Cryptocurrencies I
"How money was created, and on what basis it circulated, defined in critical ways the relationships of farmers, urban workers, and commercial participants in the emerging industrial state. The answers would go a long way toward determining who controlled the rules of credit and commerce, who shared in the fruits of increasing American production, and, ultimately, how many Americans obtained that minimum of income necessary to ensure that they lived lives of dignity. With the stakes so high, all questions about the currency were clearly not of equal weight. One of the weightiest concerned the origin of money. Whether the government issued money, or whether private bankers did, obviously shaped the precise forms of finance capitalism to a telling degree. The resolution of this issue might well determine which occupational groups had a measure of influence over their own economic future and which did not. How much money circulated also was important―in terms of price and income levels, interest rates, and the relations of creditor and debtor classes. Central to the whole issue, of course, was a clear definition of money itself. Was it gold? Gold exclusively? Silver and gold? Did the currency include paper money?” – Lawrence Goodwyn, Democratic Promise, 1976
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The global financial system is a bit of a mess or a real catastrophe depending on your perspective. Nothing represents this better than the rise of cryptocurrencies. The first thing one might ask is crypto a currency? To answer that you first have to define what a currency is, and well, contrary to conventional wisdom and common belief, as Goodwyn lays out above concerning the late 19th century US, that’s never been a simple question to answer.
Currencies are a way to transfer value from one person to another. A currency’s value is almost always entirely implied, opposed to an inherent value of the currency itself. Specie advocates pushing gold, silver, and copper claim there’s some sort of natural value to these metals, but at best that’s debatable. Nonetheless, whatever a currency’s intrinsic worth, whether gold, silver, paper or electronic, it’s real money value is only bestowed by the greater monetary system it is part. All currencies fundamental money value, no matter the currency, lie in the collective belief of its value, always has, always will.
How such value is derived is another matter. It could be mandated by centrally controlled government, for example by the priests of an ancient Mesopotamian temple, or its value might be derived by markets, which may or may not be organized in a more decentralized manner. The present system of leviathan global corporations bestowing monetary value is more similar to centralized governments than “free-market” myths propagated by contemporary academia's economic priesthoods.
Whatever way a currency’s value is gained, for it to be much use as money, the volatility of its value needs to be kept to a minimum. For millennia, volatility was largely constrained simply by the supply of the currency. On a finite planet, there’s a limited amount of silver and a lesser supply of gold, providing a natural hedge against monetary inflation. In much of the ancient world, for example the Roman empire, the supply of specie became not just a hedge against rising monetary values, but constrained economic activity.
Across history, the finding of new metal mines allowed a previous monetarily constrained economy to grow and be perceived wealthier. No greater example is Spain’s plundering of gold and silver from the Americas, which funded the Hapsburg’s various wars across Europe and plenty of vile, gauche, and gaudy decorative arts. The Mexicans and Inca did not used gold and silver as currencies, they valued them only as shiny, pliable, decorative metals.
Paper currency is not as new many think. Paper notes, that is paper representing a claim on another value, have been around since at least the Romans. Roman personal debt-notes, syngrapha, were used as a paper currency in the last decades of the republic. They may have been marked by each holder, a sort of ancient paper blockchain. In the proscriptions of the republic's last decades, confiscating syngrapha or destroying them were significant political acts of wealth redistribution and debt relief, though it also shrank the money supply.
However, only in the last two centuries did paper notes come to dominate currency use. In the last several decades, electronic currency, simple notations on banks’ computer spreadsheet ledgers, rapidly replaced paper. The move to paper currency was fraught with volatility, but not so much the move from paper to electronic ledgers. The simple reason for this was banks. All currencies are simply an aspect of a greater monetary system. A key component of modern monetary systems are banks. Modern currency, paper or electronic, is bank-debt money.
In the US, across the entire 19th century an ongoing political battle established banks as the foundation of the monetary system. Their position became codified and institutionalized with the establishment of the Federal Reserve at the beginning of the 20th century. The most significant political power of any currency rests in its origin, its creation. By leveraging debt, banks became the primary creators of money. Even the US Treasury is subject to the banks money creator role with treasuries sold into circulation by certain government certified banks known as “primary dealers.”
One thing learned in the 19th century, bank-debt money could not be leveraged to infinity. Gradually rules, i.e. regulations, were established for banks to keep a a certain amount of reserves/capital to limit leverage, say at 10 to 1. For every ten dollars out in loans, banks were required keep a dollar in their “vaults.” Leverage is limited through various regulatory mechanisms, for example the FT has a recent article, “Federal Reserve unveils plans to reduce capital rules imposed after 2008 crisis” stating,
“The biggest and most globally systemic US banks, including JPMorgan Chase and Goldman Sachs, need to have so-called tier one capital — common equity, retained earnings and other items that are first to absorb losses — worth at least 5 per cent of their total assets.”
There’s other regulatory methods than this, but in this case, regarding what the banking system considers quality money—tier one capital–there’s a 20 to 1 leverage ratio, one dollar is limited to creating twenty new.
Two very important elements were established with the codification of bank-debt money. First, with the creation of the Fed, an interconnected banking system was established. The banking system is the political structure of the money system. As a social belief, all money is a political construct. Again, the greatest political power in any money system is the ability to create money, whether by minting, printing, or leveraging, hence the banks are the most significant political force in a bank-debt money system.
