History of Money: From Fiat to Crypto Explained

What is Money?

Money is a method of storing value and worth or a medium of exchange that allows individuals to exchange goods, services, and proxies thereof. The value of money depends on how much importance people place on it.

Money is fundamentally a unit of account – a social consensus by which things are priced and with which payment is accepted. With money, people can trade goods & services conveniently and indirectly. It can take various forms, from seashells, coins, and paper currency to virtual currency or digital assets. Still, the utilities and forms of money have evolved significantly throughout history, and we will thoroughly go through its journey from barter to cryptocurrency.

Economic Functions

Money is "the set of assets in an economy that people regularly use to buy goods and services from others." It fulfils specific economic functions that necessitate physical properties of assets.

• Medium of exchange: For a transaction to take place, the seller must accept the medium of exchange the buyer is offering.
• Store of value: Either the buyer receives the good before paying, or the seller receives payment before providing the good. Therefore, money needs to keep its value over that period. The longer the period is, the better.
• Unit of account: Money adoption must be so prevalent that people express prices in it.

Legal types of Money

Over time, people have utilised many types of money as medium of exchange, store of value, and unit of account. The advanced national economies of the last 200 years experienced an evolution of money along three different legal types.

• Commodity money: carries intrinsic value from the commodity by which it is made. (e.g., gold)
• Representative money: has no intrinsic value but is backed by a commodity (e.g., The Goldsmiths story: they stored people’s gold and silver for safekeeping and give them a receipt on paper to represent their coins. To get coins back, they just need to hand in the receipt). Representative money flourished at the end of the 19th century, with around 50 nations were on the gold standard (explain later)
• Fiat money: money without intrinsic value that is used as money due to government decree (e.g., printed notes and minted coins or bank deposits). In essence, they only have value as the government declared them ‘legal tender’, and it asks for tax payments in legal tender, creating a relentless demand for its money. Unlike the other two types of money, the ultimate backing of the fiat currency is military state power.

How did Money Evolve: from Barter to Crypto

The earliest types of currency were objects of barter, such as stones and livestock, serving as mediums for trade and valued according to their utility, scarcity, demand, and supply. Basically, people exchanged what they wanted with what they had. For instance, a farmer might exchange 12 kilograms of apples for a pair of shoes from a shoemaker who desires apples.

As human settlements expanded and people began to assert ownership over their environment after the agricultural revolution, concepts like the economy, trade, and eventually money emerged. Commodity money, dating back to ancient civilizations, involved using goods as currency. However, it was the introduction of metal currency that significantly influenced the progression of money.

Metal coins played a crucial role in the establishment of centralised political systems and the formation of modern states. They enabled rulers to create bureaucracies and armies to govern large territories. Money also facilitated trade and commerce, leading to increased wealth and economic growth by enabling standardised exchange rates and promoting trade.

In early banking, goldsmiths stored metal money in their vaults and issued receipts, which evolved into representative money. Eventually, this led to the development of paper money still used today.

Until around half a century ago, money was primarily physical. In the modern era, fiat money, represented digitally, has become the predominant form of currency exchange, utilising electronic record-keeping of banking transactions. Fiat money is government-backed and valued based on public trust in governmental and central banking institutions, which have the authority to control the money supply through measures like printing more money or adjusting interest rates.

Modern fiat currency is typically not tied to a physical commodity like gold or other reserves. Instead, it is inconvertible and lacks intrinsic value.

In the digital age, money has taken on new forms such as credit cards, digital assets, central bank digital currencies (CBDCs), and cryptocurrencies. Mobile payments and online banking have gained popularity, and since the advent of Bitcoin in 2008, cryptocurrencies have presented a challenge to the current fiat currency system. The widespread use of mobile payment technologies and the growing prominence of cryptocurrencies reflect the evolving nature of money and its societal role.

What was the gold standard?

Until 1971, many nations relied on the gold standard, a monetary system where a country's currency was backed by gold, allowing paper money to be exchanged for gold at a fixed rate. The decision to move away from this system sparked debates. Some view it as a cause of economic instability and a reduction in state power, while others see it as essential for a more dynamic global economy.

