Book Summary: The Bitcoin Standard — by Saifedean Ammous

The Bitcoin Standard Book Cover

Money makes the world go round, whether it’s the coins in your pocket or the internationally accepted credit card in your wallet. Our ancient ancestors relied on barter to get by. In small villages, bartering chairs with pigs and candles with milk makes sense, but it’s difficult to scale this system beyond that, and it’s all but useless in the global commodity trade.

Something everyone can accept and trust is the key. As a result of the modern era, a paper currency backed by gold became the norm. The concept was simple but effective. After all, precious metals are among the best at retaining their value. Unprecedented economic expansion was the end result of this. In the early part of the 20th century, governments abandoned the gold standard and began printing money. When it comes down to it, what do you get It’s been a century of economic booms and busts, and rising debt.

When it comes to financial stability, we don’t need to go back to gold. Cryptocurrency bitcoin has emerged as an ideal solution for our digital age. They can be used anywhere and at any time, just like gold. After some teething problems, the new cryptocurrency may become the new standard for a brand new age of growth.

Frederic Leighton — Phoenicians Bartering with Ancient Britons [from Frederick Lord Leighton]

Money was first used as a medium of exchange.

How does an economy function in the absence of money? It’s as simple as that. It’s referred to as barter or direct exchange. You could exchange two pigs for a cow or a haircut, depending on what you have and what your neighbor requires, or vice versa. But here’s the catch: those things don’t always line up. You don’t have anything to offer your potential trading partner? So, you’re out of luck — you’re not going to get what you want, either! That is where the cash comes in. Because it is in high demand, you can use it for any transaction. This is referred to as an indirect exchange.

However, early money was nothing like what you keep in your wallet today.
Consider the people of Yap Island in the Federated States of Micronesia. They traded with “Rai stones” well into the nineteenth century. These stones came in a variety of shapes and sizes, with the largest weighing a whopping four tons! When a new stone was ready, it was dragged up a hill for all to see. The stone’s owner would then trade ownership or part ownership in exchange for goods and services. Every transaction was broadcast to the entire community, which acknowledged the exchange.

This kind of money worked for so long because it was salable. The Yap Islanders knew that if they owned Rai stones, they could also sell them. The added boon was that they could be used around the whole island since the stones were visible from any point. They were also divisible. If you wanted something small like a basket of fruit, you sold a small part of your stone; if you wanted something bigger like a raft, you sold a larger piece or even the whole stone.

So, if Rai stones were so effective, why aren’t the Islanders still using them today? But there was a catch: they didn’t hold their value or salability over time. That wasn’t an issue at first. Because quarrying and transporting stones from neighboring islands was such a difficult business, the supply of stones was limited and their value remained stable. That changed in the late 1800s with the arrival of David O’Keefe, an Irish-American captain who had been shipwrecked on the island. O’Keefe began importing large quantities of Rai stones in exchange for coconuts, using modern technology. They became so commonplace that they no longer functioned as money — they had been reduced to the status of mere stones!

Gold became the foundation of sound money.

The first money resembling the change in your pocket was created by metallurgy, the craft of smelting metals, which was pioneered in early pre-Christian civilizations. This technology enabled the production of highly salable coins that were both small and light enough to be carried long distances.

When it came to coinage, one metal stood out above the rest: gold. Why? It does, however, have a few distinguishing characteristics. For starters, it is nearly impossible to destroy and cannot be synthesized with other materials. Also, if you want gold, you’ll need a shovel because the only place you’ll find a decent amount of it is underground. Furthermore, the more gold mined, the deeper one must go to find more gold, implying that, even as gold-mining technologies improve, the supply of gold grows slowly and predictably.

Combine all those traits and you have a material that’s incredibly effective as a store of value, which makes it salable across time. It didn’t take long for people to figure this out. King Croesus was commissioning gold coins in Greece over 2,500 years ago!

Gold may have been around forever, but the love affair between money and gold only really blossomed in the eighteenth, nineteenth, and twentieth centuries. That’s gone down in history as the age of sound money. But before we define this term, let’s provide a little context.

Rapid advances in communication and transportation shaped these centuries. Technology such as the telegraph and trains made it easier than ever for people and goods to travel from point A to point B. As a result, the increasing use of ultraconvenient, nonphysical forms of payment such as checks, paper receipts, and bills was justified. But how do you persuade merchants and consumers that the paper they use to buy and sell is worth anything?

