Money itself is not the problem. In fact, money is a solution to facilitating trade. On a large scale, trade would not be possible without money (Those in favour of anarchist communism might disagree with this statement but I will leave this discussion for another post). Money has three primary functions that makes trade possible. These are as follows.
- Medium of exchange
- Store of value
- Unit of account
Medium of exchange is necessary for goods and services to be exchanged. Store of value is necessary for people to be willing to possess and hold money. Unit of account is necessary for goods and services to be priced and compared using a common unit.
In order for money to perform these functions, it requires several characteristics. Different sources quote slightly different characteristics. I have seen lists ranging from 6 to 10 different characteristics. In this post, I will refer to the following 7 characteristics.
- Possess intrinsic value
- Limited supply
- History of acceptance
Source: Miles Franklin accessed on 16/08/2020
Matching functions with characteristics
For money to operate as a medium of exchange, it requires several of the above characteristics. Money needs to be convenient. People should be able to carry it on their person or be able to access it electronically. Money needs to be consistent in order to be recognised as holding the same value or else it cannot be relied upon as a medium of exchange. Money needs to have a history of acceptance or else it will not be recognised as a medium of exchange; this holds true even if all other characteristics are met.
For money to operate as a store of value, it requires several of the listed characteristics. Money needs to be durable or else its value will deteriorate with age. Money needs to possess intrinsic value to reliably validate its value and provide the holder with assurance it will retain its value. Money needs to be limited in supply and remain scarce. If it can be easily recreated, it will lose value quickly .
For money to operate as a unit of account, it requires several of the above characteristics. Money needs to divisible. Goods and services have different prices, money needs to be divisible for people to buy the exact amounts of everything they want. Money needs to be consistent. Every unit needs to represent the same value; otherwise, goods or services cannot be measured or compared.
What can serve as money?
We have assumed that money is necessary for trade and is required to fulfil three core functions. In order to fulfil those functions it requires several characteristics (seven are outlined in this post). However, we have not established what can be used as money. I believe there are three possible candidates. These are precious metals such as gold and silver, fiat money issued by Central Banks, and cryptocurrency. In Table 1, I have compared how I believe these three possible types of money fulfil the 7 characteristics described earlier in the post.
Table 1: Fulfilling characteristics of money
As can be seen from Table 1, none of the three possible types of money meets all 7 required characteristics of money. Gold lacks convenience, fiat money lacks intrinsic value and is not limited in supply, and cryptocurrency lacks acceptance and possibly intrinsic value. Which of these types of money better fulfils the three functions of medium of exchange, store of value and unit of account?
Gold and silver fulfils the roles of store of value and unit of account. However, lack of convenience is a big problem for gold and silver. Gold and silver are bulky physical assets that requires storage. It is not easy to carry on your person and is not particularly good for facilitating online trading. The gold standard helped with convenience as promissory notes were backed with gold. However, countries no longer use the gold standard. Instead, Central Bank issued fiat money is used as a medium of exchange.
In Table 1, for gold, I have included a question mark next to ‘Yes’ against possess intrinsic value. There is no doubt that gold and silver have intrinsic value but that intrinsic value may not be able to match its trading value if gold and silver are the most commonly used money. The supply of gold and silver is limited, which is good for maintaining it as a store of value but it is limited to such an extent that the increase in supply will fall very short of the increase in productivity. This will cause the price of gold and silver to become excessively high (i.e. highly deflationary).
Central Bank issued fiat money fulfils the roles of medium of exchange and unit of account. However, store of value is a big problem for fiat money. Fiat money has neither intrinsic value or limited supply. It is just paper or numbers on a screen and can be created at ease and in almost any quantity. The value of fiat money has not collapsed in many countries because of blind faith in banks and Government. This faith can be expected to be eroded as Central Banks and/or Governments are rapidly increasing money supply to stimulate the economy during economic crises.
Cryptocurrency fulfils the role of unit of account and partially the role of store of value. Many cryptocurrencies struggle to fulfil the role of store of value. This is partly because of lack of intrinsic value. This is not the case for all cryptocurrencies. Some cryptocurrencies have value from staking. For example the cryptocurrency Hive, staking Hive provides holders with influence in governance (i.e. witness voting as part of delegated proof of stake, influence in development (i.e. Hive proposals are selected through stake based voting), influence on reward distribution (i.e. voting of content through proof of brain). However, most cryptocurrencies are not widely accepted. Therefore, do not adequately perform the role of medium of exchange. Bitcoin is gaining popularity and acceptance with several businesses such as Whole Foods, Microsoft, and Starbucks (Buy Bitcoin Worldwide). In time, other cryptocurrencies are likely to gain broader acceptance; thus enabling more cryptocurrencies to perform the function of medium of exchange.
Another problem cryptocurrency faces is wide fluctuations in price. This is caused by the very small market capitalisation of most cryptocurrencies. Bitcoin has the largest market capitalisation and some of the smallest swings in price when compared to many other cryptocurrencies. According to coinmarketcap.com, over the past year, Bitcoin’s highest price has been approximately three times higher than its lowest price. See Figure 1 for fluctuations in the price of Bitcoin over a year.
Figure 1: Price of Bitcoin in 2019 and 2020
Source: Coin Gecko
Bitcoin is also likely to suffer the same problem as gold and silver in regards to being highly deflationary. The increase in supply of Bitcoin is halved approximately every 4 years. This places great pressure on the price of Bitcoin to rise in respect to fiat currencies. However, other cryptocurrency’s supply is coded differently and therefore might not be as deflationary in nature.
