Money?

After I wrote my last post On Consumption, it sparked several lively responses and conversations with friends regarding the nature of money. I’ve been reading the works of David Graeber over the past few years and recently finished Debt: The First 5000 Years, which tackled the historical dimensions of debt, credit, money and power through an anthropological lens. It led me to revisit the definitions of money as proffered by the various schools of economic thought. I was reminded that something we take for granted in our day-to-day lives still lacks an academic consensus: what money is or should be.

While there’s obviously no shortage of practical financial advice for the individual — and popular economists for the past forty five years have written much about economic policy, GDP, inflation, interest rates, debt and the balance of international trade — the fundamental concept of money is either glossed over as obvious, or framed in the current practical context of financial markets operating in terms of fiat currencies relative to the US dollar as the dominant currency issuance for global trade. It’s not unlike stopping a game of chess to talk about the pawn pieces. Why? It’s easy to assume that the game pieces and rules governing those pieces are less important than the game. We can change the rules. We’ve done it many times. As an old friend once said, “most people are local thinkers.” It’s impractical to think about grand systems when we have our own financial futures to worry about. However, several fascinating trends are simultaneously emerging in the world of finance and economics: Protectionism, Modern Monetary Theory, Cryptocurrency and BRICS.

The question I keep coming back to is whether the system of money we use today is working and if there are better alternatives on the horizon? There’s great public interest in the potential of cryptocurrency. One can’t look at the Internet without seeing headlines about its endless growth potential or immanent collapse, controversial scams or scandalous schemes involving shady people who were heralded as innovators merely months before. The lure of easy money has a very strong appeal.

People often ask, is cryptocurrency real money, a commodity, a speculative asset, a safe investment, a hedge against inflation, an alternative to centralized banking, a digital equivalent to gold or a new technology to replace banks? Perhaps the answers are yes and maybe. The more relevant question from the perspective of technology (and I consider all forms of money a type of technology) is what can we do with it for the betterment of society?

When people use something as a medium of exchange, it becomes money. If people were to begin accepting glass beads as payment for most goods and services, glass beads would be money. Cigarettes make an appearance throughout history as an alternative money when other systems of money break down or are unavailable. There’s good evidence that something like this has existed in most cultures for millennia. Even without a practical form of portable currency, peoples have probably always found various ways of accounting for credits and debts, simply because barter constrains economic operations in obvious ways, requiring a “double coincidence of wants“. If I only grow apples, I’m faced with the problem that if the blacksmith doesn’t want or need apples, it will require an inconvenient process of multilateral exchange for me to get an iron skillet for my apples. Barter has always been an option, but it’s doubtful that it was ever the only option.

The fact is we don’t really know when and where money originated but there’s evidence of it everywhere in archaeology. No ethnographic studies have shown that any present or past society has used barter without any other medium of exchange or measurement, and anthropologists have found no evidence that money actually emerged from barter.

Thus, money is usually categorized as money of account (debits, claims and credits on ledgers) and money of exchange (tangible media of exchange made from clay, leather, paper, bamboo, metal, etc.).

Metal?

Classical economists and their modern descendants in the Austrian tradition aren’t terribly interested in “the money question” prior to what’s called metallism, or a commodity-based money made of scarce metal, usually gold or silver. This school of thought favors the supply and price dynamics of metallism, using the phrase “sound money” — a double entendre referencing the sound that pure gold or silver coin makes when someone bounces it off a hard surface. From their perspective, money works best when it is directly tied to a foundational commodity of finite supply and cite the gold standard in the 19th century as (literally) the golden age of money.

Metallism is considered advantageous by the Austrian school for many of the same reasons that people today like the concept of Bitcoin — the foundation is decentralized and exchange is possible internationally, outside of the institutional banking systems. Private financial entities may operate independently, even issuing some form of IOU or investment share with reasonable fractional reserves to honor redemption.

