Modern money for modern markets – Part II

by | Jul 6, 2018

The nature of money

We’ve already looked at how USD Vault (USDV) works, why gold-based currencies appeared and began to understand what different needs modern crypto markets have. Now, it’s time to explore what few economists dared question – what is exactly money? We all use it, we all think about it, but do we understand its nature?

Note, however, that this is a dangerous endeavor. Karl Marx once joked that William Gladstone, a British Prime Minister, “observed that even love has not turned more men into fools than has meditation upon the nature of money.” So keep reading at your own peril. They say money doesn’t buy happiness, but we’re sure financial knowledge won’t hurt.

The key difference between money and currency

Let’s start by settling the difference between money and currency, as there’s a lack of good definitions out there and plenty of confusion. In brief, money is any ownable thing that is both widely considered as valuable, as well as widely accepted in exchange for something else. Put simply, money is an asset that can be used to make payments.

More specifically, within the prevalent ‘commodity theory,’ money is the ultimate asset – one that is exchangeable for all others. Within the opposing ‘claim theory,’ money is debt – it’s a promise to pay that is independent of form and is able to cancel the said debt, thus linking the definition of money to the existence of an authority that can enforce it.

Currency is a term that is often used interchangeably with money, but that is better defined as a subset that encompasses its physical or virtual representations. To clarify, while money is purely a social construct – because we trust such assets to be valuable, whether or not they have an intrinsic value – currency exists outside our collective minds, either as a material token or as an electronic account of what we deem to be money.

To further explain the difference between the terms, etymologically currency comes from the Latin currens: that which is moving. So coins and notes in circulation are currency as they represent a more liquid portion of the money supply. But the money one has in a savings account isn’t currency until it is transferred into a checkings account.

This is key to analyze cryptocurrencies because regardless of their name these projects can be money. In this case, the digital representation of the protocol is the currency, while the money is the collective confidence in the value of its properties – such as security, uncensorability, a predictable supply, divisibility, fungibility, or even privacy.

Why is it important that money is able to store value?

Now that distinction is clear, let’s continue to analyze what is money. As introduced in Part I, a popular textbook definitions define money as anything that a) stores value over the long term, b) is a unit of account for such value and c) facilitates exchanges between willing individuals.

This is a simplistic model, but, for now, it’s a useful framework to understand how cryptocurrencies can become money.  So, what drives the belief something is a good store of value? The main drivers for an asset to survive depreciation are the lack of direct utility, durability, and unforgeability. Naturally, stability is a desired consequence of these.

This comes from the fact money didn’t originate to solve the double coincidence of wants in a barter economy – in such hypothetical scenario anything useful, perishable, and forgeable can be used as payment, as it would be more efficient than barter. There must have been something else involved in the emergence of our collective belief in money.

How did money come to store value?

The most persuasive argument is that money originated in hunter-gatherer tribes, with archaeological accounts dating early forms of currency from at least 100,000 years ago. Why and how? You might have known shells, ivory beads or jewelry were among the earliest forms of money, but their primary use was not to facilitate trade.

Instead, as laid out by Nick Szabo – a well-regarded cryptographer, scientist, and legal scholar – these were used to solve problems of cooperation among the members of those tribes. The important takeaway is that “the primary and ultimate evolutionary function of primitive money was as a medium for storing and transferring wealth”.

Unmistakably, some transfers of wealth represented trade, but the most important uses for original money – or collectibles – were inheritance, settling disputes, tribute – in essence, an early form of taxation – and marriage. In brief, by reducing “the need for favour-tracking”, money replaced reputation and promoted reciprocal altruism between tribes.

These meant collectibles shared key attributes that justified humans considering them a store value. They should be wearable, durable and compact, to ensure it could be safely carried or stored for large periods of time, and they should be evidently costly to find or make, in order to guarantee it couldn’t be easily forged and therefore devalued.

In a nutshell, this means the value of a collectible depends on its stable scarcity. That’s why useless objects were the first to be desired as money – the useful ones were being used. Then, those wearable and compact objects which survived the test of time – such as gold due to its inert properties – became the most prevalent stores of value.

Is scarcity a key aspect of a store of value?

What about scarcity? Limited supply has always been key in positively influencing the value of things, but it’s more important if one expects an asset to increase in value rather than to store value – assuming an increase in demand. In the case of money, it’s only important that it is able to maintain its purchasing power over large periods of time.

By definition, money is the most liquid store of value, but different types of money are better stores of value than others. And even the same money, gold included, might be considered a good store of value in one day and a poor one in the next. In this regard, it’s important to remind that purchasing power must be adjusted for changes in real wages.

Critics of fiat currency are right in noting governments around the world have a reckless record of debasing their countries’ money through excessive supply which can lead to hyperinflation. However, whenever they point out that the U.S. dollar has lost over 95% of its value over the past 100 years they fail to account for the equivalent increase in income.

In addition, such comparisons – popularised in Ron Paul’s ‘Money Illusion’ book, also conveniently forget that if those idle dollars are removed out of currency and applied in treasury bills, bonds or stocks, then the same money that some deem to be a poor store of value increases its purchasing power, even considering minimal returns.

In the case of cryptocurrency, scarcity is driving speculation – as those who believe demand for this new form of money will increase expect prices to appreciate given most projects’ fixed monetary policy. But it’s also a legitimate source of value as most projects are created to enable its users to resist governmental manipulation of the money supply.

Looking Ahead

Now that we’ve covered how and why money is considered a Store of Value, we can look ahead to understanding the function money serves as a Unit of Account. After all – where’s the fun in having “Money” if there’s no way of knowing just HOW MUCH you have. We’ll see you in Part 3…