The solution devised by governments around the world was to print paper money backed by precious metals, which were then stored in vaults. Gold was the most commonly used metal in the leading European nations. Britain set the example, with Isaac Newton, Warden of the Royal Mint at the time, introducing the “gold standard” in 1717. By 1900, approximately 50 other countries had officially adopted the same standard. As more nations issued paper currency backed by gold reserves, gold became more marketable — and thus more valuable. This was sound money: the markets had freely chosen gold as the best store of value, and it was now backed by money.

10 pfennig, Germany, 1916 - Bank of Canada museum

To fund their war efforts, European governments devalued their currencies.

The Roman emperor Julius Caesar issued the “aureus,” a coin containing approximately eight grams of gold, in the first century CE. It became a common method of payment throughout the Roman Empire. As the Empire’s growth slowed, rulers began “coin clipping” — a sly practice in which a portion of the precious metal contained in coins was removed to boost the government’s spending power. Isn’t it simple money? Perhaps, but it eventually drove up inflation and triggered a series of economic crises that led to the fall of the once-mighty Roman Empire!

The gold standard, however, had a major flaw: the gold had to be stored in a limited number of bank vaults. This simplified the exchange of paper money for gold, but it also established a highly centralized system in which governments controlled the value of paper money. They could always increase the supply of money without increasing the supply of gold if they wanted to. In other words, the salability of paper money was entirely at their mercy.

In 1914, nearly every major European power decided to take advantage of the situation. They needed money to fund their operations because war had broken out. Rather than raising taxes, they followed in the footsteps of the Romans and simply printed new money. However, it was not “backed” by gold, and no new gold was added to the banks’ vaults while the printing machines churned out new notes and bills. Within a few weeks, the countries fighting in World War One had suspended the convertibility of paper money into gold. The standard had been dropped.

This had two consequences. For starters, this ready source of funds allowed governments to continue funding their war efforts for four more bloody years. The second effect of this money-printing binge was to severely devalue existing currencies. The Austro-Hungarian krone, for example, fell by 68.9 percent against the Swiss franc, a currency that remained linked to the gold standard due to Switzerland’s decision to remain neutral and wait out the war. Both of these factors would go on to have a significant impact on the economic life of postwar Europe.

Austria emergency money Schoenbuehel 1920

During the First World War, gold-backed money was replaced by government-issued money.

Revaluing currencies was a thorny issue for Europe’s victors after World War I ended in 1918. The gold stabilizer standard would have been the obvious solution, but a fair exchange rate would have revealed how little currencies were worth.

It was also impossible to go back to the old exchange rates because it would have overvalued paper currencies. A flood of citizens would have demanded gold in exchange for their paper receipts, which they could then sell abroad for a profit.

Fiat money is money that is backed by government decree rather than gold. This led to an era of unsound money marked by ever-increasing economic intervention as governments scrambled to stabilise their currencies’ exchange rates.

As the Second World War came to an end in 1944, the victorious nations began to plan the postwar economic order. So, they came up with a plan called Bretton Woods, named after a small village in New Hampshire where they signed their agreement. A fixed exchange rate would be used to link all currencies in circulation with US dollars. Gold’s value, in turn, would be tied to the dollar at a fixed exchange rate. It would be up to the newly created International Monetary Fund (IMF) to keep an eye on the currency market’s exchange rate fluctuations. Incredibly, the entire system required that the gold reserves of all participating countries be transported to the United States.

In theory, Bretton Woods was similar to the pre-1914 gold standard in that all currencies were ostensibly convertible into gold. In practice, it didn’t work quite like that. The United States broke the rules by inflating its currency in relation to gold, while other countries inflated their currencies in relation to the dollar to fund economic expansion. Eventually, the ruse was dropped, and gold was no longer used as a standard. It was simply impossible to keep a rapidly inflating currency tied to gold.

President Nixon declared on August 15, 1971, that dollars would no longer be convertible to gold. The value of currencies would now be determined freely by the interplay of the world’s major fiat currencies.

source: NYTIMES

A well-functioning economy is built on sound money.

In the nineteenth century, sound money was at its peak. Paper money was backed by gold, a precious metal that was adopted by the free market because of the properties that made it such an effective store of value. This, in turn, paved the way for a prosperous era.

