In this article we publish a "Q and A" discussion on the nature of money itself and what this means for the growing digital currency industry. Why is this important for investors? Firstly, the almost exponential growth in the amount of computer processing power now being devoted to the creation of digital currency systems is starting to "move the needle" on the revenues and profits for several technology companies. Specifically, I'm talking about semiconductor companies such as Nvidia (NASDAQ:NVDA)and AMD (NASDAQ:AMD). Therefore it is important for investors to understand whether this industry in its current format is sustainable and not just a "niche" market in the throes of a speculative bubble
Furthermore, the unchecked growth in the digital currency market could also start to create systemic risks in the broader financial system. As the involvement of the investment community becomes more entrenched we have no way of knowing how much leverage or complex financial arrangements are evolving in tandem with the growth in this market. As we have learnt from past experience, it is that there is always one significant commonality underlying all speculative bubbles. Apart from greed and the desire for easy money, it is also underpinned by a certain level of irrationality or economic and financial misconception.
As it pertains to digital currencies, the central misunderstanding is what can or can't ultimately serve as money or a credible medium of exchange in the modern economy. Despite the fact that "money" has in one form or another been around for millennia, the concept itself can, even for trained finance professionals or economists, remain somewhat mystical. In this dark void, it is easy for many potential participants in the evolving digital currency mania to become converts and ardent participants, perhaps in the process, risking their hard-earned savings.
Therefore in our view, it is becoming increasingly important that we pay more attention to this growing market and understand the risks that may be forming tangentially. But to do this will require a deeper understanding and conversation about the nature of money, and trying to dispel certain misconceptions, which, in the final analysis, really underpins the evolving speculative mania in digital currencies.
No single person has a monopoly on the truth nor what the future holds, and as such, we won't pretend to be the final authority on this topic. But, it is important to start a discussion given the sums of money now involved. So for our part, we offer below a series of questions and answers that we hope can provide a better sense of the nature of modern money and where, if anywhere, digital currencies may have a role to play in the future.
Before we get to the Q&A part of this article we would like to direct readers to the following website which has some excellent data on the relative power consumption of various digital currencies and mainly Bitcoin relative to traditional payment processors. As the chart below shows, a key vulnerability of Bitcoin is its growing power usage as the number of transactions on the network grows. Visa facilitates some 82bn payment transactions per year compared to roughly 100mn for the Bitcoin network (based on recent daily but annualized figures).
We are not computer engineers and won't pretend to understand the technicalities attached to the algorithms that underpin Bitcoin or any other digital currency for that matter. However, it is difficult for us to envision a scenario where a Blockchain payments system that consumers vastly more power in order to complete the same number of transactions as a traditional payments processor, can ever really "takeover" this market or industry. Common sense suggests that if the power usage differential per transaction is substantially large, then ultimately when comparing two payments systems in equilibrium, the one with the lower power usage will be able to offer payments services at a lower price.
Without the added revenues that come from mining "new coins", digital currency operators or "miners" will simply not be able to sustain a cost effective payments system. To be sure, the anonymity that Blockchain offers will also attract a certain number of users who would be willing to pay a premium in order to transact on the system. However, at best this will then remain a niche market. Investors in Bitcoin or any digital currency would then have to asses what this market is worth in total and how many credible digital currency networks will end up competing for "market share".
Digital Currency - Q & A
Well, can you explain in your own words, what is money?
Money is first and foremost a medium of exchange, and has to have several characteristics. Primarily, it should be homogenous and fungible at all times. Something is fungible if all the individual units comprising the medium are essentially interchangeable. This is why gold became the preferred unit of exchange in ancient times. It was both homogenous and fungible. One gram of gold was the same as any other gram of gold and its value relative to its weight/size was very large.
Another important characteristic of money is that it has to have an intrinsic value, or at a minimum, offer a guaranteed representation of something of value. Whether it has an inherent value or is a guaranteed representation of something of value (perhaps an asset), that value itself must also be relatively stable in relation to the value of the goods and services generated by an economy.
