It is important to understand the history of our monetary system in order to understand how our current financial system came into existence. You will see money is subject to many changes, and what society now perceives as ‘money’, can be completely different tomorrow. Money is a continuously evolving process. In this series, this subject will be exposed on the basis of a weekly article. In this week’s subject: ‘What is Money?’.
What is money?
The definition of money is complex. Countless books have been written about it. A lot of different materials have been used as money in the past. From shells and salt to scarce precious metals and paper notes.
Money has three different functions regardless of its form. First, money can be used as means of exchange – a means of payment with value in which everyone (read the largest part of society) has confidence. In any case, enough confidence the same amount of services and products can be bought with practically the same amount of money. Second, money is a unit of account with which the price of goods and services can be determined. Last, money is a store of value. (ECB, 2015)
Economist Karl Polanyi, known for his heterodox views and his studies of economic phenomena in their social, cultural and historical context made a distinction between “general purpose” and “special purpose” money (Ravies, 2016). The conditions in which “general purpose” must be met according to Polanyi are: portability (easy to transport), divisibility (easy to divide into smaller denominations), convertibility (easily exchangeable), generality (generally accepted), anonymity (used without the owner having to identify himself) and legality (the guarantee of value by a government agency) (Ravies, 2016). Questions can be raised about whether the last two conditions, anonymity and legality actually are a requirement of money. The digital fiat money you see on your bank account is not anonymous at all. Banks must meet their Know your Customer (‘KYC’) policy. They know exactly from whom the money is and where it came from. This in contrast to cash money. In addition, we have noticed money does not necessarily have to be issued by governments to serve as a means of payment.
The History of Money (part 2)
In ancient times, long before Bitcoins, euros and dollars were in circulation, people exchanged goods to provide for their living. One of the first payment methods used was salt. Salt was a precious product because food could be stored in it. In the Roman Empire, soldiers were paid in ‘sal’, the Latin word for salt. The word ‘salary’ owes its existence to this form of wage. Civilizations in Africa and Asia used feathers, shells, beads and teeth of animals as a means of payment. (From salt to Bitcoins, means of payment through the years, 2018)
Over the course of history, three independent currency traditions have emerged in the world:
The Chinese tradition
Around 770 BC. the first Chinese money was manufactured. At that time money consisted mainly of bronze molded models of knives and spades with Chinese characters on them. This started with the use of ‘kèpèngs’, round bronze coins with a square hole in it to tie a rope through them. These coins were often traded per string due to the small value of the individual coins. These ‘kèpèngs’ were minted by the government for circulation until 1912. Today they are mainly seen as lucky coins. (Ravies, 2016)
The Indian tradition
Independent of other cultures, the first coins in India were minted around the year 500 BC. At that time, it were mainly slices of silver with small stamps representing plants, animals and other figures. Up to about 100 BC. Greek- (by Alexander the Great) and later also Roman cultures gained strong influence on Indian coins. (Ravies, 2016)
The Western tradition
Spread from Asia, the first European coins were manufactured around approx. 700 BC. Many coins were made from a mixture of precious metals. Often a symbol of the city or castle was burnt or carved on the coin. In the 6th century, this use spread into the Persian Empire and the Greek world. This resulted in a strong efficiency drive in trade. (Ravies, 2016)
The first country in the world which realized heavy coins are not at all useful for transport on trade trips and switched to paper money on a large scale was China. The first paper money was printed with which payments could be made from the 7th century onwards. These were a kind of certificates. These certificates were registered so that people did not have to worry about being deprived. In Europe people only began to use paper money in 1661. (From salt to Bitcoins, means of payment through the years, 2018). Paper money is in fact fiduciary money. Money that does not derive its value from a commodity, and therefore has no intrinsic value. The money only derives its value from trust in the solvency and integrity of the eminent. When this trust is lost, the money is worth nothing. The word ‘fiat’ comes from Latin and means ‘Let it be so’. (Galbraith, 1975)
