Government & Currency
We live in a unique time in history when technology has evolved to provide the means for peer-to-peer, trustless transactions. Code is law and trustless systems can govern without central authority or intermediaries.
The journey from our history of centralized control over money to today has been exciting to say the least. People have gone to war or been burned at the stake over money and control of the financial system. Endless cycles of boom and bust, and constant economic disparity have become the norm.
How did we get here and are we destined to repeat ourselves? Are we standing on the precipice of a new paradigm shift for truly fair money or are we just repeating history with a new face?
History of Money
Money has come a long way from centrally minted Roman coins or naturally minted Wampum seashells. It has evolved to fit the needs of humanity and so has its governance mechanisms.
Central authorities haven’t always defined, issued, and managed money throughout human history. Furthermore, money hasn’t always been a symbolic, physical medium of exchange.
The barter system was the default before currency. People traded physical items or favors in exchange for various goods and services. However, the barter system itself presents many issues. It can be difficult to agree on a fair exchange of goods, especially when people’s needs and preferences are different. Additionally, long distance trade or trades in large quantities get logistically difficult as you’d have to send whole caravans of goods in order to make a substantial purchase.
Unlike most modern coins, early civilizations like the Romans had coins that derived not only symbolic value representing trust in the government, but also intrinsic value from the precious metals they were minted from such as gold, silver, and bronze.
This meant that the value of each coin was slightly higher than its precious metal content. Conversely, if trust in the minting authority eroded or the government fell, they still retained their intrinsic value from the precious metals they were minted from.
Fiat currencies are symbols of value that are intrinsically worthless but decreed legal tender by fiat (order) of the issuing body. Fiat currency is the natural progression towards a more convenient, lighter means of transaction that can be stuffed in your pocket.
The first fiat currency issued by a government dates to China in around 1000 AD. For the first 900 years of fiat’s existence, it existed alongside other commodity-based currencies, including gold standard certificates.
In modern times, a central bank manages the money supply, controlling how currency is added and removed from circulation. Up until the early 20th century, however, these notes still had the backing of gold. If you held a U.S. dollar in 1932, for instance, it was worth a certain amount of gold in the government’s vaults. While more notes were printed than gold in the vault, limits on the ratio between notes and gold were such that there was unlikely to be a run on the nation’s gold stores.
Case Study: Central Banking in the United States
In the United States, Alexander Hamilton established the First National Central Bank after the Revolutionary War to manage the war debt, increase liquidity in the new American economy, and create a standard form of currency. Later, Thomas Jefferson and James Madison would abandon the bank, leaving private banks to print their own bills. This brought massive inflation and debt, leading to the creation of a Second Bank of the United States to bring the currency back under control and provide funding for the War of 1812.
In 1934, President Roosevelt signed the Gold Reserve Act to ban privatized use and ownership of gold and signed the total supply of the U.S. gold reserves over to the U.S. Treasury. This act also entitled the Treasury to the Exchange Stabilization Fund (ESF) which had 2 billion dollars worth of government profits made from gold price increases. The Treasury was able to spend the funds to buy or sell gold, foreign currencies, financial securities, and other assets in order to encourage inflation in the dollar’s value.
The change effectively allowed the government to manipulate the dollar’s value by banning private gold ownership and then setting the government’s price for gold. A higher gold price (the 1934 Act raised the price of gold from $20.67 to $35 per ounce) would devalue the dollar. The goal was to lower interest rates and encourage investment in durable goods following the Great Depression.
The U.S. government (and governments around the world) have used such measures to manipulate currencies ever since. By 1971, it became clear that the gold standard was no longer a good store of value because the Treasury could set the price of gold wherever they wanted. In 1971, President Richard Nixon officially ended the gold standard in the United States by executive order. The U.S., among other nations, moved onto an inflationary debt system backed by GDP.