Gold is not representative of any other asset, but it has an inherent value itself. Gold has always been in demand for use as jewelry and it is difficult and costly to mine, therefore limiting its supply growth. In a basic sense, gold's intrinsic value over the long-run is loosely tied to its marginal cost of production, which is fairly stable and in turn implies a fairly stable value in relation to the value of goods and services generated in an economy.
These characteristics are what gave gold its ability to act as a credible store of value, and also in times past, as a preferred medium of exchange. There have been other forms of money with no real inherent value, like sea shells for example. However, they worked only temporarily and as long as everyone believed they had a certain value (perhaps a bit like Bitcoin today)? They also would have worked as money if you were mandated to use them as money by the village chief!
If gold is a credible store of value, then why do we not still use gold as money today?
Although the cost of producing gold is reasonably stable, it is not entirely stable and therefore its value can and does fluctuate in relation to the value of goods and services produced in an economy. Importantly, and we will address this in more detail later, the actual demand for money itself is never stable. It is for this reason that at times when a gold standard has been adopted, the value of gold itself was "pegged" at a certain exchange rate.
However, the gold standard failed because more gold-backed currency (paper money representing a certain quantity of gold) was issued and put into circulation than actual physical gold held by the various commercial banks, including the central banks. What was particularly problematic for commercial banks was accommodating a demand for loans, when there wasn't sufficient gold available (usually in the form of deposits). Commercial banks would issue paper money equivalent or exchangeable for some quantity of gold to the borrower instead. By doing this, if a bank say only had $1000 worth of gold on deposit and available for lending, it could actually lend out $5000 worth of gold, because on average only 10% of depositors ($100) would require their deposits to be repaid back to them.
This is called fractional reserve banking, and one can easily see the problems that can be encountered running a system like this. Although, in theory, many countries officially "fixed" their currencies to gold until the 1930s, in reality this was not a true gold standard. In most cases, the commercial banking systems in these countries extended credit (or paper money) that far outstripped the available gold reserves in the banking system. In part, this led to the collapse of the global banking system in the early 1930s, and inevitably the gold standard following that. A true and stable gold standard can never be consistent or workable with a fractional reserve banking system.
Yes, that seems pretty unstable, but what about the present day, are banks still running a "fractional reserve type system"?
Yes, and no. We obviously no longer use gold as money, and instead use credit money or IOUs. When a bank issues a loan there is always a corresponding funding liability (either a deposit the bank creates at the same time as the loan, or shareholder equity or a debt security). So you could say that the total amount of IOUs in circulation or money supply largely reflects the total amount of credit in an economy. This is an important concept to understand, money and credit are really two sides of the same coin. Today's monetary system is in effect a credit standard.
From this perspective, commercial banks today by and large (there are technical exceptions), are not really fractional reserve in the true sense. In economics 101, students are taught that the money commercial banks can create is dependent or constrained by the supply of central bank reserve money (or "high-powered money). But in practice, central bank reserves are not a constraint and one only need observe the sustained and sometimes elevated growth in credit and money over the past three decades to come to this conclusion.
However, commercial banks still fractional reserve in nature as a result of their capital structure. By this I mean, because they are able to lend out a multiple of their equity capital (usually between 8 and 15x), for every $100 of capital a bank has, it can in theory create $1000 in newly minted money. This is why maintaining appropriate capital levels in the banking sector is so critical for the health of the overall economy. Without capital, it impairs the ability of the banking sector to extend credit and therefore create "money".
But the fact that commercial banks can just create new money still makes me somewhat uncomfortable. Wouldn't a new digital currency such as Bitcoin be better?
No, because like gold, Bitcoin has a largely fixed and inelastic money supply (as pre-ordained by its creators). It could be used as a medium of exchange, but if the loan or transactions demand (i.e., demand for money) for Bitcoin exceeds the supply of bitcoins available for lending or facilitating transactions, either interest rates for lending a Bitcoin or the price of Bitcoin itself would spike or become inherently unstable.
There are some that will argue that the velocity of money (how many times the same monetary unit will change hands in a specified time period) will always change instantly to accommodate any change in transactions demand. But again, in practice this theory just doesn't seem to hold up. In any event, a system that continues to grow in terms of the number of transactions cannot increase its velocity infinitely.