Secondly, bank-debt money was a step in the right direction in making money more information rich. Specie, whatever form, is largely bereft of information, representing only specific quantitative values. However, bank-debt money is more information rich, pun intended, from the debt underlying it. Every loan a bank initiates represents some sort of real economic activity. The money created from that loan is good if the loan is paid back, not so good money if it’s not.
Without going into great detail, the bank-debt money system has changed in many ways over the years. In the last several decades, the banks created all sorts of dodges to get around leverage constraints. Things like derivatives, MBS, private equity, shadow banking, the list is long, all induce greater leverage. The details are not important for this piece, just an understanding the top of the money system constantly does everything they can to get beyond regulated leverage constraints. After all, money creation is literally free money, lord knows everyone likes free money.
In bank parlance, loosening leverage constraints, is known as financial innovation. As John Kenneth Galbraith said long ago, when someone talks of financial innovation the thing to do is run. In 2008, financial innovation led to the crash of the system, historically known as a panic. In financial panics, people look to dump various debt instruments for “quality” money, but remember when push comes to shove or when previously considered sound finance turns to panic, in a system leveraged 20-1, there’s only one immediate $1 available for any given $20 that might be demanded. When everyone starts demanding at once, monetary values begin dropping hard and fast.
In tandem with the 2008 Panic came the introduction of the first cryptocurrency, the infamous bitcoin. With its white paper introduction, its anonymous prophet/designer, Satoshi Nakamoto wrote, “We have proposed a system for electronic transactions without relying on trust.” So stereotypical of the asocial computer whiz spending day upon day, week upon week, year upon year, in front of his (overwhelmingly they are he) screen, seeking to replace all human interaction with a machine. What can be more anti-human than seeking to replace trust, the foundation of human social interaction? Once again in 2008, the banks, the rest of the financial system, and their political toadies demonstrated they were the last people to be trusted. What better solution than trust-less money? If you understand the history of money, you know there can be no such thing.
Electronic currency was nothing new. Every time you use a credit card you're using electronic money – a simple notation on an electronic spreadsheet kept by a bank. Bitcoin seeks to remove the banks, instead of an electronic entry, bitcoin is a block of code protected, so much as it is protected, by cryptography. Nothing new about cryptography either. Cryptography is an ancient method of keeping secrets by encoding messages, only sender and receiver have a “key” to decipher. Across human history, cryptography has largely been a military concoction. Its modern use and cracking in WWII important to creating some of the first computers.
However, and this is very important and little understood, bitcoin isn’t really the code, it’s compute power demonstrated in what's known in compute lexicon as “proof of work.” Bitcoin isn’t validated by its code, but by vast amounts of compute power required to create, transfer, and verify transactions. As the Prophet wrote, “Transactions that are computationally impractical to reverse protect sellers from fraud.” So, humanity's deemed shells, metals, paper, and electronic ledgers as currency, now, and this has been sold as progress, the Tech boys advocate we use an almost innumerable opening and closing of transistors.
Most amusing, this initial opening and closing of transistors, the creation of a bitcoin, the requisite compute power is referred to as mining. The visionary money Prophet borrowed the archaic notion of currency as a metal, not unlike Tech huckster Elon’s shilling a century old technology, the electric vehicle, as something new.
As an anti-inflationary measure, just like the finite ancient gold and silver mines of Spain, the creation of the number of bitcoins is limited to 21 million. The vast majority already created. Amusingly, with a single bitcoin now valued today at $100,000, its use as a currency is severely limited. Not to worry. The Prophet’s acolytes say any coin can be conveniently divided into a thousandths, millionths, or hundred millionths, Phew! If that ain’t inflation, I don’t what it is.
The Prophet correctly understood his currency, like all before, is part of a greater monetary system, in this case a “peer-to-peer” network. Now, peer to peer, to compute illiterates might imply a simple transaction between two individuals, no middleman. Nothing is further from the truth. Peer to peer networks are comprised of what in the end might be an almost limitless number of individuals. The code stored in numerous computers. The compute necessary for validation distributed across a multitude of “nodes” as opposed on centralized server.
In the original bitcoin scripture, the Prophet explains in a section titled "Network,”
"The steps to run the network are as follows:"
1) New transactions are broadcast to all nodes.
2) Each node collects new transactions into a block.
3) Each node works on finding a difficult proof-of-work for its block.
4) When a node finds a proof-of-work, it broadcasts the block to all nodes.
5) Nodes accept the block only if all transactions in it are valid and not already spent.
"6) Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash."
Behold the bitcoin!
What we have here is money system, like all money systems, requiring a body of individuals, not one, not two, but the entire community to believe in the value of the currency. The difference in this case, instead of metal or paper, the currency itself is compute power verified as “proof of work,” which at its core is simply innumerable number of transistors opening and closing.
To this point, bitcoin has proved limited as currency, but in a financial system greatly lacking in trust, it has proved a most excellent instrument of speculation. However you want to value raw compute power, in this regards, it is best valued as a complete energy sink. Bitcoin’s value as a currency has proved immensely volatile. Beyond speculation, hyper-volatile currencies aren’t worth much of anything.
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Continued: Cryptocurrencies II: Stablecoins