Understanding Money Is Key To Understanding Bitcoin

Only by reflecting on the fundamentals of how we transact can we understand what money is and how bitcoin is another evolution of money.

You might have heard or read this phrase before, as it gets stated often, but without many people realizing that it’s a misquote of the biblical “For the love of money is the root of all evil” (1 Timothy 6:10). This misquote is completely wrong. Money, the Bible asserts, “is the answer for all things” (Ecc 10:19) and therefore is one of, if not humanity’s greatest, inventions of all time.

Take a moment and try to imagine a world without money. Think about all the things you enjoy in your lives: watching movies, playing games, a house, a car, a meal at your favorite restaurant. It’s all possible because you can pay others for these goods and services in the form of money without needing to make these things by yourself. In the absence of money, you would have to participate in barter exchange which has a lot of complications involved in it.

In 2005, American novelist David Foster Wallace gave the commencement speech to the graduating class at Kenyon College. In his speech, he said, “There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says, “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”

It posits that how often we turn a blind eye to the things that are most important in our lives. There are things that are hidden in plain sight waiting to be discovered and a lot of people won’t even bother to figure them out. As an example, Native Americans had been using pottery wheels for 300 years before the invention of the wheel, but no one could ever think about turning the pottery wheel on its sides and using it as a wheelbarrow or wagon. It’s quite mind-boggling to think that it took us 300 years just to come up with the idea of turning the pottery wheel on its sides and using it as a wheelbarrow.

Just like fish had no idea of what water is, the majority of the population of the world today is clueless about money.

We work to earn money for our whole lives; we are taught at school to get a job and start earning money; our parents tell us to save money; a person is generally considered successful or otherwise depending on the amount of money he has. We talk and hear about money a lot, but we rarely ask the most basic questions: What is money at its core? What is the history of money? Why do we need money in the first place? Schools can teach us about all the nonsense that never gets implemented in our lives, but not about money.

Money is to the economy what oxygen is to our body. If I can deteriorate the quality of oxygen you intake, you will surely suffocate to death. Well, that’s what happened with our economy for the past 100 years and more. The Federal Reserve is in charge of the money we use and they have been devaluing our money at a slow pace until the start of 2020. Since March 2020, every government around the globe has been printing money like never before and we have just started seeing its effect as everything around us is getting a lot more expensive. Therefore, the question “What is Money?” is more important to ask today than ever before.

“It’s well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” – Henry Ford

With this quote from the great American industrialist, let’s go deep down the rabbit hole of money.

How Does Money Emerge?

Exchange, And Division Of Labor:

Exchange is the basis of every economy, meaning that there would be no economy if humans didn’t exchange goods and services with other beings. Humans are not self-sufficient; we always need other people to survive through our lives. We are all dependent on each other in one way or another. An exchange usually involves two persons or groups that give up what they value less to receive what they value more. For example, if Jack exchanges his shoes for a notebook with Shawn, this means that Jack values the notebook more than his shoes, and Shawn values shoes more than his notebook. From the process of exchange, the concept of division of labor came about which means that we can become more efficient if we divide work into smaller tasks and assign those tasks to different people depending upon what task they are specialized at. I know this is a bit complicated to wrap your head around, so let’s understand this by the beautiful example that Robert Breedlove provides in his article “Money, Bitcoin, And Time.”

He writes:

“If John makes axes faster than Steve, and Steve makes bows faster than John, then they both are better off by specializing and trading.”

Instead of making both tools by themselves, both John and Steve can work at the task that they are better at, and then exchange the goods with one another. It is mutually beneficial as it saves their time.

If there was no division of labor, there would be no need for money as we would only consume what we produce, and only produce for our consumption. This is called autarky where we are self-sufficient and need nobody for survival.

If we force a person to be self-sufficient, meaning we force him to grow his food rather than buying at the grocery store, make his fertilizers rather than buying from a factory, construct his own house instead of buying one, take drinking water out of the ground by himself without asking for anything from anyone, he will probably starve or freeze to death. The only way for him to survive is to buy food and fertilizers, hire house constructors, buy the necessary equipment to dig out the water, and for this, he needs money so that he can pay others with it. Now you might understand that exchange and division of labor are not only imperative for the economy, but for civilization as well.