As we have discussed, it is important that any medium of exchange retains a largely stable value in relation to the value of the goods and services generated by an economy. Imagine running a business in a country with hyperinflation one year and deflation in the next, and you can get a sense of what it would be like trying to run an economy off a virtual currency such as Bitcoin!
In essence, it is important in these situations that any medium of exchange ultimately have an elastic supply of money, which as we have discussed, is why the gold standard failed. There are some ways in which a modified or hybrid gold/credit standard could work, or at least better than a traditional gold standard, but that is another topic entirely which we won't go into in this discussion.
So you would not advocate a return to the gold standard nor the widespread adoption of digital currencies?
I would not advocate a return to the gold standard or the use of gold as money specifically, nor would I advocate the adoption of a digital currency such as Bitcoin. In both cases, the total supply is limited or constrained, which makes them ill-suited for the use of money in a modern-day economy. The money supply needs to be elastic in order to sustain an equilibrium level for interest rates, which is optimal for sustainable growth. Importantly, not only should the supply of money be elastic, but that elasticity of supply should be correlated to the demand for money itself. In economist lingo, one would say that money supply is endogenous or determined endogenously. This is a really important concept to get one's head around and for those so inclined, they should take a look at the following article, which can be found here.
Using a medium of exchange where the supply of the medium is limited or inflexible to changes in the demand for money will lead to periodically large and volatile changes in interest rates associated with lending and borrowing that specific type of money, something which is likely to be equally as damaging to an economy in the long-term as a small group of men or women trying to guess the correct interest rate for an economy.
Is this the only reason you are not a fan or advocate of digital currencies?
No. In their current form, digital currencies such as Bitcoin are also not a currency in the sense that they have no intrinsic value, nor are they representative of anything of value. One could perhaps argue that the intrinsic value of Bitcoin is either tied to the cost of 'mining' a new Bitcoin, namely the associated computer equipment and electricity costs, or its regulatory 'arbitrage value' for users trying to circumvent the law, exchange controls or launder money.
However, even in this case, the inherent intrinsic value would be extremely unstable given that computing and electricity costs can be substantially different across different geographic regions, and could also fluctuate as the price or even availability of electricity and computing hardware fluctuate.
And as we have already noted earlier, the levels of power consumption per transaction really need to be compatible (or at least in the same ballpark) with traditional payment systems, otherwise they are unlikely to gain significant market share from traditional payments systems.Additionally, any arbitrage value that Bitcoin may have, could also change swiftly if the regulatory authorities chose to remove them.
Some would say that present day money does not have any intrinsic value either?
Again, this underlines a vital misunderstanding of the nature of money and the present day financial system. Money that we use today is 'credit money' or in essence, IOUs. Very simply the loans created and extended by banks to their customers become IOUs, which we then use as money in the economy. These IOUs are theoretically, albeit indirectly, backed by the cash flows (future labour) and assets that borrowers from the banking system have used as collateral to obtain these loans in the first place.
In a world with a single legally mandated (FIAT) credit-backed medium of exchange, it also becomes quite easy to ensure that the value of this currency is stable in relation to the value of goods and services generated by an economy. In simple terms, all the issued money is fungible so each single Dollarin part is backed by a tiny fraction of the total assets and cash flows in the economy. Think of it like owning a share or bond in a company, where the company is the entire economy.
Given that the annual rate of inflation in most of the world runs at between 1% and 3%, this is inherently far more stable than gold would be (freely trading), and certainly any digital currency thus far.
Ok. But getting back to the elasticity of money, shouldn't interest rates rise if the demand for money increases?
Yes perhaps, if we believe that investment should always and everywhere be equal to savings. However, strictly observing this rule (ex-ante) would make it difficult for an economy to accommodate a surge in productivity or the advent of a new technology which leads to a sharp rise in investment or simply population growth.
I don't understand what you mean here, can you explain it a little better?
Credit has an important role to play in a properly functioning economy. Credit serves as the "bridge" between future consumption and potential present-day production. Without credit, that potential production and therefore future consumption may never be realised. Additionally, credit is not a modern day innovation it has been around since Babylonian times and more than likely, ever since the agricultural revolution more than 10,000 years ago.
