I’m here to help. I know the pain that you’ve experienced when you were at your last dinner party or work lunch and all your colleagues started talking about bitcoins and block chains and cryptocurrencies and malleability attacks. You wanted to participate. Maybe you even tried to toss in a random statement like “Gotta be careful of those dime teeth because you don’t want to be bitbyacoin. Heh heh” and then everyone at the table stared at you for a bit. Maybe they patted your head and took away your fork and knife too.
Like I said, I’m here to help.
Bitcoin and virtual currencies are hot topics these days. But they’re not as simple as they seem. They appear to be easily understandable (It’s money, right?) but then a story comes up about a website being hacked and all the bitcoins are gone and suddenly you don’t think you get it anymore. Or they start throwing around how it’s actually different from current money. Or they start calling money fiat money and then you’re totally lost. That’s where these posts come in.
I started putting this primer together because I find some of the legal issues around bitcoins to be fascinating. But in order to discuss those legal challenges you have to understand how bitcoins work and what’s new about them. And to understand that you also have to step back and think about the role of money. So that takes a while.
Rather than post this all as one giant article, I’m breaking it up a bit (because Lionel told me to) to make it easier to digest. For the first part of the primer, we aren’t even going to talk about bitcoins but rather the basics of money. If you’re a money theory expert then you can just come back tomorrow for part 2 where we start talking about bitcoins. But if you’re a money theory expert, you probably don’t need this primer. Everyone else, let’s get started.
The Basics: What is currency?
To understand bitcoins and the related world of virtual currencies we first have to take a step back and think about the concept of money. It’s a strange exercise for those of us who don’t engage in this kind of thinking, we’ve just grown up using money to buy things. But embedded within our daily usage of money are several important concepts that are worth noting.
(Please note that currency is a very complicated topic and I’m not covering all aspects, just some highlights. If you want to read more about it–well, you are connected to the Internet. Use that.)
1. Money has fixed units of measurement
If you have a ten dollar bill that is worth ten dollars. What that buys you depends on how much someone wants to charge for a good or service, but both sides in a transaction agree that the ten dollar bill is worth ten dollars. This gives money an edge over barter systems where two sides in a transaction agree to swap goods or services. Say in a barter system there is a man who will sell you a goat for the low, low price of three chickens. But you walk in with three sickly chickens and he refuses to make the sale based on you not having enough chicken as payment. Or you come in with two extremely healthy, robust chickens and insist they are worth the same as three ordinary chickens. Barter systems have the potential to make each transaction a negotiation and that can be inefficient. Money has an advantage by removing the argument about how much the proposed payment is worth.
Another advantage of using money or some substitute item of value, like gold or other precious metals, is that you have fixed units that can be divided. Most modern forms of currency have smaller units in the form of coins and larger units in the form of paper. With precious metals you can measure the weight and divide the metal into pieces with less weight. You can’t divide a chicken. Well, you can, but only once and then you can’t use it again a week later.
2. Money doesn’t disappear
Did you ever wonder why gold is sometimes referred to as a substitute for money? (Or why government money used to be a voucher for that value in gold?) There are a few reasons–it isn’t readily available but also not completely rare, it is very dense so you can store a lot of its value (weight) in a small space, and you can find gold all around the world so that makes it a good exchange internationally. But another really good reason for using gold or other precious metals like silver is that gold doesn’t dissolve upon contact with air. Or water. Or coffee. Or any other substance that you might accidentally spill on it during the day.
The Trobriand Islands famously use yams and scored banana leaves as currency among the native population. This is a tradition and annual practice for them, but I think we can all agree that it’s really difficult to save up for a big purchase over the years when your money might start to rot and smell and grow mold.
Generally speaking, we like having money that you can keep and use whenever you need to without worrying if your money has been made useless through contact with air, water, coffee, or evil, evil squirrels.
3. Money is controlled and scarce
For modern currency, money is typically issued by a government or central bank. This not only regulates the amount of money in circulation but also lets each form of currency come up with ways of ensuring the integrity of money by making sure the amount of money in circulation is authentic and scarce. Scarce being a relative term–there could be billions or trillions of it floating around, but the scarcity is because it is limited. If you have an economy based on unlimited currency you can run into situations where the issuing government just starts making more and more money, decreasing the value of the money already in circulation and causing people to increase prices. This is called hyperinflation and one of the many concerns that governments attempt to address when issuing currency.
That’s not to say governments don’t screw this up. The worst case of hyperinflation ever recorded was the Hungarian pengo in 1946. In 1944, the largest paper note in the country was 1,000 pengo. By the middle of 1946 there was a paper note worth 100,000,000,000,000,000,000 pengo. That’s One Hundred Quintillion pengo. At the worst time of this hyperinflation, prices were doubling every 15 hours.
Keeping money scarce, both through controlling how much is issued and ensuring there are no counterfeit supplies, is an important aspect to modern currency.
4. Money is transferable
Money is designed to be exchanged. That’s its sole purpose. I’m not saying you are obligated to exchange it once you get it–savings are good, people–but money that can’t be given to others as payment is useless. At its simplest, currency in the form of coins and paper notes can be physically given to someone else. You give someone a ten dollar bill in exchange for something worth ten dollars. At the slightly more complicated level both sides of a transaction can trust a third party to transfer the money for them. You give your credit card number to a vendor when buying your ten dollar item–the vendor trusts the credit card company to send them ten dollars and the credit card company trusts you to pay the ten dollars. And by trust I mean you both signed contracts with the credit card company that allows this transaction to take place.
5. Money has value
This last element is not just the byproduct of the first four but they certainly feed into it. Ultimately, though, money must have actual value to be used to purchase things. That value can come from three different origins.
First, the value can be inherent to the item. This is what happens in the barter system. A chicken is, by itself, valuable. How much value can be debated, and will be negotiated when exchanging for something else, but if you have a chicken you have some value. Tasty, tasty value.
Second, the value can come when the currency is a voucher for something valuable. Historians believe the earliest form of currency were paper vouchers that could be redeemed for grain stored in Sumer’s temple granaries. The island of Yap used large stone wheels as currency called Rai stones. Moving these wheels around wasn’t practical so instead the currency became the oral tradition of remembering who owned which stone. Currency in this case becomes an easier substitute then hauling around the actual item of value you are exchanging. It’s more efficient than the first type of value.
Third, the value can be conjured out of thin air. No joke. This is called fiat money. It comes from the Latin “Fiat” meaning “small Italian car.” Or, if you prefer the more often used definition,
a command or act of will that creates something without or as if without further effort. – Merriam-Webster Dictionary
Governments do this a lot, create something out of nothing. Like the legal limits to vote or the requirement to pay taxes. Or money. While currencies used to be attached to gold reserves (you may have heard of the Gold standard), that isn’t true anymore–all modern currencies are simply created by their issuing authority. Their value derives from people accepting those values. The various issuing authorities work very hard to keep that value consistent, but different countries and regions will change their opinion of the currency’s value from time to time. This is why you have fluctuating exchange rates and people who make a living buying and selling currency from different origins.
These five elements together combine to form the essential characteristics of modern currency: fixed units, doesn’t disappear, scarce, transferable, and valuable. In part 2 of the primer we’ll learn what is a bitcoin and how it potentially has these five characteristics and could be considered a modern currency.