How Money Stores and Exchanges Value

Examining the properties of money provides an understanding of value

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Money is a representation of value that has achieved General Acceptance as a Medium of Exchange (GAME). To achieve and maintain such general acceptance, money must first be perceived to exhibit an acceptable ability to store value. 

Historically, many different things have been used as money from shells to metal coins to paper notes, each achieving varying degrees of success in storing and exchanging value. To evaluate the effectiveness of different forms of money and their ability to hold and exchange value over space and time, they can be compared across six criteria:

Durability: Money should resist degradation or decomposition over time

Portability: Money should be movable from one place to another

Fungibility: Money should be interchangeable with other units of the same money

Verifiability: Authentic money should be distinguishable from inauthentic money

Divisibility: Money should be able to be subdivided into smaller units

Scarcity: Money should have limitations on its supply

For money to store value to such a degree to gain acceptance as a medium of exchange, it must be relatively robust across these six criteria. Impairment across one or more of these criteria will negatively impact an asset’s value and exchangeability.

Gold and Silver

Precious metals, and in particular gold, were able to gain popular consensus as money because they are relatively robust across these criteria. If gold rusted like iron, or was immovable like land, or was indivisible like livestock, or was abundant like sand then it would be severely diminished in its ability to hold or exchange value over space and time. 

This robustness in holding and exchanging value is based on physics rather than subjective opinion. Resistance to degradation, physical weight, ability to be subdivided, and relative scarcity in the earth’s crust, are determined by these metals’ physical properties and are not changeable, much to the chagrin of alchemists. 

Gold has value because its monetary characteristics are favourable and immutable, and that immutability serves as evidence that valuable resources were used in acquiring it.

Gold and precious metals do have limitations as money, most notably in their portability, verifiability, and divisibility. They are heavy to carry, their purity can be difficult to verify without proper equipment, and they can only be subdivided up to a certain point. Although these metals were effective means by which to store value, these limitations made them cumbersome as mediums of exchange.

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Paper

Due to these limitations, people began to offer custody services (banks), whereby gold would be deposited in exchange for paper receipts that were redeemable for gold. These receipts acted as paper money, as they could be used in lieu of the underlying metal. 

Paper money was an advancement as a medium of exchange, as it was easier to carry than gold and could be printed in arbitrarily smaller denominations. In essence, people’s trust in gold as a representation of value migrated to trust in banks and their ability to redeem paper for gold. 

The downside to this arrangement was that over time banks tended to break or impair the redeemability of paper money for gold by issuing more paper than was held as gold reserves. Minters of coins also had the tendency to dilute the precious metal content of their coins over time, a phenomenon that occurred from Roman times through to the 20th Century. 

The most notable instance of this impairment took place in WWI, when gold-backed currencies across the world had their redeemability temporarily restricted or suspended in order to finance war efforts. When the redeemability of money is inhibited, new money is able to be created with little to no marginal cost, also known as money printing. Such addition of un-backed money to the money supply diminishes that money’s ability to store value, as it becomes relatively less scarce and is irredeemable for anything that is scarce.

Paper money outcompeted gold because it had superior medium of exchange properties, but this came at the expense of its store of value properties.

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Fiat 

Although major currencies resumed redeemability for gold after WWI, all redeemability was permanently ended in 1971, when President Nixon changed the US dollar from a gold-backed currency to a fiat currency. Fiat currencies have no redeemability for precious metals, meaning that their value exists simply because a central authority has declared that they have value. 

Instead of being redeemable for a scarce asset, the dollar’s scarcity became artificial and subject to political decision-making. Printing a new dollar no longer required expending resources in acquiring a scarce asset, it simply required the motive to do so. Although a dollar before and after 1971 would have appeared the same, and functioned equally as a medium of exchange, the basis upon which that money held value was fundamentally different. 

The American switch from gold-backed money to fiat money led to all major currencies transitioning to fiat. With the advent of computers, fiat money became digitized, to the point where a very small percentage of fiat money now exists as paper notes or metal coins. Popular trust in paper money as a representation of value expanded to include trust in digitized account balances as well.

