In search of Money — episode 2: Issues with the modern fiat money
Hello people of Earth! We live in an exciting time.. as if there was a generation who could say the opposite.. Anyways, as we’re dashingly moving into new decentralised model of economy we decided to cover the topic of money as we think that its form is transforming extremely fast creating gaps in understanding its nature which is essential for making smart moves in the coming future world. You all use cryptocurrency term a lot, most of you are very well aware of the stablecoin notion, maybe not so well of the decentralised reserve currency ideas while many probably struggle to understand the mechanics behind token minting process performed by various DAOs offering crazy APYs. As this is quite a topic, the material will be released in four episodes:
Issues with the modern fiat money
Cryptocurrency to replace fiat?
Stablecoins and future of money
Issues with the modern fiat money
Ok, folks, we hope that your short attention span nevertheless allowed you to get through the first episode of our Money series and you remembered very well that:
Money originally was meant to represent the value of real world goods and services to facilitate the exchange of those and therefore money is not the ultimate value, it represents value of something else (i.e. it is a price tag)
People quickly realised that money then had superpower to capture the value of those goods and services in a notional form — seashell, gem, gold and eventually a banknote — that were used to measure and move value in a convenient way
Also they realised that the captured value can be accumulated and carried through time in that notional form to exchange it for the goods and services in the future, i.e. can be delinked from the actual value of existing goods and services it represents
In the end people figured out different ways to play with this superpower and often it led to very bad results.
Let’s start with the most obvious example — once money volume got delinked from the real goods and services, 1 unit of money ($1, ¥1, £1 etc) failed to consistently reflect value of real goods and services. In other words delinking resulted in constant depreciation of the purchasing power of 1 unit of money. When McDonald launched its Big Mac in mid 1960s it went for $0.45 in US, now it averages $4.00 in there. You can see the historical growth of prices everywhere — the housing prices, furniture, cars, food and services. In some countries — hello Argentina, Turkey, Russia and others — prices may change dramatically within a year! If delinking the volume of money from the actual worth of goods and services it should represent creates such issues then why does it happen? Well, despite the humanity has been constantly looking for the ways to build a fair and effective economy, it has always been coming to a few institutions and ultimately a few people who decide on the rules.
By the way, you might want to get yourself familiar with our recent article about DAO which might replace the current forms of the organisation and help fight the root cause of ineffective decisions making particularly in the area of monetary policy.
When you leave major decisions in the hands of few people it is inevitable that the decisions are biased by what those few people believe in, interests of their stakeholders and sponsors, their needs, anxieties and fears. Since money printing in every country is owned by a central bank with its minting machine, the decision on how much money is supplied to the economy is taken by those few people.
Ideally, the central bank should only print new money only in the following cases:
Replace decrepit banknotes which are taken out of the circulation (i.e. no increase in total value of money in the circulation)
Reflect the net additional value created (i.e. new goods and services less the goods and services that disappeared from the economy)
In reality it is not possible to accurately assess the latter point thus general statistics is used — the revenue that the companies and the economy in general generates vs the previous year assuming that the additional revenue is driven by higher value those companies and organisations produce (more and better products and services that will be consumed). Often the money is printed in advance anticipating new future value to be created (i.e. actual worth of economy + expected new value to be created).
You can imagine that it is never accurate so more often than seldom there is more additional money printed than actual value is generated. Why? Put yourself in the shoes of the government and central bank. Your ‘stupid’ citizens for some reason want better life so they demand lower taxes and better public services, roads, healthcare. Plus you need to fund a couple major initiatives here and there, maybe some secret missions. Where do you get money for it? You have few painful options — raise taxes dramatically or cut majority of initiatives or raise taxes a bit and then deploy your initiatives step by step in the next decade. In all cases the public will be discontent and you will not win their hearts in the next election or just will be ousted. You can also issue a government debt — i.e. you will borrow money from the market expecting to create new economic value in the future and will pay the debt later with the interest though. But have you checked the government debts recently? They are going up, like.. always and few want to think about how it will be all returned (it seems like ‘party while you can and let others deal with it later’). Thus no pleasant options. However… what if you just print a little bit of extra money? You can fund many of the things the public wanted + you can invest in some initiatives which are close to your heart and pocket and you do not need to raise taxes. Everyone is happy, right? Short term it is right. But what you do is you flood the economy with money which are not backed by any value.