The desertion of the gold standard was prompted by its restrictive monetary policy, which prevented central banks from adjusting the money supply to address economic fluctuations. The US dollar's departure from the gold standard in 1971 effectively turned money into a form of debt. Consequently, the dollar's value has significantly decreased since then, while the value of gold has surged, resulting in a substantial loss of purchasing power for the dollar.

This shift has had far-reaching consequences for states, individuals, and societies. It led to increased currency volatility, weakened financial discipline among governments, and widespread economic instability and inflation. Furthermore, it shifted economic power from the state to the market, diminishing state sovereignty and control over monetary policy.

The abolition of the gold standard has particularly harmed middle and lower-income groups, exacerbating economic inequality through inflationary pressures. However, proponents argue that moving away from the gold standard was necessary for a more adaptable global economy. They suggest that it has enabled governments to respond more effectively to economic crises and implement policies to promote growth.

Moreover, the shift away from the gold standard has created new opportunities for economic mobility and wealth creation through the expansion of credit and financial markets.

The intrinsic differences between a barter system and a monetary system

The barter system is a system in which goods and services are exchanged for other goods and services.

The monetary system is a system in which money is used as a medium of exchange.

Basically, the barter and monetary systems are shared fiction created by humans to meet their needs of trade. Therefore, both systems ask for the trust and acknowledgment of all parties involved in the transaction.

In a barter system, goods and services were exchanged directly. People would trade items they had for which they needed or desired. For example, if you have a piece of fabric and you need some grains, you may exchange your clothes with a farmer who makes grains. However, what if the farmer does not need clothes and he demands some shoes? You then must find a shoemaker and exchange with him before taking those shoes to the farmer. The process and time of this trading are ineffective.

The monetary system, by contrast, provides standard value measures, making it easier to facilitate trade. Money acts as an intermediary between traders. Now instead of carrying the clothes around, you only need to sell them and use the money for your desired goods. While the barter system was mainly a product of humans, today’s monetary system is also a consequence of centralised political institutions. For instance, states and governments decided to abolish the gold standard and replace it with modern monetary policy frameworks.

However, its centralist characteristic makes the monetary system vulnerable from several perspectives. Particularly, it requires a central ledger, which is sensitive to censorship and doesn’t allow for anonymous transactions (unless cash is used). Moreover, trust in the value of money remains a fundamental element despite high inflation rates and decaying confidence in governments and central banking. Ultimately, they control access and the use of the system.

The crypto era: Bitcoin, digital dollars, and the future of money

In just over a decade, cryptocurrencies have transitioned from mere digital curiosities to trillion-dollar innovations capable of fundamentally altering the global financial landscape. Regulatory approaches differ significantly worldwide, with some governments welcoming cryptocurrencies while others outright banning or imposing restrictions on their utilisation. As of January 2024, approximately 130 nations, including the United States, are contemplating introducing their own central bank digital currencies (CBDCs) to counter the burgeoning cryptocurrency phenomenon.

What are cryptocurrencies?

Cryptocurrencies (named for their reliance on cryptographic principles to generate virtual coins), are typically traded on decentralised computer networks among individuals with digital wallets. These transactions are publicly recorded on distributed, tamper-proof ledgers called blockchains. This transparent framework prevents duplication of coins and eliminates the necessity for a central authority, like a bank, to validate transactions.

Bitcoin, introduced in 2009 by the pseudonymous software engineer Satoshi Nakamoto, stands as the most prominent cryptocurrency, with its market capitalisation surpassing $1 trillion at its peak. Over recent years, numerous other coins have emerged.

Crypto users transfer funds between digital wallet addresses, which are then recorded in a sequence of numbers known as a "block" and verified across the network. Blockchains do not contain real names or physical addresses, only the exchanges between digital wallets, thus providing users with a level of anonymity.

Bitcoin "miners" earn coins by solving intricate mathematical problems to arrange these blocks, thus validating transactions on the network; this process utilises a system termed "proof of work." While many cryptocurrencies adopt this approach, Ethereum and some others employ an alternative validation mechanism known as "proof of stake." In the case of bitcoin, a transaction block is appended to the chain every ten minutes, with new bitcoin awarded at that point (though the reward diminishes over time). The total supply of bitcoin is capped at twenty-one million coins, although not all cryptocurrencies have such a limitation.

