Transaction tech can’t compete with savings tech, pt 1
Since the bitcoin whitepaper was published in 2008, we’ve witnessed a Cambrian explosion of cryptocurrencies come into existence. With the sudden ability for anyone to invent their own form of digital money, we find ourselves in a Wild West scenario characterized by experimentation, competition, and very few rules. Looking back, this era will surely serve as a fascinating case study on money and economic behavior.
One of the most notable storylines of this period is bitcoin’s continuous dominance, in the face of tens of thousands of newer alternatives. Some suggest that this can be explained by the phenomenons of first-mover advantage and the network effect. These concepts are certainly relevant, but they can’t be the definitive factors when deciding a victor among monetary competitors. If they were, it would be impossible for one form of money to ever overtake another more dominant form, which would be the first mover and have a larger network. This would contradict history, and also imply that bitcoin could never outcompete the U.S. dollar.
So what is a more complete answer to the question of how different forms of money compete and win?
Money is chosen as a medium of exchange
In The Origins of Money by Carl Menger, he explains that money is chosen by a marketplace of individuals deciding what the most marketable good is—for use as a medium of exchange.
The term “medium of exchange” is often misunderstood, even among some dictionaries. It is not meant in the same sense that a painting is a medium of artistic expression. Rather, the word “medium” is conveying something in the middle, used as an intermediary between exchanges. This is according to some of the most renowned economic literature exploring the topic, such as the works of Menger, Jevons, and Mises.
“A medium of exchange is a good which people acquire neither for their own consumption nor for employment in their own production activities, but with the intention of exchanging it at a later date against those goods which they want to use either for consumption or for production.”
— Ludwig von Mises, Human Action
“[A] tailor, as we are reminded in several treatises on political economy, may have a coat ready to exchange, but it much exceeds in value the bread which he wishes to get from the baker, or the meat from the butcher. He cannot cut the coat up without destroying the value of his handiwork. It is obvious that he needs some medium of exchange, into which he can temporarily convert the coat, so that he may give a part of its value for bread, and other parts for meat, fuel, and daily necessaries, retaining perhaps a portion for future use.”
— William Stanley Jevons, Money and the Mechanism of Exchange
This proper interpretation shifts the emphasis away from the act of exchange itself, and toward the time that the monetary instrument is held between exchanges. It becomes a clear error to treat the concept of a medium of exchange as distinct from the concept of a store of value, as people seem to often do. The two ideas are inexorably linked, because a rational actor would never choose a medium of exchange without the expectation of storing trade value.
Categories of usage for tools and goods
For most tools and other goods, we can identify three unique categories of usage:
To actively consume or employ for production
To actively trade to someone else
To passively hold in reserve, providing assurance that it can be employed for the other two usages
As an example, let’s look the quintessential tool, a hammer. A hammer can be actively employed for a physical task, such as driving a nail. Or it can be traded to someone else who wants a hammer. Or it can be kept in a toolshed to provide its owner with assurance that he has a hammer available if he ever wants one, rather than being required to go out and source a hammer from elsewhere.
Goods and tools held in reserve are still being used, albeit passively. They provide the owner with the peace of mind that they are equipped to handle situations. If this weren't true, they could be discarded indifferently.
A monetary tool is a bit different. Because it is not acquired for the owner’s own consumption or production, the relevant categories of usage are reduced to two:
To actively trade to someone else
To passively hold in reserve as a medium of exchange
Of course, when people use tools, they prefer that those tools possess properties conducive to all of their intended tasks. Money is no different. People would like their money to serve as an effective medium of exchange, by successfully storing trade value across time and between exchanges. People would also like their money to be able to be actively exchanged without inconveniences.
But if there are multiple intended tasks, how does the importance of each task stack up against each other? Do people tend to care about one task more than another? Would they be willing to accept certain disadvantages in the area of one task if it created advantages in the area of another? We will explore these questions in the following sections.
The bias of active interaction
Colloquially, the word “use” often refers to active interaction. When people speak of a hammer “being used,” we understand that to mean the hammer is being employed for an active physical task, rather than the other usages mentioned above. In fact, if a hammer is sitting in a toolshed, we will go as far as to say the hammer is currently “not being used.” Furthermore, if someone is asked “what is a hammer for?” they will likely answer that a hammer is for the purpose of active hammering. Not for the purpose of sitting in a toolshed as a mental comfort.
This idea also carries over to money. When people are asked how money is used or what money is for, their mind will often travel to the instances when they are actively interacting with money—which is during transactions. Someone “using money” might be imagined as someone who is spending their money to buy something. Whereas someone holding money in reserve and not engaging in transactions might be thought of as “not currently using their money.”