Imagine you have a tiny country with 10 equal houses. There is 10,000 USD in circulation. Each house costs 1,000 USD. If someone invests their efforts and build the 11th house, the central bank based on the statistics will print 1,000 USD to maintain the same purchasing power (i.e. locked value) in 1 USD. So 11 houses, 11,000 USD in circulation. Status quo. But imagine a different scenario. There are still 10 houses, but the government prints additional 1,500 just because it wanted to buy an existing house so not waste time and efforts to build it. It goes and offers 1,500 USD (500 as premium to secure the deal). Now there are 10 houses and 11,500 in circulation. Other owners learn about the recent deal (i.e. by monitoring market deals/prices) and raise their prices to 1,500 per house. At this point there is no such amount of money in the economy (1,500 x 10 = 15,000 USD). So others are not eager to buy for 1,500 as in average they do not have that money and gradually the prices settle to approximately 11,500 / 10 = 1,150 USD per house which is market equilibrium based on the money in circulation. This is how the government depreciated 1 unit of money. It is not that your house has appreciated as a good investment, it is the value of 1 unit of money has depreciated. Your house is a tangible asset and it just held its original perceived value.
Because it takes time for the market to absorb and react to such new supply, it is not visible on ongoing basis but if you take snapshots in time — 1 year, 3 years, 5 years you can see how the worth of 1 USD, Lira, Peso etc is constantly depreciated. We just seem to get used to that.
Now, the above example is extremely simplified version of what happens in reality. There are many other factors impacting the value of national currencies but it shows the essence of the problem with the fiat money — its worth tends to dilute and we have no control over it and our income and savings in fiat money are not protected at all.
Many people understand that the fiat money is loosing this superpower to hold value over time. What do they do? They protect the value they accumulated by getting rid of fiat money and locking the value back in property, jewellery, knowledge, shares in businesses, goods and services which are the ultimate value generators. But the HUGE issue with that is that by doing so they accelerate the depreciation of money even further because what they do is they release money back into circulation, i.e. increase supply by preferring real assets over fiat money. This leads to further price increases of virtually everything, making housing ownership hardly affordable, making people work their lives off to pay the mortgage.
If money could hold the value then there will be no need to buy buildings, land and other properties just to protect the wealth, people would just keep on accumulating money, thus stopping inflating the prices of real world assets and therefore more people could afford better living conditions.
Fiat money can hold the value only if its supply is not susceptible to political games or the interests of the elite. When it is hardwired to the overall value of the economy, the value of 1 unit will be more or less always the same.
The value of the economy defines the value of the national currency — the whole worth of the economy + its potential to generate new value divided by all national currency units in circulation. That is how 1 USD is worth what it is worth — it represents the value of US economy per 1 USD banknote. In open market the players also add the potential of economy — future value it might generate. Thus sometimes if the prospects of a country seem gloomy — due to weak policy or social unrest or low prices of the commodity it heavily relies on — the worth of national currency goes down though the actual value of economy might currently remain the same.
If the economy is not growing, i.e. no new value created but new money is printed — it is bad. Even if the economy is growing but the new money is printed at higher rate — it is also bad.
Well, we guess you already understand where this essay is coming to, don’t you? If you now imagine that there is a limited, finite volume of money in circulation. What does it mean? It means that the all additional net value that is created in economy needs to fit the existing units of money. It means that the value per 1 unit of money will be actually increasing over time. Oh, wait, isn’t it what is happening with the bitcoin? Breathe in, breath out… wait for the next episodes!