A GDP-backed debt system allows for the continuous minting of new currency in order to fit the needs of the government or institution. This centralized control directly benefits those who are able to generate currency, decide how and where to spend it and, in turn, devalue what’s already in circulation.
Debt Is the Basis of Fiat
At this point, the entire global economy is built on debt-based currencies. This means that a fiat currency, like a dollar or a euro, is essentially an IOU of government or corporate obligations.
To illustrate, let’s consider how the U.S. Federal Reserve prints a new dollar. They must borrow the value of that dollar from somewhere, and most of the time it becomes part of the national debt. Similarly, when you take out a loan at a bank, the bank is essentially creating that money (credit) out of thin air. You might go on to spend that money in the economy, increasing other people’s bank accounts with money that didn’t exist before you took out the loan.
To put it simply, credit and debt is how the global economy expands. When Nixon took the United States off the gold standard, he said currency doesn’t have to have anything to back it. The Federal Reserve doesn’t need to have a lump of gold in Fort Knox for every dollar it prints. It can just print and add it to the national debt.
Therefore, if every consumer and corporation in the world paid off all their loans. And if every government in the world paid their national debts, the global economy would shrink to a tiny percentage of its current size. Without debt, there is no modern economy.
Weaknesses of Fiat
Okay, so fiat, debt-based currency has gotten us this far. However, there’s reason to believe that debt-based currencies aren’t the best thing in the long term. The arguments break down two ways:
Inflation is a consequence of debt-based currencies, and it will only get worse. The dollars in your bank account lose about 2-4% of their value every year, and that compounds on itself. We’ve come to take inflation as just a cost of modern economics, but what if we could have an economy where currency doesn’t lose its value or even gains value over time?
Central control of the money supply also imposes a single point of failure in the security of a currency. When you save a dollar, you’re placing implicit trust in the Federal Reserve to manage the value of that dollar wisely. You also have to trust the Federal Reserve to protect the integrity of its internal systems. As banking increasingly moves online, so too does money and remittances. Security is a major concern with a centralized currency.
According to James Lewis at the Center for Strategic and International Studies in Washington DC, “Hacking is a major threat to the stability of the financial system.” Over the past few years, the Fed, Treasury, and major banking institutions have seen major security breaches. These breaches have led to the disclosure of personal records and loss of millions of dollars in funds.
Technology Is Part of the Solution
Satoshi encoded in Bitcoin’s genesis block the architecture and mechanisms of blockchain and cryptocurrency. They fundamentally change the two key weaknesses of fiat:
- Inflation becomes deflation. Because asset issuance on Bitcoin is fixed and predictable, a new type of economics is possible. One where currency doesn’t have to lose its value over time. Instead, it gains value.
This is true because Bitcoin is not debt-based. Nobody took out a loan or increased a nation’s debt in order to finance the creation and value behind Bitcoin. Instead, a Bitcoin derives its value from being unique and scarce. So long as people want to believe in and accept Bitcoin, it doesn’t need debt as its basis of value.
- Centralized control becomes decentralized trust. There’s no institution at the center of Bitcoin, as we all know. When you use a dollar, you have to trust the Federal Reserve. When you use a Bitcoin, you have to trust the source code. You have to trust Satoshi and the other developers who have contributed to and audited Bitcoin. If you feel confident in the Bitcoin protocol, then you can feel good about any transaction on Bitcoin.
Blockchain and cryptocurrency alone doesn’t solve all our money problems. It certainly does change the paradigm around money and its role in our economy, though. A full switch to cryptocurrency would mean more security and privacy. It’d also likely mean lower debt and less credit in the economy.
These tradeoffs are the tricky path we’ll have to navigate between crypto and fiat. Indeed, credit is important to growing an economy. It’s difficult to start a small business or buy a home without credit. Certain cryptos that are inflationary and don’t have a maximum supply will help with expanding the economy. Fiat will also likely continue to exist alongside cryptocurrency in the long term.