Since 1971, the world has been operating on a fiat money system: inconvertible paper and coin money made legal tender by a government decree. As long as I’ve been alive there have been folks who don’t like this arrangement and want to see a return to a currency system that is backed by something finite like gold. These days there is talk of a respectable and established cryptocurrency like Bitcoin evolving to serve that role, ostensibly without the downsides of gold, because it’s a digital technology that has a predictable supply forecast that precious metals do not and features inherent decentralized transactional integrity as part of the proposed whitepaper specification published by Satoshi Nakamoto in 2009. Thus, assuming electricity, computer systems and network connectivity, Bitcoin meets almost all the basic criteria for money: general acceptability, portability, durability, divisibility and homogeneity. What it has failed to achieve to date is stability. Bitcoin’s short life as an asset has been speculative and volatile.

But if cryptocurrencies like Bitcoin are already fully functional currencies that don’t require a central authority to broker viable transactions, then why back an existing currency with another form of money? Wouldn’t that eliminate the advantage of decentralization? Yes it would, but much like gold, Bitcoin, while being divisible and transactable, is proving to be much more popular as an investment asset class rather than a practical replacement for daily legal tender. Bitcoin has slowly established institutional credibility and that is likely to continue. Furthermore, the synthesis of government issued currency with Bitcoin would potentially offer the benefits of both to the consumer: wider adoption, greater flexibility in portable denominations, interest-bearing credit, fractional reserve banking, greater stability, protections like FDIC insurance and perhaps most importantly from the perspective of advocates, a common foundation across global currencies that remains decentralized and beholden to no government authority, thus allowing for true free trade. There’s nothing stopping any entity from holding Bitcoin in a private wallet and trading it internationally on any market, just like gold, but without the shipping.

“I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A.“
– Milton Friedman in 1991

Could looking back on the pros and cons of the gold standard help us understand the potential application of crypto-backed currencies? While crypto is not gold, the principles and market dynamics of all historic currencies pegged to a fixed supply asset are nonetheless fundamentally similar. The money supply was backed by precious metals for significant periods of global history. The United States and most countries were bimetallic, minting or backing currencies with gold or silver throughout the 18th and 19th century.

• The international classical gold standard commenced in 1873 after the German Empire transitioned from the silver North German thaler and South German gulden to the German gold mark. This transition by a large European economy triggered a switch to gold by several European countries in the and the US in the 1870s.
• In 1863, during The Civil War, the National Currency Act allowed banks to issue standardized money certificates that were used as a legal claim on their metallic property, or as a dollar equivalent currency.
• The Coinage Act of 1873 or Mint Act of 1873 was a general revision of laws relating to the Mint of the United States. By ending the right of holders of silver bullion to have it coined into standard silver dollars, while allowing holders of gold to continue to have their bullion made into money, the act created a gold standard by default. It also authorized a Trade dollar, with limited legal tender, intended for export, mainly to Asia.
• Following The Panic of 1873, The Specie Payment Resumption Act of January 14, 1875 restored the nation to the gold standard which helped stabilize the money supply but prolonged a deep depression.
• The Gold Standard Act signed by President William McKinley on March 14, 1900 defined the United States dollar by gold weight and required the United States Treasury to redeem, on demand and in gold coin only, paper currency.

This “golden age” of metallism had no federal reserve bank and saw numerous boom and bust cycles leading to bank runs, bank failures, and evisceration of fortunes if it happened to be your bank that failed. During the rapid expansion of industrialization, speculative bubbles would lead to inflation, a bust and then a period of precipitous deflation that cleared out bad investments and recalibrated the market. It was often brutal but fair. Unlike today where currency is consistently inflationary over time (what Keynsians would consider a good pro-growth attribute) metal-backed dollars oscillated in relation to supply and demand dynamics in the market but maintained a relatively stable mean value over time.

The classical era of money was quite different than what we know today. Bankruptcy laws were not favorable to debtors until the passage of the Bankruptcy Act of 1898. There was no FDIC, no central bank to control money supply, no social safety net and thus poverty and starvation were ubiquitous, economic inequality extreme and it was common for people and institutions to hoard gold much like crypto investors hoard bitcoin today. The Panic of 1873 saw the longest depression of the 19th century with unemployment rates as high as 25% in many areas. Railroads and large corporations failed and Wall Street closed for ten days. Even after the establishment of the Federal Reserve, The Great Depression of 1929 followed a speculative bubble that collapsed into a liquidity “death spiral” — something many argue would not happen with today’s modern central banking systems acting as lenders (or bailers) of last resort.