In England, a different system had been conceived. Certificates were printed that represented a certain amount of gold. People received a ticket called the ‘goldsmith note’. This indicated the value of the amount of gold that they possessed. As you can already guess, more notes were issued at that time than there was gold in custody at the goldsmiths. In the eyes of some, this is one of the first modern forms of credit. For this reason, the first central bank in the world was established, in 1694. The bank guaranteed the amounts printed on the banknotes. (From salt to Bitcoins, means of payment through the years, 2018)
Over the centuries, more countries decided to set up a central bank. First to act as trusted middlemen and to guarantee that the paper money was covered by gold, later central banks were given more powers and tasks such as conducting monetary policy, promoting payment transactions, circulating base money and supervising financial institutions With the help of the external reserves of central banks, it is ensured that central banks are sufficiently liquid to carry out foreign exchange operations where necessary. The objectives for the management of the foreign reserves of the most central banks are, starting with the most important: liquidity, security and returns. The external reserve portfolio of central banks consists mainly of American dollars, Japanese yen, Chinese renminbi (CNY), gold and special drawing rights. The composition of the portfolio changes with time and reflects changes in the market value of the assets invested, as well as the currency and gold transactions of the central banks. A lot can be said about reserve currencies. In the history of mankind there have been many world reserve currencies. The US dollar has been the currency of the world for decades, because the United States is an economic world power and many commodities such as oil and gold are listed in this currency. This does not mean, however, that the US dollar will remain the world’s largest reserve currency forever. In our opinion, it will not take long before central banks include Bitcoin in their portfolios.
It is important to understand the history of our monetary system in order to understand how our current financial system came into existence. You will see money is subject to many changes, and what society now perceives as ‘money’, can be completely different tomorrow. Money is a continuously evolving process. In this series, this subject will be exposed on the basis of a weekly article. In this week’s subject: ‘Digitization of Monetary Objects’.
Digitization of Monetary Objects
Ralph Schneider and Frank X. McNamara devised the credit card under the company ‘Diners Club’ in 1950. From that time on, people were able to consume credit on credit cards. (Invention, 2018)
In the euro zone we have a European System of Central Banks (ESCB). These central banks are public institutions whose main task is to ensure the stability of the euro, the legal tender of the Member States of the European Monetary Union. Issuing euro coins – which still have a minimum intrinsic value – are still a national competence and are issued by the member states of the European Monetary Union itself. (ECB, 2018)
Central banks issue physical banknotes. Commercial banks can then use digital balances at the central bank. The residents of the euro countries only have access to the physical banknotes of the central bank. They cannot open an account at a central bank (Bollen, 2018). When a citizen pays with his debit card or online, he does not pay with the money from the central bank, but with scriptural money. Money that is therefore issued by private parties in the form of commercial banks. A report from the ECB shows that in 2016, 46% of the value of all payments in the Eurozone took place digitally (European Central Bank, 2017). In some countries, however, this percentage is already considerably higher. So, no ‘real money’ is involved in all these payments. (Bollen, 2018)
‘Real money’ in this case literally means ‘real money’. Scriptural money, the money you see when logging into your bank account of a commercial bank is not real money, issued by central banks as a legal tender. Scriptural money is a claim on a private bank and therefore a common, but not a legal tender (De Nederlandsche Bank, 2014). So, in fact, we largely use claims on private banks instead of real money for our daily payment transactions. ‘Money’ is therefore not an unambiguous concept.
