By Oleg Andreev
Friday, June 28, 2013
We all know that variety and competion is a good thing. We all want
slightly different things, value the same things differently or make
different trade-offs. That’s why we have a wide variety of products,
prices, quality, colors and materials on the market. Interestingly,
money is different. We all want one single universal money. It may not be obvious to many people, so let me explain.
How money is different from everything else? On one hand, money is
just an asset. You can produce, buy, sell or hold it. On the other hand,
money is a medium of exchange. It allows you to trade your 8 hours in
the office for a new iPhone. It also allows you to delay consumption
decision. You can spend 8 hours of work today, but then be free to
decide when and for what to spend your salary. If suddenly you need to
buy a ticket to Hong Kong, you can do it without working extra couple of
hours to earn it.
The function of money is to exchange the widest variety of products between each other.
iTunes credits allow you to choose between many songs. This make them
money to some degree. But dollars are even better money because they can
buy all those songs, but also a myriad of other things as well.
Therefore, people tend to keep savings in dollars, not in iTunes
It seems obvious that the best money is the cheapest and the most widely recognized and accepted one. Cheapest in a sense of handling it. If your money is a huge stone you
have to carry around, it is more expensive than a small gold coin
(provided they both have the same price in terms of goods they can buy).
Piece of paper named “gold certificate” could be even cheaper than gold
itself, but carries a risk of fraud, so in some cases it could be even
more expensive to hold than the gold itself.
For a huge part of the civilized human history we used two metals as
money: gold and silver. They were not perfect, but universally accepted
and recognized. All other things like seashells, diamonds, IOU papers
were less universally recognized, so they were naturally used in some
very niche markets while everyone was keeping cash in gold or silver.
Both gold and silver were durable, easy verify, easy to cut and melt
together, compact enough to be stored and moved around cheaply. And they
were very hard to obtain, so there was very low inflation cost (every
new gram of gold created eats into everyone’s savings because it
increases purchasing power of its owner comparing to everyone else
around). Other things were either easy to produce, or not durable, or
hard to split in arbitrary parts.
Why gold did not outcompete silver? Or vice versa? That’s because they both had weight.
For small purchases gold would have to be split in tiny difficult to
handle pieces, while to make big purchases one would need to move
several kilograms of silver comparing to much smaller amount of gold.
This naturally created two parallel global markets: one for small
purchases where the silver was used (and small droplets of gold would be
impossible to handle) and another market for big purchases where silver
was too heavy, so the gold was used instead.
Make a thought experiment now: if there was a gold-like metal that
allowed moving both big and small amounts equally cheaply, it would be
useful on both “small” and “big” markets. Thus it would be more marketable
(more exchangeable) which by definition would make it a better money.
Better than gold and better than silver. People would then tend to keep
their cash in that magic metal because it would allow them access to
bigger variety of goods: from bread to houses. And they would not lose
money on conversion rate like when they sell some silver for gold or the
other way around.
There was a competition in private coinage. Kings and private
merchants were making their own coins in gold and silver and selling
them for premium. The well-recognized coin was easier store and to
verify if you trust the issuer. Instead of measuring each coin, you
could simply read the number on its face. Names like “dollar”, “pound
sterling” and others were all names for private coins or bullion and
meant particular weight of the metal. That is, dollar was not some sort of separate money, it was simply a name
for a certain amount of silver, like “gram” or “ounce”. The money was
still the same — gold or silver, but there was a big variety of shapes
of that money.
Of course, gold and silver were still quite limited. You could not
drop a bag of gold across the ocean. That’s why people invented banking.
Bank was simply a warehouse for your metal. You give them gold, they
give you a receipt. Then, if the bank had good reputation and
connections with other banks in the world, you could transfer those
receipts of any face value quite cheaply anywhere. The only real cost
was trust in those banks. Because if the bank is robbed or steals your
metal, your receipt becomes worthless. If the bank prints additional
receipts for the same amount of metal, the value of your receipt goes
down proportionally (or you face a risk of bank run, when more people try to redeem their receipts than is available in the vault).
In old days, private currencies were simply those receipts for gold
or silver. Each currency could have different name and different
reputation. Bigger bank’s notes had more value on the market because
they had less risk associated with them and as a result, wider
acceptance. But ultimately, they all were receipts for the same metals
that you could redeem at any time and move to any bank or under a
mattress. Because people valued receipts only for their ability to
represent readily accessible metal. Without the metal, those pieces of
paper would be worthless.
