If there are presentations about what is money, then we usually hear, that money has to be durable, portable, divisible and fungible. We fully agree with this discussion.
But there is a bigger picture. The money doesn’t have only one dimension, but it has two dimensions — there is base money and there is credit money. The notes and coins in your wallet are the base money. The money what you have on your bank account is actually credit money.
This article:
• Analyses how the base money and credit money work today
• Analyses how the base money and credit money worked in the last 5’000 years
• Discusses what will happen with the credit money in the crypto sphere
Below is the picture of the first known credit money, from Mesopotamia, from ca 2’500 B.C., now in the possession of the British Museum in London:
The intuitive answer to the key question of this article will be — yes, as the credit money has been around so long, then it will be around in the future as well. But how?
The crypto sphere today does not have credit money. Bitcoin, Bitcoin Cash, Ether, etc can be only base money because credit money is dynamic, it is elastic — it is created and destroyed together with the economic transactions.
Base money versus the credit money
Let’s start with how it works today. Base money is created by the central banks and the credit money is created by the commercial banks. Base money is today 3% — 7%, the rest is credit money.
Credit money is elastic, the amount of it is growing and declining, together with the economic transactions — more economic transactions result in more lending result in more credit money. And vice versa.
This elasticity parameter is the key reason, why Bitcoin, Ether, etc. are not the credit money, but the base money.
Credit money supply is pulsating — additional economic activities lead to additional need and reduced economic activity to the reduced need.
Credit money is, by principle, temporary. However, in our current monetary system, more credit money is created than destroyed, resulting in the continuous growth of total credit money circa 5% — 7% per year.
How is credit money created today?
Credit money is created by the commercial banks in the lending process (no, commercial banks are not lending your grandma’s deposits, they create credit money by the so-called “balance sheet extension” procedure).
The credit money is created every time you are getting a loan from a bank. The credit money is destroyed every time you are paying back a loan to your bank. The money, which you have on your bank account, is not as durable as you thought till now — there are continuous destruction and creation happening in the background.
Banks create credit money and they protect it with their reserves (don’t think here about the Deutsche Bank which has balance sheet to equity ratio of 100:1) and there are national deposit insurances as well (don’t think here for example about Swiss deposit insurance, which has funds to cover 4% of all Swiss deposits).
Practically banks do the following:
Banks protect the value of the credit-money which they have created with this mechanism.
Well, what happens, if this mechanism does not work? No problem, it’s fixed by creating more of the same (creating more credit money):
• The central banks will create additional base money and they push it into the circulation via the commercial banks (Quantitative Easing) or
• The lending criteria’s are simplified (for example Federal Reserve interest rate is reduced or the balance sheet to “mark to model equity” requirements are relaxed) so that more and more credit money will be created via lending or
• Governments will take on more debt and try to pump it via the multiplication effect into the real economy (works in case of real investments, doesn’t work in case of just spending)
Obviously, this mechanism will result in inflation (some when later) or in deflation (if no-one wants to borrow anymore), but as this happens later, then this is someone else problem.
Some people say, that this reminds a little bit of a “musical chairs game”. We think it’s not correct formulation — it is “the musical chairs game”.
Monetary systems now and in the past
Monetary systems consist always from the base money and from the credit money. The difference is in:
• Who is creating the base money?
• Who is creating the credit money?
Our current fiat monetary system is actually not very old, it started in the time period between the Federal Reserve creation (1913) and the gradual gold standard abolishment (1933 — nationalizing gold in U.S., 1944 -Bretton Wood agreement, 1971 — removing gold backing from USD base money, 1992 — removing gold backing from CHF base money).
Our fiat system looks as follows:
How did it work before our fiat system? It was the following:
• Practically, commercial banks created their own private credit money’s, which were exchangeable into physical gold
• Central banks created national base money, which was backed by the gold and was exchangeable into gold
This system started to emerge around the time period of creating the first central banks (Sweden and England in 1660’s) and lasted till the Federal Reserve was created in 1913.
There were several sub-phases — free banking area, gold-based system, some countries introduced central banks earlier, some later. In some cases, the central banks were “independent”, in other cases their state treasury’s, etc.