Our bias towards noticing uses that involve active interaction can emphasize their importance, but is this warranted? Perhaps not. In the case of money, this bias can make it seem that money exists for the primary purpose of exchanging it for goods and services, facilitating trade. However, as we’ve covered, money held in reserve is serving its owner as a medium of exchange, which was the emphasis of economists like Menger. Let’s investigate this further.
Desirability through unique sets of attributes
What makes a hammer special enough to attract people’s desire?
Is it the hammer’s ability to participate in trade? No, there is an uncountable number of things that have attributes allowing them to participate in trade, so a hammer is completely ordinary in this regard.
Is it the hammer’s ability to be passively held in a toolshed? No, once again there is an uncountable number of things that have attributes allowing them to be held in a toolshed, or a storage facility more generally, and a hammer is entirely typical.
Is it the hammer’s ability to effectively drive a nail? Why, yes! This is where a hammer excels compared to alternatives, because it possesses a unique set of attributes that is highly conducive to this specific task. Clearly this set of attributes must be the source of desirability for a hammer.
Now, what makes money special enough to attract people’s desire?
Is it the money’s ability to participate in trade? No, as mentioned previously, there are an uncountable number of things that have attributes allowing them to easily participate in trade.
Is it the money’s ability to passively store trade value between exchanges? Indeed! This is what drives people to accept money as payment. People want a unique set of attributes conducive to defending trade value over time, such as durability to resist deterioration, compactness to shield from the vision of vandals and pillagers, and scarcity to protect against dilution.
The bootstrapping process of money
Let’s look at this from another angle—how a form of money begins being used by a society in the first place. For someone with a bias toward the active interactions of money, it could lead to a particular theory that money is a tool selected for the purposes of trade and exchange, and a residual effect of this is that people end up holding the money between trades. However, it’s easy to come up with an opposite theory: that money is a tool selected for the purposes of being held (as savings), and a residual effect is that people end up trading with it.
At first glance, these competing theories seem to be presenting us with a chicken-or-the-egg dilemma. However, as Parker Lewis points out in his article discussing the necessary chronology of bitcoin’s adoption, this is actually not the case. There is a logical order, and a logical answer to which theory is correct.
All we must do is conduct a simple thought experiment. Let’s consider the first-ever transaction that a new form of money is involved in. What motivates it? Is the merchant willing to accept the money as payment because he recognizes that the money is convenient for the task of exchange? Or is the merchant interested in the money because he believes it has attributes conducive to preserving trade value, so that it may be used as a medium until a future exchange?
Of course it is the later. If it were the former, then economic activity would seem absurd. If customers could convince merchants to accept things as payment on the basis of their convenience to transact with, then customers could pick leaves off the ground and hand them to merchants as acceptable payment. Or send an email containing a drawing of a spider. Or blow air into a jar.
"I do not have any money so am sending you this drawing I did of a spider instead. I value the drawing at $233.95 so I trust this settles the matter." — David Thorne
A recipient of money tends not to be primarily interested in the performance of the money during the transaction process—they are primarily interested in the performance of the money while it is held as a medium of exchange. Ideally, they would also like the money to be convenient to transact with, but this is just one factor. If the holder plans to use the money as a means of saving trade value for the long-term, then inconvenient transactions (e.g., heavy gold bars, or bitcoin not being accepted everywhere) may not be a significant concern, and could be considered an acceptable tradeoff.
Laws of monetary competition
If we turn our attention away from the theoretical and toward money used in the real world, we find that the same logic holds true. On a long enough time scale, the winner of a monetary competition is determined by the desirability of the money to hold, not to transact with.
Thier’s Law describes the observation that if merchants are in control of what type of money they accept as payment (which would be the natural state of things in a free market), then they will demand the form of money that they believe will be more effective at holding value over time. A “good” money will drive a “bad” money out of the economy, and the bad money will cease to be used or valued for monetary purposes.
Gresham’s Law is perhaps more well known, but only applies under a special set of conditions. In some cases, governments introduce price controls or legal tender laws, preventing merchants from having the free choice of what to accept as payment. The merchants may be forced to charge the same prices across multiple forms of money at a specific exchange rate. This can lead to an unnatural situation where customers get to choose which form of money they’d like to pay the merchant. When the customers are in control, they will similarly demonstrate their preference for the form of money that they believe will be more effective at holding value over time. They will choose to keep that form of money for themselves as savings, and pay the merchant with an alternative. This means the “bad” money will drive the “good” money out of circulation, because the good money will hoarded as savings until the eventual demise of the bad money, or the demise of the government laws enforcing its use.
