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The Story of Inflation and Hyperinflation
People don’t think much about currency; they just use it. They don’t notice a currency holding its value; they only notice when it doesn’t. Historically, the most frequent cause of a currency losing its value is: governments printing money.
To illustrate the effect, let’s consider a very simple example. There are 100 pencils for sale, and there is a demand for exactly 100 pencils. If there is $100 available to buy the pencils, the price will tend towards $1 per pencil. Increase the supply of dollars to $200, and the price moves towards $2. The supply of pencils and the demand for them did not change, but the supply of money did, and it pushed up the price.
In a big America-size economy with millions of people and millions of things to buy, the same thing happens. If the economy remains the same, but you increase the supply of money, the prices rise — which means that the value of the dollar falls.
If the change in value becomes noticeable, people will spend the dollars as fast as they can, because the value of the dollar is falling. If they don’t need to buy with their dollars, they will buy something that will keep its value (gold, silver, or whatever). The currency has become “debased”.
Such inflation occurs when a government prints money like it’s going out of style, and naturally, it does go out of style.
How Does the Fed Print Money?
In truth, it doesn’t print anything. You may picture the Federal Reserve commanding printing presses to spew out vast numbers of pristine 100 dollar bills. But that isn’t the mechanism “for money printing”. Paper dollars account for only about one-tenth of the dollar money supply.
The full dollar money supply includes sources of money that are rarely converted into dollar bills but could be: money in checking accounts, savings accounts, money orders, 24-hour money market funds, certificates of deposit, and so on.
When the Fed prints money, it does so by extending credit to (i.e., loaning money to) the banks and managing the interest rate they have to pay. The banks can then, if they so choose, lend that money to people or businesses and it will find its way into those various sources of money. That’s how the game is played.
Does This Mean the Fed Can Print as Much Money as It Pleases?
Not really. If you listen to the financial news once in a while, you’ll hear reports about the regular monthly meeting held by the Fed, what the Fed chose to do, and how the financial markets reacted.
If the Fed starts printing money in a big way, the markets will react negatively. The Fed prefers not to roil the markets unless it has no choice. If theFed wants to mess with the money supply it has to explain itself.
If the Fed Lends Money to the Banks, Do the Banks Have to Lend It Out?
No. In fact, they don’t have to accept the money at all. But lending is how banks make money. Typically, banks lend out more than they borrow from the Fed. They could lend out, say, ten times what they borrowed. This is called “fractional reserve banking.”
If the banks make good lending decisions and the borrowers payback, then everything is hunky-dory. Problems arise when banks make too many bad loans. That’s when banking collapses occur. That’s why banks are regulated.
So How Does That Compare to Cryptocurrencies?
Cryptocurrencies are not like that at all. Not even close.
With a cryptocurrency, there is no Fed. And there is no fractional reserve banking. Software controls the money supply and people never have a say in it.
With Bitcoin, for example, the money supply grows gradually — currently at about 3.85% per annum. It is slowing down. It will eventually come to a stop when 21,000,000 Bitcoin have been created.
The supply grows because (and only because) Bitcoin miners are paid in Bitcoin for mining blocks. The increase in the supply of Bitcoin is the payments made to miners.
Miners are also paid the transaction fees from each block. Eventually, when all the 21,000,000 Bitcoin have been created, the Bitcoin miners will make a living from transaction fees alone.
Other Cryptos
Different cryptos have different money supply growth rates. Most (like Litecoin and Ethereum) imitate Bitcoin and have a declining growth rate. Others, like Permission (ticker: ASK) and XRP (Ripple), have zero growth rates.
In each case, the blockchain ensures either that no new crypto can be created or enforces the rate at which the new crypto is created. The only currency in existence there is the cryptocurrency recorded on the blockchain.
Is It Possible to Have “Fractional-Reserve Banking” With a Cryptocurrency?
No. This needs to be well understood, because — aside from the automated nature of the crypto money supply — it is the critical difference between fiat currency and crypto.
