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Money: Origins, Purpose and Inflation

Money is a social and economic construct that, like all things humans create, rests on resources, technology and need, plus belief. Money is not government sanctioned, like most of the world thinks, but it actually arises about naturally as a result of human interaction in groups.


  • 14th, October 2021 (4 days ago)
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What is money?

Money is a social and economic construct that, like all things humans create, rests on resources, technology and need, plus belief. Money is not government sanctioned, like most of the world thinks, but it actually arises about naturally as a result of human interaction in groups.

“Money is a matter of belief” - Adam Smith

Money is a good with network effects, and can be thought of as the most persuasive “technology” ever invented as a social construct/technology. Money is created out of the human need for 3 things, namely:

1. the need to transact easily ie. to have an easy to exchange medium
2. the need to hold value over time
3. the need to be able to easily count and measure value using prices, where prices always appear as an information and signaling mechanism in a market

Regarding strict definitions of money, it depends on who you ask. A lawyer would say that money is “official” government (central bank) issued currency. Economists that grasp classical economics, the austrian school, monetary economics and economic history often have a good sense of the origins and workings of money. Money is defined through these 3 functions/properties, it is a:

Medium of exchange: is easy to transfer, divide and use to ease voluntary exchange. It is closely tied to the second property of store of value, as a currency that quickly loses value is not desired to be held and consequently loses it’s medium of exchange properties.

Store of value: easily holds value over time, and for this it requires certain properties where it must be: non-perishable, very scarce meaning it’s hard to inflate it’s supply through production, easy/cheap to hold and secure, as well as socially acceptable. It must be scarce, for without this condition met the value of money drops and it ceases to be used as money. Related to scarcity is certainty of the future supply of the resource (money) in question — the more certainty we can have about the supply schedule of the resource that’s used as money, the better it can potentially serve as a store of value.

Let’s look at some examples to help illustrate the store of value property for ‘X’ (where X could be anything..) to be used as money. If we wanted to use an agricultural product like bread as money we can’t really as it perishes quickly, hence it is terrible as a store of value. Metals like silver or gold do not perish (especially gold), however due to their relative levels of abundance, ease of production & chemical properties it is very easy to mine and use copper as a market good, which makes it weak as a monetary good (and so it was debased over time and stopped being used for that purpose..) while it is much harder to mine gold in order to easily increase it’s supply. Because of this, out of all goods and monies out there, and because people experienced this and formed beliefs and expectations around gold, gold has proven to be the leading store of value asset in the world over the centuries, and it is viewed this way today as well (check out gold’s price and the drivers of gold price performance by the World Gold Council). The higher the stock-to-flow ratio of a money, the better it acts as a store of value, and gold has the highest stock to flow ratio of all currencies/stores of value.

Unit of account: is used to denominate prices of goods and services in easy to use terms - a numeric benchmark - in order to make goods priced in this money comparable and exchangeable easily between persons and over time. The best example of a unit of account today is the US dollar, which is the global reserve currency that individuals, businesses, banks and central banks globally use for everyday exchange, as well as cross-border transaction and transfer settlements. That is due to the dollar’s acceptability across the world and relative low volatility. In contrast, the worst currency to be used as a unit of account right now is the Venezuelan bolivar that is undergoing hyperinflation at the hands of the oppressive socialist regime. No one uses the bolivar as a unit of account even domestically as prices rise even during the day. You can’t plan investments, expenditures, revenues, you cannot trade nor save in such a currency.

These three properties of money, when fulfilled, create what is called sound money which is money that maintains value to have an extremely strong network effect (perhaps the strongest network effect of all). Cryptocurrencies need to provide utility to users and need to fulfill money’s functions in order to become used as a money with medium of exchange (people are willing to use the particular resource to transfer value), store of value (to hold currencies not necessarily as an investment, but simply as a way of maintaining value over short or long periods time in order to transfer value with themselves across time periods) and unit of account (measurement and benchmarking means across society to help prices fulfill their role in a market through the use of such a money) properties. If that’s not the case then they should provide token utility (redeemable or discounted for goods, services, consumables, experiences , discount function, anonymity etc.) or be a security token.