Although exchanging goods with one another (barter, in other words) is better than self-sufficiency, it has its limitations. Direct exchange or barter works only among smaller groups of people and as the number of people involved in trade gets larger, this method doesn’t work because of lack of “coincidence of wants.”

Lack Of “Coincidence Of Wants”

This means that the person you want to trade with doesn’t want or need something you have to offer. This problem has three dimensions:

• Lack Of Coincidence Of Wants In Scales: If I hire 20 laborers to construct a house for me, how am I going to pay them after the house is built? With the pieces of my car? With the parts of the house? Or with the parts of material used? It is not practical.

• Lack Of Coincidence Of Wants Of Locations: Had I owned a cotton factory and wanted to exchange it with the iron mill located far away, this trade could not be possible because both the goods are immovable.

• Lack Of Coincidence Of Wants In Time Frames: If I want to buy a house and I only have bananas to offer, this trade would not occur because bananas are perishable and they would have been rotten before the deal could be reached.

Without any shadow of a doubt, barter or direct exchange of goods and services was a good idea initially, but suffered shortcomings as our trade networks expanded throughout history.

After trial and error, we discovered another way of trade, one that is completely different from the earlier one, and it is called an indirect exchange. In this way of trade, we use an intermediary good that helps us facilitate the trade rather than exchanging goods directly. Let me try to explain this with an example: Let’s say that Michael has a bunch of eggs and John has a pair of shoes. Michael wants to trade his eggs for a pair of shoes, but John doesn’t want eggs; John would prefer to have a bottle over eggs. So, for this trade to occur, Michael first has to exchange his eggs for a bottle and then exchange that bottle for a pair of shoes. In this example, Michael used the bottle as a medium to facilitate this trade. Therefore, the bottle served as a medium of exchange – which is the first function of money. Over a long enough time horizon, societies tend to converge towards a single medium of exchange, which is called their money.

In reality, this is the only way by which money can emerge into the marketplace, and this process takes time. Nobody can turn any useless thing into money and not even the government can produce a piece of paper and label it as “money.” To be clear, money and currency are not the same things. Money is something that is voluntarily selected by market actors to facilitate trade that is not possible with direct exchange, and on the other hand, the currency is something that is imposed by the government on its citizenry. Currencies are not selected voluntarily as a medium of exchange. Our governments force us to use their currency by legal tender and tax laws. For instance, the dollar we use today is not money, it is a currency. We did not select it as a medium of exchange by ourselves, it was the government that imposed it upon us. Money is the most liquid asset in the marketplace of all the goods, meaning that it can be converted into almost anything else you want – it’s called salability. You can convert it into a cup of coffee, a house, a car, and anything you want to have. The higher salability of a good means that it has higher chances of being chosen as money by the market.

Imagine you have 10 pounds of wheat and one telescope: which of these two has higher chances of being sold in the market first? You will find a buyer of wheat more easily than the buyer of the telescope, and at a fair price. This shows that wheat has higher salability in the marketplace than the telescope. The salability of any good deeply depends upon how well it addresses the three problems associated with the lack of coincidence of wants:

• Salability across scales: Money should be easily divided into further smaller units so that anyone can trade it in whatever quantity needed. Imagine two scenarios where money A can only be subdivided into four smaller units and money B which can be divided into 40 smaller units. In this case, money B is said to have higher salability across scales than money A.

• Salability across space: Money should be easily portable meaning that it should offer the least resistance while being sent from one place to another. A piece of paper can be easily transported as compared to a piece of rock; therefore, a piece of paper has higher salability across space.

• Salability across time: Money should hold or increase its purchasing power over time. In simpler words, the same amount of money should buy the same number of goods and services every year. This is not the case with dollars we use today; we need to spend more and more dollars every year just to maintain our standard of living. Therefore, the U.S. dollar’s salability across time is low.

