy with that money has started to cost more, as well. This is called inflation. These days people will refer to any rise in prices as inflation, but traditionally it only refers to a general rise in prices due to increased supply of money in the economy.
Other reasons why prices might rise are usually temporary, and due to a shortage of supply, or an increase in demand, for that specific good. For instance, if a natural disaster hits a region particularly hard, then food and bottled water will become very expensive there, because much of the existing supply was likely damaged, and it may be a while before new supply can be brought in to replace it. At the same time, people who normally are able to drink water from their faucet may not have working plumbing, and they may not have food stored up for emergencies, creating a higher level of demand than usual. However, these spikes in price will not last forever. Prices will drop again when things go back to normal and supply lines are restored.
This is not the case when the supply of money is increased. Unless there is a mechanism to reduce the amount of money in the economy, or else permanently increase the amount of other goods, the price increases will be permanent. Increasing the amount of goods through increased productivity is possible, but it usually doesn’t affect all goods in the economy, because increased productivity for one good rarely translates to a similar increase of productivity for all goods. For instance, finding a way to grow more wheat doesn’t usually coincide with finding a way to build more homes. In fact, they might be inversely correlated, since growing more wheat likely requires more land, resulting in less space to build homes. So, wheat may get less expensive at the same time that homes become more expensive, and behind it all, the general prices of most other goods can still tend to become more expensive over time if the money supply is always growing.
Societies throughout history have tended to converge on a single form of money that has the best combination of these characteristics: divisibility, durability, portability, verifiability, fungibility, and scarcity. Some forms of money might have been less than ideal in one or two characteristics, but they possessed all the others. For instance, on the island of Yap, they used large limestones as money that were difficult to move, so they just kept track of the ownership without moving them, and it worked despite the lack of portability, because they were on a small island in a close-knit community. These limestones would have ceased to be useful as money if the number of people they needed to trade with, or the distance traveled for trade, expanded. Portability becomes a far more important characteristic under those circumstances.
The people of Yap no longer use those limestones as money, but not because they weren’t portable. Just like the glass beads in Africa, Europeans with superior technology came along and added many new limestones into the economy, driving down the value of each stone and obliterating the wealth of the community.
Monetary Metals, and Their Fall
Historically, one form of money has outlasted others as a dominant currency for centuries, because its supply is not easy to inflate. I am speaking of precious metals, especially when minted into coins. Gold, silver, and other metals can be mined, but the process is hard work, which means that most people decide to focus on other productive work instead. Advances in technology have increased our efficiency at finding and extracting these metals, but not to the point that the new supply added to the economy each year is a significant portion of the total existing supply. This means that productivity for other goods generally outpaces the increased productivity in mining precious metals, thus they tend to retain their purchasing power or relative value over time, or even appreciate in value.
Yet, despite their nearly ideal characteristics to be used as money, precious metals still had some downsides. First, they aren’t always the most verifiable form of money. When they were minted into coins, other metals would often be added in small quantities so that it was hard to tell that it wasn’t pure gold or silver. Next, gold tended to be used for larger value transactions, since it wasn’t terribly divisible, while silver and other metals were used for more day-to-day transactions, but it proved difficult to maintain a predictable exchange rate between metals, because they didn’t have the same inflation rate. If only 3% more gold was added into the money supply each year, but 6% more silver was added, then silver would devalue compared to gold, and it would take more silver coins to be of equal value with one gold coin. This hurt the fungibility of the coins, and made it hard to know how to price goods. However, the lacking characteristic that proved to be the downfall of precious metals being used as money directly was their lack of portability.
As advances in technology resulted in people regularly traveling greater and greater distances, it became cumbersome to carry around metal coins. To resolve this problem, banks offered to hold precious metals on deposit, and issued receipts stating a value of gold or silver, transferable to anyone, and redeemable on demand. These receipts were the rudimentary beginnings of what would become the gold standard, where banks issued paper currency denominated in US Dollars or other currencies, with set exchange rates for turning them back in at the bank to redeem them for gold. This allowed people to forgo carrying around heavy coins, and increased the divisibility of the money at the same time. However, it introduced a new layer of trust, because depositors had to trust that the gold was actually on deposit to back up the paper money that represented it. As long as depositors were able to go into the bank and redeem the bank notes for gold whenever they wanted, there wasn’t an issue, and soon people were so used to the idea that they didn’t bother trying to redeem the bank notes unless they had a very specific need to do so.
This left a major loophole for banks to capitalize on. They knew that very little gold needed to be kept on hand compared to the number of bank notes they had issued, because so few people would ever want to exchange their bank notes back into gold. This meant that they could rehypothecate the gold they were holding by loaning out additional dollars over and above the value of the gold they had, trusting that they would not have too many people coming to redeem those dollars for the underlying gold at one time.