Today things are different. After several huge economic disasters
created by the governments of Russia, Europe and U.S. in the beginning
of 20th century, we now have state-issued money in almost every country
with a nice twist that now the money is not redeemable for metals.
People use that money, though, because various controls and regulations
make it almost impossible to use gold, silver or respective certificates
in daily transactions. Every bank needs expensive license and must not
be very creative at what it can offer to its clients.
Dollars can buy things in U.S., euros can buy things in E.U., but if
you try to use them in inappropriate places, you would have to pay very
high conversion fees. (Setting up your own clearing house or exchange
with the lowest fees is not possible due to regulation.) It should be
clear now that if, for instance, U.S. Dollar can buy more than Russian
Ruble, Russians would tend to use Dollars in daily life. The reason why
it does not happen anymore (it used to during liberal times in the
1990s) is stricter controls on currency exchange that make it illegal to
price goods in dollars and expensive to exchange currencies frequently.
For the same reason, gold and silver are not used: they are too
expensive or illegal in some contexts, or there is a huge risk and cost
on those who are going to store them. Several years ago, Liberty Dollar,
alternative silver-based currency was shut down and all silver was
confiscated by U.S. government. Founder was pronounced guilty of
“making, possessing, and selling his own currency”.
Here we do not discuss whether it is good or moral to make your own
currency or store other people’s money. The point is about demand for a
single, most universally accepted money. If gold, silver and foreign
currencies need violent intervention to not be used, it’s only a proof
of existing demand. Because if there was no natural demand, no
government would care setting up restrictions in the first place.
Now we enter crypto-currencies. It is a fancy name for Bitcoin and
its many clones based on the same source code. Bitcoin itself is very
different to ubiquitous government money, application-specific “credits”
(like in multiplayer games) or gold and silver. It is absolutely
digital, does not have a single controlling entity and is very cheap to
store and transfer both huge and tiny amounts of money. This property
makes Bitcoin very useful on certain markets: be it illegal market, or
“sending money to family in another country”, or a market where banking
is unavailable or too expensive.
What about alternative Bitcoin-like currencies? They all provide the
same security risks and benefits. Nominally, they all have different
divisibility (so called “larger number of coins”), but at the scale of
trillions of smallest units in total money supply extra divisibility
does not really matter.
Economically, all Bitcoin clones (altcoins) have the same problem:
they all have much smaller market exposure than Bitcoin while not
technically superior. When people decide in which one to keep their
money, they would keep it in the money with the biggest market. There is
not point in “diversification” in the long term. If Bitcoin fails for
some reason, all its clones fail for the same reason automatically. If
Bitcoin works well, any amount in altcoins is simply inferior in its
purchasing power. It does not mean there won’t be any market. You can
always keep some empty plastic bottles for selling later, but the
bottles can only buy cash, while cash can buy anything.
Second problem of alt coins is mining. In the long term, any miner
will throw 100% of computing resources into the most profitable
currency. Even if Bitcoin is only 1% more profitable than Litecoin,
since there is no fundamental difference between them, all the resources
will be thrown into Bitcoin. In the short term, there are plenty of
enthusiasts who find themselves equipped with a lot of outdated GPU
hardware that was once used for Bitcoin, but now cannot compete with
specialized ASIC hardware. These people now mine Litecoin in short-term
expectation for any amount of reward. It is sort of a private club of
people trading in their own funny money. All new miners devote all their
energy to Bitcoin, while people who will sell or retire their GPUs will
make Litecoin network weaker and less technically stable.
In the end, it is clear that we want the single money to be able to
sell anything and buy anything. We all want it to be cheap to store,
move and verify. And secure. With as little trust in middlemen as
possible. Today we find ourselves with a lot of artificial barricades in
the sphere of money, which causes artificial demand for various local
currencies. Gold is being seized or moved from the country. Foreign
currency is prohibited for merchants to price their goods at. Legal
tender laws force you to accept government-issued currency as a payment
Regulations and licensing limit variety of private currencies
or money substitutes. But all that trouble only proves almost universal
desire to use the single virtual entity for buying food and saving for
the future. Bitcoin gives us a mechanism to overcome all these
regulations and trade as freely as was ever possible. Maybe it will
allow us to achieve that single, most marketable entity that we all so
Reprinted with permission.