Bitcoin & alternate cryptocurrencies
There are 10 ( binary for 2 ) types of people in the world, those who own bitcoin ( 1 ) and those who don’t ( 0 ). The question that keeps me up every night is, whether Bitcoin, in its current shape and form, be ever used as money? To understand the potential of Bitcoin, it is essential to revisit the concept of money. There is hardly anything that hasn’t been used as money, rock salt in Ethiopia, brass rings in West Africa, cowrie shells in Uganda; anything can be used as money.
A need triggers an invention
In 6000 BC “barter” was introduced by Mesopotamia tribes. A “barter” is an exchange of goods or services for other goods or services. A farmer may agree to sell his crops to a buyer for bullocks. The farmer receives bullocks ( beneficial for the production of crops ), the buyer gets crops ( food to satiate his hunger ). Simple right, the seller gets what he values; the buyer receives what he appreciates. Here’s how such a simplicity suddenly becomes a burden.
Scandinavian and Russian traders bartering their wares. Olaus Magnus, 1555
Suppose, another buyer initiates an exchange of horses for crops from the same farmer. Such an exchange adds unwanted cost to the farmer because the horses do not contribute to the productivity of crops. The farmer must involve in an additional barter to exchange horses for bullocks. The chain of such extra barter grows adding to the unwanted cost in time and effort.
We, humans, came up with a reasonable solution to overcome such a problem. “Salt barter” is an exchange of goods or services for goods essential for human survival. In simple words, a farmer would barter crops in exchange for highly demanded goods, such as salt, cow, etc. Although such an awesome idea eliminated problems arising from pure “Barter”, it directed our attention to a new problem, “Store-of-wealth”.
“Store-of-wealth” or “Store-of-value” is a function of an asset to be saved, retrieved and exchange at a later time. Salt, cow, etc had a highly inadequate store of value. Salt could be washed away by rain, cows inevitably had to die. Such degradable property increased the difficulty of wealth transfer by inheritance and safe accumulation of wealth.
We evolved and so did our thoughts, “Community agreed barter” was established. “Community agreed barter” is an exchange of goods or services for a physical symbol, such as cowrie shells, animal horns, etc. The agreed physical symbol must possess few properties, such as difficult to acquire from nature, and robust to natural degradation. One may argue that symbols fell short on intrinsic properties which “Salt barter” had; cowrie shells could be only used for creating pieces of jewelry. But lack of intrinsic properties did not deter its use as a medium of exchange provided the community agreed.
Money Cowry; Length 2.6 cm; Palou Tello, Batu Islands, Indonesia.
Chinese shell money, 16–18th century BCE.
“Community agreed barter” presented us with a new set of problems, such as the unit of account. The cowrie shells were troublesome to proportionately divide. It worked perfectly until the lowest “unit of account” represented a whole cowrie shell. The value of certain goods was lower than one whole cowrie shell, say half, three-fourths, quarter of a cowrie shell. Failure to proportionately divide for such small exchanges reflected the limitation of cowrie shells.
Also, the growth of such “Community agreed barter” in isolation hindered exchange of goods across communities. Community A upheld cowrie shells while Community B upheld animal horns as money. Merchant of community A exchanging horses with the buyer of Community B expected cowrie shells as payment rather than animal horns. Due to the lack of intrinsic value, community A merchant would fail to exchange animal horns with other community A peers. To continue healthy trade across communities, we took a step backward by using “Salt barter”.
We knew “Salt barter” was a temporary solution due to the “store-of-value” problems that accompanied such essential goods. We needed to find a commodity which everyone accepted, had an intrinsic value like salt, and would also robustly withstand changes in nature.
Then came metal.
Metal was “godsend”. Metal was robust against changes by nature, divisible by weight, difficult to acquire from nature, attractive and used to produce weapons, jewelry, vessels, etc. Who would say no to such a shiny multi-facet object?
Relative sizes of an 860 kg block of gold ore, and the 30 g of gold that can be extracted from it. Toi gold mine, Japan.
Metal achieved all goals, “Community agreed barter” and “Salt barter” set out to solve in the first place, until smart smiths discovered a lucrative workaround. The malleability aspect of metals provided effective divisibility by weight, but the same property was leveraged to counterfeit metals. Metals like gold, had more value, than metals like copper. Smart smiths counterfeited gold by mixing with cheap copper increasing the final weight, thereby increasing the value. Counterfeiting became a considerable problem, essential to be eradicated.
Kings saw a tremendous opportunity to gain economic control over their kingdoms using their current political power. They purposed a solution.
“The kingdom treasury will issue a coin. A coin is a round metal stamped with the king’s symbol along with the final price representing the round metal. Any entity counterfeiting the king’s symbol would be punishable by death.”
A Kuru punch-marked coin, circa 350–315 BC, one of the earliest example of coinage in India.