The first thing to note about sound money is that it is an excellent way of encouraging people to save and invest — the ideal recipe for long-term, sustainable growth. Why? Humans, on the other hand, have a natural positive time preference: we prefer immediate gratification over future gratification. Sound money encourages us to think about the future more. After all, if we can reasonably expect the value of our money to rise over time, it makes sense to consider what we can do now to maximize our future income.

And that is what investing is all about: deferring gratification today in order to reap greater rewards later. Thus, investment leads to capital accumulation. People invest money in capital goods, which are commodities that can be used to create other goods and revenue streams in the future. And the more capital is accumulated, the greater the likelihood of long-term, stable economic growth.

Unsound money is a problem because it distorts capital accumulation. The reason for this is straightforward. When governments intervene in the money supply, such as by manipulating interest rates, they also intervene in prices. This is a problem because prices provide investors with the information they need to make sound decisions without requiring them to learn every minute detail about global events. If a Malaysian businesswoman decides not to expand her offices because the cost of copper wiring has risen, she doesn’t need to know that the price increase is the result of a recent earthquake in Chile. Everything she needs to know is in the price. However, because of government intervention, prices no longer reflect market movements. Investors lack the necessary information, which distorts capital accumulation.

source: east asia forum

Recessions and debt are caused by unsound money.

Unsound-money policies, such as those implemented by European governments during World War I, cause a slew of issues. There are two issues that stand out: recessions and the never-ending accumulation of debt.

Let us begin with recessions. Central planning is a form of government intervention in the market. Here’s the catch. No single person, agency, or department will ever have access to all of the information required to comprehend the vast and ever-changing web of preferences, choices, costs, and resources that constitute an economy. And if you don’t have that information, you’re bound to make poor decisions — exactly what governments do when they manipulate the money supply. Their interventions distort markets, particularly capital markets, resulting in a “boom and bust” cycle. During the upcycle, artificially inflated money misleads investors into believing they can purchase more capital than they can afford. The resulting boom quickly turns into a bubble, and when it bursts, the economy enters a slump.

Then there’s the issue of debt. Consider the Great Depression of the 1930s to see how unsound money causes economies to become indebted. During that time, governments adopted policies advocated by British economist John Maynard Keynes. Recessions, according to Keynes and his followers, the “Keynesians,” occur when total spending in an economy is too low. They argued that the best way to respond to recessions is to increase spending.

How do you go about doing that? You could lower taxes, but people rarely spend their extra cash. The only other option is for the government to fund all of that spending. Because raising taxes in the midst of a recession is difficult, governments almost always decide to expand the money supply. This has a knock-on effect on how people spend their money. All that money sloshing around the economy tends to focus people on the present. Saving becomes less appealing, and a culture of rash, opportunistic investing emerges. People are soon in debt up to their eyeballs.

The overall effect is a never-ending crisis. Government intervention causes recessions, and the Keynesian response exacerbates the situation. However, there is an alternative. We must return to sound money and establish a new gold standard. Bitcoin’s new technology may be able to assist us in this endeavor.

Because of its scarcity, Bitcoin is one-of-a-kind.

After decades of reckless spending and debt accumulation, governments must change their ways and return to sound-money policies. This is where Bitcoin comes into play. So, how exactly can the world’s first digital currency aid in the recovery, stability, and growth of economies?

Consider the gold standard. Markets chose gold as a store of value for two reasons: it is scarce and predictable, which means there is little risk of supply increasing sufficiently to significantly deflate its value. Bitcoin exhibits similar characteristics. In fact, it has a finite supply. Whatever happens, the total number of bitcoins will never exceed 21,000,000. Once that number is reached, no more bitcoins will be issued.

The method by which bitcoins are created also contributes to stability because the currency’s supply grows at a constant diminishing rate. Here’s how it works: Bitcoins, like gold, are mined. Computers on the Bitcoin network pool their processing power to solve complex algorithmic problems in order to gain access to new coins. When these puzzles are solved, the “miners” — the computers that assisted in the solution — are rewarded with bitcoins.

To prevent online gold rushes, Satoshi Nakamoto, the creator of Bitcoin, built in a failsafe: the number of bitcoins issued is halved every four years. The cherry on top? The algorithmic problems become increasingly difficult to solve as the number of computers working on them increases, ensuring a steady and reliable supply in much the same way that the increasing difficulty of mining gold ensures a steady and reliable supply of gold. Bitcoin will continue to be issued in ever-smaller quantities until 2140, when no new coins will be issued.