The demise of the gold standard was a gradual process over the course of the 20th century through a series of historical failures and monetary reforms, starting with Woodrow Wilson’s Federal Reserve Act of 1913 to establish a backstop to bank runs, the massive spending required to fund WWI, the Great Depression leading congress to pass the Glass-Steagall Act in 1933, establish the FDIC, and required bank holding companies to be examined by the Fed. Roosevelt also issued Executive Order 6102 in 1933, which outlawed the holding of more than $100 of gold or gold certificates to stop the hoarding of gold and restore public faith in the dollar.

Following The Second World War, the Bretton-Woods agreement established an era of stability in the global financial system by making the gold-backed US dollar the reserve currency of the world’s largest global trading partners until US deficit spending on space, military and social welfare programs through the 1960s led to a lack of confidence among the allies and Richard Nixon’s unilateral cancellation of the direct international convertibility of the United States dollar to gold in 1971. While this did not formally abolish Bretton Woods and maintained the dollar’s status as the world’s reserve currency, it rendered it practically inoperative and currency exchange rates were no longer a principal means of monetary policy for sovereign governments.

We’ve been living in an era of modern fiat monetary systems since, where ever-more sophisticated networked currency markets determine the exchange rates of global currencies. Sovereign governments may choose to pursue a fixed exchange rate against the dollar and implement monetary policy (printing money and setting interest rates) but as a result must forego control of capital flows in and out of their country due to what’s called “the impossible trilemma.” Governments like to keep their exchange rate stable so that import and export prices are predictable. They also like to control interest rates so they can keep borrowers happy without upsetting savers. Moreover, they like to let money flow in and out of their country without causing disruption. Unfortunately, they can’t do all three at once without dire consequences, so usually they opt to let their currency “float” on the FOREX or foreign exchange market.

Put quite simply, this is not theoretical, it’s the operational reality of global finance today, and while nothing is perfect, it has many advantages over the gold standard or backing a currency with something like a cryptocurrency.

Modern Monetary Operations

Modern Monetary Theory, a “heterodox” neo-chartalist view of economics turns classical economic theory on its head, noting that the operational realities of fiat systems open up an entirely new way of looking at economic policy that while controversial, have influenced governments around the world in an age of ballooning national debt.

In many ways, Modern Monetary Theory observes the same realities that John Maynard Keynes described in his 1940 pamphlet, How To Pay for The War and how many countries like Great Britain, The United States, Germany and Japan conducted their economic policies during and after the Second World War when Keynsian theory emerged as the dominant ideology in national economic policy.

Modern Monetary Theory’s main tenets are that a government that issues its own fiat money:

• Can pay for goods, services, and financial assets without a need to first collect money in the form of taxes or debt issuance in advance of such purchases.
• Cannot be forced to default on debt denominated in its own currency
• Is limited in its money creation and purchases only by inflation, which accelerates once the real resources (labor, capital and natural resources) of the economy are utilized at full employment
• Should strengthen automatic stabilizers to control demand-pull inflation, rather than relying upon discretionary tax changes
• Issues bonds as a monetary policy device, rather than as a funding device
• Uses taxation to provide the fiscal space to spend without causing inflation and also to give a value to the currency. Taxation is not to fund the spending of a currency-issuing government, but without it no real spending is possible.

This perspective seems backwards to most classical economists, but the proponents of MMT claim they are not arguing for a change in financial policy, but simply observing the operational realities as they have existed for over fifty years. In fact, the MMT movement emerged not out of the ivory towers of major universities, but from a successful hedge fund manager named Warren Mosler challenging a group of academics on an economics USENET group (an early Internet discussion system) who proceeded with research and various models that couldn’t refute his claims. So basically, MMT was started by a guy working on Wall Street who had the gall to point out that most academic economists are in denial of the way that the global financial system made of “soft” money actually works.

Floating currencies today act as shock absorbers for international trade, naturally rising and falling in value as the economies they represent experience boom and bust cycles. When an economy faces a downturn, its currency depreciates in foreign exchange markets, making its exports more competitive globally and bolstering domestic industries. Conversely, a booming economy sees its currency appreciate, allowing for increased foreign investments, which theoretically benefits other economies.