I am not sure what you mean by credit serving as a "bridge," can you explain that a little better?
Let's think of a very simple economy consisting of a successful farmer and a young unemployed man. In this economy, there is no bank and there is no money.
Let's say the young man learns a new skill, making furniture from wood. However, he needs money to buy the wood and tools to make the furniture before he can sell them. The farmer has a forest on his land as well as tools that can be used to make furniture.
So, the young man enters into an agreement with the farmer. If the farmer allows him to chop down some of his trees for wood and also gives him his tools, then the first batch of furniture he makes he will give to the farmer as payment.
In reality, the young man has taken out an IOU with a farmer and in a simple economy of this nature, a bank or an institution that keeps track and facilitates transactions like these is not needed. However, given the complexity of today's economy, comprising millions of economic participants and millions of such transactions, clearly a sophisticated third-party such as a bank would be required.
If we introduced a bank in the above simple economy, then the transaction between the farmer and young man would have perhaps looked like this.
The young man would have approached the bank for a loan, and lets say the bank issues an IOU which due to state decree, has to be accepted as money or as medium of exchange. Let's say for argument's sake this IOU has a notional value of 100.
The young man approaches the farmer and pays him with the IOU of 100 for the wood and tools. Later on when the young man has completed the furniture, he goes back to the farmer and sells his furniture for the 100 IOU. As you can see, this is for all intents achieving the same economic outcome as when the young man approached the farmer directly and entered into an agreement with him.
The young man can then repay his loan to the bank or perhaps he goes back to the farmer and buys vegetables to eat worth half of the IOU or 50. The young man then agrees to pay off half his loan at the bank. Let's say we now have a new individual who suddenly enters this economy. This person is an accountant and offers his services to the farmer who needs to keep track of all his transactions, etc. The farmer agrees to pay this individual the IOU of 50 he has for these services.
The accountant then goes to the young man and pays him the 50 IOU for some more furniture. Now the young man is able to go back to the farmer and buy more wood and produce for himself. And so it goes, soon we have a functioning economy exhibiting the circular flow of money that all modern-day economies exhibit.
So if we have a fixed money supply, then we can only lend out what people save?
In essence. And while this sounds rational, in essence, it limits the ability of the economy to grow at its potential. In these situations with a fixed money supply, interest rates could rise substantially and the economy may also experience deflation, i.e., prices will fall.
I am starting to understand this a bit more, but why would falling prices be bad?
Declining prices are not specifically bad, but if there is large amount of outstanding credit or loans, it will become more difficult for borrowers to repay these loans as the cash flows needed to do so may be diminishing as prices for goods and services decline. Ultimately, the most stable economic system is where prices remain largely unchanged from year to year, or increase very slightly. This why today most central banks have set themselves an inflation target of between 1% and 2% per annum.
The current modern-day monetary system or "credit standard" is not perfect, but like democracy, it is the least bad option. An area of weakness is the fact that the 'price of credit' is controlled by a central bank to some extent, and the policymakers that inhabit these institutions are narrowly focused on controlling inflation for goods and services. Their remit should perhaps extend to ensuring that the total amount of credit in an economy does not persistently or significantly outstrip the growth in the economy for a sustained period of time. This is how credit bubbles such as the one we now observe in China develop, but that is also a topic for another conversation.
Yes, that makes sense. Getting back to elasticity, digital currency systems could also change the number of units in circulation, say by amending their "algorithms" etc
Indeed, but this change in supply is arbitrary and set by the developers of the system. Instead of controlling the price of money (as modern-day central bankers do via the interest rate), these new monetary "authorities" seek to arbitrarily control the supply. As we said it is important not only for the money supply to be elastic, but also to have that elasticity linked to the demand for money.
This is one of the unique advantages of using credit as money. The elasticity of supply is inherently tied to the demand for the money itself. The modern day monetary system with numerous individual and private banks acting as an agent for the central bank in the extension of credit does quite a good job at this, despite all the scorn that bankers attract!
Do you see any way that a digital currency system could potentially work?
As we have discussed, there are two important structural issues a digital currency system would need to address. Firstly, the ability to set an inherent intrinsic value, and secondly, the elasticity of supply and more importantly tied to that, the correlated elasticity of supply with demand for the currency itself.
