One of the more interesting recent developments in finance has been the creation of Bitcoin and other crypto-currencies. They are being touted as a revolution in how we think and use money; characterised as an internet of money to accompany the internet of information. It is certainly futuristic.
Alternately, there are many who want to go in the opposite direction — return to the past. This group argues we should go back to the gold standard that was dismantled by Richard Nixon in 1971, mainly in response to the soaring cost of the Vietnam War.
Returning to the gold standard is seen by this group as a way to solve the problem of soaring global debt levels, which are out of control. The global stock of debt is about $US200 trillion, the equivalent of 230 per cent of global GDP.
Both sides have a common enemy: what they call fiat money. This is money whose credibility and value is determined by government dictate (fiat). Allowing governments to dictate in this way, both sides argue, is the core of the problem.
To a significant extent, both sides are wrong. For one thing, private banks, not governments, create most money. As economist Nicholas Gruen has argued we would have far fewer problems if central banks were to create money instead.
Worse, in recent years the problem has been not so much government fiat as the lack of government fiat — or what is known in financial circles as 'deregulation'. For about three decades, the mantra to 'deregulate' the financial markets has been deafening — and successful. Governments progressively withdrew from the financial markets, allowing traders to make up new forms of money.
These were known as derivatives. In effect, they were 'derived' from traditional forms of money (which continued to be subject to government fiat or regulation). The global stock of derivatives, according to the Bank for International Settlements, is now over $US750 trillion. To give some idea of how that compares, the global value of cash is about $US31 trillion; the world's gold stocks are worth about $US8 trillion and the market capitalisation of the world's stock markets is about $US68 trillion.
It is a mess. So where is it headed? To get a sense of that, we first need to understand what money is. Since Henry VIII reduced the amount of gold and silver in the mid-16th century (known as The Great Debasement), money has been more a symbol of value rather than something of worth in itself. Now, it is mostly just blips on a computer network, data.
"Crypto-currencies are still in their infancy. But there is little doubt that they will eventually change how we think of money."
The question is what makes people trust the symbol? The gold standard worked because people trust that gold is always precious. Physical cash is considered of value because people trust that its worth is government guaranteed (that is, fiat). The derivatives market functions because the traders trust in each other, although this broke down spectacularly in 2008, nearly destroying trust in the world's financial system.
Crypto-currencies like Bitcoin seem to have a genuinely new approach to the issue of trust. Proponents say that it is a 'trustless' system. Although this is not quite right — what they seem to mean is that it does not rely on human trust — it is crucial to why it is significant.
Bitcoin is based on mathematics. More specifically, it is based on a solution to what is known as the 'two generals' problem. Imagine two generals must attack a castle together if they are to win a battle. But they must do so via intermediaries who cannot be trusted. How do they know that the message has got through? In other words, how do they get rid of the middleman?
An ingenious mathematical solution was devised to this puzzle that makes it unnecessary to trust intermediaries. This mathematics forms the basis of the blockchain: the ceaseless calculations that drive the heavily decentralised Bitcoin network.
Trusting maths is a lot less risky than trusting human institutions, but there are a number of questions yet to be convincingly answered. The Bitcoin network is tiny; it is only worth about $US40 billion, a fraction of the cash in the world system. It seems unlikely that it will be possible to achieve the required scale to make it a true global currency. Already, there are growing problems of inefficiency.
Still, the basic ideas — removing financial intermediaries, using the collective intelligence of a decentralised global network, and questioning why governments should be respected when they have vacated their obligation to govern — seem defensible enough.
Crypto-currencies are still in their infancy. But there is little doubt that they will eventually change how we think of money.
David James is the managing editor of businessadvantagepng.com.