What is Money?
What does the US dollar and bitcoin have in common? (15min read)
Money is a tool we use to do three main tasks in our society:
Account for things
Exchange between things
There are different types of money, like the US Dollar and Bitcoin, that work differently but fundamentally provide the same key services for consumers and economies.
Some money works better than others. The more people, businesses, and institutions buy, sell, trade, invest, and use a type of money, the more valuable that money is as a tool. In other words, money has a network effect.
Welcome to the first edition of Common Cents!
As they say, Cash is King so it seems like there is no other place to start then, well, money.
Money is a popular topic. Today, the term money appeared in my google news search with 1,530,000,00 results. The United States Government is working on a COVID-19 stimulus package to send US dollars to millions of Americans. Bitcoin, another form of money, is more valuable than it's ever been.
Hopefully, by the end of this, you'll understand what money is, how money works, and why money matters.
What is Money?
Money is a tool we use to perform functions in our economy. Money has three main functions.
Unit of account
Medium of exchange
Ok, but what does that actually mean?
Unit of account = Basically, you can define anything in terms of money. $1 = 1 cup of sugar = 10 gummy bears and so on and so forth. Most every tangible (and many non-tangible) things can measured in money. It's like the metric system, but for capitalism.
Store of value = If I have a $1 today, tomorrow that same dollar will still be...one dollar (over time, inflation, but we'll save that for another post). Or, maybe your economy runs on chocolate. That chocolate today will still be chocolate tomorrow.
Medium of exchange = Because we can define anything in money, and we trust a dollar today will still be a dollar tomorrow (#1 and #2), it becomes easy to turn money into anything, and vice versa. Anything in. Money out. Anything out. Money in! (For you tech types out there, money is the finance world's greatest API.)
These concepts are almost hard to grasp simply because we live so close to it every day, and the combination of these three functions make money one of society's most powerful tools. Money has value, so we trust that we can use it to measure most anything, and then we can use it trade for other things, easily.
Every time another thing can be turned into money, or another business or individual or country or institution accepts money, the money becomes more useful. Or said another way, the value of the network gets stronger.
How Money Works:
I'm in the US, as are many reading this. So, when this group thinks of money, we probably think of the US Dollar.
Let's use the above framework to understand how USD actually works.
Unit of account:
Try and think of something that does not have a price in US dollars. (ok ok, happiness, love, I know.) Try to think of something tangible. It's hard, right? The US dollar is widely and frequently used across the world, which makes it one of the easiest currencies to use and track. In fact, the Federal Reserve, the US central bank responsible for managing US dollars, keeps track of every US dollar transaction. Anytime you swipe your credit card or send money from your bank account or pay someone on Venmo, the Federal Reserve tracks those transactions in a nifty system called Fedwire. How do they do this? Through the network of 12 regional Federal Reserve banks and the US banking system.
At the end of each day, banks send instructions via the Automated Clearinghouse Network (ACH) to the Federal Reserve saying. “Hey! Julianne sent $25 from her Chase bank account to Venmo. Here's the account and routing numbers. Please debit her Chase account, and credit her Venmo account.” (ok, that's not what the transaction file looks like, but you get the idea).
Using this centralized system of account and routing numbers, the Federal Reserve moves and keeps track of money. With nearly $700T banked transactions in USD last year, it's a lot to keep track of.
Store of value:
This is where it gets exciting! How does money have value? Without value, money is just currency. Currency needs something of value to make it money. In the case of the US dollar, the US Government gives the currency value, and this is how USD becomes money. Stay with me. The US Government says that money is valuable because we the government will always buy it from you - that's the "backed by the full faith and credit" of the US Government at work. Simply put, we trust the system.
Quick history lesson, the US Government used gold to help ensure the value of the US dollar until 1971. You could go to the central bank of the US government and swap your $1 bill for the same amount in gold. This helped people trust that the US government could always buy dollars back from you. During the Great Depression, the US began moving away from gold. The US government needed more money for Depression-era relief programs, but it didn't have enough gold. The government said as long as people know there is always a buyer and seller for US Dollar - bingo enter The US Government - there will always be trust in the value of the US dollar. The US scratched "the gold standard" completely in 1971. We now rely solely on The Federal Reserve to maintain the value of money.