In terms of the intrinsic value problem, as we have noted, this value also needs to be reasonably stable in relation to the value of goods and services generated in an economy. It may be possible in the future to create a digital monetary system where we can reliably estimate the cost of running such a digital monetary system. At a very basic level, this cost in the form of computing power and electricity would act as the basis for the digital currencies' intrinsic value.
However, I'm not sure that processing cost itself will ever be sufficiently stable to act as a monetary anchor. That is something that could change potentially, given the likely evolution of economic and efficient energy storage technology in the future. This is perhaps an area where engineers could add to the debate.
As an example, computer bytes or processing power (or even perhaps electricity itself) could one day form the basis for a digital currency and prove to be a reasonable and durable medium of exchange if the cost of "producing" a byte of processing power was relatively stable in relation to the value of goods and services generated in an economy. But even here, given that money demand is inherently unstable and unpredictable, you would still likely need some kind of large and credible central organization (like a central bank) to intervene and maintain the value of the currency or its "exchange rate" relative to the value of goods and services in the economy in order to ensure a level of price stability (i.e. inflation targeting!).
But couldn't Bitcoin then "fix" its value?
Possibly, but the first question would be to what? If it was fixed to the underlying processing cost of maintaining and growing the system then it would tick one box. But as we have highlighted, for Bitcoin to become credible, these underlying costs would also need to be relatively stable.
And even then, Bitcoin has no elasticity in its supply to cater for fluctuations in transactions demand, and ultimately credit demand if such a market developed and therefore ensure that the fixed exchange rate holds at all times. You would still need some entity (a Bitcoin central bank perhaps) that would be able to buy or sell Bitcoins at the agreed "fixed" exchange rate and in infinite amounts. And ultimately, if this fixed "exchange rate" was markedly higher than the cost of "mining" new Bitcoins, the central bank would end up having to buy all newly mined Bitcoin. That is a supply which is only elastic in one direction!
What about fixing the value of Bitcoin to gold?
Yes, it is perhaps an idea worth exploring, or more broadly, a gold-backed digital currency. But to be credible it would need each Bitcoin to be backed by a specific weight of gold held in some physical vault somewhere. At the current value of all outstanding Bitcoin (USD 71bn at time of writing), this would unfortunately require the Bitcoin operators or miners to find 57mn ounces of gold or roughly 1,900 tonnes, which would make it the 6 th largest gold reserve in the world!
Ok, but what about the 'elasticity of supply' problem? Is it possible to solve this?
With regard to the elasticity of supply, for a digital currency to overcome this problem, the system should in some way be able to regulate the amount of digital currency in circulation, and the way the supply is regulated should be tied to the demand for that very same currency or the transaction demand for the currency. It is not in itself an entirely intractable problem, as it would in theory be possible to establish a system where the ability to grow or mine a new unit of the currency is tied to the number of transactions being completed on the system in a given time interval.
However, even if a digital monetary system could be created whose elasticity of supply could be tied to the inherent transactions demand for the currency, it would still not cater for the inevitable demand for credit. As we have already discussed, in order for a monetary system to be stable and therefore credible, the supply of money should also be able to accommodate a demand for credit that may temporarily exceed the pool of available savings.
This means that for a digital currency system to work, it should also be able to increase the supply of the available digital currency in order to accommodate an increase in the demand for credit. Therefore in the final analysis, you would still need something like a central bank that would stand ready to buy or sell this type of digital currency (perhaps our byte-based currency mentioned earlier) if the value of the currency does end up fluctuating too much (i.e., inflation, deflation) in relation to the value of goods and services generated by an economy.
Sure, but why then can't we have a digital currency that is purely credit-based?
You certainly could. However, because your "pool" of issued digital currency would be small relative to the overall pool of money or credit in the economy (at least initially), the value of your digital currency would still fluctuate significantly as demand for the digital currency ebbs and flows. In order to be credible, you would need to fix the exchange-rate of this digital currency relative to existing FIAT money until the amount of digital currency in circulation became sufficiently large to ensure a level of stability in its value. This would be a type of "currency board" arrangement. Such a system would probably require a substantial amount of FIAT reserves as well, which would deter most private citizens or organizations from such a venture.
