Let us start with talking about bad money, by which I mean the US dollar, the euro, the Japanese yen, the Chinese renminbi, the British pound, the Swiss franc, and basically all official currencies.
They all represent fiat money. The term fiat is derived from the Latin word fiat and means “so be it.” Fiat money is “coercive money,” or “money forced upon the people.”
There are three major characteristics of fiat money:
- The state (or its agent, the central bank) has a monopoly on money production.
- Fiat money is produced through bank credit expansion; it is literally created out of thin air.
- Fiat money is intrinsically valueless. It is just brightly colored paper and intangible bits and bytes that can be produced at any time and in any amount deemed politically expedient.
How We Got Bad Money
Just in passing, I would like to let you know that fiat money has not come into this world naturally. States have worked long and hard to replace commodity money in the form of gold and silver with their own fiat money.
The final blow to commodity money came on August 15, 1971: US President Richard Nixon announced that the US dollar would no longer be convertible into gold. This very decision (which I like to call the greatest monetary expropriation in modern history) effectively put the world on a fiat money regime.
Against this backdrop, it may not come as a surprise that fiat money suffers from economic and ethical deficiencies.
The Defects of Fiat Money
First, fiat money is inflationary. Its buying power dwindles over time, and history has shown that this entropy is almost as irreversible as gravity.
Second, fiat money enriches a chosen few at the expense of many others. The first receivers to get a hold of the new money benefit to the detriment of latecomers.
Third, fiat money fosters speculative bubbles and capital misallocations that culminate in crises. This is why economies boom and bust.
Fourth, fiat money lures states, banks, consumers, and firms into the pitfall trap of excessive debt. Sooner or later, borrowers find themselves in a deep hole with no way out.
Fifth, fiat money feeds big government. And as the state expands and sprouts like weeds in an untended garden, this outgrowth strangles—even destroys—individual freedom and liberty.
On Good Money
I have spoken enough about bad money. Let us talk about good money.
What is good money? To answer this question, we just have to think about how a free market in money works.
Here, people are free to decide which kind of money they would like to use, and they also have the freedom to cater to the needs of fellow people seeking good money.
The outcome of a free market in money will be good money simply because people will demand, out of self-interest, good money—not bad money. This is actually what sound monetary theory would tell us. Money has emerged from a commodity and spontaneously from the free the market: no state or no central bank was needed in the process.
To qualify as good money, the “thing” or good in question must have specific properties. It must be scarce, homogeneous, divisible, durable, transportable, mintable, etc. Gold and silver meet these requirements par excellence, and this is why they were chosen as the universally accepted means of payment whenever people were free to choose.
How does Bitcoin fit in?
Cryptocurrencies: The Search for Good Money
I would argue that from a monetary theory point of view, Bitcoin qualifies as a good money candidate. It has emerged from the free market through the voluntary actions of all participants involved, respecting individual freedom and private property rights.
I would also argue that Bitcoin complies with the regression theorem and thus provides the crypto unit with a necessary requirement to potentially become money. The key question, therefore, is whether Bitcoin will stand a chance in challenging and outcompeting official fiat currencies or gold money. Let us think about this in further detail.
A Free Market in Money
One exciting feature of Bitcoin is that its quantity is limited to 21 million units. This hard cap means that at some point, the quantity of Bitcoin will not grow any further. If the quantity of money is constant and the economy expands, prices for goods and services will fall.
Would that be a problem for money users or the economy? No, it would not. Firms can still be successful if prices decline. Their profits result from the spread between revenues and costs. If goods prices fall (in nominal terms), firms just have to make sure that revenues keep exceeding costs.
Consumers would be pleased to see the prices of goods fall. Their money becomes more valuable. They can reduce their cash balances and increase spending.
Buying Now or Buying Later?
But wait: would consumers not refrain from buying goods if and when prices can be expected to fall over time? Imagine a car costs $50,000 today and only $40,000 in a year. If I need the car right now (because my old one has broken down), I would have to buy a new one right away, I would not and could not wait.
The general answer is this: People make their decision to buy now or later based on discounted marginal utility. The marginal utility of buying the car for $50,000 ranks lower on people’s value scale than paying only $40,000. But the car available for $40,000 is not for sale now but in a year. When it comes to decision-making, people will, therefore, discount the marginal utility of purchasing the good for $40,000 in a year using their individual time preference rate.
They will then compare the result with the marginal utility of buying the good now for $50,000. If the discounted marginal utility of buying the car for $40,000 in a year is lower than the marginal utility of buying at $50,000 now, people bu