Salt, Cigarettes, and Gold
Do you know what’s common between these 3 commodities? Take your time if you need to………
If you are like most people, you probably could not figure out what is the underlying commonality between these 3 commodities. And the answer might even come as a shock to you. However, I guess a small fraction of the readers might have been able to figure it out.
They all are or have been money. Yes, all of them.
In this blog, I will be discussing in brief(brief being a relative term here) the history of money. Don’t worry yet, the title wasn’t clickbait. Later in this post, I come back to answering the all-important question of “if and where does bitcoin fit in the monetary system”. It will be after answering this question that I will be putting forward my arguments and reasons why I believe that Bitcoin isn’t as great as many believe and many others want to believe it is.
It’s going to be a long post, but it will be worth your time, I promise.
A Very Brief History of Money
Humans have exchanged goods and services for millennia. Throughout most of history, this exchange was based on a barter system wherein goods were exchanged for other goods. However, the barter system came with a lot of drawbacks such as lack of the coincidence of needs, and divisibility. Among commodities that were exchanged in the barter system was gold(and silver, of course). However, these metals were in the form of odd-sized and odd-purity nuggets. It was not until 600BC that Gold was minted into gold coins of fixed weight and purity in Lydia. These gold coins soon became widely used as a standard for the exchange of goods and services, i.e, they were being used as money. And soon enough, gold and silver coins were being used as money all around the world.
Now the obvious next question that arises is-
What made gold(and silver) coins the preferred form of money?
The reason that gold and silver coins became so widely adopted forms of money is that they have properties that an ideal form of money should have. These properties are-
- Durability– An ideal form of money should be durable. Something like fruits or vegetables can be used as money, but they are not durable enough to function as a form of money. Metals such as iron which corrode or react with air, water, or other common fluids are also not desirable. Metals that dissolve in water or other commonly used solvents are also not ideal forms of money. Fiat/paper currency is only somewhat durable. However, metals such as gold and silver are highly durable. Although silver does tarnish, it is a very slow process and does not result in a metal loss like rusting of iron.
- Fungibility– Fungibility means that a unit of money should be interchangeable. For example, a $1 bill anywhere on the planet is the same in the sense that it has the same value. Something like clothes or fabrics can be used for money, but not all fabrics are the same, they are made of different materials and have different qualities. Whereas a gold coin of a fixed weight and purity is fungible, it can be interchanged for another gold coin of the same weight and purity.
- Divisible– An ideal form of money should be divisible. For example, you can exchange a $10 bill for 10 $1 bills. However, not all commodities can be divisible. For example, something like shells can be used as a form of money(and they have been), it’s just that they aren’t divisible. However, a 5-ounce gold coin can be exchanged for 5 1-ounce gold coins.
- Portable– An ideal form of money should be easy to carry around. Something like grains is not an ideal form of money because, among other things, they are not portable. The value-to-weight ratio of grains is very low. Therefore you will have to carry a huge amount of grains to exchange them for other goods. Whereas, precious metals such as Gold and Silver have a very high value-to-weight ratio and hence are much more portable.
- Store of Value– Lastly, but most important of them all, any form of money should definitely be a store of value, and hence maintain its purchasing power for extended periods of time. For a commodity to be a store of value, it has to have a value(i.e, an end use-case) and rarity. Metals, including precious metals, have value- They have industrial and/or scientific uses. However, not all metals are rare and hence cannot act as a store of value.
Additionally, a form of money should be a unit of account, i.e, it can be measured or counted. And needless to say, it should be safe in the sense that it should not be and poisonous if consumed or radioactive.
But this implies that fiat/ paper currencies are not a store of value, since they are just pieces of paper with numbers on them and therefore have no final use. So what makes them money? This is exactly what we will be discussing in the next section.
But before moving to the next section, I will be talking about one very important topic, Debasement. This topic is important because history is full of episodes of money debasement by the emperors and governments. And it was one of the factors that led to the creation of Bitcoin.
Debasement
Debasement refers to reducing the value of money. It is an activity that is perhaps as old as money itself. And it is this debasement of money that manifests itself in the form of inflation. When gold coins were used as money, debasement could be carried out by reducing the purity of the precious metal in a coin, or by decreasing the weight of a precious metal coin, all the while keeping the face value of the coin constant. This allows more coins to be in circulation and hence decreases the value of money, remember the rule of supply and demand- If supply goes up, the value goes down. This decrease in value results in an increase in relative prices, also commonly known as inflation.