In addition to tracking money, the Federal Reserve is tasked with setting the price, quantity, and ultimately, value of USD.
The Federal Reserve is responsible for two key things when it comes to the value of money (It has other goals but these are pertinent for this post.)
How much USD is in circulation
The price (or federal funds / interest rate) of USD
This makes the Federal Reserve responsible for the value of US currency because:
Value = Price X Quantity
(My Econ 1 professor is thrilled right now)
The Federal Reserve manages the value of money by distributing dollars into the economy and setting interest rates (or, what it costs to buy those dollars). The Federal Reserve loans money at a certain price (called the federal funds rate) to the banks we know and err love? (JP Morgan, Bank of America, ect.) Then individuals and businesses can borrow money from those banks at a certain price, or interest rate. Because the Federal Reserve can impact both the price and quantity of money, they need to balance the above equation. For example, if the Federal Reserve sends more dollars into the economy, like with a COVID-19 stimulus package, in order keep the value of money consistent the price of money has to go down. If the price of money is near zero (like it is today), the value of USD will go down over time, and we'll need more dollars to buy the same good or service.
Medium of Exchange:
Last, but not least, the above two properties help USD be exchanged for most anything. Any currency can be exchanged into it. Any banks accept it. Any individual or business can use it. It goes on and on. Consumers, investors, and governments like the stability of the US dollar because we use USD to buy and sell items and many governments and institutions own US bonds.
The "full faith and credit" of the US dollar has created the platform for this network to exist, but it is the sheer number of individuals, countries, businesses, and banks that keep the US dollar the reigning Cash King. That's why we call USD "the word's global currency."
It works decently well.
Let's take another example - cryptocurrency, and more specifically bitcoin.
Crypto currencies, like USD and other forms of money, functionally do the same three jobs. Crypto currencies account for transactions and are exchanged for other goods and services. They also have value, but receive it from a different source than USD.
Unit of Account:
Bitcoin originated to make moving money digitally easy and secure. Rather than use banks as a trusted intermediates, they created a system to securely move money directly between people. Instead of using a centralized organization, like the Federal Reserve, to keep track of it all, bitcoin relies on a network of computers to track each transaction. This ledger, called a blockchain, is transparent and unchangeable. Everyone can see it, and each transaction must be verified to ensure that only one coin is used for one transaction at at time. Instead of bank account and routing numbers, bitcoin uses public and private keys to track and move money. One bitcoin has value (see below), as does one satoshi (a way smaller amount of bitcoin).
When you want to send money to another person you pay a small fee for the computation power to execute and verify your transaction. It goes something like this: “Hey! Julianne wants to send $25 from her Coinbase digital wallet to her MetaMast Digital Wallet. Here's her public keys for both accounts so you can move the money, and here's the verification from her private key saying to send the money."
Store of Value:
Ok, so how does crypto currency have value? It's simple, really.
Remember our above equation, Value = Price X Quantity? Bitcoin has set a maximum number of bitcoin that will ever be used for buying, selling, trading, and investing. Since quantify is fixed, the value of bitcoin money equals the price that people pay for it. With a set number of bitcoin in circulation, the buyers and sellers in the market to decide the price of the currency and ultimately the value of the market. Buyers and sellers rely on the system put in place to accurately track transactions, ensure their validity, and their security. The other neat thing about bitcoin is that labor and computational cost of each transaction helps set the price, and in turn the value, of bitcoin.
Simply put, users trust the system. While Bitcoin, and other cryptocurrencies, do have governing bodies, but bitcoin holders vote for any change in the system, rather than a centralized government.
Medium of Exchange:
While your local pizza shop might not yet be accepting bitcoin (famously, one kind of did) you can use bitcoin to buy some items. Most commonly, people trade bitcoin for other forms of money, and vice versa. Bitcoin is not yet a widely used way to buy and sell stuff. You can use bitcoin to buy some things...it's just not that great at it at yet.
