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The Future Of Money

2014 November 16
by Greg Satell

In the early 1970’s, the financial industry was transformed by a strange confluence of events.  In 1973, The Chicago Board of Trade opened the first options trading floor and, almost as if on cue, a month later the Nobel prize winning Black Scholes options pricing model was published.

Soon after, Hewlett Packard introduced a pocket computer small enough for traders to use on the floor and that, combined with a glut of engineering talent made available by the closing of the Apollo space program, created a wave of revolutionary change that is still being felt even today.

Almost overnight, finance was transformed from a clubby world of cozy relationships to a mathematical one of complex securities, abstract formulas and computing power.  Now, a generation later, the financial industry is about to be remade once again, except this time, it is not obscure financial securities that are being transformed, but very nature of money itself.

What is Money?

The concept of money dates back to the beginning of civilization.  The Israeli currency, the shekel, was originally a measure of weight (11 grams) and each shekel coin originally corresponded to that amount of silver.  Coins were stamped to certify that they contained the required weight, infusing transactions, even among strangers, with an element of trust.

It’s easy to see how money caught on.  It was a much more efficient way to transact business than bartering one good for another.  Money was also a useful store of wealth, certainly more convenient than livestock or grains.  These two core functions—a medium of exchange and a store of value—still define money today.

The nature of money changed after the Bretton Woods Conference in 1944, when most countries tied the value of their currencies to the US dollar, rather than to gold or silver. When the US went off the gold standard in 1971, all currencies essential became fiat moneys, with their value essentially derived from faith in the governments that issue them.

Many people object to the concept of fiat money because of the control governments have over it.  Central banks can increase or decrease the money supply at will, giving them enormous control over economic activity.  In extreme cases, hyperinflation can ensue, debasing the currency and wreaking havoc.

So it’s not surprising that innovating the concept of money through a digital currency has been a recurring theme in technology circles.  Intuitively, it seems that the global financial system should be based on more than the judgments of a small group of central bankers.  Yet only recently has digital money actually become possible.

A Mathematical Problem Of Trust

As Marc Andreessen points out in his excellent NY Times piece, the best way to understand digital currency is through the Byzantine Generals Problem.  Imagine a group of generals that needs to coordinate an attack, but must do so only through intermediaries.  Clearly, trust becomes an issue, because of the possibility that their communication will be sabotaged.

One way of solving the Byzantine Generals Problem is by establishing a trusted third party, which is the role that governments and banks have traditionally played in financial transactions.  Yet a third party is not a true solution, because there’s always the possibility that the third party can be corrupted as well.  In effect, it merely assumes away the problem.

Another solution would be to create unforgeable signatures, which is what digital technology makes possible (digital signatures have been around for some time).  Moreover, in digital form, these signatures can be distributed—both instantly and ubiquitously—making it an ideal vehicle for an alternative currency to fiat money.

These types of currencies are called cryptographic currencies, the most famous of which is Bitcoin.  It works through a widely distributed digital ledger, which makes it not only super secure, but also incredibly efficient because payment processing is automatic.

Storing And Protecting Value

The most publicized aspect of Bitcoin is its function as a store of value.  Bitcoins can only be created by mining, which is done by solving complicated mathematical problems.  The supply of Bitcoin is also capped.  So no one, not even its inventor, can create unlimited Bitcoins. There’s no Federal Reserve or other central bank that can intervene.

This made Bitcoin supremely popular among Silicon Valley’s libertarian set who don’t trust government entities.  The idea of a currency impervious to debasement, ruled by algorithms instead of humans, has intuitive appeal.  Establishment figures initially feared Bitcoin for many of the same reasons.

Yet as it turns out, Bitcoin is not a particularly good store of value.  Its popularity led to a massive speculative bubble, rising in value to almost $1000 and then crashing down to under $400.  The truth is that algorithms are no better—and possibly much worse— at managing currency than humans are.