A similar process is carried out in the modern age of paper money by something known as Quantitative Easing, which basically means printing money out of thin air and spending them to ‘stimulate’ the economy. However, this too, results in a decrease in the value of paper money, hence creating inflation.
The Gold Standard
The Gold standard is a monetary system in which the currency of a nation is pegged to Gold. This means that issuing authority has a fixed amount of gold for a particular amount of currency they issue. The United States, for example, had a gold standard from 1934-1971 wherein, the price of gold was fixed at $35 for one ounce of gold. During that time duration, the US Dollar was also convertible to Gold. This meant that you could exchange your US Dollars for Gold for $35 an ounce.
To convince you that I am not making up any of this, let’s take a look at a $20 bill of the 1928 series.
There are a few important details to take note of in this $20 note. The first is the Gold Certificate stamp on the left side of the note, and the message along with it- “This certificate is a legal tender in the amount thereof in payment of all debts and dues public and private”. Also of interest is the message split between the top and the bottom of the bill- “This certifies that there have been deposited in the treasury of Twenty Dollars in gold coin payable to the bearer on demand”. This means that the dollar is both pegged to, and exchangeable for gold at a fixed price.
But why even go to the trouble of backing a currency with Gold?
Throughout most of history, paper money has not only been backed by commodities(and particularly gold) but also convertible into these commodities.
One of the first examples of such a paper currency backed by commodities comes from the Tang dynasty in 7th century China. During that time, copper coins were used as money. However, it became very difficult to use them for large commercial transactions(they were not much portable). For facilitating these large transactions, the copper coins were deposited and paper money was issued against these deposited coins. Therefore, these paper money notes were just receipts for copper coins, that could be exchanged for copper coins when desired by returning the receipt back to the one who issued it. This allowed paper money to circulate along with copper coins for use in transactions.
The reason paper money became accepted for transactions was the trust that the issuer of them would exchange it for the commodity that backed it whenever demanded. History, however, is full of breaches of this trust. Under the assumption that not everyone will demand payment(the commodity that backed it) for their paper money at the same time, the issuing authorities have time and again created more paper money than the commodities that backed it. And this approach works really well until it doesn’t. During times of rising uncertainties, and inflation, the trust in paper money can decrease. This causes a large majority of the holders of paper money to exchange their paper money for commodities. And when this happens, there isn’t enough for everyone.
Now coming back to our original question, Why do we even need to go to the trouble of backing our paper money with gold? The answer is that gold(or any other commodity) is what value and confidence to that paper money, without which it is nothing but a piece of paper. The trust that paper money can be redeemed for gold is what gave paper money its value.
However, in today’s modern world, there are no currencies that are backed by gold or any other commodity. Why? What happened? and what gives confidence in modern currency? This is what I will be talking about in this next section.
Out goes Gold! or does it?
On 15th August 1971, the president of the United States, Richard Nixon took the world off the Gold standard. This would mean that governments and central banks around the world were no longer able to exchange their dollars for Gold(or other reserve assets). This was one of the few economic measures taken by Richard Nixon to address the rising inflation during that time. These economic measures are collectively known as the Nixon Shock.
Here is a part of Richard Nixon’s speech in 1971-
I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.
Richard Nixon, 15 August 1971
Although the convertibility of dollars to gold was suspended only temporarily, it’s already been about 50 years since the world went off the Gold Standard. So if Gold(or any other commodity) is not backing the dollar, what gives confidence in the dollar? The answer, as shocking as it may sound, is nothing. There are brief moments in history when paper money becomes unbacked by any commodity, however, these fiat-based monetary systems all collapse sooner than later.
In the last section, we took a good look at a dollar that was backed by gold. Now compare that to a modern fiat-based $20 bill, and notice the differences.
This $20 bill is from the 1996 series. Notice that while the message declaring this note to be a legal tender is still present, the “Gold Certificate” stamp has been replaced by a Federal Reserve stamp. Also of interest is the removal of the message that guaranteed the convertibility of dollars into gold. This has been replaced by the message “Federal Reserve Note“. Hence, dollars are no longer a receipt on gold, they are just fiat paper money.
I would end this section with a quote from Milton Friedman, an American economist, and proceed to the next section to finally start discussing Bitcoin.
Nothing is so permanent as a temporary government program.