The key to this phase was however
- Base money was backed by the commodity — gold
- Commercial banks created their own private credit money, which they protected with their own reserves
The earlier phase started around 500 B.C. and lasted till 1660. First coins were created 500 B.C. — this was the time when the standing armies in Europe, India, and China had to be financed — they were financed with the sovereign minted coins.
In the beginning, the coins were usually 100% gold or 100% silver. Then later the kings started to reduce the ratio of precious metals in the coins — it was the hidden inflation in the base money. However, the coins were legal tender and one had to accept them.
This was the time period when the Phoenicia, Islamic Trading Network, Mediterranean and Hanseatic Trading Networks existed. The credit money was created decentrally, in peer to peer transactions. The obligations to pay were used as bearer notes and they could be used to pay third parties, who could pay fourth parties and so on. On the end, the borrower had to pay to the owner of the bearer note.
So, the key to this phase was:
- The base money was created by the sovereigns and was inflated slowly
- The credit money was created decentrally by the people in peer to peer transactions
But how did it worked before the 500 B.C? There were many blossoming civilizations and common to all of them was the following:
- Commodities — gold, silver, grain, shells — were used as base money
- Credit money was created decentrally
Governments or sovereigns didn’t involve into the definition what the base money had to be — the people decided it. Neither did Government or Sovereigns defined how the credit money had to work — the people decided it. There was no government involvement. But there was a court system for enforcing the contracts. And there was a government system for enforcing the court’s decisions.
The first credit money is known from the Mesopotamia, from 2’500 years ago. It was created decentrally, in peer to peer transactions. Mesopotamia used grain as base money — the unit of account was a barrel of grain. On top of this was decentrally created peer to peer credit money, on the clay plates, with the stamps of the borrowers.
Obviously, the barrels of grain were not easy to use in daily life. And this facilitated, even more, the usage of clay plates based credit money.
Classification of the monetary systems
By using base money and credit money dimensions we can classify the monetary systems in the last 5’000 years as follows:
The current crypto sphere doesn’t have the credit money approach, but none of the civilizations in the past has survived without the credit money. Which leads us to the next question:
How will it work in the future?
The first conclusion is that credit money has been always there. It has been created either as:
• Decentrally in the peer to peer transactions
• Private credit money of the commercial banks
• Central credit money of the commercial banks
The second conclusion is that we have two different possibilities to create base money:
• Controlled creation of the base money — in this case, it’s created by the central banks or sovereigns
• Un-controlled creation of the base money — in this case, commodities like gold, silver or grain are used as base money
Having un-controlled base money creation means that a commodity, which cannot be manipulated, will be used as a base currency. Swiss National Bank has increased the amount of base money 10x in the last 10 years since the Lehman crisis. One cannot do this with the commodity based base money.
U.S. Courts have defined Bitcoin as a commodity. Some people are unhappy about this. However, we are very satisfied with this — it allows to move back to the commodity base money systems (which are then by the definition non-manipulatable).
But what’s about the crypto credit-money, if we use the Bitcoin as the base money. Who will create the crypto credit money? On the end, there will 3 possibilities — decentral credit money, private credit money or central credit money.
Summary
The credit-money has been around for the last 5,000 years. There are no key civilizations from the last 5,000 years, which have survived without the elastic credit money.
But the credit money is missing in the crypto sector. Bitcoin, Bitcoin Cash, Ether, etc. have only the base money characteristics. They are missing the elasticity, the continuous creation, and destruction, as it is with the credit money.
So, who will create elastic credit money for the crypto sector?
• Will it be created by the existing commercial banking infrastructure? Probably no, probably the crypto sector will not accept the “old world credit money”
• Will it be created decentrally without commercial banking? Probably yes!
Our thesis is the pendulum will move back to where we started:
• We will have commodity based base-money (Bitcoin, Ether, …)
• We will have decentrally created elastic credit money
• The court system will be there for enforcing the agreements
• The government will be there for fulfilling court decisions
It will be the same as it was in Mesopotamia 5,000 years ago. But this time empowered by the blockchain.