This distinguishes bitcoins. They are the only good that has an absolute scarcity. When compared to traditional commodities such as oil and gas, this is a significant difference. We consider them scarce, but we also understand that if we are willing to invest the necessary resources, we will most likely be able to find new sources. Despite our increasing consumption of oil, total proven oil reserves around the world are increasing! Bitcoin is a game changer. There is no amount of time or resources that can be spent to create more coins than the algorithmically programmed supply allows. As a result, bitcoin can never be devalued by manipulating supply, making it an ideal store of value.

source: The Guardian

Bitcoin’s security is unrivaled.

Sound money is more than just the scarcity of the unit in which its value is held. It must also be secure. After all, if you are not completely convinced that bitcoins are secure, you are likely to seek an alternative. Fortunately, digital currency is also extremely secure.

This is due to the Bitcoin ledger, which employs a cutting-edge technology known as public blockchain. What exactly is it? When a mining computer solves an algorithmic puzzle, it creates a block. This is a log of all recent transactions and mining activity. The Bitcoin blockchain is formed by adding each new block to a chain of older blocks. This ledger contains every last detail about every blockchain transaction that has ever occurred. And here’s the kicker: every network user has access to all of that information. Bitcoin ownership is only valid after it has been registered on the blockchain, which is only possible if a majority of network users approve it.

This means that the Bitcoin network is completely self-sustaining; there is no need for a centralized authority to oversee transactions. More importantly, in terms of security, it means that verifying transactions is less difficult than cheating. This is due to the fact that would-be fraudsters must expend a significant amount of processing power in order to create a fraudulent block — and, thanks to Nakamoto’s difficulty adjustment, this will become even more difficult as bitcoin grows in popularity. Verifying new blocks, on the other hand, takes almost no energy. A majority of nodes can simply refuse a suspect block without consuming any processing power.

It’s a good fail-safe because it stacks the deck against cheaters. Even if a user expended enormous amounts of energy and successfully hacked a majority of all network nodes in order to approve a fraudulent block, they would still gain very little. Breaching Bitcoin’s security would quickly erode trust in the network, causing demand and value to fall. That’s like chopping off your nose to spite your face!

Despite its challenges, Bitcoin has the potential to become a new standard.

We all know Bitcoin is both scarce and secure but is that enough to make it anything more than a passing fad? The answer is determined by how well it handles a couple of major challenges.

Consider price volatility. When bitcoins were first used to complete a transaction in May 2010, each coin was worth $0.000994 USD. Fast forward to October 2017, and that had risen to $4,200 — a 422,520,000 percent increase! That is simply long-term volatility. In just one year, the value of a bitcoin increased from $750 to $20,000. These fluctuations are caused by changes in demand. Because the supply of bitcoins is limited, the currency’s price can only respond to rising interest. Because Bitcoin is still relatively new, demand has been highly volatile. As a result, the currency’s status as an effective store of value has been jeopardized.

Will things calm down? These fluctuations, according to Dr. Saif Eddine Amous, should even out as the market grows.
This brings us to the second issue that Bitcoin is facing. If the currency is to become a new standard, it must grow; however, even Bitcoin’s growth will be contingent on increasing reliance on large, centralized institutions. That is a problem when a currency is intended to provide people with an exchange system that does not rely on government-approved third parties such as banks!

Unfortunately, it appears that there is no way to square this circle. The daily transaction limit for Bitcoin is currently set at 500,000. That figure could be raised, but no matter what the new figure is, there will be a daily limit. Then there’s the issue of cost. The more transactions that occur, the more nodes are required. This increases the number of Bitcoin ledger copies that must be updated, increasing both transaction fees and the amount of processing power required. Put these facts together, and you’ve got a pretty compelling case for bitcoin trade-off the blockchain — in other words, bitcoin-backed trade-in currencies. This would set a new standard, but it would also necessitate the formation of centralized institutions to manage the system.

Bitcoin could very well serve as the foundation for establishing a modern sound-money policy. But a question hangs over its future: will it be able to avoid the fate of the gold standard? The only way to find out is to wait and watch.

A Quant Trader | Data Scientist | can I help you?

A Quant Trader | Data Scientist | can I help you?