Policy, preciousness or proof: which is best, as a basis for money?

. 4 min read

I got into one of those frustratingly circular conversations recently, if you’re into crypto in any way then you’ll know the kind I mean. The one which generally ends up with the frustrated no-coiner declaring, ‘but it isn’t backed by anything!’

The only way I can deal with this one is to ask them what the money in their pocket, in their bank account, is ‘backed by’, and it’s always interesting to see the extent to which they have considered this question - or possibly never have done so. We all frequently fail to examine the things we take for granted, and if you have never had cause to question the integrity of your national reserve currency or the financial institutions you use (and perhaps you have a short memory or don’t read the news about other parts of the world), then it’s easy to keep the faith with that piece of paper in your wallet (or the numbers on a screen - but who would believe in money that is digital..?)

The person I was talking to the other day was actually misinformed to the tune of many decades, holding fast to the view that the British pound sterling was in fact backed by an equivalent quantity of gold, held forever in trust by the Bank of England, against the day said bearer turned up and demanded it.

This is a lovely idea, and I can’t help but picture something like J K Rowling’s Gringott’s goblin bank with vast underground vaults, or perhaps it’s all lined up in the Warren Buffett’s imaginary olympic swimming pool into which all the gold in the world ever mined could be fitted. Indeed, scarcity of supply is one defining characteristic of money as a store of value, and gold fits this definition well. However, the Bank of England abandoned the Gold Standard in 1931 to avoid a run on the currency during the Great Depression, and this act - which instantly devalued the pound - helped the UK economy recover relatively rapidly.

The US clung on to the Gold Standard until 1971, which probably helps explain the pervasiveness of the legend in people’s hearts and minds. With the first use of gold as a currency recorded in 645 BC Lydia, it’s a powerful and attractive notion, that the dollar or pound coin in the pocket of your jeans has a fixed value in terms of a rare and precious metal. But there is not one country in the world which still uses gold, or other valuable and scarce commodities like oil, to underpin its national currency today.

Instead we have fiat money, which is specifically defined as that which a government adopts as its legal tender but is specifically not backed by a physical commodity.

So it’s people and policy who decide what that US dollar or Pound Sterling is worth - and what it will be worth in the future. Committees at the Federal Reserve Bank or the Bank of England make the decision for us based on what they think is best to serve the economic objectives of the government of the day. And indeed we may consider ourselves fortunate that our net worth is not under the whimsical control of the Reserve Bank of Zimbabwe or the Central Bank of Venezuela. Or the Reserve Bank of India, whose decision to recall all 500- and 2,000-rupee notes virtually overnight in 2016, bringing a 90% cash-based economy to its knees…

No, in our sophisticated, developed-world economies, our reserve banks steadily inflate our wealth just enough to keep us spending and the markets propped up, and only print new batches of it when they really, really want to… So, that’s a win-win.

Which brings us to what’s different about cryptocurrencies like Bitcoin - what secures their value?

Well, on a day-to-day basis they are at the mercy of the markets like everything else. Many people have learned that the hard way during the early part of 2018, and being such a relatively small market cap they are highly volatile and subject to swings, fluctuating wildly on a daily basis. But the currency itself comes into being by a process known as proof of work, which gives it a value by consensus which is unique in the global economy.

Whilst the power demands of the complex hash solving to generate new Bitcoins and other currencies via mining gets variously blamed for everything from destroying the environment to slowing down time, it’s a vital part of the value equation. And as other models are being considered for some major currencies such as proof of stake, they all require skin in the game - the commitment of resource, to consolidate a position in the asset itself.

Breaking that consensus would take such a vast input of resources as to devalue the currency under attack, as the distributed nature of the blockchain makes it impossible to alter without updating every copy of every block. The power and time demands involved would make the idea itself completely infeasible - which is why in over 9 years of mining, Bitcoin has never been hacked or subject to a 51% attack.

That’s ‘what it’s backed by’. Mathematics, community, consensus, and proof. Not politicians subject to election cycles, or rare metals whose actual global quantity remains unknown.

Nope, it’s just not real, it’ll never catch on...