Money has two main functions: medium of exchange and store of value. Its medium of exchange function is determined by how well it can solve the three-dimensional problem of lack of coincidence of wants. Its “store of value” function depends upon its salability across time, which is described above.

One might ask, ”Why does the money need to store value? Isn’t being a medium of exchange enough for money?”

Well, the answer to that question is: Humans live uncertain lives, and they can’t know how much money they might need in the future. That’s why we tend to save as much as we can so that saved money can help us navigate an uncertain future. What if the value of saved money keeps on falling with time, meaning it buys less and less stuff over time? It makes our future even more uncertain, which is contradictory to the whole point of saving money. Therefore, money must be a store of value along with a medium of exchange.

Historically, we have used lots of things as a medium of exchange; for example, sugar has been used in West Indies as money, as has salt in Abyssinia, copper in ancient Egypt, nails in Scotland, cattle in ancient Greece, and many more examples can be named. Eventually, they were all replaced by gold which proved to be a better form of money than anything else available at that point in history. Gold became the world’s reserve money because it addressed the problems that a true money needed to. Because gold could solve the lack of coincidence of wants, it served well as a medium of exchange; and it held its value over time, making for a good store of value. Therefore, it served both the functions of money better than anything used as money before it. It shows that if there’s anything that is a better medium of exchange and a better store of value, it will eventually replace all the monies and become the dominant money worldwide.

Value is always subjective, meaning that different people find value in different things and, therefore, choose different monies.

As Saifedean Ammous says in his book “The Bitcoin Standard,” 

“People’s choices are subjective, and so there are no ‘right’ and ‘wrong’ choices of money. There are, however, consequences to choices.”

What Should The Supply Of Money Be?

By this, I mean what amount of money should an economy have in circulation? In short, the supply of money doesn’t matter as long as it is fixed and divisible enough. You could run an entire economy on, let’s say, $1,000 or even $100 if the dollars are divisible enough so that everyone can participate in the economy. To understand it better, let’s imagine a country that has a population of 200 people and has only $100 in the entire economy, but those $100 cannot be divided into cents. This means that only 100 people can access $1 out of 200 people. What about the other 100 people? To fix this, we can make every dollar divisible into 100 cents, which means that there are a total of 10,000 cents in the economy. Now, everyone can have 50 cents, all we had to do was to make the money divisible enough so that everyone can get it.

If the supply of money is not fixed, it can’t hold its value across time. It will buy less and less over time due to inflation, which leads to a fall in the standard of living. This is the opposite with consumer goods and capital goods because as we increase their supply, productivity and standard of living go up. Think of how our productivity skyrocketed when we invented the computer, automobiles, mobile phones, and so much more. What if we increase the supply of money in an economy? Again, I will try to make it clear with an example. Let’s say a country has only 10 cars and it has $1,000 in the entire economy. What would the price of every single car be? Each car will cost $100. Now, let’s say the government prints $1,000 more out of thin air, bringing the total to $2,000. How much would each car cost now? It would take $200 to buy the same car that once only needed $100 before the government printed an additional $1,000. What I am trying to make you understand is that money is the only commodity on this planet whose supply, when increased, causes the standard of living to fall. Therefore, money printing and standard of living are inversely correlated.

Hard Money Vs Soft Money

Let’s first make these terms clear. Hard money is one that is hard to produce. This kind of money is the most resistant to inflation or debasement, because nobody can increase its supply easily.

Whereas, soft money is something whose production is easy, meaning their supply can be increased easily, almost infinitely. Soft money leads to erosion of purchasing power.

Naturally, the market favors the one which is hard and rejects the soft one. That’s why we chose gold as money, not copper because gold is hard to take out of the ground (resistant to inflation) and copper can be easily produced (loss in purchasing power).

There’s a metric we use to know which money is harder than others, called stock-to-flow, which measures the hardness of money by dividing its existing stock (or supply) with yearly production. As an example, the total supply of gold that’s above the ground is approximately 197,000 tons (existing stock), and around 3,000 tons of gold are mined every year (flow). Therefore, gold has a stock-to-flow ratio of approximately 65 (197,000/3,000). In comparison, the total supply of copper around the world is about 700 million metric tons, with around 20 million metric tons mined every year. Thus, it has a stock-to-flow ratio of 35, which is lower than that of gold. It indicates that gold is hard money as compared to copper, and copper is soft money as compared to gold.