The laws of Thier and Gresham make claims about the process of one money driving out another during a competition for dominance. But they do not make claims about how long these processes take to occur. It’s not instantaneous, and is largely dependent on what individual merchants and customers believe will be more effective at holding value over time. It’s not uncommon for people to believe things that are wrong, or copy the misguided behavior of others without much thought. This can help explain why some forms of money are used today which have inferior attributes for the task of saving trade value over time.
Examples from history
History is full of examples of one form of money replacing a previously more dominant form within an economy. Let’s examine this in the context of attributes conducive to acting as a medium of exchange, as well as their attributes conducive to participating in active exchange.
Primitive money: The initial chapters of books like Broken Money and The Bitcoin Standard go into detail on how stones, shells, beads and similar items served as primitive money in various societies, and each shared similar fates. They were eventually exploited by foreigners who knew how to source the items with greater efficiency, inflating the supply and diluting the trade value. The ability of these items to serve as an effective medium of exchange across time was damaged, and as a result the societies eventually moved on to a new monetary tool. This is in spite of the fact that the items retained their attributes relevant to their ability to participate in active exchange. Additionally, their replacements were typically small objects of a similar nature, not much easier to actively exchange (and perhaps sometimes worse in this regard, as beads could be marginally more convenient to transfer than the coins replacing them).
Gold vs. silver and copper: Some may point to silver and copper coins as an example of humans consciously choosing to use a form of money known to be inferior at storing value across time, compared to gold. These metals had an advantage in active exchange when dealing with smaller values. However, it’s important to note that these metals did not succeed in replacing gold as money, rather they were used alongside gold, by necessity alone. In the end, it was gold and gold-backed paper that replaced the other metals, which supports this article’s thesis.
“But as paper and financial instruments backed by [gold and silver] became more and more popular, there was no more justification for silver’s monetary role, and individuals and nations shifted to holding gold, leading to a significant collapse in the price of silver, from which it would not recover. […] The demonetization of silver had a significantly negative effect on the nations that were using it as a monetary standard at the time. India witnessed a continuous devaluation of its rupee compared to gold-based European countries […] By the time India shifted the backing of its rupee to the gold-backed pound sterling in 1898, [it] had lost 56% of its value […] For China, which stayed on the silver standard until 1935, its silver (in various names and forms) lost 78% of its value over the period. It is the author’s opinion that the history of China and India, and their failure to catch up to the West during the twentieth century, is inextricably linked to this massive destruction of wealth and capital brought about by the demonetization of the monetary metal these countries utilized.”
— Saifedean Ammous, The Bitcoin Standard
Commodity-backed paper: A type of historical monetary transition that can be clearly attributed to convenience in active exchange is the development of commodity-backed paper. This refers to paper certificates that are backed by—or redeemable for—an underlying commodity, often precious metal. In theory, if the custodian of the commodity and issuer of the certificate is trusted and reliable, then the paper certificate could serve as an upgrade to convenience for active exchange. Yet, this comes with the implied understanding that the paper represents the commodity, and is therefore no worse at storing value between exchanges. In practice, this understanding was often misguided, and issuers of the certificates abused the trust placed in them by printing paper backed by nothing at all.
Fiat currency: Fiat money is currency backed by nothing, but declared legal tender by government decree. It is the most widely used form of money today (e.g. dollars, euros, yen) and at first glance, it may also appear to be a counter-example to the thesis of this article. After all, fiat money is notoriously bad at storing trade value across time, because governments tend to shamelessly dilute the supply of it to help fund their expenditures. So, why have people chosen to use it as money, replacing what came before it? Perhaps we ought to first ask: did people choose it, or was it forced upon them? In the vast majority of cases, the type of money that fiat currency has replaced was commodity-backed paper (the backing was simply removed). Such an event offers users no practical advantages for the users whatsoever, and can hardly be attributed to the decision of a free market, but rather a forceful decree. Furthermore, the track record of fiat currency is extremely shoddy, with hundreds of examples that have failed and needed to be replaced. None have ever lasted more than a century, with the longest standing at 93 years and counting, the British pound.
Conclusion
Therefore, history supports the notion that on a long enough time frame, monetary competition is ultimately decided by which forms of money possess the attributes most conducive to storing value across time, thereby serving as an ideal medium of exchange. Any evidence to the contrary has not proven the test of time, not even a single century.
In Part 2, we will apply this knowledge to investing in new forms of money, particularly in the context of novel monetary technology—cryptocurrencies.