Fixed currencies disrupt this self-correcting mechanism, potentially leading to economic instability. Under the Bretton Woods system, the US dollar was uniquely pegged to gold and several other currencies. In a floating exchange model like we have today, a strong US economy would have led to an appreciating dollar, but the peg system prevented this, allowing other countries to stockpile undervalued American dollars. This minor cost secured the US dollar as the global reserve currency, yielding significant long-term benefits.

The situation reversed in the late 1960s when high borrowing levels to fund the Vietnam War and domestic issues weakened the US economy. Typically, this would have devalued the dollar, aiding American exports and mitigating economic turmoil. However, pegged rates prevented this. Bretton Woods nations perceived the dollar as overvalued and opted to exchange their American reserves for physical gold, particularly France. This move caused two major issues: reduced American economic influence, as holding gold instead of dollars diminished US control over the global medium of exchange, and the depletion of America’s gold reserves, which could not sustain unlimited transfers.

Crypto Backed Currencies?

Despite its perception as an outdated relic, commodity-backed currencies do have potential advantages. It simplifies foreign trade, as something like Bitcoin is universally fungible. Nations on a crypto standard can trade without worrying about currency fluctuations. This, however, doesn’t necessarily improve trade on a global scale, but offers individual convenience.

Commodity-based currencies do carry significant risks. If confidence in the availability of crypto reserves wanes, a rush to withdraw could rapidly deplete reserves. France’s exchange of US dollars for gold highlighted this vulnerability, prompting the US to suspend and eventually eliminate the gold standard to prevent a catastrophic collapse.

A crypto standard also has the potential to curb financial repression, where savers earn interest below inflation rates, effectively transferring wealth from savers to borrowers. We’ve seen this growing phenomenon over the past twenty years and especially as we witnessed investors hoover up dollars pumped into global markets after the pandemic stimulus programs by every major world government. Severe financial repression can act as an invisible tax on responsible savers, something a crypto standard prevents by backing money with an asset.

Moreover, a crypto-backed currency offers price stability, limiting reckless money printing. However, this stability is theoretical and historical analysis of the gold standard doesn’t indicate this would necessarily hold true. Modern fiat currency systems, like the current Federal Reserve model, use interest rate adjustments and asset trading to maintain price stability. While not perfect, this method offers far more flexibility than a asset-backed standard, which ties a central bank’s actions to asset reserves, potentially misaligning economic needs.

Historically, the gold standard’s rigidity contributed to the Great Depression’s severity, as central banks prioritized gold reserves over economic stability. Conversely, post-2008’s quantitative easing focused on price stability and economic stimulus, avoiding a repeat of the 1930s. Despite the detractors, Ben Bernanke spent his career studying The Great Depression, and took a page directly from Milton Friedman’s analysis that during the great depression the Federal Reserve could have provided liquidity as the lender of last resort by aggressive bond acquisition on the open market.

The 1970s and 1980s inflation, often cited against the gold standard’s abolition, resulted from delayed inflation, low interest rates, expensive wars, and oil price shocks, not from abandoning the gold standard. Economists largely agree that the departure from the gold standard wasn’t the root cause.

Ultimately, while the possibility of a crypto standard has merits, its limitations and the flexibility of fiat systems suggest it’s not a panacea for economic stability.

Where Hard-Backed Currencies Fall Short

The adoption of a cryto-backed standard poses significant challenges due to the unequal distribution of the core asset worldwide. Early adopters have first-mover advantage, leaving other nations reliant on these countries. Obtaining the asset could involve undesirable methods such as investment into quantum hacking, increased cyber pillaging or adopting mercantilist trade practices—exporting as much as possible while minimizing imports to accumulate. This would disrupt economies, especially the US, which is already grappling with large trade deficits.

Another issue is the valuation of any asset to serve as a viable backing. For the US to implement a fully crypto-backed system, the price of the asset would need to increase to provide reserves to back all dollars at current market rates — something that is absolutely plausible. However, such an artificially high asset price would lead to arbitrage, where traders could exchange dollars for crypto, sell the crypto abroad for other currencies, and profit from the difference, quickly undermining the system.

A more practical and likely approach would be a fractional reserve crypto standard, where only a portion of crypto reserves backs a given currency. However, even this requires a significant increase in value, shifting trust from fiat currency to the Federal Reserve to prevent bank runs.