Modern digitized fiat currencies offer even more advancements in terms of portability, divisibility, durability, and verifiability. It is faster, cheaper and easier to transact with digital money rather than paper money, especially in large quantities and over large distances. However, just like the transition from gold to gold-backed paper, these improvements as a medium of exchange came at the expense of scarcity. A central monetary authority’s marginal cost of “printing” new digital fiat money is zero, thereby enabling issuers of currency to create infinite money, instantly. 

So long as fiat money’s artificial scarcity remained close to that of pre-1971 money, it could continue to function similarly in terms of storing value. However, in the subsequent 50 years, fiat money has been printed at an accelerating rate to finance government operations and support economic activities. From August 1971 to August 2021 the supply of money in the American economy (measured as “M2”) increased from $685.5 Billion to $20.8 Trillion, with over 40% of that money being created in the last two years.

Source: St. Louis Federal Reserve

The lack of scarcity of fiat money means that its ability to store value is diminishing at an accelerating pace. Holding fiat money is a guaranteed way to lose value due to inflation, thereby incentivizing people to spend or invest their marginal dollar more quickly when they would otherwise prefer not to. 

Whereas the scarcity of gold is established by its immutable physical properties, the scarcity of modern fiat money exists only at the behest of political officials.

Bitcoin

The growth of the Internet and advancements in cryptography enabled a new form of digital money to be launched in 2009: Bitcoin. 

Bitcoin is a decentralized, digital form of money, with a decreasing inflation rate towards a final supply cap of 21 million. Bitcoin’s preset supply and inflation schedule are cryptographically enforced by a global network of computers, which operate in a decentralized and self-interest-based competitive marketplace. It is also a bearer asset, in that whoever holds the private keys that are needed to transfer the bitcoins, effectively owns the bitcoins.

Bitcoin’s decentralization and cryptographic enforcement makes it economically and mathematically infeasible to change Bitcoin’s supply and inflation schedule outside its preset parameters. Bitcoin is the world’s first digitally scarce asset, and that scarcity is based on mathematics.

Bitcoin’s robustness as a form of money can be evaluated across the same criteria as legacy money:

Durability: Bitcoin does not tarnish, degrade or decompose.

Portability: Bitcoin can be transferred globally with final settlement within minutes or seconds, and ownership of Bitcoin can be stored on paper as a 12 or 24-word passphrase, or simply memorized

Fungibility: One bitcoin equals one bitcoin

Verifiability: Anyone with an Internet connection can audit the total supply of Bitcoin as well as the balance of any Bitcoin address 

Divisibility: Each bitcoin can be subdivided into 100 million units, known as satoshis

Scarcity: There can only ever be 21 million bitcoins

Across these six criteria, Bitcoin is most notably a scarce asset. When compared to legacy monies such as gold, commodity-backed paper money, and fiat money, Bitcoin offers a superior alternative in its ability to store value over space and time. Owning one bitcoin all but guarantees the ownership of 1/21 millionth of the total possible supply of bitcoins.

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The fact that Bitcoin is a digitally scarce bearer asset that trades 24/7/365, in a permissionless, global, open marketplace means that it also offers a competitive alternative as a medium of exchange. With the Bitcoin Lightning Network, which is a “layer 2” of bitcoin, it is possible to instantly trade tiny fractions of a bitcoin globally at little to no cost. Pennies’ worth of Bitcoin can be instantly transmitted anywhere in the world at the cost of fractions of a penny. Exchanging value via Bitcoin is an advancement even beyond digital fiat money.

Bitcoin is a monetary innovation both as a store of value and as a medium of exchange. Since money is whatever gains general acceptance, the growth rate in Bitcoin’s daily value traded and transaction volume on the lightning network should be regarded as its progress towards becoming money. 

In a monetary landscape where digitized fiat currencies are losing value at an accelerating rate, while an alternative digitally scarce asset is gaining popularity, the future of money will almost certainly be different than its past.