With fractional-reserve banking, a bank borrows, say $1 million from the Fed. It then loans out, say, $10 million. $9 million are thus “created from nowhere”. Yes they are recorded in bank accounts, and they circulate around, and eventually, most of those dollars are paid back. So they exist, “sort of”.
But do you know what happens if the borrower cannot pay the bank back and instead goes bankrupt?
Those dollars disappear. They vanish as if they never existed.
That’s what happens in a banking crash. Too many loans go bad, and the bank itself goes bankrupt — unless the Fed lends it some money to stay afloat.
None of that can happen with a cryptocurrency, because the amount of currency created is always there on the blockchain. It may pass from one owner to another, but it is always right there.
Would It Be Different if the Dollar Was Backed by Gold?
The dollar was backed by Gold once. And so were other currencies. The Gold standard was first abandoned when the First World War broke out. The countries involved in the war could not afford the war, so they printed money to pay for it.
If your currency is backed by gold, it is exchangeable for gold. If you print money like a drunken sailor, people buy gold with it, your gold reserves are quickly exhausted and the currency collapses. So if you back a currency with gold, you just cannot afford to print money. With crypto it’s quite similar, you simply can’t print money.
Fiat and Crypto Are Staggeringly Different
People earn money, buy stuff with it, and squirrel it away under a mattress but understand very little about its nature. We hope to change that though, so provided below is a stepwise introduction to both money and cryptocurrency.
A Mild Dose of History
The alternative to money is barter, and when money fails — as it does in situations of hyperinflation (caused by moronic politicians believing you can print mountains of money without consequences) — barter takes over.
Then people have to find ways of swapping goods and services with each other and it’s complicated. The problem is that without money there is no unit of measure for value. You know this already.
You have an inner psychic mechanism that assigns value to things based on the currency you are familiar with: Dollars in the US, Balboas in Panama, Quetzals in Guatemala, and Dongs in Vietnam.
Cryptocurrency Exchange
Try changing countries. If you’ve ever done that, you’ll know it’s hard to adjust your sense of value because costs are different, taxation varies, trade barriers exist and different (cultural) values predominate.
Small tribal communities of hunter-gatherers can survive without money by sharing everything according to some established order, but this doesn’t scale well. Even in tribal societies that use barter, usually a “unit of value” emerges. This happens so naturally that some academics claim there are no pure barter economies.
The Measure of Value
The prime function of a currency, then, aside from payment is to provide a stable unit of value. Effective currencies are difficult to invent because people cheat. A good currency needs to be cheat-proof.
Many things have been tried as currencies, including:
- Food (Salt, from which comes the word “salary”. Also cocoa beans, turmeric spice wrapped in coconut fibers. And incidentally, Parmigiano Reggiano and Parma Ham are still used as collateral at some Italian banks)
- Cowries (she hoards seashells by the seashore)
- Cigarettes
- Coins — bronze, silver, and gold
- Hard to forge paper portraits of presidents with numbers on them
- Electronic records attached to a blockchain, using cryptography
And Now Something Different: What Is a Reserve Currency?
I do think some digital currency will end up being reserve currency of the world. I see a path where that’s going to happen.
I agree with Brain Armstrong (CEO of Coinbase) that a cryptocurrency will eventually become the world’s reserve currency. To think about what that means you need to know what a reserve currency is.
A reserve currency (sometimes called an anchor currency) is a currency is used in international transactions and hence a currency that is “global.”
There needs to be a unit of value to price internationally traded commodities (oil, copper, tin, wheat, cocoa, etc.). Right now, the US dollar is that unit.
The only other significant reserve currencies are the Euro, the Japanese Yen, and the British Pound. The dollar dominates (estimates suggest 62% of foreign reserves held in dollars, 20% held in Euros, with the Pound and the Yen at about 5%).