Milton Friedman
Its 2008 and Bitcoin is born
In 2008 the creator of Bitcoin, who goes by the pseudo-name Satoshi Nakamoto published the white paper on a cryptography mailing list at metzdowd.com that introduced the world to Bitcoin. This white paper went by the title- “Bitcoin: A Peer-to-Peer Electronic Cash System” and explained the workings of Bitcoin. This white paper is still available at bitcoin.org. The basic idea of bitcoin was to create a decentralized peer-to-peer transaction system, hence de-necessitating to rely on a centralized entity, such as a bank, for facilitating the transaction.
On 3rd January 2009, the creator of Bitcoin did the first transaction on the Bitcoin network and created 50 Bitcoins in the process. However, unlike every other Bitcoin on the network, these bitcoins cannot be spent. The transaction also contained an embedded message that read
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks
This message refers to the The Times newspaper news headline on 3rd January 2009. Refer to the image below-
The purpose of the message was to draw attention to the currency debasement by central bankers around the world in wake of the 2008 financial crisis. Satoshi Nakamoto further expanded on his embedded message in a post, see source here.
The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.
This was not the last message on the Bitcoin network to call out on debasement of the currency by governments around the world. More than a decade later, a similar message was embedded in the block by the miner of the 629,999th block on the bitcoin network. The message was-
NYTimes 09/Apr/2020 With $2.3T Injection, Fed’s Plan Far Exceeds 2008 Rescue
This message refers to the NYTimes news headline on 9th April 2020. You can check this news out here.
Time and again, the bitcoin community has called out on the government for debasing the money supply. Recently, Bitcoin has also been compared to Gold and called ‘Digital Gold’. But is it, or can it be a substitute to gold, or is it another doomed alternative to gold, the only form of money and safe haven asset that has stood the test of time? This is what I will be talking about in the next section.
Bitcoin, Digital Gold, or Fool’s Gold?
I have already discussed the features of a good form of money in one of the previous sections. In this section, I will be discussing how Bitcoin stands on each of these features, and particularly, a store of value. I will also point out a few weak spots of Bitcoin.
While Bitcoin is very durable, fungible, highly divisible, and quite portable, it is not a store of value because it has no value to store. And this is a very important non-negotiable feature that any form of money should have. The reason copper, silver, and gold have been used historically as money is that they are a store of value. Copper, for example, can be used for manufacturing electrical transmission lines which makes it valuable. Silver and Gold can be used for manufacturing electronics which make them valuable. It is the potential for an end use-case that makes a commodity valuable. But since Bitcoin has no end use-case, it has no value and therefore cannot act as a store of value. Bitcoin has a price, yes, but it does not have a value.
Additionally, while Bitcoin can act as a unit of account, it is never used as a unit of account. Recently many companies have started accepting Bitcoin and Alt-coins for transactions, however, the goods or services they are selling are not priced in them. Consider this example, say Tesla is selling their Roadster model at $200,000 and say the price of Bitcoin is $100,000(for sake of simplicity). Then the current price of a Tesla Roadster in Bitcoin is 2 Bitcoins. However, a week later, if the price of Bitcoin drops to say $50,000, will the price of that Tesla Roadster still remain 2 Bitcoins? Absolutely not! It will change to 4 Bitcoins now. Hence, Bitcoin is just being used as a medium of exchange, and not as a unit of account.
So far I have discussed Bitcoin from the standpoint of a form of money. However, it has many other weak spots which I will be talking about next.
- Sustainability – Bitcoin ‘mining’ relies on the Proof of Work(PoW) algorithm to establish trust and consensus on the Bitcoin network. Proof of Work proves that a certain amount of ‘work’ has been performed for validating the transactions performed on the network. The term ‘work’ obviously refers to computational work. Bitcoin’s hunger for energy is insatiable, the more computational resources are committed to mine bitcoins, the more difficult it gets to solve the problem, and hence the energy requirement keeps on increasing. At the time of my writing, the energy consumption of the Bitcoin network is roughly equivalent to that of Sweden or Argentina and amounts to about 0.5% of the global energy production.
- Vulnerable to 51% attack – Bitcoin is vulnerable to a 51% attack. This means that if someone is able to acquire 51% computing power(hash-rate) of the network, they can unanimously decide that they own all the Bitcoins.
- Does not place you outside the System – This is contrary to the popular belief that owning Bitcoins places you outside of the system consisting of government and banks. However, more often than not, this is not true. Most of the People who own Bitcoin own it in their crypto-exchange trading accounts, and not in their Bitcoin wallet. These crypto exchanges can be used or even forced by the government to acquire information about the funds or portfolio of each individual who is set up on the crypto exchange.
