In recent years there has been a significant increase in the value of cryptocurrencies, particularly ‘Bitcoin’. Cryptocurrencies are units of value which are used to verify the transfer of funds independently of a central bank. They are based on secure encryption techniques and are seen by many as the way forward. Before we can understand the assumed need for cryptocurrencies we need to assess the current monetary system and the history of its development. Money like crytocurrencies is a medium of exchange, but before money was invented we used the bartering system.
The bartering system is a method of trade where goods and services are traded for other goods and services instead of for money. The value of goods and services compared to the value of the goods or services for which it is being traded, is subjective and based on the parties involved. The bartering system was introduced by Mesopotamia tribes and adopted by the Phoenicians. this method of trade dates back to 6000 BC (1). The system was improved by the Babylonians. Roman soldiers were paid with salt as it was a very valuable commodity. It is interesting to note that the bartering system was used during the Great Depression of the 1930s due to the lack of money (1).
Bartering has the advantage of flexibility as items traded do not have to be consistent. on one day a cow can be traded for 2 goats while on another day a cow can be traded for a service. The system however suffers as there is no trade protection. Defected items can be exchanged without prior knowledge. Trade may also be unfair to one party or even impossible and goods may not be divisible to allow for fair trade, for example trading a chicken for a turkey. Portability of goods being exchanged was also a major limitation.
The bartering system formed the basis of trade which gave rise to the invention of money. Initially value was placed in gold and silver and they became a medium of exchange. The Greek state of Lydia introduced the first old coin in 560 BC (2). The use of gold quickly spread and the gold Ducat introduced by Venice became the most popular coin for half a millennium. Silver came into use when the bimetallic monetary system emerged in 19th century America. The USA didn’t authorize the printing of paper until 1861. Paper money became a sort of receipt to represent gold owned in the bank as paper money was backed by gold. The Bretton Woods agreement, in 1946 fixed the price of gold at $35 when the USD became backed by gold (2).
So why did the bartering system end? Why was paper money introduced?
There are several features of money that must be satisfied for efficient exchange. Money must be:
- Widely accepted
- The same for equal unit values
- Easy to Identify (3)
This made it more practical to have paper money as a representation of value.
This seems to be a good enough system but there is a significant problem. Who controls the money? Not the government! The central bank does. This bank can freely print money and loan it to the government and has the power to cause or prevent inflation. In 1971 the USD was taken off the gold standard, meaning it was no longer backed by gold. The money is then called fiat currency and its use is completely based on trust. The currencies of all central banks are backed by the USD but the USD is backed by nothing. Unlike the case of the gold standard, money is now very unstable. Gold is valuable because there is limited quantity in existence. This forced stability. But now that money is not backed by gold and can be freely printed, its supply is not limited making it much less valuable (4).
How is money created?
When the government needs more money than it receives from taxes it asks the treasury for money. The treasury then receives a bond (IOU) from the government. The treasury then gives this bond to =the federal reserve through the banks. The federal reserve then writes a cheque for the bond and gives it to the bank, which then hands it to the government. At this point money is created as the federal reserve writes the cheque with no existing money to back it (4). Another example is the credit card, a bank issues a credit card which allows you to spend money you don’t have, this money literally comes from nowhere as it is not drawn from another person’s account. you repay this debt with interest and as a result the bank creates money. It is legal as they create the system and please note that this is not run by the government. We therefore have a debt based monetary system as increasing debt is needed for the creation of money.
What would be the issue with having a decentralized monetary system not controlled by any one individual? Wouldn’t it be amazing to have a system in which the supply of money is limited and not subject to inflation? Well Bitcoin appears to have the solution. In the next installment we will explore the new method of accounting for transactions using cryptography.
Aldeam Facey 2018