The dominant money system today has a long and complex history, way back in the mists of time villages had a natural tendency to have populations of around 150 [1], as per the Dunbar number. This meant that trade within a village could be carried out mostly on the basis of favours and trust, and perhaps one or two village elders could be trusted to record more significant debts (Joe spent a summer helping Peter build his house). Trade between villages might well have been mostly barter. Over time silver came into use as a sort of free market community money, then coinage created silver units with a makers mark that acted as a form of certification with regards to the authenticity of the coin and thus its silver content - forging coins would have been possible but I'll claim that this would have been difficult to do to a standard sufficient to fool people. Private minters may have been tempted to start using cheaper alloys, but the market soon discovers this - and before the age of common law or any kind of police force the community was your protection, so there was a very good motive not to cheat them.



Enter stage left a regional king, he sets up his own mint and outlaws private minting. Now he is free to cheat because the free market forces are suppressed by threats of violence. Fast forward a couple of thousand years and we have centrally controlled money systems, backed not by limited precious metals, but by the promises of governments that have proven themselves to act with questionable motives and even more questionable skill. They tell us that inflation is good because it encourages spending, it may well do, but of the things we need in life we buy no matter what, thus if this 'carrot' does work then it must merely be encouraging us to buy things we don't need. The scarce resources we have then become used to make things we don't need at the expense of things we do need. Strange.



The system of steady inflation requires a steady creation of new money by a central bank, and this money must be spent somewhere to release it into the economy. The spenders of this money (the government) spend it using the current purchasing power of the money, as do the early spenders of it (e.g. civil engineering firms). Everyone else loses wealth since the money they own is devalued by the increase in the money supply. The choice of where to spend the new money is susceptible to corruption, at the surface these appear to be free market contracts to do public works, in reality the profits being made are large and the choice of contractor is biased towards friends of ministers and central bankers.



The most recent evolution of the system was as recent as 1971 when the US government terminated dollar to gold conversion, this was the last remnant of a sane metal money system born at the birth of civilisation. In the subsequent 40 years or so we've seen significant instability, most recently with the money system effectively collapsing in 2008 and being massively manipulated to keep it working. This is not a sane system, but it's the one we have and one which we have numerous good reasons for keeping, not least of these is the apparent lack of any better options. Like democracy it's presented as the least worst system. In any case, any change would cause shifts in geopolitcal power, and thus the most powerful actors of the day (e.g. the US) have little incentive to change things, despite being the entities most able to enact change.



There appears to be no way of changing this state of affairs that has evolved over hundreds, even thousands of years, except for the plain fact that the system is on a path of self destruction. The system effectively collapsed in 2008 and was propped up, this is perhaps not novel if we look back to the money system crises of the 1700s and 1800s as we transitioned from metal to fiat money; from free market competing monies to central control. What is novel is the scale, globalisation, and systemic effects. Another 2008 type event is inevitable since instability is a quality that is baked into the system, people push risk taking until the system blows up, no amount of regulation can prevent this since the regulators are people, and people are fallible.



What are some possible outcomes of the next crash? The 2008 crash resulted in a 'flight' to the dollar, i.e. sell everything you can and get back to 'safe' dollars (preferably M1 'narrow' dollars, US bonds are a good proxy there). Another crash would likely play out similarly, with central banks creating new money to prop up bank reserves to prevent bank runs and bankruptcy. The issue is the scale of the money printing that would be required combined with the amount of money already created since the 2008 crash. This very large amount of money in circulation, for the USD in particular, will eventually lead to devaluation of the dollar and thus US bonds. This is the problem tipping point, if flight to the dollar isn't safe then what is? What is the next best asset.



An interesting feature of the 2008 crash was that gold initially fell along with most other assets, that is, gold was being sold to get back into dollars. This seems a little odd but remember that a dollar is a dollar, whereas the price of gold in dollars is a free floating market price which is an unknown quantity in a global market panic, so in some sense this is sane behaviour. It may also be related to gold derivatives and people closing dollar denominated leveraged gold contracts. In a flight from dollars the next best(safe) asset would be physical gold. This would be a sort of nod back to the gold backed monies of yore - gold is limited in supply and widely accepted as a store of wealth. It's a money of last resort.



The problem with gold is that it's pretty awful for use in trade, so although a flight to gold for wealth preservation is a workable situation (for both individuals and central banks), it's not a workable solution for international trade, and with the USD in crisis that raises the question of what is the next best option for use as international money?



Some background. The USD money supply has been expanded to supply dollars for use as a foreign currency reserve following the demise of gold in that role, and also for international trade. Even countries with strong political differences with the US, such as Iran and Russia, use the USD in trade, simply because it is widely accepted and has a stable value. Prior to the USD the British Pound served this role, the pound was ubiquitous due to the dominance of the British Empire in world trade. A dollar crisis may be further compounded by a sale of dollar reserves around the world, this massive pool of dollars could cause collapse of the dollar and dollar bonds. That is the problem tipping point.



International trade would likely stall as it did in 2008/9. Eventually trade would pick up, perhaps using a mix of currencies purely out of necessity. Want to buy oil from the Saudis? Maybe use a mix of Euros, Renminbi, Pounds, maybe even a physical gold shipment. Ultimately the Saudis want to buy - food, goods, machinery, expertise, shares in foreign companies, etc. so they want something they can use in exchange for those things. They may have to revert to exchanging oil directly for goods, and perhaps oil becomes part of the international money mix (noting its bulk makes it worse than gold, but since we have to ship it anyway...)



A word on bitcoin. Bitcoin was forged in the fires of the 2008 financial crisis [2], it is a response to a dysfunctional world money system. Bitcoin liquidity is far too small for use as an international trade currency at this time, it's also a very young experimental technology and as such it would be unwise to use it as the basis for large scale international trade. However, a dollar crisis with flight to gold would also cause some flight to bitcoin, this would be a small effect relative to the amount of wealth invested in gold, but large enough to cause a large increase in the liquidity and total market value of bitcoin.



This in turn would allow bitcoin to be used in a small way for international trades (as a small part of that mix of currencies), and that usage of bitcoin over a period of time will cause trust to grow. It would take several years, but if the bitcoin network did not experience any problems then eventually a virtuous cycle threshold point would be reached were usage would increase in lock step with total market value. Eventually it's possible that bitcoin would have enough total value and liquidity to be a major currency in international trade.



The point is that bitcoin was born out of the events of the 2008 crash but it will likely not be mature enough to become a major world currency when the next crash occurs, rather, the next crash will be a major phase in the maturing of bitcoin in the same way the price leaps of 2013 propelled bitcoin from obscure tech for transacting tiny amounts within a small group of people, to useful minority money with busy exchanges and a promise of much more.



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[1] As reported in the Domesday book of 1086.

[2] As evidenced by the bitcoin white paper and the message encoded in the genesis block. Tags: bitcoin