- Bitcoin is Deflationary – The number of new Bitcoins that will be mined will keep on decreasing as the block rewards keep decaying exponentially every 4 years. A deflationary currency can make it very expensive to obtain credit as borrowing becomes very expensive due to an increase in the value of money when repaying in addition to interest due on that borrowed money.
- Inflationary Threat from Alt-Coins – Although Bitcoin has a limited supply of Bitcoins. Every couple of years there is a hard-fork on the Bitcoin ledger, which leads to the creation of more and more crypto-currencies and hence more tokens in circulation. It is a result of these hard forks that we have crypto-currencies derived from Bitcoin such as Bitcoin Cash(BCH), Bitcoin Classic, Bitcoin Gold, etc. Additionally, there are various alt-coins available which further increase the supply of tokens. This increase in the supply of tokens can lead to inflation in the crypto-currency space.
- Not suitable for Micro-Payments – Bitcoin has very high traffic(transactions) on its network. This causes an increase in verification time of payments, or you can get your transaction verified on priority by paying an additional premium. This makes Bitcoin highly unsuitable for micro-payments.
- Threat from Quantum Computing– I agree that this point is somewhat hypothetical, but over the coming years and decades, the threat to Bitcoin from Quantum Computing can materialize. It has long been proved that quantum computers can perform some tasks exponentially faster than classical computers. One such task that can be performed exponentially faster on a quantum computer is factoring integers. Bitcoin and other Public Key Encryptions(PKEs) rely heavily on the fact that for classical computers, factoring integers takes exponential time. Whereas on a Quantum Computer, Shor’s algorithm is used to factor integers in polynomial time.
Another common argument that I hear in favour of owning Bitcoin is this-
Since its inception, looking at the longer trend, Bitcoin has always gone higher. Therefore, it will keep on going higher.
This is a classics example of a cognitive bias called ‘Hot Hand Fallacy’. Just because it has kept on going higher for the last few years doesn’t imply that it will keep on going higher. Consider this, someone aged 50 hasn’t died yet, so does this imply that they will never die”. Absolutely not! Similarly, just because bitcoin has kept on going higher for the last 10 years or so does not mean that it will keep going higher. The price of bitcoin can go higher, but this does not mean that it definitely will just because that is what it did in the past? Absolutely not.
Ending Note
In this blog, I talked in brief about the history of money and the origin of Bitcoin. But more importantly, I talked about why I think Bitcoin is not as great and a good form of money as many claim it to be.
Thank you for sticking to the end. I hope you had as much pleasure reading this blog as much as I had writing it. I will close this blog right on the topic with which I started it. Lord knows that I have talked enough about Gold throughout this blog. Therefore stories of how salt and cigarettes were used as money will be the code to this blog.
Today salt might be viewed as a worthless commodity but this wasn’t always the case. Throughout most of human history, salt has been an important part of human civilization. Salt was difficult to obtain and had many use cases, such as preservation of food, and of course, for seasoning. This made salt a much-valued commodity throughout human history. There have been claims that soldiers of the roman empire were paid in salt. In fact, the word salary comes from the Latin word for salt, ‘salarium‘. However, this isn’t the only episode in history where soldiers were paid for in salt. During the war of 1812, the American government also paid its soldiers in salt. In fact, salt is still a form of money in some parts of the world such as Ethiopia’s Danakil Plains where nomads use it as money.
The use of cigarettes as money occurred in the Prisoner of War(PoW) camps during the 2nd World War. A particular incident of cigarettes being used as money was described by R.A Radford, a soldier in the British Army who became a Prisoner of War in Libya. Each PoW was provided with basic allowances like food items, toiletries, cigarettes, etc. Soon enough, cigarettes started to be exchanged for other commodities, say food items. This made cigarettes a unit of account to trade in for other commodities, even for non-smokers. Similar to Salt, and unlike Bitcoin, cigarettes had an end use-case – they could be smoked by smokers. Hence, both salt and cigarettes are a store of value. However, along with the use of cigarette money also came with all the usual issues that accompany money- inflation, deflation, debasement, and even Gresham’s law.
Disclaimer
The views expressed in the blog are my own. They are not supposed to be taken as investment advice, and the reader should their own research before making any investment. Further, I am not pessimistic about blockchain, or Distributed Ledger Technologies(DLT). I believe that these technologies will have an equal or greater impact on everyone’s life as the Internet had. This blog talks in general about Crypto-currencies and specifically Bitcoin.