One of the largest borrowers of these dollars was the civil government, particularly during times of war. This led to the supply of dollars far exceeding the supply of gold that supposedly was backing it, and resulted in multiple occasions when convertibility of bank notes back into gold was suspended. Famously, FDR issued executive order 6102, prohibiting the private ownership of most gold, and requiring banks to transfer all gold deposited with them to the Federal Reserve Bank. Eventually private ownership of gold was restored, but the ability to convert US Dollars into gold was never restored for private citizens. Some semblance of a gold standard was maintained under the Breton Woods Agreement, with member nations able to exchange their US Dollar reserves for gold, but the exchange rate was set at $35 an oz, rather than the historical exchange rate since 1834 of $20.67 an oz. In 1971, even this semblance of a gold standard was abandoned, though Nixon said it was "temporary" at the time, resulting in the monetary system we have today, which uses cash and digital dollars, without any backing except the demand of other nations—who currently need dollars to purchase oil—and the military might of the US government.
Since 1971, the supply of US dollars that can actually be estimated with any confidence has gone from about $600 billion to about $22 trillion at the time of writing, which is an increase of nearly 3,700%, with about 1/5 of that occurring just in the last two years alone. As a result, the purchasing power of the US Dollar has also dropped about 86% in the same period of time. This means the US Dollar severely lacks the characteristic of hardness, or salability across time. Yet, it remains the dominant currency in the world simply because the vast majority of other fiat currencies are even worse off.
The Need for a New Hard Money
So, why hasn’t our society reverted back to using a harder money like gold and silver coins? The answer is simple: We want to continue to be able to engage in trade at vast distances nearly instantaneously. Since the development of the internet, we have been able to purchase all sorts of things from people and businesses all around the globe. Can you imagine using gold and silver coins as money again in this type of an economy? We would have to be willing to send them in the mail, and wait long periods of time to receive the goods, hoping that no one stole the money in transit. Even though US Dollars are terrible for saving for the future, they are vastly superior to any other commonly accepted form of money for transacting at a distance, particularly in their digital form, facilitated via credit and debit cards and other digital money transfer methods.
It leaves us with a bit of a conundrum. If we want to have a hard money, we must sacrifice our ability to transact at a distance, and if we want to continue to buy things from outside of our local communities, we must sacrifice the ability to save our money for the future. We have generally opted for the latter route, and have looked to other means for saving, usually by turning to speculative risk in stocks and other investments.
Many people have reverted to gold for saving, though they still use the dollar for day to day commerce. Others use mutual funds, bonds, and other investment vehicles. However, when we do so, these things begin to take on what is called a “monetary premium”, which is simply a way of differentiating the level of demand that a good would have for its inherent usefulness, compared to the additional demand added by people choosing to use it as a savings vehicle. For instance, gold has a certain amount of usefulness for creating jewelry and electronic components. If that’s all that people ever did with it, its price would likely be far less than it is now. However, people also choose to store their wealth by purchasing and holding it for years, taking it out of the available supply for other uses. The more people who do so, the more its price will increase. The price increase that can be attributed to people using gold as a savings vehicle is the monetary premium.
Goods can only maintain a monetary premium if their supply is hard to increase. Otherwise, when a good begins to show a monetary premium due to its price rising, it will encourage people to bring more of it to market, until the supply can meet the demand, and the price goes back down to near the cost of production, eliminating the monetary premium, and discouraging people from using it as a savings vehicle. So, again, scarcity becomes an important factor in any good developing and maintaining a monetary premium, even if that good is never used as money for day to day commerce.
Describing the Ideal Money
It would be far more ideal for people to be able to store value in the money itself, rather than having to resort to other goods that can be highly volatile in their price, resulting in the risk of losing their principle. But how do we get around the problem that highly portable forms of money in our digital age also tend to lack scarcity, and therefore cannot hold their value over time? If we could imagine the ideal form of money for our digital and global economy, what would be its characteristics?
It would be a digital form of money that could be sent from anyone to anyone else instantaneously in any amount, so that it is both highly portable, and highly divisible. Its supply would somehow be limited intrinsically, so that no one person, group of people, or government could increase its supply at a whim; this way it can be truly scarce and therefore maintain its value over time. It would be easy to keep away from thieves, without sacrificing the ability to spend it when desired. It would not maintain a history of transfers that could be linked to the identity of the person transacting, so as to ensure it will be accepted by anyone. And finally, it would be issued in a way that requires real-world time and energy to be spent, so that its existence is provably costly and decentralized.
With only one possible exception, I have just described Bitcoin, a digital currency invented in 2008, and which has been running almost entirely uninterrupted since it went live in January of 2009. Bitcoin is more portable and divisible than the fiat currencies we use today, and yet more provably scarce and verifiable than gold and silver coinage. It excels in every characteristic of money mentioned above except fungibility, and that only on the base layer. However, because it is going from zero adoption to millions of people using it in such a short period of time, its price is highly volatile. As a result, it currently proves to be an excellent store of value for time horizons of 5+ years, but not yet an ideal medium of exchange for day to day commerce.
For more details on how Bitcoin works, so that it has such ideal characteristics for use as money, see the next article in this series: Part 2 - Bitcoin’s Invention and Monetary Characteristics.