Further, it is unlikely that a digital currency will ever displace national ones like the dollar. As long as governments have the power to tax, they have the power to demand payment in whatever form they choose.  Invariably, that will be a national currency.

Facilitating Transactions

While digital currencies are unlikely to impact national currencies’ role as a store of value, there is vast potential in using vehicles like Bitcoin as a medium of exchange.  Consider that Visa and Mastercard make over $30 billion per year in interchange fees and you can see the possibilities.  Bitcoin can do a far better job at a much lower cost.

Remember that Bitcoin has a widely distributed ledger, so it’s much more impervious to attack than a centralized institution like a bank.  It also transacts business instantaneously, so there is no “float” (i.e. the bank can’t keep your money in limbo while it earns interest on it) and because processing is automated, fees can be lowered substantially.

A recent article in TechCrunch describes another interesting aspect of digital currencies, the ability to program currency to create new financial products with functionality built in. Imagine being able to set up an automated escrow account or a trust on your smartphone, with no lawyers involved.

Digital currency is still a very new concept and these are merely initial ideas.  Surely, as the market and technology matures, more useful applications will arise.

The Democratization Of Finance

Money has always been intertwined with centralized power.  Only governments could issue it and only banks had the resources to facilitate transactions.  That model worked well enough, but had obvious drawbacks.  Many were shut out of the system while others earned fortunes as gatekeepers.

The revolution underway in finance going on now has the potential to be even more consequential than the one that took place in the 70’s.  While financial innovation forced many practices in the industry to evolve, its institutions remained intact.  The financial world today is still ruled by a relatively small cadre of bankers, clearing houses and regulators.

Digital technology, however, is making finance exponentially more democratic. Crowdfunding and microlending have made it possible for people to acquire financing who never could before.  New payment systems like Square, Paypal and Apple Pay have made it easier for merchants to accept electronic payment.

Yet digital currency is something else altogether because it represents a decentralized form of money that is more secure, more fungible and more functional than anything we’ve seen before.  More than a mere store of value or medium of exchange, digital money has the potential to be more transformative than anything we’ve seen before.

– Greg

11 Responses
  1. November 16, 2014

    Greg – maybe this missed your radar:

    HISTORIC DEBATE ON MONEY CREATION THIS WEEK
    There is an historic debate on money creation in the House of Commons (UK) due on Thursday. Yes 20th November 2014. Potentially this can provide a way to stimulate an economy without any government borrowing and there are other significant benefits that people only dream about at present.

    My Macro-economic Design team invented this idea. Our book entitled ‘Restarting Economics with New Fianncial Architecture’ is due out very soon.

    Money Creation is dealt with in Part 2 this three part book. The idea was also invented by the Positive Money Group. They have a lot more money. They arrived at the same conclusions totally independently unless they cribbed from me, which I doubt. But I have published a lot for a very long time…

    The proposal is that money should be created solely by the Central Banks, as opposed to being created by the banks generally whenever they lend money. There will be a limited stock of deposits for lending and savings and payments plus cash.

    As for digital money – digital transations that are used outside of the banking system as it now is has many uses, and in particular when it is using the official currency for making payments and transfers, digitsl transfers are a great help. But that is not really a new form of money.

    Bitcoins and the like, as an alternative currency of value – No! A big “No.” Only money that is used for payment of wages and goods and services has a value that can be defined – by those very transactions. In that way the value of money is negotiated. How do you negotiate a currency that is not used regularly for such purposes? It has a value if another person is willing to trade in it. And only for that one transaction.

    People understandably wish that money should have a constant value. Against what kind of transactions? Money cannot have a constant value – ever. It cannot have a constant supply either. The two go together if you like: changing supply and the constantly re-negotiated value at the shops and at the wages negotations and hired skills. It is important that the supply of money used for such urposes is managed properly. Hence the debate and our proposal.

