To get a full understanding of why crypto is truly revolutionary, we first have to understand what money actually is. Nowadays, we take the concept of money for granted. Whenever you look at your bank account balance, you know exactly how much money you have. But do you ever take the time to think about what money actually is, where it comes from, where its value is derived from, and how it’s created today?
In this article, we’ll explore what money is in four parts.
- How money evolved throughout history
- What ‘’fiat’’ money is
- The properties of money and their limits
- The contrast between modern money systems and cryptocurrencies
Without further ado, let’s get straight into it.
How money evolved throughout history
Money plays an important role and is such a fundamental part of our everyday lives, yet most people have no clue how it works.
Money is a technology that was invented by humans to facilitate economic activity. Hence we use it to make payments and repay debts. There are different kinds of money in economics. For simplicity’s sake, we will cover three types of money in this guide: commodity money, representative money, and fiat money.
Commodity money is what was primarily used in pre-industrial civilizations. There are many examples of this type of money, such as rare precious metals, like gold and silver, which were used as coins. Apart from precious metals, humans also conducted transactions with sea shells, barley, grain, and salt.
We say that commodity money has intrinsic value because of the material it is made of or whether you can do something with it, like consuming it as food. Some commodities also have intrinsic value because they can be used to fabricate something else. A simple example is the use of cigarettes as a bartering system or money in prisons.
As civilizations modernized, we realized that commodity money has its limits and becomes progressively harder to use. For this reason, we’ve replaced it with a new form of money; representative money.
If you’re of a certain age, you might remember a time when paper money was backed by gold reserves. Back in those days, you could walk into a bank with a $100 bill and walk out with the equivalent in gold. This was the era of the so-called gold standard, and paper bills were mere representative currencies. A representative currency is a stand-in for a commodity and makes it easier to use on a day-to-day basis.
In the 40 years which followed the Second World War, new economic policies backed by the US and its allies were introduced. As a result, governments around the world got rid of the gold standard.
Nowadays, there is not a single nation that has a gold-backed currency. Although many people believe that their money is backed by something of value, this isn’t the case.
Ever since the abolition of the gold standard, we’ve used fiat money. The US Dollar, Euro, and Japanese Yen are all examples of fiat currencies. Within this guide, we’ll mention the term ‘’fiat’’ frequently, so be sure to remember this.
What is fiat money?
In a fiat money system, the value of money is based on governments declaring it as legal tender. This means that economic transactions within fiat money systems are enforced by law. For example, by making it unlawful not to accept the currency or by making it the only way one can pay his or her taxes.
As we mentioned before, fiat currencies aren’t fully backed by a reserve commodity like gold. The value of fiat currencies is derived from the issuing country’s government promises and monetary policies.
These currencies then retain their value through the stability of the government and the national economy. Currencies like the United States Dollar, which have a strong and stable government and economy, see their value appreciate relative to currencies of less stable countries and economies.
Every time you use paper money, national coins, or some digital equivalent, for example, by using a credit or debit card, you’re using fiat.
Even though today’s paper money looks very similar to the gold-backed paper money we used in the past, it is, in fact, very different. When we had representative currencies, the amount of national currency in circulation was closely coupled with that country’s gold reserves.
With fiat currencies, central banks control the issuance of money through policy decisions. The most recent example is the COVID pandemic. During this crisis, central banks around the world expanded the money supply to prevent a massive financial crisis.
When you think of printing money, this might bring up images of huge machines minting new bills. In today’s digital economy, there’s less and less cash in circulation. In most modern economies, cash represents less than 20% of the total amount of money in circulation. Most of the money that gets created today ends up as numbers in bank databases.
Central banks decide to increase or decrease the money supply by assessing key metrics such as:
- The strength of the economy
- Current inflation levels
- Unemployment rates
- Supply and demand
They have different tools at their disposal to do this, which we’ll cover in a different guide.
How do banks create money?
In short, central banks create money by either lending it to commercial banks or by buying government bonds from commercial banks. The result of either of these operations is that commercial banks have more money on their books. This money is then used to lend to people so that they can buy houses or cars or to businesses so that they can invest in factories, computers, or raise the salaries of their employees.
Whenever you hear about central banks reducing interest rates, this is to stimulate the economy by making it cheaper to borrow money and thereby encouraging people and businesses to spend.
Now that you know the different types of money and how fiat money is created, it’s time to discuss how they are used.
How is Money Used?
People and organizations have different uses when it comes to money. Money basically serves three functions: a medium of exchange, an accountancy unit, and a store of value.
- Medium of Exchange – This simply means money can be used between people and businesses to purchase goods and services. Whenever you buy something with money, it acts as a medium of exchange.