Crypto backed currencies also impact the potential for economic growth. As economies expand, the money supply should grow accordingly to facilitate increased production and consumption. If the money supply is restricted to crypto reserves, it could lead to rampant deflation or limit economic growth due to insufficient liquidity.

Historical data shows that America’s economy grew significantly faster after abandoning the gold standard. From 1951 to 1971, the US GDP tripled from $336 billion to $1.1 trillion, and from 1971 to 1991, it grew sixfold to $6.1 trillion. Factors such as unrestricted trade, flexible monetary policy, and inflation, which encourage spending, contributed to this growth, creating an environment an asset-backed monetary standard could not support.

The most critical flaw of the gold standard was its failure to achieve its intended stability. While the idea of money being backed by a fixed asset is appealing, today’s money derives its value from global markets rather than physical backing.

The real challenges of such “hard backed” monetary schemes are related to inelasticity and deflation. All markets need adequate amounts of price-stable currency to issue credit and continue to function. Crypto-standard banking systems, whether public or private, will inevitably require networks operating on an inverted pyramid of fractional reserves at each level, where the actual amount of fiat currency is multiplied from a fixed stock of hard currency to meet the demand of liquidity and circulation. For example, a central bank may hold a fractional reserve of hard currency and its subsidiaries in turn hold a fractional reserve of the central reserve notes backed by hard currency. However, the entire system is elastic up to the defined limits of the fractional reserves. This encourages fiscal responsibility but puts significant and unnecessary constraints on lending and thus growth.

It’s a common myth that the 1923 hyperinflation in Germany led to the rise of Fascism and the Second World War in Europe. That’s only half of the story. After six years of price stability under a gold price peg to counteract inflation, it was the severe deflation of the early 1930s that pushed Germany into a very deep depression with massive unemployment. A desperate German electorate turned to an autocratic solution. Mild inflation is arguably pro-growth and high inflation is obviously bad as it reduces spending power, but severe or extended deflation is typically a hallmark of a depression because outstanding debts become more expensive to repay, and can easily trigger a liquidity trap and debt-spiral.

During the gold standard era, price stability was still a significant problem and liquidity traps could bring spending to a crawl, spiraled into bank runs, bank failures and recessions or depressions where there were no levers to restart the spending/employment cycle. The causes of the great depressions of 1873 and 1929 have been studied and debated endlessly, but the fundamental proof of Milton Friedman’s liquidity solution has been arguably demonstrated somewhat effective since 2008, when Ben Bernanke implemented unprecedented levels of quantitative easing, where the Federal Reserve Bank buys bonds on the open market to provide desperately needed liquidity.

Governments’ response to the unprecedented COVID-19 crisis further demonstrated that government debt fiat spending directly to businesses and consumers could provide the liquidity required to not only avert total financial collapse, but result in an utterly astonishing soft landing. It’s possible that further WW2 style intervention in the form of temporary price controls, capital gains taxes or an immediate increase in short term interest rates could have also mitigated the two most deleterious side effects: inflation (as a result of sudden flood of M2) and rampant equity price speculation (by making treasury bonds and private savings products more competitive to stocks as retail investors flocked to invest “free” dollars in the market). The government could have even issued a new attractive short term high-interest instrument called something like Recovery Bonds to encourage saving, much like the War Bond programs in the 1940s.

The Power Of FOREX

Finally, if there’s one major force stopping the adoption of crypto-backed currencies today, it’s the colossal power of FOREX, or the currency exchange markets. Currency exchange markets emerged in the late 19th century, but it wasn’t until the collapse of the Bretton-Woods system with Nixon that this financial juggernaut was born.

Despite the absence of a centralized exchange, the FOREX market today boasts an estimated daily market cap of $6.6 trillion. In 2020, the global Forex market was valued at $2.4 quadrillion, making it the largest financial market in the world. By comparison, the stock market has a total market cap of about $80 trillion, while the global bond market sits at around $100 trillion.

This colossal FOREX market is driven by the immense volume of daily currency trades. The market operates 24 hours a day, five days a week, with continuous global transactions fueling this staggering value.

High leverage availability also contributes to the FOREX market cap. Leverage enables traders to control large positions with minimal capital. For instance, a trader with $1,000 might control a $100,000 position using leverage, allowing for significant profits or losses from even small market movements.

