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Why Bitcoin is essential for the people: Part 1

Why Bitcoin is essential for the people: Part 1

If you’ve followed financial news at all in the last few weeks, you’ve probably seen an onslaught of articles, discussions, and even memes about the Federal Reserve’s quantitative easing program. While it’s certainly humorous to boil the Federal Reserve’s actions down to “printer go brrrr,” the joke glosses over the highly complicated nature of the Fed, money, and inflation. In this two part series, we’ll be breaking down quantitative easing and why this policy has serious implications not only for the average American citizen, but also the Bitcoin and other cryptocurrency enthusiasts.

What exactly is money, anyway?

Don’t worry, this isn’t a philosophical exploration of whether or not money is the root of all evil, as it’s described in the Christian tradition. Rather, the very nature of what makes money, money, is very important for understanding all of the tricks and manipulations that get utilised in a modern economy. Ultimately, money is a medium of exchange. Put simply, money is what we give and receive from others in exchange for goods and services. It is much simpler to use an intermediary like money when conducting a transaction: long before the invention of currencies, bartering systems were king, and those systems are full of inefficiencies. If you were a fisherman, but wanted to eat chicken for a change, you’d have to hope that the chicken seller was in the mood for fish. On top of that concern, some days you might have a large haul, more than you could reasonably eat, but no one else might have anything of value to you, effectively rendering your haul worthless. With money, these sort of concerns melt away. Money, despite having no real world functions, serves a store of value. That means that despite a currency lacking any particular uses, people in a community agree that it has a certain value, which can be exchanged for goods and services. For much of human history, commodity money was the primary form money existed. Commodity money is goods that act as money. They’re different from paper money in that they have some functional purpose or cultural value. In the early settler days of America, colonists would frequently trade beads and similar items for food from Native Americans. Perhaps the most famous example of a commodity money is gold. Governments have used gold as the basis for their currencies for centuries. Gold is interesting because its functional purpose is somewhat limited; in reality, gold maintains a value because it is nearly universally considered to be beautiful, and it is known to be considered beautiful, and therefore it is valuable. It’s a some what circular logic, but nonetheless, gold has been an enduring symbol of commodity money. It is this logic and understanding that will help explain the system that runs the modern monetary world.

Why Did Governments Move Away from the Gold Standard?

When a government backs their currency with gold, it means that a holder of its currency would be able to go to the federal government, and exchange the dollars that they had for a set amount of gold. This didn’t really apply to the average person, it was largely foreign governments that were able to exchange the dollars they had with the US government for gold. In the early 20th century, every major government backed their currency with gold - until, that is, the Great Depression brought it all down.

In 1931, the Great Depression struck one of the world’s largest economies particularly hard. Once the economic downturn became severe, people began to rush to their banks, and exchanged whatever paper currency they had for physical gold. In isolated incidents, this sort of event is bearable for a bank. However, when a panic sets in and many people start demanding gold for their dollars, banks run the risk of running out of gold. This, of course, is a massive problem, because it then exposes the idea that the money you have isn’t really worth a set amount of gold; after all, if it was, a government would be able to satisfy all trades of paper money for gold. The Bank of England eventually had no choice, it simply wasn’t possible to satisfy the demand for gold anymore, and from then on decided to abandon the gold standard.

This led to a cascading effect internationally. If the world's largest economy could drop the standard, it was reasoned, the smaller parties should be able to as well. Across the pond in the United States, American banks were also suffering from a run on the banks. Even though most of the top economists surrounding President Roosevelt insisted that the country remain on the gold standard, likening such a move as a blow fatal to western civilization, Roosevelt finally decided to take the plunge. Since you’re reading this article, you can imagine that those fears were slightly overblown. This new type of currency, one that is unbacked by anything but trust, is known as fiat currency.