    DEFINING FINANCIAL STABILITY
    In my book I define financial stabiity as adjustability. Everything has to be ABLE to adjust smoothly to the changing value of money so that wealth and debt repayments and everything else do not get distorted or mangled up, creating instability. Currently that is not the case. My book sets out to show how it can be done and it is getting some serious interest and great reviews. I have been told that it will be an historic book.

    Governments are all-powerful and they can destroy the benefits of any system but that is not my problem. The book is just saying what can be achieved.

    For the benefit of your readers and all other persons – I will be keeping people posted on our suggestions and the debate in the House of Commons on my website:

    http://macro-economic-design.blogspot.com

    Greg Reply:

    Thanks for the info Edward.

    – Greg

  2. pankaj garg permalink
    November 18, 2014

    I am slightly confused with bitcoin stuff. Is the value based totally on trust? i.e. when somebody started mining the coins for the first time, how was the value associated to those? What if governments ban the currency, will the value go down to 0 in that case?

    btw because it cant be tracked, it is associated with lot of illegal activities which is unavoidable by definition. so eventually it will be banned, no?

    Greg Reply:

    Pankaj,

    I’m not sure it’s feasible to ban cryptocurrency. In any case there’s little reason to. As I noted above, it has a ledger and is easily tracked.

    Here’s some info on bitcoin mining: http://www.bitcoinmining.com/

    – Greg

    pankaj garg Reply:

    by banning, i mean declaring exchanges illegal.

    Exchanges are the only viable way to invest in bitcoins. Right now mining is much more expensive than what you earn. So from banning, I mean banning the exchanges. So there is no way to exchange bitcoins with the real money.. (assuming that is a must)

    One of the issues which I am aware are, if an exchange (or anybody) has got more than 50% of mining machines in the system, they can play with the algorithm. This has happened once.

    Also, my basic question remains, who associated the dollar value with the bitcoins when it started?

    Can anybody come up with the currency similar to (but independent of) bitcoins. I think that can happen. And if so, maybe its the way to go for the Amazon and other ecommerce platforms to launch there wallets, no?

    Greg Reply:

    I’m not sure that you understand the concept of a fiat currency. The vale is derived from the faith in the issuer. In most cases, that’s a government. In this case, it’s an algorithm.

    And yes, governments can declare exchanges illegal, but I don’t think that would be very effective. They could create a firewall like China to limit access, but firewalls leak. They would have to build and maintain firewall (which is expensive) and enforce strict penalties for using cryptographic currencies. I don’t see that happening.

    – Greg

  3. November 19, 2014

    It is difficult to understand the logic of .mining/ to create more Bitcoins.

    If it is intended to show that using gold as a currency has merit, then it fails to do so.

    The basis of valueation is flimsy and the values is quite unpredictable.

    As Greg says, it wold be difficult to ban this but the risks of using it are considerabe.

    Ideal for laundering money maybe.

    Greg Reply:

    FYI. The ledger makes Bitcoin a very poor vehicle for laundering money. Every transaction creates a trail.

  4. November 27, 2014

    Mitchell & Goldsmith in UK “Great Money Creation Debate” http://youtu.be/bfR5kBcJS24
    Jct: The best of of Austin Mitchell and Zac Goldsmith from the “Great Money Creation Debate” in the UK Parliament on the most important issue on the planet, who controls creation of our credit, private banks or government utility, the whole debate I posted with commentary at http://youtu.be/k6bLZl697fY

    Greg Reply:

    Thanks for letting me know John.

    – Greg

    Edward C D Ingram Reply:

    Yes that UK Parliaent debate is my idea. But in my draft book the loose ends are dealth with as well – like the effects on currency and the currency effects on money / credit supply. AND the loose end of how to deal with the residual instabilities.

    http://macro-economic-design.blogspot.com

    My researches came up with it independently of the Positive Money Group.

    As I pointed out, Bitcois could be trouble and should not be allowed to take a serious role as a medium for credit.

    Maybe as a means of trasfering funds but that is risky.

Comments are closed.