So, what actually is a legal tender? These are means of payment that are enshrined in law as ‘legal tender’. Most governments do not prescribe which means of payment you should use. The banks decide that they make it possible to pay electronically. The role of the government lies in the legislation and keeping supervision of payment transactions. In addition, the law does not oblige anyone to accept legal means of payment (Rijksoverheid, 2018). Scriptural money does not have the status of ‘legal tender’. That does not, however, prevent society from making payments and even paying taxes with it. Former Minister of Finance of the Netherlands said in June 2017 in response to parliamentary questions about cryptocurrencies: ‘Bitcoin is not a generally accepted or legal means of payment and therefore no money in the generally accepted definition of that term’. However, the definition of money remains vague. In practice, it often concerns whether the payment method is accepted as a means of payment. It does not have to be a ‘legal tender’ for this. Legislation often lags behind technological developments, for example cryptocurrencies. (Bollen, 2018)
There is a significant difference between a monetary object and a monetary claim. The distinction between monetary objects and monetary claims is essential for the discussion about our monetary system. A monetary object is an item that is used for payments, for example cash. Monetary objects are movable properties with payment power. In layman’s terms this means you can pay with it by transferring the object to someone else. Physical monetary objects are not a claim on the entity that issues them. A monetary object is not a claim, but the property of the rightsholder. (Bollen, 2018)
The bottom line is that the monetary power of monetary objects is not based on the amount of gold or debt a central bank has on its balance sheet, but on the trust, society has in it. Even if the central bank ceased to exist, people would still be able to use the same monetary objects as a means of payment, as long as one has confidence in the monetary object and as long as it remains generally accepted. (Bollen, 2018)
For example, in a prison the medium of exchange could be cigarettes. In this case the cigarette is the monetary object. If Philips & Morris suddenly declares bankruptcy, the cigarettes in circulation will keep their value until they are consumed. (Bollen, 2018)
The problem in modern society is that the money stalled at commercial banks are not monetary objects but monetary claims on the bank in question. This creates a credit problem. If the bank declares bankruptcy most of the clients lose their monetary claims. The clients can only hope on reclaiming a part of their claim when and if the curator starts to partially refund clients with whatever monetary value is left. This process often takes years to complete. In the meantime, no sane person would accept a monetary claim on a bankrupt bank. (Bollen, 2018)
The government has theoretically devised a trick for this called the ‘deposit guarantee scheme’. Deposit guarantee schemes (DGS) reimburse a limited amount to compensate depositors whose bank has failed. Under EU rules, deposit guarantee schemes protect depositors’ savings by guaranteeing deposits of up to €100,000. In theory, this sounds pleasant (European Commission, 2018). In practice, however, it remains to be seen whether this is possible. When shit hits the fan and big banks fall over, it will probably undermine the entire system we know.
Because cash is currently the only monetary item issued by a public institution to which citizens have access, our payment infrastructure has been slowly and silently privatized. When you make a payment at Amazon or Alibaba, you pay with a claim on your private bank. As a result, the power of our money has largely come into the hands of a relatively small number of private parties. These same private parties can lend money that they do not actually have.
Most banks are broke. Why are they broke? It is not an act of God, it is not some sort of tsunami. They are broke because we have a system called fractional reserve banking, which means that banks can lend money that they do not actually have. To add to that problem, you have moral hazard from the political sphere. Most of the problem starts in politics and central banks which are part of the same political system. In addition, a very select group of undemocratically chosen central bankers decides on how much money is being printed, with a nice word called ‘quantitative easing’. The artificial printing of money, which if any ordinary person did they would go to prison for a very long time. And yet central banks do it all the time. Central banks repress the amount of interest rates so we do not have the real cost of money. Yet we blame the real retail banks for manipulation LIBOR. The sheer effrontery of this is quite astonishing. Its central banks that manipulate interest rates (Bloom, 2013). In the eyes of many millennials, our current monetary system is a sick old man who will not live for long.
And then there was Bitcoin
Then suddenly a revolutionary man or group of people who is / are called ‘Satoshi Nakamoto’ created Bitcoin. Potentially a digital monetary object. Digital monetary objects are easy to move over large distances, without the drawbacks of monetary claims. There is no credit risk, because they are registered per address (a sort of account number) and are not a claim against a counterparty that can go bankrupt (Bollen, 2018). These digital monetary objects, whether that is Bitcoin or another decentralized currency of ‘the people’ instead of a select group of undemocratically chosen bankers, could ensure sufficient liquidity in our economy, without the credit risk of scriptural money. As a result, they have the potential to revolutionize our payment system, which, if managed properly, will benefit the stability of our financial system. Until then, it will be a Wild West chaos.