Prevent, Solve, or Manage
Throughout this series, I have been using the ‘prevent, solve, or manage’ approach to address problems and achieve outcomes. How can the ‘prevent, solve, or manage’ approach be applied to money? We can consider money in regards to its functions. ‘Prevent’ would be the prevention of the loss of these functions. ‘Solve’ would involve restoring the function if it is lost. ‘Manage’ would involve coping with money that does not fully perform its desired functions.
I would like to begin with ‘solve’ rather than prevent as none of three types of money (gold and silver, fiat money, and cryptocurrency) adequately performs all three functions described. Gold and silver struggles to perform the function of medium of exchange as it is inconvenient to transport and there are very few gold and silver backed currencies. Reintroducing the gold standard would help gold and silver regain its ability to be a medium of exchange but it would be highly deflationary because of its finite supply.
Central Bank issued fiat money struggles to perform the function of store of value. The only way fiat money can fulfil the function of store of value is if there is 100% trust that its value will not be eroded. This would only be possible if no central authority or body could change the flow of supply of the currency. This would remove existing monetary policy instruments from existing bodies. Adding intrinsic value to fiat money does not appear possible. However, assigning value from potential earnings or utility from stocks or bonds could be a creative method of claiming indirect intrinsic value of fiat money. This value is more linked to the investment itself than from the money used to acquire it.
Cryptocurrency struggles to perform the function of medium of exchange, as it not widely accepted as a medium of exchange. The problem that could gradually correct itself as more businesses accept cryptocurrencies. Cryptocurrency is also subject to wide fluctuations because of its low market capitalisation and extent of price speculation. If cryptocurrencies are commonly used and in the hands of more people, the market capitalisation will grow substantially. This will reduce the extent of price swings and therefore reduce speculation, which will further reduce price swings.
If we assume that cryptocurrency or some cryptocurrencies in particular become widely accepted and used, these cryptocurrencies would adequately perform all three functions. How do we prevent these cryptocurrencies from losing their ability to perform these functions? The function most vulnerable is likely to be store of value. Decentralisation is essential to maintaining a cryptocurrency as a store of value. If a cryptocurrency becomes centralised, its governance loses credibility. For example, the rate of increase in supply of cryptocurrency could be increased and directed towards particular people or causes. If the distribution and control over the cryptocurrency and blockchain is sufficiently decentralised, a person or groups of people cannot easily control it.
If a decentralised cryptocurrency achieves mass adaptation it should be able to adequately perform the three functions of money. However, if mass adaptation is not achieved by any decentralised cryptocurrency, we are likely to be left relying on Central Bank issued fiat money. Cryptocurrency faces considerable resistance from Governments and banks because it is a threat to their power structure. Cryptocurrency could replace many of the roles and services the current banking system provides. Blockchains could replace many of the roles of governments. Blockchain governance could replace parliamentary governance.
If Central Bank issued fiat money remains as the dominant form of money. Governments and banks would require significantly tighter regulation to maintain confidence in the fiat money as a store of value. This also seems unlikely as we would be trusting Government to regulate themselves and restrict their own power, which goes against the nature of those in power or will ever be in power.
Applying prevent, solve, or manage approach
I normally recommend favouring ‘prevent’ followed by ‘solve’ followed by ‘manage’. In the case of money, ‘solve’ needs to be the most desired step as none of the candidates to be called money adequately meet the three functions of money. I believe cryptocurrency is the closest to meeting the functions. The ‘solve’ approach requires mass adoption and acceptability. Once cryptocurrency or a cryptocurrency has achieved all three functions, we need to ‘prevent’ them from losing these functions. The biggest threats are centralisation of control and possibly lack of growth in utility of the coins and tokens. Maintaining decentralisation should prevent both if these from occurring. ‘Manage’ only becomes an approach if cryptocurrency fails and we are required to rely on fiat money.
- Money is required to facilitate the exchange of goods and services
- Money has three core functions:
o Medium of exchange
o Unit of account
o Store of value
- Money has between 6 and 10 characteristics which are required for it to fulfil its three core functions.
- There are many types of money; I believe the best candidates to be called money are gold and silver, fiat money, and cryptocurrency.
- Gold and silver fulfils the functions of store of value and unit of account.
- Some cryptocurrencies fulfil the functions of store of value and unit of account.
- Central Bank issued fiat money fulfils the functions of medium of exchange and unit of account.
- If mass adoption and acceptance can be obtained, decentralised cryptocurrencies are the most likely candidates to adequately fulfil the three functions.
- Governments and banks can be expected to always favour centralised issued and controlled fiat money as it gives them more power.
- The ‘prevent, solve, or manage’ approach can be best applied as ‘solve’ followed by ‘prevent’. ‘Manage’ should only be required if decentralised cryptocurrency or a cryptocurrency does not become accepted.
I could have approached this post in the context of trade. However, the topic of trade is too broad and has been covered, in part, in several of my other posts in this series. Money is essential to the existence of trade on a broad and large scale. However, if money does not adequately perform the three identified functions. Not only is trade hindered but also a host of other problems can occur. These include inflation, deflation, redistribution of wealth, asset security, and investment. Bitcoin, and several other cryptocurrencies offer the best opportunities to date with providing a form of money that could fulfil all three functions. A key advantage decentralised cryptocurrencies have over Central Bank issued fiat money is that trust is not required. Code changes require broad user consensus. Whereas, Central Banks or Governments do not require any user consensus or permission.
If you want to read any of my other posts, you can click on the links below. These links will lead you to posts containing my collection of works. These 'Collection of Works' posts have been updated to contain links to the Hive versions of my posts.