What matters much, besides scarcity of the underlying resource and constrained supply of the money good, are expectations. What helps solidify user expectations is certainty, to be specific: certainty of security and certainty through predictability around the supply schedule of a money. Certainty of money supply is an essential property of sound money. 

Evolution of money

During the course of history humans saw thousands of minor and large scale attempts at creating forms of money that were successful in being a medium of exchange, unit of account and store of value, and almost all of which were disrupted and devalued (commodity money/collectibles, sea shells, metal coins, fiat currencies). Only the most scarce and lasting precious metals - gold above all - have withstood loss of value while simultaneously being a medium of exchange and unit of account.

Origins

Money came about because of human needs, as it is a purely social construct of humans, to satisfy the most basic human needs, such as: exchange of goods, inheritance, dispute settlement around for example marriage or compensation for injury. These are examples of real human needs for a ‘good’ that serves as a medium of exchange between people to trade, a store of value across time and space, and a unit of account. As humans, local and regional civilizations evolved thanks to technological development, trade, as well as human capital and capital stock accumulation, so did money evolve.

10,000+ years ago all humans were foragers who engaged in hunting, gathering, fishing in village ecosystems. Before money people engaged in barter - the exchange of goods for goods - without value equivalence. Exchange (both barter and post-barter exchange), preservation of value, as well as transfer of value among humans - one-way, mutual, voluntary and coerced transfers - began to occur through the use of commodity money (cattle, salt, sea shells) - the most primitive form of money were collectibles (non-fungible treasures and fungible money) like sea shells. Money, before the recent rise of nation-states, came about naturally there where markets formed (predominantly villages).

Metals

Later metal coins were used by humans as a means of exchange (these were rare to find/extract and produce due to their chemical composition, but easy to use as a medium). Metals were used in the past as money, debased by monarchs, leading eventually to the gold standard system in the 19th century, which became centralized at government level, and after it to the creation of fiat money by governments that increase money supply to debase currencies. It’s worth noting that one of the means that enabled money growth and commercial activity is that of gold-backed notes and letters of credit. These were easy to use and helped the transfer of value between parties and in time.

With gold’s strength came about the gold standard, where gold and gold-backed notes were used as money - this came about out of people’s and enterprise’s bottom-up market choice, as other metals/monies lost their value due to the workings of monarchs and increasing production, not top-down government sanctioned money, least until the moment that governments started issuing fiat redeemable into gold (which ultimately failed in the first half of the 20th century).

Fiat currencies

Towards the end of the gold standard we got paper/fiat banknotes as government took over the supply of money. Post-World War II saw the creation of an international settlement system with fixed exchange rates between the world’s currencies and the US dollar, where the US dollar was backed by gold (a pseudo gold standard). Basically the US dollar became the world’s reserve currency, and in 1971 the US announced it won’t be backed by gold. Most recently the technological development of the internet and digital transfer mechanism advances (eg. PayPal) made it much easier for consumers to directly use money but via intermediaries, as a medium of exchange over large distances and globally.

Contrast fiat currencies to pre-programmed digital money, which, as long as it is secure in terms of the resources used to produce and maintain it (decentralized mining/computing power) is more certain and predictable than eg. fiat monetary policy that fluctuates, changes, and is manipulated by governments to their benefit.

Digital money

There were attempts at the first forms of digital cash in “b-money” and “bit gold”, which had failed. In 2008–2009 came Bitcoin: private, decentralized secure digital money. The invention of Bitcoin is a leap in both technological design (in particular: distributed peer-to-peer network, proof of work, cryptographic security (solving mathematical puzzles), secure time stamps, difficulty adjustment, programmable money) and socio-economic design (decentralized nature - lack of a centralized third party, a high and escalating marginal cost over time due to the fixed supply and programmed supply schedule, free circulation within the system which enables bitcoin to function as a medium of exchange, store of value and unit of account), probably the most important one since the internet itself. This design is to re-create sound money in the digital realm.