- Store of Value – When you save money for a rainy day or for future projects, you’re using it as a store of value. By putting money into a savings account, there’s a sense that you can store it and that, at some point in the future, you will be able to retrieve it whilst it has remained at its value.
- Accountancy Unit – Money serves as a way for everyone to agree on a certain value of goods and services. An accountancy unit has to be divisible in smaller units like cents, easy to count, and has to be equivalent to any other unit of the same currency. This last part means that every dollar is equal to another dollar. They have the same value and are interchangeable, which is called fungible. Although a dollar is fungible with another dollar, it isn’t fungible with a Canadian dollar, a gram of gold, or a bag of rice.
Gold as a store of value
Gold may be the best store of value as it maintains its value over time. Ancient civilizations used gold to pay for things centuries ago, which means it can perfectly be used as a medium of exchange. However, can you imagine paying for things online with gold?
Nowadays, gold isn’t a great medium of exchange and certainly not an accountancy unit because no one prices things in gold. What can we conclude? That gold is a pretty good store of value, but it isn’t that great as a medium of exchange and an even worse accountancy unit.
Fiat currencies as a store of value
If you live in the United States, dollars are a great medium of exchange because they’re widely accepted, and there’s wide adoption of digital payment systems in USD. They’re also great accountancy units because everything is priced in them. However, are dollars, or other fiat currencies for that matter, a good store of value?
In the last decades, things have become increasingly more expensive, which means purchasing power has decreased. A simple way to look at this is to consider how much groceries you could buy with $100 in the year 2000 versus today. Depending on where you live, it’s probably close to half the amount.
Why fiat currencies lose value
In the last 20 years, central banks have created more money than ever before. Ever since the 2008 financial crisis, the world’s biggest economies have tripled the amount of money in circulation.
In the US, 40% of all dollars in existence have been created since the beginning of the pandemic.
But what does this mean for you as a consumer or taxpayer? It means your money is worth a whole lot less. When you look at your bank account and see $1,000, even if that number stays the same, the value of that money decreases over time. This is the result of inflation. Just like a balloon, the amount of money in the system is inflating while people’s savings remain flat.
We all suffer from inflation in our day-to-day lives as everything is getting more expensive yearly. Unless your salary is increasing, you will be able to do less with the money you earn. This is inflation at work, and every national currency across the globe has been steadily inflating for the last decades.
Inflation is an invisible tax on your savings. The worst part? The poor and middle class are getting the short end of the stick. Wealthy people are usually less affected by inflation. This is because the wealthy have better access to investments that appreciate in value over time, such as stocks and real estate.
This has created an even wider gap between those with a lot of money and the shrinking middle class. This disparity in opportunity is compounded in the US by the fact that certain types of investments are legally reserved for those with a certain amount of wealth, also known as accredited investors.
Cryptocurrencies as an alternative money system
Cryptocurrencies offer an alternative to the fiat money system and its weaknesses. Earlier in this article, we learned that central banks control the issuance of money by making decisions based on economic events and indicators. Cryptocurrencies are also governed by monetary policies, but the rules which govern the issuance of cryptocurrencies, like the issuance of what pace they are issued, are totally programmed in.
Let’s take Bitcoin as an example. As of writing this guide, 6.5 Bitcoins are created for every block, which takes about 10 minutes. In the spring of 2024, this will be cut in half. After another four years, it will be cut in half again. These are the rules of Bitcoin and its built-in monetary policy.
Different cryptocurrencies have different rules regarding their monetary policy, but most major cryptocurrencies have the following things in common:
- Their monetary policy is transparent, meaning everyone can see its rules.
- It’s highly predictable, meaning that we can predict to a certain extent how much money there will ever exist in the system at any given time in the future.
- There isn’t a single person or group of people that can decide to create more Bitcoin than the system is programmed to allow.
The rules are built-in and programmed to execute only as expected. For this reason, cryptocurrencies are very different from central-issued fiat currencies with no clear or enforceable rules. As a result, a pandemic, war, or the wrong people in charge can be the catalyst for massive inflation, of which there have been countless examples in human history and even in our lifetimes.
Our current understanding of money is based on concepts that have existed in human civilization for millennia, and cryptocurrencies are challenging some of the most fundamental concepts which govern money.
Cryptocurrencies are powerful tools of empowerment and innovation. Just like the internet has empowered people all over the world by enabling access to information and more opportunities to learn and connect, crypto is giving people access to a new form of money that isn’t controlled by politics and is, therefore, so revolutionary.
The bottom line is that cryptocurrencies enable better access to financial services and opportunities for billions of people across the globe.