But even here, if there are other similar competing forms of digital currency, your "market share" so to speak may never become sufficiently large enough in order to ensure stability. As an example, in the world today each country has its own credit-backed currency and even here where the value of each currency is tied to very large economies, the relative exchange rates can be very unstable.
Just think of how unstable our monetary world would become if you added another 1,000 (and in theory there is really no limit) private credit-backed digital currencies! There is a reason why we have a single mandated legal credit-backed currency in each country and it is to ensure stability in the value of the currency. It's not because of some conspiracy!
And how does such a system advance credit in a sound manner and ensure that the borrower has legitimate collateral in the form of either an asset or future services (labour) that the borrower can make available to repay the loan? You can imagine the chaos and relative instability in the exchange rates between different credit-backed digital currencies, if one "lending platform" suddenly experienced a much higher default rate relative to the others.
That brings us back full circle to a requirement for a very credible third-party (and well capitalised) to act as an intermediary between the borrower and the system, unless the system ends up being a legally mandated bank itself!
Are you saying that banks could end up issuing their own digital currencies to compete with Bitcoin?
Well, if we really think about the characteristics that I have outlined that would be required for a successful digital currency system, it sounds an awful lot like the modern-day monetary and banking system! In essence, the advantage is that the currency would still enjoy the protection and backing of the government (it would remain a FIAT currency). This would ensure relative stability in the value of the currency, as no one would ever need to worry about default rates on a specific lending platform relative to other lending platforms.
The only real difference would be the technology used to run the payment systems. In the final analysis, I guess there is nothing stopping present day banks from adopting Blockchain technology and transitioning the payment system to Blockchain technology, assuming it was more efficient in terms of power usage than the existing payments systems.
As an example, traditional banks could issue digital currency using Blockchain technology, but the digital currency will just be an electronic version of the credit money they already hold on deposit and routinely lend out and that with which we already transact with. This will ensure that any digital currency is still based on a universal or government-backed credit standard.
So although you advise people to stay away or not invest in the likes of Bitcoin, you are a believer in the technology?
Indeed. The technology behind Bitcoin appears quite ground-breaking, namely the use of an electronic private and distributed blockchain ledger. Blockchain technology could revolutionise the payment industry at some point (and some others such as financial exchanges), in effect, further reducing transaction costs. I can see commercial banks either individually or perhaps collectively (as this would make the most sense) transitioning their payment systems to this type of technology, which would save them substantial amounts of money, but become a threat for existing payment processor companies.
So we will probably eventually all transition to using "digital currency," but it will in all likelihood be the same currency we have today. We would still have $100 in the bank, but we could use Blockchain technology to pay others from that bank account directly?
I think that's one possible scenario. I can see a situation where all banks (or perhaps even the central bank itself) partner to create a "co-operative" that establishes and runs a distributed ledger system, but more importantly, still operating off a government-protected credit standard. In theory, with Blockchain you would not need a traditional bank account to make peer to peer payments, but you will probably still require certain banking services. For instance, if you wanted a loan in order to buy a car or home or if you wanted to earn interest on your excess savings. Although in the future we may not require a traditional transactional bank account, in this case we would probably still want a savings account.
What about the idea you mentioned of a digital currency backed by "processing power"?
It is probably not feasible for the time being. Perhaps one day, a very large and credible organisation or organisations in tandem (Apple or Google) will be able to build a credible digital currency backed by bytes or processing power or even electricity AND act as a reliable central bank to "fix" the value of this currency in relation to the value of goods and services generated by the economy. Furthermore, in order for such a central organisation or central bank to credibly fix or manage the exchange rate, it would have to have very large resources.
Even then as discussed, we would need the cost of the technology (hardware, software) and perhaps most importantly, electricity, to be stable and uniform across geographies. Furthermore, as already noted, we would probably need the ability to store vast amounts of electricity very cheaply and efficiently. This type of technology, at a commercial level, is probably at least a decade away if not more. We would also probably need a single integrated worldwide electricity grid and given the daily news headlines we read, this reality seems very far away!
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.