The FOREX market cap is further influenced by economic and political factors. Currency values fluctuate based on interest rates, economic growth, inflation, and political stability, affecting currency demand and market value.

A key feature of the FOREX market is its high liquidity, ensuring there is always a buyer and seller for every currency pair. This liquidity facilitates easy entry and exit for traders and reduces the likelihood of market manipulation, contrasting with the stock market.

The Bond Market

It’s impossible to understand the FOREX market and global trade independent of the bond market. Government bond yields act as an indicator of the overall direction of the country’s interest rates and expectations. A rising yield is dollar bullish. A falling yield is dollar bearish. A bond’s yield is rising or falling based on interest rate expectations or market uncertainty and a “flight to safety” with capital flowing from risky assets like stocks to less risky assets like bonds. Bond yields serve as an excellent indicator of the strength of a nation’s stock market, which increases the demand for the nation’s currency.

Economic Amnesia

As we’ve seen, the Federal Reserve can conduct open market operations by buying or selling treasury bonds and other securities to control the money supply. With these transactions, the Fed can expand or contract the amount of money in the banking system and drive short-term interest rates lower or higher depending on the objectives of its monetary policy. Open market operations have played a key part in navigating recent economic downturns including the 2008 Global Financial Crisis and the COVID-19 recession. People naturally downplay disasters that never happen, and it strikes me as odd that modern monetary operations just averted what should have been the greatest financial disaster since The Great Depression. Not only did smart modern monetary policy avert catastrophe, but the US stock markets more or less rallied through it and job growth exploded once restrictions were lifted and demand was unleashed. For the first time in my lifetime, US demand experienced dramatic supply constraints that led to price increases, which underlined the strategic weaknesses of offshoring and globalized supply chains. We successfully pulled off an unprecedented “soft landing” with the “minor discomfort” of price inflation. Utterly astonishing. Yet the average American remains mostly oblivious to this success. This is precisely the moment where, according to modern monetary policy, four things should typically happen:

• Taxes on the wealthiest could be increased to modest levels to balance the budget to appease the bond market vigilantes and more importantly reduce inflation, which is absolutely essential.
• Industrial policy in the form of tax incentives and spending should develop high value industries and infrastructure to be competitive in domestic and global markets.
• Trade barriers with key competitors and allies should be managed in a focused way to protect the re-constitution of strategic industry and provide a balance against the damage done by 45 years of what many pejoratively call neoliberal economic policy. Trade protections are best wielded like a scalpel, not a sledgehammer.
• Government programs and their bureaucracies should be reformed and optimized.

These moves will impact global trade in myriad ways, perhaps the most important being the strengthening of BRICS. With reduced access to US markets, export-driven competitors will be forced to find other markets for their goods in emerging economies that are less credit worthy and where financing is lacking. China in particular will either be forced to become a major alternative financier to create new markets or face decades of stagnation like Japan experienced after the Plaza Accord of 1985. China is not dependent on the US protections Japan was in the 80s, so there’s no reason to think that Beijing will follow suit.

China’s Digital Currency

China is well on the way to developing a fully digital currency called the e-yuan or RMB that, despite involving blockchain technology, is credit fiat and trades privacy for wallet limits by capping a wallet tied to nothing more a phone number to under 1,500 USD (at the time of this writing), which is quite a generous balance for the average person living in an emerging economy that has access to mobile phones but no reliable banking system. Mobile phone providers and their payment stations essentially become micro-bank branches in the villages of the developing world. China will mine the data of these “low income” populations with relative anonymity to extend lines of microcredit. Higher wallet limits require proof of identification and must be linked to a formal bank account. Master wallets can be created with sub-wallets with limits and rules, which could be exploited for any hierarchical arrangement from families to businesses. This can be used as an Orwellian digital lending and currency system throughout China’s Belt and Road Initiative to track the credit worthiness of wealthier individuals, much like the existing private credit agency networks throughout the world that people voluntarily participate in to fuel their debt consumption. And of course China is free to change these rules at any point as they see fit. Chinese finance has tremendous potential to become market makers for their low cost export goods. A centrally planned economic power like China should not be underestimated and could achieve this, all while utilizing low-carbon technology.