The human need to price things ensures that one reserve currency dominates. At the moment, it is the US Dollar. Before that, it was the Pound
Is There an Advantage to Being a Reserve Currency?
For a country, yes. Right now all nations (and most international businesses) hold copious quantities of dollars. The US gets to print them and other countries have to buy them. This enables the US to run a much bigger balance of payments deficit than any other country. A persistent balance of payments deficit in other countries soon impacts the value of their currency.
Since the end of WWII, the US has leveraged this to boost the US standard of living. The downside is that the US has built up substantial debt. In 1985, it ceased being a net creditor nation and became a net debtor nation — and the debt grew like bamboo in spring.
Everyone else was helping to finance the US standard of living.
Will it end badly?
Yes, it will, at some point. When those US dollars get homesick and fly back to the US, they will inflate the stateside supply of US dollars, which will, in turn, drive up prices. The natives will surely become restless.
What Is the Money Supply?
If you ask this question of most cryptocurrencies you get the same answer. The supply of the currency is determined by an algorithm. With some cryptocurrencies — the Permission Token and Ripple are examples — the money supply is fixed from the get-go. When that’s the case, the currency is said to be “pre-mined”.
So for crypto, either an algorithm determines the growth of the money supply, or it is fixed at birth. This is not the case with National currencies or “fiat currencies” as they are often called.
In case you didn’t know “fiat” is Latin for “let there be”. According to the Old Testament, the first recorded words of God were “fiat lux” (let there be light). The label “fiat money” is not a sarcastic term that emerged from the crypto community, but an Americanism dating back to circa 1870–75 pointing out that paper money has no intrinsic value.
This is the defining difference between cryptocurrencies and all other currencies. The money supply of a cryptocurrency is fixed and immutable. With all other currencies, including gold, the money supply is not fixed and immutable.
Some people have a deep faith in gold as a currency because the supply and its destruction (through loss and industrial use) are roughly the same and have been for a few centuries.
However, when the Spanish filched the Aztec and Inca gold, the supply of gold in Spain grew dramatically. There was gold-provoked inflation.
If new highly productive gold deposits were discovered at the bottom of the ocean or on a mineable asteroid or wherever it could happen again.
With crypto, the money supply is publicly displayed on a bullet-proof blockchain. It cannot be manipulated. The crypto money supply is thus easy to understand. With fiat currency, it is not, as we shall see.
What Are Notes and Coins?
When we speak of the fiat money supply there are four species; usually labeled M0, M1, M2, and M3. They live inside each other like Russian dolls.
The first of these, MO, is the easiest to understand; it is the coins and notes in circulation. This is what most people think of as money because you can touch and see it.
Most fiat money of this species. In the US such money accounts for about 8.3% of the dollars in circulation. It’s the same for most other currencies.
Curiously there is no equivalent of this kind of money with a cryptocurrency. This kind of money is “bearer money”. If you carry it, you own it. Nothing about notes or coins enable you to prove ownership.
Cryptocurrency is always held in a wallet and belongs to the wallet owner. Muggers cannot steal it from you.
Of course, hackers can steal it from you and fraudsters may find ingenious ways to lay their hands on it, but in either case, it will be because you took insufficient care of it — you allowed it to be vulnerable.
Paper notes and coins can be lost or destroyed. And that too is the product of carelessness.
Ragged, Worn, and Torn Notes
Paper notes wear out, provoking the mint to renew them with pristine replacements. To make money, you have to spend money. The perpetual printing activity costs about 5 cents (for $1 and $2 bills), about 10 cents (for $5, $10, $20, and $50 bills), and 12.3 cents for Benji’s.
It doesn’t sound expensive, but for every $1 bill it costs ¢1 to keep it in circulation and for a year, and as there are 11.7 billion such notes, were looking at over $110 million per annum just for $1 bills.
With cryptocurrency, there is no equivalent cost, and perhaps that is an advantage — or perhaps it is not. Paper money does not require electricity. It can be used when your battery dies.