The prices of bitcoin and numerous other cryptocurrencies fluctuate based on global supply and demand. However, some cryptocurrencies have fixed values because they are backed by other assets, which are called "stablecoins."

The DeFi world

Cryptocurrencies and blockchains have catalysed the emergence of a novel realm known as "decentralised finance" or DeFi, similar to the crypto Wall Street. DeFi endeavours to democratise access to financial services—borrowing, lending, and trading—without reliance on traditional institutions like banks and brokerages, renowned for their hefty commissions and fees. Instead, DeFi operates through "smart contracts," which autonomously execute transactions upon meeting predefined conditions.

The majority of DeFi applications are constructed on the Ethereum blockchain. Given its efficacy in transaction tracking, blockchain technology harbours a spectrum of potential applications beyond cryptocurrency, according to experts, including streamlining international trade.

Central Bank Digital Currency: Is this the solution?

Central bank digital currencies (CBDCs) represent a digital form of currency issued and regulated by a nation's central bank. A crucial distinction between CBDCs and normal crypto is that their value is tethered to the fiat currency of the respective country. Many nations are actively developing CBDCs, with some already in implementation, underscoring the importance of comprehending their implications for society.

CBDCs aim to furnish businesses and individuals with attributes such as privacy, transferability, convenience, accessibility, and financial security. Moreover, they hold potential to alleviate the burdens associated with maintaining a complex financial infrastructure, mitigate cross-border transaction expenses, and offer more economical alternatives for those utilising alternative money transfer channels.

Inflation & Deflation: How does monetary policy affect these notions?

Understanding Inflation and Deflation:
Inflation: Commonly defined, inflation is an increase in the overall level of prices. Besides, we can stick to the primary definition presented by Hazlitt: “Inflation is the increase in the supply of money and credit. Each individual note and coin becomes less valuable because there are more of them available. Goods then rise in price not because goods were scarcer before but because notes & coins are more abundant.

Deflation: Deflation refers to a general decrease in prices for goods and services, often linked with a reduction in the availability of money and credit within the economy. During deflation, the buying power of currency increases gradually. This phenomenon leads to a decline in the nominal expenses associated with capital, labour, goods, and services, even though their relative prices may remain unchanged.

How does monetary policy affect inflation & deflation?

Monetary policy refers to the strategies employed by central banks to regulate the money supply and interest rates to achieve specific economic objectives. By adjusting interest rates, central banks can influence the availability of money for lending, which in turn affects inflationary pressures on consumer prices and wages.

Central banks prioritise maintaining price stability, which involves keeping inflation levels in check. They achieve this through monetary policy, primarily by manipulating interest rates to stimulate or restrain economic activity.

Lowering interest rates is a common tactic to reduce the cost of borrowing money, encouraging more spending and investment. However, this influx of money into circulation can lead to inflation, where prices rise as the value of money decreases over time. Printing additional money, such as through quantitative easing, can also exacerbate inflationary pressures, potentially resulting in rapid price increases that diminish the purchasing power of currency.

Conversely, central banks can tighten monetary policy by raising interest rates, which restricts the flow of money in circulation. While this may help control inflation, it can also lead to deflation and slower economic growth due to reduced spending.

Central banks have now expanded their toolkit with the introduction of wholesale and retail Central Bank Digital Currencies (CBDCs). These digital currencies can be leveraged to implement monetary policy by adjusting interest rates on bank deposits held at the central bank. By managing the supply of wholesale CBDCs, central banks can directly influence monetary conditions. Additionally, they can set interest rates on retail CBDC deposits or impose restrictions on the amount of CBDCs individuals or businesses can hold, thereby impacting currency supply, demand, and inflation rates.

How to determine whether a cryptocurrency is inflationary or deflationary?

Cryptocurrencies can be inflationary or deflationary depending on their native monetary policy and design. You would assess this by examining its supply dynamics, the demand incentives, their usage and whether they preserve value and stability.