As blockchain technology becomes more mature, new capabilities have arisen that make it an even more compelling candidate to replace or extend fiat in the history of money.
Multi-Signature Escrow, Smart Contracts, Hardware Wallets, Decentralized Audit, and Algorithmic Proof of Reserves are capable of providing all the oversight needed to keep the decentralized payment system in order, and provide predictable outcomes. If these are provably effective, we may not need external governance of financial systems at all.
However, these advancements are all new and relatively untested. They may not work, have flaws, or result in unintended consequences for consumers.
One great example that has already played out in cryptocurrency is the rapid development from CPU to ASIC mining over just a few years. Mining began as a system to allow anyone to contribute to the security of the network using their home computer. Now, mining is a business with razor thin margins and high startup costs. These costs centralized mining to a few major players, having the opposite effect of the original decentralizing vision.
The Human Element: We Make Mistakes (Spoiler!)
As new advancements come to cryptocurrency, there is ample opportunity for developers to make mistakes. It’s clear that attackers are always on the hunt for vulnerabilities, and currencies like Bitcoin and Ethereum present big bounties for anyone who can infiltrate them successfully.
Many new developers, for example, begin smart contract development and don’t take the time to properly debug, fortify, and audit their code. Some simple solutions from groups like Open Zeppelin and Consensys are encouraging Smart Contract Security Best Practices to help bring security standards to the open source space.
Still, we may not be ready yet for a monetary system that’ governed entirely by code, simply because the humans who wrote the code were fallible.
The Challenges of Decentralized Governance
A decentralized organization brings many new exciting automated possibilities to our world. It’s possible to imagine a self-policing organization across industries where the users themselves can vote directly on how to run the organization itself.
Christoph Jentzsch conceived the first decentralized autonomous organization and creatively named it The DAO. It deployed into working production in 2016. The idea caught a lot of attention and raised over 100 million dollars during its ICO, but the new invention wasn’t without its flaws.
On June 17, 2016, the DAO’s funds slowly started to siphon off into an unaffiliated DarkDAO contract. Over time, the attack siphoned total of 50 million dollars worth of ETH. Christoph and his team weren’t able to take back control of their funds, which led to their final move. At the consultation of Vitalik Buterin, Ethereum’s founder, they chose to propose a hard fork of the Ethereum blockchain at block 1,920,000, which would effectively roll back the funds that went missing.
This decision led to a split in the community and the creation of two chains: Ethereum Classic, which did not accept the new hard fork implementation and Ethereum which did accept the roll back of the funds.
The DAO isn’t alone. Many attacks, poorly written smart contracts, and outright frauds have cost consumers millions. In the face of such dangers, many consumers are demanding protection in case of attack.
The DAO leads to an interesting ethical decision. On the one hand, we can vote to resolve technology’s problems and reset accounts. On the other hand, we stand by the principles of tech’s immutability and code as law.
It’s clear that there’s still a need for government to regulate and oversee financial systems and organizations, even if they’re decentralized. Still, increasingly, regulation and governance can and should happen at the platform level. Determining the future of cryptocurrencies and blockchain platforms should be the domain of people actually using those platforms, not disconnected federal regulators.
History & Future of Money
Nearly everyone can agree that cryptocurrency and blockchain will play an interesting role in the history of money. Crypto maximalists see cryptocurrencies replacing fiat entirely as a new global financial order. Minimalists believe that fiat will continue to dominate and blockchain will only play a small role in banking and remittances.
The real answer is likely somewhere in between. Cryptocurrencies will live alongside fiat currencies as a way to balance out the debt and inflationary basis of fiat. The road ahead will face resistance on many fronts. But the biggest hurdles for cryptocurrency are compliance and security, prerequisites for integration with the global financial sector.
More generally, self-governance will exist alongside governmental oversight in blockchain platforms across industries. Expect this self-governance to increasingly shift power and control over money away from centralized institutions and toward a more democratic, decentralized future.