Electrum coin from Ephesus, 620–600 BC. Obverse: Forepart of stag. Reverse: Square incuse punch
Thus striking the beginning of centralized economic control. A slight deviation from the story, but I thought it would be wise to mention it in this portion. Bitcoin is decentralized, as well the form of monies used before the kingdom coins. Nature issued metals at a rate it desired, and Bitcoins are issued by the system at a codified rate. Since bitcoin is secured against counterfeiting by cryptographical proofs unlike metals, Bitcoin could have been the perfect form of money to substitute the kingdom issued coins.
But today the dollar is made out of paper, not gold. Why so, What happened to coin over the period of years?
The coin was the most sound form of medium of exchange we experienced, triggering coinage. Every kingdom issuing their coins flooded the world with many different coins ( even they experienced a fair share of initial coin offerings ). Due to the metallic property of each coin, a coin issued by kingdom A had value in kingdom B vice-versa. Trades between kingdoms boomed, and a rise in the global economy emerged.
Despite the soundness of the coin, new problems came under recognition. More wealth resulted in heavier weight in metals, the cost to transport wealth and cost to securely store wealth skyrocketed. The coin also had a volatile intrinsic value of a pure gold represented by weight. A coin holder would melt the gold coin worth 5 and sell the gold to the goldsmith for 6, creating 1 from thin-air ( volatile value attack ).
King’s metal coin dethroned by a piece of paper
Tang dynasty in China had an elegant solution to coins, “a piece of paper”. Paper was comparably light-weight solving transportation and storage issues, and an honest exchange for a fixed amount of gold weight from the treasury removed volatile value attacks.
Song Dynasty Jiaozi, the world’s earliest paper money.
“Paper money” had extrinsic enforcement of the value on a piece of paper by Kings, and intrinsic value to be redeemed back for gold. Today, we sugarcoat such a solution as “gold-standard”.
As Milton Friedman once said, “With money, there is a tendency of it to grow, for more and more of it to be produced”.
Kingdoms became empires, empires united to form countries. Now the federal reserve of each nation had the ability to print money equal to the amount of gold reserved. To stimulate a growing economy or tackle depression, there was a necessity to increase the quantity of money supply. The race to acquire more gold to print more money began.
Under a gold bullion standard, paper notes are convertible at a preset, fixed rate with gold bullion.
The difficulty in obtaining new gold prevented the printing of new money. The need to increase the quantity of money overruled the gold standard and 1:1 paper-to-gold reserve ratio collapsed. Fractional reserves became a norm to the gold standard, later discarded for the concept of fiat.
Today, we use fiat money as a legal tender. Fiat money has extrinsic enforcement and no intrinsic value. Federal reserve prevents counterfeits by advanced printing methods and manages the quantity of money. The dollar has more value than rupees simply due to the independent productivity of both the countries.
Federal Reserve money printing machine
The cost of printing new money for Federal reserve may be low, compared to the cost of acquiring new cowrie shells from nature. This surfaces a risk for the devaluation of the paper money with respect to goods and services over time, known as “inflation”. The cause of inflation is due to a sudden increase in the amount of money printed, the cure for inflation is to print less. We as citizens have assigned the Federal Reserve an impossible task to accurately measure the amount of new money needed to be supplied for a stable economy.
We have empirical evidence how unchecked control over the money supply can destroy economies, with inflation rates more than 500% in Chile and Argentina.
Argentina Inflation rate. credit: tradingeconomics.com
Chile Inflation rate. credit: tradingeconomics.com
Fiat money in hyperinflated countries such as Zimbabwe no longer serves the purpose of adequate store-of-value, hence citizens resorted to other intrinsic commodities for a store-of-value, such as a whiskey, mobile minutes, etc.
Zimbabwe banknotes ranging from 10 dollars to 100 billion dollars printed within a one-year period. The magnitude of the currency scalars signifies the extent of the hyperinflation.
The largest denomination of a Zimbabwean banknote (Z$100,000,000,000,000)
How do we keep centralized authorities such as Federal Reserve accounted for their actions?
Milton Freidman purposed a simple solution,
Federal Reserve must decide a rule, say an increase of 3~5% in money supply every year and honestly adhere to it.
Friedman strongly believed though such a rule would create unemployment as a side-effect in short-run, benefits in a long-run would be tremendous. While the reactionary increase in money supply ( as practiced today ) alleviates economy in short-run with adverse effects of higher unemployment and inflation in a long-run.
Friedrich Hayek instead had a radical alternative.
Allow an institution to create private money to compete against government-issued money, competition would act as an indirect force on the Federal Reserve to control their monetary policies. The citizen would be the decider, by choosing between government-issued money and private money based on empirical evidence of price stability.
Institutions, to issue such private money, had to overcome legal hurdles and faced the threat to be eradicated overnight by government authorities, due to a physical single point of failure. E-gold, a privately issued centralized currency redeemable for gold was shut down due to legal issues.
Single point of What?
Wei Dai in 1998 through his writings about bmoney, and Nick Szabo through bitgold in 2005 had conceived a novel idea of decentralized private money. Those theoretical concepts began to be codified around May 2007, by Satoshi Nakamoto. Nakamoto elegantly solved the Sybil attack problem faced by decentralized systems by using Adam Back’s hashcash, also known as proof-of-work, enabling a fully decentralized trust minimized monetary system. Nakamoto definitely understood deeply about the ways money could potentially evolve in society, thus motivated enough to build a working software.