Of all the metals, gold emerged as money because it had the highest stock-to-flow ratio. The long-term consequences of ignoring the hard money are horrific. When it became quite obvious that gold plays the role of money better than any other metal, the majority of the western world adopted it as money. But some countries kept using silver (soft money) as money instead of gold (hard money), and sadly, India was one of them. Today, it is clear that the western world is much more advanced than India because Westerners were storing their wealth in the hardest money available (gold), and Indians were storing their wealth in soft money compared to gold. To put it simply, if you don’t store your wealth in the hardest money available, you will lose the game irrespective of how hard you play.

"You can’t insulate yourself from the consequences of others holding money that is harder than yours." – Saifedean Ammous, “The Bitcoin Standard”

Properties Of Money:

Have you ever thought about why we cannot choose any random thing like a chair, or a table, etc., and call it money? Anything can become money as long as it meets the five main properties that market actors look for while voluntarily selecting something as money. Never let anybody tell you that money has to be in the paper form like we use today. If there’s something – no matter in which form – that possesses five monetary properties, there’s more than a 99% chance that it will eventually be selected as dominant money and replace the old money. Let’s dive into those five properties:

• Divisibility: A good form of money has to be divisible enough so that it can be traded with ease, and for almost everything. That’s why we don’t use cars or something big as money, because they are not divisible

• Durability: Money can’t rot or deteriorate or it will lose value. We don’t use oranges as money because they rot over time.

• Portability: Money has to be easily transportable, which means easily portable from one place to another. We can’t use factories as money.

• Recognizability: It’s easy to recognize whether the units of money you have are real or fake. That’s why dollar notes have the signature of the head of the central bank. Also, with minimal training and effort, one can differentiate between real and counterfeit gold bars.

• Scarcity: This is the most important property that any money can exhibit. It means that money’s supply should be fixed and hard to produce more of. All the other properties can be exhibited by a lot of different things, but the thing that has this property of scarcity ends up being money. Seashells were used as money because they were hard to find (scarce), but with technological breakthroughs, we found cheap and easy methods to find seashells which led to the decrease in their value and eventually they collapsed as money. Those who stored their wealth in seashells suffered the most and it teaches us a lesson that we must always – without any excuse – store our wealth in something that has a fixed supply, or one that is difficult to increase (a high stock-to-flow ratio). Government-issued fiat currencies are the complete opposite of this, as they can create as much as they want with the press of a button. This property of money demands a different essay which I will write about at some time in the future.

Just to understand how important scarcity is: Silver is better at divisibility than gold, silver is more easily portable than gold, but there was one property that any other metal didn’t have except gold, and it was scarcity. Although silver was better at other properties than gold, it still didn’t become money because it was not scarce, which shows how important scarcity is.

Just like the modality of language kept changing over time – first spoken, then written and typed nowadays – but its motive remained the same: to communicate and express our views, the motive of money remains the same – to store and exchange value – but its modality keeps on changing like language. So, you should never be influenced by people who say money has to be in one form or another, it can be in any form as long as it has monetary properties.

I hope that by now you have a bit clearer understanding of what money is and why it is important for humanity.

You might be wondering that even though government currencies do not fill the criteria for being money, then why do we use them? How did we go from using gold as money to paper currencies? Was it by force? Were the paper currencies better than gold? We will uncover a lot more of these topics in the next essay, until then, keep learning, keep growing.

Resources:

• “Money, Bitcoin And Time” by Robert Breedlove.
• “What Has The Government Done To Our Money?” by Murray N. Rothbard.
• “The Bitcoin Standard” by Dr. Saifedean Ammous.

This is a guest post by Harwinderpal Singh. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

Read more: https://bitcoinmagazine.com/business/understanding-money-is-key-to-bitcoin

Text source: Bitcoin Magazine: Bitcoin News, Articles, Charts,