Money has value because of the trust in the system, but money holds value because of the network.
Why does $$$ Matter?
The US dollar is today's most powerful form of money because it has the strongest network. This network - the buyers and sellers and users - enables it to performs the three key jobs of money really well.
The USD functions as money because of the US government. Just like crypto currencies function as money because of the blockchain. However, USD's advantage is the network it's created. And even though money isn't quite a winner take all market, it sure as heck helps.
It's not that bitcoin isn't money, its just that it's not working all that well today for all of the functions we require of money. This is in part by design. USD optimizes for stability by balancing the Value = Price x Quantity equation so we can buy and sell goods easily, and it does an incredible job at this. Bitcoin, today at least, does best at storing value.
If you live in a country whose government has nearly defaulted on its debts, like Greece or Argentina, you may inherently understand that not all money works very well. In Argentina, it costs you 50% more to buy the same item today compared to one year ago. It's almost easier to understand the network effect when you don't have it. Unsurprisingly, bitcoin and other crypto currencies have been exceedingly popular in these places. More people are starting to notice the challenge of simultaneously keeping USD's value stable so we can exchange it for goods and services, while also maintaining its value over time.
History suggests that USD won't always reign supreme. Different forms of money have reigned throughout time - from the first known form of currency Sila to gold in the early western world to our present-day global currencies. As societies changes, the jobs we need our tools to do change too. Trust in these emerging, distributed forms of money continue grow, and we may find they fit our current globalized society better than our current ones. More people and organizations are using bitcoin - the value of bitcoin hit an all time high in 2020, and the user base is expanding - Square Cash App's Bitcoin investing product grew nearly 600% year over year fueling the majority of the Cash Apps revenue growth. Fidelity is now offering an investment fund with bitcoin as its primary asset. Stablecoins (cryptocurrencies who match the value of a fiat currency, like the USD, EURO, or similar) have jumped from from $2.6B in market cap to $20B in from 2019 to 2020.
For money to be successful, it's just as much about the network they create as it is the trust in the entity beneath it. Cryptocurrencies have a ways to go to create the network of say, USD (the market cap of bitcoin is $700B (ish) today, whereas the Federal Reserve processed $700T in USD transactions in 2020.) Bitcoin has built enough trust for people to use it, but there's a long way to go to create the network to make it widely used. Bitcoin, and cryptocurrency, do have one big advantage. Bitcoin has an explicit network effect - the system gets more secure, more trusted with every transaction on the system. Whereas, the US dollar has more of what I would call an implicit network effect - more users make it easier to use USD and make it more powerful because we turn our “labor and assets” into USD, thereby requiring that it’s use continues (not to mention we have to pay taxes with it). There's no doubt that crypto currencies have created value uniquely, but it's the networks they create will make the currency work. To make it not just a currency but money. So, when PayPal offer its 350M users access to invest in bitcoin - it matters because it expands the network - (maybe even your local pizza shop that still uses PayPal for heavens sake!)
What seems true is that crypto currencies are here to stay, and there's a world of opportunity to build a better money system for our global economy. We'll likely start to see a convergence of the different types of money we use daily. Different money may perform different functions for us. For example, we invest and store value in bitcoin, but we transact in stablecoins tied to USD that settle instantly. Or, we use fractional shares of bitcoin for moving money between peers, but those transactions are denominated in USD.
As they say, Cash is King. The question for us is...which Cash will be King.
A quick note: I’ve made some changes from the original post thanks to your incredible feedback. Those changes are in italics for full transparency.
Additional (non-comprehensive) Resources:
Ray Dalio - How the Economic Machine Works
My instinct tells me the greenback will persevere. I’ve read arguments in the Economist on the yuan being the greater threat. And what’s to stop the Federal Reserve from creating a cryptocurrency of their own if necessary? Digitizing the dollar, the new frontier. Great read and great subject