Understanding the monetary mechanisms and supply dynamics of tokens, whether inflationary or deflationary, holds significant implications for their utility and valuation. If a cryptocurrency has a fixed supply, it tends to be deflationary as the currency's value is expected to increase with rising demand over time.

Deflationary tokens are practical at encouraging holding and discouraging spending, leading to increased scarcity and accelerated adoption of the token as a store of value. This gradual scarcity contributes to a continuous improvement in purchasing power over time. Moreover, a decreasing token supply acts as a safeguard against inflationary pressures stemming from external factors like government policies or economic events that may lead to inflation, hyperinflation, or stagnation.

By contrast, cryptocurrencies with a variable supply can be either inflationary or deflationary, depending on factors such as the rate of new coin creation and other variables. Inflationary tokens may promote spending and discourage hoarding, thereby enhancing their adoption as a medium of exchange and improving liquidity.

A notable difference of inflationary tokens is their flexibility, allowing adjustment of the inflation rate to suit the company's requirements, such as for airdropping new tokens or other purposes specified by the tokenomics of the company.

Future Trends in Money and Finance

As cryptocurrencies and digital wallets gain prominence, the nature of money is undergoing a profound transformation, becoming more decentralised and digital. This contrasts with the inclination of governments to tie their fate closely to the evolution of money.

Many currencies worldwide derive their value from government management of the economy and the control of inflation through fiat currencies, which rely on public trust in central authorities responsible for currency issuance. It could be argued that the trajectory of money is intricately linked with the trajectory of political structures. Governments and central banks will persistently strive to maintain significant influence in the creation and regulation of money.

Nevertheless, it is evident that money is inevitably moving towards increased digitalisation, driven by the emergence of new payment methods such as cryptocurrencies and digital wallets. The use of physical cash may decline further, with numerous countries already aiming for cashless societies, regardless of the Central Bank Digital Currencies (CBDCs). The rise of cryptocurrencies, along with advancements in Web3 and decentralised finance (DeFi), could lead to a complete separation of money from institutional power.

FAQs

How long has money existed, and what were the earliest forms of value exchange?

Money has been a part of human civilisation for at least 5,000 years, with historians suggesting that bartering systems were likely utilised before this period. Bartering involves the direct exchange of goods and services, such as a farmer trading a bushel of wheat for a pair of shoes from a shoemaker.

When and where did coin minting originate?

The world's oldest securely dated coin minting site was discovered at Guanzhuang in China's Henan Province. This mint began producing spade coins around 640 BCE, marking one of the earliest instances of standardised metal coinage.

When did paper money replace coins?

The transition from coins to paper money occurred in China around 1260 CE. By the time Marco Polo visited China in approximately 1271 CE, the Chinese emperor had established control over the money supply and its various denominations.

What is Fiat Money?

Fiat money is the money without intrinsic value that is used as money due to government decree. For instance, they can be printed notes and minted coins or bank deposits.

Will Crypto replace Fiat Money?

Cryptocurrencies, with their borderless and decentralised nature, bring about both positive and negative ramifications. Unlike fiat currencies in developed nations, they operate outside the purview of central banks and traditional monetary policy tools, such as interest rates and open market operations, which are designed to manage inflation and employment.

The potential consequences of a complete substitution of fiat currency with cryptocurrencies are still under scrutiny. Such a shift could yield substantial adverse effects on economic and financial stability, although it might alternatively herald a new era of global equilibrium.

The International Monetary Fund (IMF) advises against adopting cryptocurrencies as primary national currencies in their current state due to their inherent price volatility and perceived deficiencies in macro-financial stability and consumer protections.

Nonetheless, the IMF recognises that adoption may accelerate in countries where the risks associated with cryptocurrencies represent an improvement over existing financial systems.

Cryptocurrency exhibits considerable potential and utility as a currency. For instance, during the 2022 Russian invasion of Ukraine, many Ukrainians turned to cryptocurrency as a means of financial survival. Without access to cryptocurrency, their ability to weather the crisis may have been severely compromised.

Moreover, cryptocurrency is increasingly utilised by individuals in countries experiencing severe fiat currency devaluation to safeguard their savings, facilitate remittances, and conduct business transactions.