There is one thing that today’s global, tech-savvy economy cannot function without: money. Though modern currencies would be unrecognizable to past generations, the need for and purpose of money are unchanged. From commodities to bitcoins, currencies have evolved throughout the ages. But new forms of money come with new problems. A lesson in the history of money provides useful context for evaluating the benefits and limitations of new currencies.
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What is “money”?
In the Ascent of Money, Niall Ferguson defines money as trust inscribed, whether on metal or paper. Its worth is derived from its scarcity and the belief in its exchangeability for desired goods and services. Money has taken many forms throughout the centuries from commodities, to coins, to bills and bonds, but its three main functions, as a medium of exchange, a unit of account, and a store of value, have remained the same.
- Medium of exchange: People accept money in trade for goods and services
- Unit of account: The value of a good or service can be measured with money. For example, a car with a price of $2,000 is worth twice as much as a car with a price of $1,000
- Store of value: Money can be saved and used in the future.
But must money be tangible to have value? The emergence of virtual currencies, such as bitcoin, is challenging the traditional concept of money as a physical medium of exchange. Bitcoin cannot be held or touched, yet it has considerable worth. Investor exuberance surrounding this new currency is reminiscent of bubbles past, when a herd mentality drove asset prices beyond fundamental justification. A consideration of the evolution of money provides valuable lessons to consider when assessing the value and viability of new-age currencies.
The shape of money has changed significantly throughout the ages
The evolution of money
It was not until 1970 that the gold standard was replaced with today’s fiduciary system
Early paper currency represented a specified amount of a precious metal. From 1792 to 1862, the United States had a bimetallic standard, in which gold and silver were used to define the monetary unit. The first government notes not backed by the metals, known as “greenbacks”, were issued in 1862, as fiscal pressures from the Civil War mounted. After the war, Congress was determined to restore the metallic standard, and succeeded in doing so by 1879, but this time with a single metal: gold. The gold standard ended in 1933, after a series of bank runs and subsequent bank failures during the prior 3 years. The Federal Reserve was unable to provide sufficient liquidity to enable banks to meet their customers’ demands. This was, in part, because of the gold standard, which limited its ability to create more money. A quasi gold standard was introduced in 1944 at Bretton Woods. This was an international monetary agreement that created a system of fixed exchange that allowed governments’ central banks to sell their gold to the United States Treasury at a fixed price. This system eventually became impossible to maintain as countries struggled to maintain the value of their currencies relative to the dollar and gold. Finally, in 1971, under the Nixon Administration, the link between major world currencies and gold was severed.
Modern currency operates on a fiduciary system, meaning that the value of a dollar is derived either from government fiat or from the belief that the paper will be accepted by another party in exchange for goods and services. There is risk to a faith-based system: changes in beliefs in the authority of the government or the transferability of currency may have dramatic impacts on value. After all, trust is fragile. Government regulation helps ensure that money is a consistent standard and store of value. The U.S. Constitution gives Congress the power “to coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures.” To this end, one of the Federal Reserve’s responsibilities is to maintain the integrity of the US currency by setting monetary policy to keep prices stable. Modern-day cash, therefore, represents trust that dollars held in hand today can be used to purchase a similar amount of goods and services in the future.
A new form of money: virtual currencies
The involvement of central banks in the monetary system provides protection and stability, but comes with a loss of freedom and confidentiality. With this in mind, the creators of bitcoin set out to develop an anonymous, unfettered exchange system. While bitcoin is a medium of exchange, it clearly does not possess the other two properties of money (unit of account and store of value). Some well-respected investors, including Warren Buffet, and even the Internal Revenue Service, argue that bitcoin should not be considered “money” at all. Unlike traditional currencies, bitcoin’s intrinsic value is difficult to define. It is not a commodity; it is not a precious metal; it is not necessarily trust inscribed, either. Bitcoin is intended to function as a fiduciary currency; however, the absence of governance weakens confidence in its enduring representation of value. The value of virtual currency is dependent on controlling its creation and preventing duplication and double-spending. Instead of a central bank, bitcoin has a self-regulating, universal ledger of transactions, which starts with the currency’s creator and ends with the current owner. The fact that all potential recipients can verify past transactions and validate new ones is the source of confidence in bitcoin as a store of value. But faith in this system can easily be broken, especially as it is new and poorly understood. Hackers have been able to exploit loopholes in the technology, leading to massive theft, and ultimately bankrupting Mt. Gox, a leading bitcoin exchange.
Bitcoin’s rapid price appreciation is reminiscent of tulip mania
Curiously, news of colossal theft at Mt. Gox only moderately shook the price of bitcoins, adding to the conundrum of valuing this elusive currency. Unlike its counterparts, bitcoin is an asset without fundamentals, which puts a rational pricing model out of reach. Professor David Yermack, of NYU Stern School of Business agrees, drawing a parallel to financial assets:
“If you invest in a stock, there is a company paying dividends that supports the value of a stock. If you invest in a government bond, you have the government’s promise to pay interest; with bitcoin, all you really have is hope.”
If history is any guide, there is danger in irrational pricing for intrinsically worthless assets. Recall the tulip mania in the 1630s, the first asset bubble, when the value of a single tulip bulb plummeted from the equivalent of an entire estate to that of an onion. Behind this hysteria was the concept of scarcity. A limited supply has underpinned the value of money in all its forms, and bitcoin is no exception. Similarly, bitcoins are created through a complicated process called “mining”, which involves using computers to solve a difficult mathematical problem to add coins to the system. A limit of 21 million coins has been set, which is expected to be reached by 2040.8 But scarcity is not the only reason for the wild fluctuation in bitcoin prices. (Figure 1) The price of bitcoin is driven largely by speculation about its potential to become a broadly accepted currency.
It can be argued that bitcoin is similar to one of the longest-standing speculative forms of money: gold. Bitcoin is difficult to “mine”, can’t be replicated, and has experienced sentiment-driven price appreciation. Just as the gold standard failed due to supply constraints, bitcoin’s strict limit of 21 million coins may make it impossible to keep up with a growing economy. Also, similar to gold, bitcoin’s price fluctuations make it an unstable unit of account. (Figure 2) While no longer the base of the US monetary system, gold has survived as a store of value and perceived safe-haven asset for investors. So, are bitcoins the next gold? Not necessarily; there are several crucial differences between the virtual and metallic coins. Gold can be stored and transported, while bitcoin could easily disappear due to a technological glitch. Gold at least has some inherent value – for jewelry and industrial purposes – albeit not in line with its price; bitcoin is merely a string of numbers in cyberspace. Finally, gold has gained investors’ trust over the years as a durable representation of value, whereas bitcoin is a new phenomenon with no such track record.
Virtual currencies are likely here to stay
The viability of virtual currencies is subject to much debate. While there are many kinks to iron out, ranging from regulation and fraud prevention to valuation and taxation, it appears we are on the precipice of another revolutionary change in money. Looking back in history, we reasonably can surmise that the concept of paper money, backed by trust instead of gold, was difficult to fathom. Today’s digital currencies are complex and ripe with risk, but they arguably are the start of a new end state in the long term. The money of tomorrow will more likely exist in cyberspace than in our pockets.