Depending on who you ask, many people outside the crypto/blockchain community (especially “experts”) will argue against Bitcoin and cryptocurrencies as mediums of exchange, store of value, and/or units of account. This is wrong. Bitcoin has risen in value significantly despite the boom and bust cycles, which attests to how it has the potential to be a store of value, on top of its design characteristics and scarcity which point in that direction, and on top of its almost religious HODLer base and core community that are propelling Bitcoin forward. It has proven that it functions as a medium of exchange, being used for that purpose for various use-cases, although not en masse or scalable (yet). And it’s not a unit of account.

Inflation

I heard on Tim Ferriss’ podcast with Naval Ravikant and Nick Szabo that “money is the bubble that never pops” (Naval). This is certainly true for sound money, however, when money enters hyperinflation and is weakened through quick debasement the ‘money bubble’ deflates, as it loses value. Unless Naval meant monies en masse, which is true in the sense that money is about beliefs and that society cannot function without money. 

Either way, this helps understand sound money as money that holds the three properties of money (medium of exchange, store of value, and unit of account). In my opinion what helps understand sound money most is gaining an understanding of unsound money and inflation.

Inflation is the increase in the prices of goods and services over time. To be more precise, inflation is the persistent rise in the general level of prices of goods related to an increase in the volume of money, which results in the loss of value of currency - it increases your cost of living. Under high inflation it becomes harder to save, plan expenditures, plan investments and run business. Thus, inflation is a silent killer of money and economies, as it reduces the purchasing power of each unit of currency (think of it this way: more coins and notes chasing after the same amount of goods and services).

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output” - Milton Friedman

This happens, above all, for political reasons. Control of money gives significant power to government by enabling excess expenditures and control over the economy and society. Money supply is managed by central banks, and the negative impact of inflation on the value of money is often called the “inflation tax”. Control of money supply enables governments to print money, which erodes the value of the currency depending on its rate of issuance, ie. how much and how quickly money supply is increased. This normally produces inflation in an economy, but can also lead to abnormalities like asset bubbles (eg. 1920s, 1990s, 2008). The value of money erodes as the prices of goods increase, because money slowly loses the function of store of value across time, and as unit of account if people start abandoning the use of this money. For instance, the US Dollar is worth 5% of what it was worth 100 years ago.

Governments care about controlling money, because it makes it easy for governments to finance their debt repayments (especially during and after major wars: WWI and WWII in particular) and unsustainable expenditures (often war, welfare, pensions). Debasing money makes way for unsustainable spending, consumption and indebtedness, as economic entities recognize that it is unattractive to save money, as money is worth less over time and government-set interest rates are low to enable this process of increasing money supply. This makes savers poorer: above all the middle class, but in the end the population at large. Money debasement has contributed to the demise of every empire and failed state in history. The main beneficiaries of inflation are the government that owns the printing press to acquire seigniorage and devalue its debt, hence making it easier to repay debt. Other beneficiaries include debtors, especially large debtors. The main casualties of inflation are savers (usually the middle class), and overall the population and enterprises at large.

Governments control money also due to ideological and interest group pressure reasons: first, Keynesianism serves well politician’s goals of maintaining power, thus they justify government interference and control of money using this economic school of thought; second, many interest groups (including financial institutions) that benefit from easy government expenditures want to maintain that status quo; third, even if the theory of maintaining money supply increases in line with increases in output is correct, in practice money supply always exceeds output leading to the erosion of the purchasing power of money over time.

The worst form inflation can take is hyperinflation (extremely high inflation), at the end of which currency is worth less than actual toilet paper (you can derive actual utility from using toilet paper in the restroom, while the only utility from a hyperinflated worthless currency is as fuel for fire, or as a resource for cheap collectibles).

Venezuela’s hyperinflation where currency is so worthless that artisans are making purses out of it.


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