It all starts with barter or direct exchange. If we were thrown back in time, in a situation in which there were no money, we would engage in barter. Barter does not work every time, though, and we would find that most transactions require indirect exchange: imagine Alicia who has apples and wants bananas; Brad has bananas and wants cashews; and Caitlin has cashews and wants apples. Alicia can make a deal with Caitlin to exchange some of her (Alicia’s) apples for some of Caitlin’s cashews. Alicia does not want cashews, but she needs it to make another deal, this time with Brad who she can now barter with. What Alicia has done is called indirect exchange: acquiring something to get what she wants, eventually. For Alicia, cashew is not directly interesting, but she acquired it for use as “medium of exchange”.

After a while, indirect exchange leads to the popularity of a commodity for use as medium of exchange. This progression from barter to indirect exchange using a popular medium of exchange is a natural phenomenon: it just happens without somebody planning it. (Somebody should write a simulation of this, to prove that money comes into existence naturally and not because of anybody’s design.)

As an example, take a group of people isolated in prison, like a detention facility in the U.S. In the U.S., prisoners are not allowed to use USD or any form of cash. After only a few barters and indirect exchanges, one thing would stand out as medium of exchange in prisons: cigarettes. Even prisoners who don’t smoke then start hoarding this particular commodity because it has become a form of “money”. It has well-defined “units” (one cigarette = one unit) and, as long as it’s kept in good condition, one unit is almost replaceable with another.

Trade and Its Benefits

Money allows us to trade with one another. This is good because whenever we trade, we increase the overall wealth of society. How so? When I buy a car for a certain price (say $10,000) I would only do it if I valued the car more than that amount of money. However, the person or company I bought it from valued $10,000 more than that car. Therefore, because the car has more value in my possession and $10,000 has more value in the sellers possession, this single trade has increased the value of things involved in this one transaction. If we consider how many trades occur in a day, we can see that trade indeed increases the wealth of society almost magically.

Trade also allows us to do what we really want to do. Imagine a world in which there is no trade: each one of us would have to spend more time tending to our fields of wheat or rice and vegetables in order to have food on the table. With trade, we can focus on doing the things we are good at and enjoy doing because we can exchange our skills and time for money, which can buy us most anything we need in daily life.

Money and Its Exchange Value

Money allows for trade and trade is good. No wonder money has value. How much value does money have?

Anything that gets used as “money” retains value over and above its intrinsic value. What this means is that a cigarette in U.S. prisons has gained value over and above its value for smoking pleasure. Even non-smokers start coveting it purely for its value as medium of exchange.

Like cigarettes in U.S. prisons, old forms of money have similar dual value:

Total Value = Intrinsic Value + Medium of Exchange Value

For example, gold has intrinsic value when used as jewelry or as a good conductor of electricity; but it also has additional value as money. In times when gold demand for monetary use is high, its “Medium of Exchange Value” can be higher than its “Intrinsic Value”; and vice-versa.

Now both paper money and cryptocurrencies have ZERO intrinsic value. Think about that for a minute and let it sink in, for this is an amazing fact, something that is not obvious. In Venezuela, Bolivar paper money has lost so much monetary value that it is worth more as paper for starting a fire than as money. (More on why money can lose its value below.)

On the other hand, both paper money and cryptocurrencies can have very high medium of exchange or monetary value. Anything that a group of people recognize as having monetary value has real value and this real value can vary depending on demand versus supply. As it turns out, just like any other commodity, the value of money is a statistical function of both demand and supply.

The Value of Trust

The key phrase in the last statement above is “a group of people recognize as having monetary value”. In order for a group of people to recognize something as having monetary value, they have to TRUST that such value holds, through time. This means that, even though people can trust their governments to issue money, that trust is not absolute: it depends on how their governments manage the quantity of money with respect to demand. When a fiat currency loses the trust of a people, it can lose its value fast. When this happens, the rough relationship among value, demand, and supply is lost: without the prerequisite trust, it would be very difficult to regain a currency’s value and even decreasing its quantity may not save it from hyperinflation.

With money, trust is a network effect. Whenever somebody somewhere in the world accepts USD in exchange for something, the trust that this somebody grants to USD enforces the value of USD. USD is the most trusted fiat currency in the world; because of this, its value is almost purely a function of its quantity vis-a-vis its demand. The Fed has a heavy responsibility to keep USD quantity commensurate with demand. If the Fed errs on the side of “printing” too much USD, its value can start to slide; from there, it’s a slippery slope to losing our trust. We trust the USD, which translates to trusting the Fed.

While it takes years to build trust, it can take only months to lose it. If a central bank simply announced that it would issue more currency for distribution to the public for “free”, people would start spending money that they already have, not only because they know they would receive more, but also because they know that its value (or purchasing power) would start to erode.

One thousand Venezuelan bills went into making the purse being held up by Alvaro Rivera in Cúcuta, Colombia. As Venezuela’s bolivar has lost its value, artisans say it’s worth more as a raw material than as a currency. Jim Wyss MIAMI HERALD

Bitcoin Volatility and the Advent of Stablecoins

We also trust Bitcoin, perhaps better than USD. However, bitcoin’s simple, decentralized “monetary policy” is inflexible: unlike USD quantity which is adjustable according to demand, Bitcoin quantity is not. Bitcoins are released according to a rigid schedule. That schedule limits the quantity of bitcoins that will ever be released to 21 million. The value of a bitcoin therefore depends only on demand. If demand is high, its value goes up; and if demand is low, its value goes down. Bitcoin demand roughly correlates to Google search term count and that’s why there’s correlation also between Bitcoin Google search count and its price.

Demand cannot be constant, which means that bitcoin price with respect to any fiat currency is as volatile as its Google search count. This makes Bitcoin not as useful a medium of exchange as the US dollar. Most vendors refuse to accept it as payment because it adds risk to their already risky business. Big online stores like Amazon and Overstock accept it, but immediately exchange it for USD.

Clearly, a cryptocurrency that is as stable as the most stable fiat currency is needed. This kind of cryptocurrency is called a stablecoin. A stablecoin’s value can be stabilized by initially pegging it to USD. Later, its quantity can be adjusted according to demand and its purchase value monitored independent of USD. There are several ways to keep a stablecoin / stabletoken value stable, but these fall in one of only two categories: decentralized or centralized. Fiat currencies fall in the centralized category, while stablecoins mostly fall in the partially decentralized category. Decentralized stablecoins are a holy grail and maybe impossible to achieve.

Summary