The Value of Fiat

As it was shown by gold, the value we give to a commodity is really just in the impression we have in it. Gold is valuable simply because we believe it to be valuable, not because it has a particular utility. Likewise, fiat currency’s value is decided by its supply as well as its demand. Even without a massive event like the Great Depression to spur such a switch, the use of fiat currency is a pragmatic choice for the vast majority of countries: countries without any gold, or the means to acquire gold, have to have some sort of money system, and growing countries also need a more efficient way to control the money supply when gold’s value is entirely controlled by people’s perception of it. That doesn’t mean that fiat currency is imaginary. Now, the value of the US dollar is tied to the overall value of the economy. If the economy falters, that’s reflected in the decreased purchasing power of the dollar. However, now government’s have a lot more flexibility with controlling the money supply, as they can print more money than there is gold. These days, the value of money isn’t arbitrary, despite what many opponents of fiat claim it to be. Fiat currencies are pegged to a purchasing power, which means a country can’t just ramp up their money printers to buy more goods from other countries. Just like gold and other commodity currencies, the value we place in fiat currencies is fueled not only by our desire for it, but what we can do with it. After all, who would want a currency you can’t buy anything with?

The Different Faces of Money

The exact number of dollars in circulation is important because it’s an indicator of whether inflation, the devaluation of currency, or deflation, the increasing valuation of a currency, is occurring. To make it a little easier to measure, economists tend to split money into three categories: M1, M2, and M3. M1 consists of all the physical kinds of money, checking accounts, and travelers’ checks. M2 includes everything in M1, but also includes time-related deposits, savings account deposits, non-institutional money market funds. It’s basically the supply of things that can be readily turned to cash if needed. M3 is the broadest classification of money, encompassing both M1 and M2, but also includes things like all large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets.

How is Money Created?

The Federal Reserve, which acts as the central bank for the United States, can print money whenever more money is deemed necessary to juice up the economy. Despite the widespread media attention, the actual printing of money represents just a small portion of how money is actually created. One of the major ways the Federal Reserve can increase the number of dollars in circulation is to buy government-backed securities held by banks and other institutions. When the Feds buy a security from a bank, the bank receives money for that transaction, which is then loaned out to consumers, effectively increasing the money supply. The Feds can also work in the reverse direction, selling banks government-backed securities, and thereby restricting the money supply, which helps mitigate the effects of inflation. Whenever people have faith in a currency, the Feds can increase the money supply without causing too much inflation. Conversely, if faith in the US government declines, such a move can cause rampant inflation as people devalue the currency by reducing the demand for the currency.

What is Quantitative Easing?

When a currency is no longer backed by a commodity, a central bank has a lot more flexibility with how they handle the money supply. Quantitative easing (QE) is one such proof of the flexibility of the modern money supply. QE is a novel monetary policy in which a central bank purchases long-term securities, such as government bonds on the open market, in order to increase the money supply and encourage economic activity. Buying these securities adds money that previously did not exist, and also lowers interest rates by bidding up the value of assets. These tactics are employed when the traditional cutting of interest rates is no longer feasible, such as when rates are at zero/near zero levels.

What’s the problem with QE?

The intended purpose of QE is to encourage economic activity when cutting interest rates is no longer feasible. This comes at the cost of bumping up inflation, as the money supply increases. However, once the money is in the hands of banks, the central bank cannot force people to loan or spend money, which means money is not only devalued but there is also no economic enhancement. After 2008, thanks to the Great Recession, the Federal Reserve began to adopt QE tactics, and ultimately increased the money supply by a staggering $4 trillion dollars. The hope was that the banks would lend out that money and spur on the economy. In reality, the banks simply held onto it as excess, and at one point, as much as $2.7 trillion dollars were hoarded by American banks. Ultimately, the program has worked well in the United States, but other countries like Switzerland and Japan have experienced mixed results with quantitative easing programs.

FRED M2 Money Stock Chart

In the second part of our two part series, we’ll be breaking down why Bitcoin, and other cryptocurrencies, are vital in the modern monetary landscape.


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