The bitcoin network follows a codified monetary rule as law with fixed supply, no single authority can alter the monetary rule eliminating the reliance on centralized power such as a Federal Reserve.
But how sound is Bitcoin as private money?
Due to its decentralized issuance, such private money pays a high cost, of lacking intrinsic value similar to cowrie shells. Cowrie shells were only accepted within a community, bitcoin would also be accepted within a community that perceives bitcoin as valuable. The size of the community is variable, with the upper bound of the global population. Price of bitcoin, on the other hand, would be close to the cost of producing new bitcoins, similar to a commodity.
“Selling price of a commodity is higher than the cost of producing it, if the demand for the commodity drops, the incentive to produce the commodity would simultaneously drop.”
From a pessimistic point of view, if the price of bitcoin drops below the cost of producing the bitcoin, miners would no longer continue to mine, triggering a reduction in difficult of mining, making it profitable to mine once again. The price will take a hard hit. From an optimistic point of view, since the cost of producing the bitcoin rises, the price of bitcoin should follow the trend.
Will bitcoin stand the test of time?
The future is an uncertain place, people may merely speculate, but never predict. The safest prediction would be by 2030–2032 either bitcoin would have a massive volume of transactions or no transactions at all.
Bitcoin as my own subjective opinion, is a digital cowrie shell, no intrinsic value but accepted by a community as a form of medium of exchange. The same bitcoiners would need to resort to “Salt barter” ( USD ) to trade outside of the community. Bitcoin outdoes cowrie shell by having the property of enhanced divisibility and impossible to be counterfeited guaranteeing security through cryptography.
If bitcoin is the “Community agreed digital barter”, then what would be the “godsend” metal coins of the digital age?
I believe, its blockchain platforms such as Ethereum, EOS, Ziqilla, Harmony, xGovern, Cardano and directed acyclic graph technology platforms such as Constellation, Hedera Hashgraph. All these digital metals possess intrinsic value, allowing decentralized trust minimized applications to execute on top of them using smart contracts. Pure metals by themselves never were sound money, problems arising from digital metal are similar to the volatile attacks on historical pure metal coins. The value of such tokens ( digital metals ) would drastically increase or decrease relative to the speculative demand for the utility of such tokens.
Periodic table for Digital Metals
**So are we on a brink of repeating history by “Paper Money”?**Dai can be viewed as an example of “Paper Money”, which is a price stable coin backed by gold-like, Ethereum. Stability of Dai heavily relies on the lower volatility of Ethereum.
Even if “Paper Money” does succeed, we have experienced a failure of gold-standard to meet the rise in demand for more money. What’s next? What is the fiat of cryptocurrencies?
Reverse Robinhood
Few wise men would argue, “Aha! Supply is limited hence the price is volatile. If supply was elastic, the price would be comparably stable similar to fiat.” Nakamoto was fully aware of such a policy in 2009, what prevented such a policy to be codified in Bitcoin, was its reliance on a trusted party to inform the system about the price.
Nakamoto once said, “Indeed there is nobody to act as a central bank or federal reserve to adjust the money supply as the population of users grows. That would have required a trusted party to determine the value because I don’t know a way for software to know the real world value of things.”
Nakamoto dilemma of software to know the real world value of things was solved by Vitalik Buterin, the founder of Ethereum. Buterin in his free time came up with a solution called “Shelling points” to inform about external variables such as the price of coin to the system in a fully decentralized way. “Shelling points” could be an article of its own, for our purpose consider it as a trustless proven fact provided to the decentralized software system.
Now for the first time in history, we have reached a point where it could be possible to build a price stable monetary system, which can be utterly decentralized as promised by Nakamoto, always adhered to a rule-based policy as advocated by Friedman, privately issued to compete against the monopoly of government-issued currencies as dreamt about by Hayek.
But will we ever witness a real-valued stable privately issued currency?
All those fiat policies mimicking stable coin projects such as Basis, Havven, Reserve, Nubits can perform fancy tricks such as inflation, contraction, constant buy wall, continuous sell wall, artificial market manipulation, and yet fall short compared to fiat. The core reason is that they lack intrinsic value, and heavily rely on faith. Faith can be acceptable only when its blind, educated faith crumbles with the first sign of fear.
When dollars gets debased we revolt against the government, because we falsely believe about the responsibility of centralized authority such as Federal reserve to maintain price stability of dollars. In case of decentralized stable cryptocurrency experiments, there is no centralized authority, when the price goes south at the expense of poor coin holders of third world countries, who would they revolt against? Would we ironically turn our hands towards the government to clean up the mess left by those who dreamt to compete them?
On a finishing note, the cryptocurrencies that can come closest to compete against fiat money would be intrinsic value backed inflationary cryptocurrencies such as Ethereum, and its competitors. The volatility issue of them can be elegantly solved by value-redeemability.
As I once said, “The future is an uncertain place. I can merely speculate, but never predict”.
Anvay Rane
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