A Network Theory of Money

Research Jan 20, 2022

(pdf version)

“One more area that I hope nation-states start paying greater attention to is the rise of cryptocurrency -- because what looks like a very interesting and somewhat exotic effort to literally mine new coins in order to trade with them has the potential for undermining currencies, for undermining the role of the dollar as the reserve currency, for destabilizing nations, perhaps starting with small ones but going much larger,”

Hilary Clinton, Bloomberg New Economy Forum in Singapore November 19, 2021

Hilary Clinton is no longer an active policymaker, but she remains influential and the sentiment she expressed echoes the sentiments of other leading policymakers around the globe. So her words are worth reflecting upon.

Certainly, there’s a lot to unpack in those 427 characters. It contains a mix of ignorance combined with some savvy insight. Most of all, it highlights a creeping fear amongst policymakers and politicians about a future world that early adopters of cryptocurrencies dreamt about - a technologically-facilitated financial utopia where money is freed from bondage to governments and politicians.

Let’s begin with ignorance… “the rise of cryptocurrency”.

Almost 13 years ago to the day Bitcoin’s genesis block was mined and the world’s first cryptocurrency was born. Fast forward to today and there are more than 16,000 cryptocurrencies in existence with a combined market cap of around $2 trillion[1]. It’s hard to argue with the “rise” part. What is ignorant, is lumping cryptocurrencies together under a single umbrella term.

All cryptocurrencies are not created equal, some are more equal than others. Of those 16,000 plus coins, very few – a handful at most - have the potential to destabilize the global financial system[2]. Part of the reason is because of the various designs of cryptocurrencies - they come in a variety of flavours - the other is because of the very nature of money itself.

Given the surge of interest in all things metaverse (Zuckerberg’s name change pivot for Facebook certainly provided a recent PR shot-in-the-arm), DeFi, NFTs and play-to-earn gaming the internet is awash with companies offering tokens in their shiny new project.

Ostensibly, these tokens are cryptocurrencies in that they are blockchain-based and utilize cryptography, but they are more akin to an equity stake in a start-up than a proper currency or form of money. They are never going to be a threat to the global financial system.

The threat arises from cryptocurrencies specifically moulded[3] to be a form of money. Of these Bitcoin is important and not just because it was first.

Let’s explain.

Google the definition of money and you will quickly come across the words “medium of exchange”, “unit of account” and “store of value”. These are considered by economists[4] to be the three key prerequisite functions for money.

According to the Federal Reserve Bank of St Louis, an entity that should know a thing or two about money, these prerequisites are defined as[5]:

·      Medium of exchange means that money is widely accepted as a method of payment. There is confidence that the person will accept the payment of money in return for the provision of goods and services.

·      Unit of account means that money is a common measure of value across the economy. It provides a yardstick to value economic transactions.

·      Store of value - the most intuitively obvious of the three prerequisites - means that money maintains its purchasing power over time.

According to it’s detractors, Bitcoin is not a new form of money but a bubble/Ponzi scheme in intrinsically[6] worthless computer code fuelled by the greater fool theory that will, inevitably, collapse under the weight of economic gravity[7].

In support of their bearish view, they point out – correctly - that Bitcoin is rarely used as a unit of account. At present, few companies around the globe price their goods and services in cryptocurrencies[8].

They also question Bitcoin’s ability to serve as a medium of exchange[9] or store of value, given its price volatility is significantly higher than fiat currencies - average daily volatility of Bitcoin is 3%, six times higher than the average daily volatility in major FX pairs[10].

On the face of it these seem compelling arguments for thinking that Bitcoin and other cryptocurrencies will not threaten the current financial system. So is Hilary Clinton and her ilk worrying needlessly?

Perhaps not. This is where we get to the savvy part of the comment.

Although economists separate these three functions of money, in reality, there is a great deal of interdependency between them. They are like the three legs of a stool.

Unit of account is, superficially, the least challenging hurdle as almost anything can be used as a unit of account. Amazon could, in true retro fashion, decide to price all its products in sugar, or wheat, or gold – but it chooses not to. Why?

Entities will only display their goods and services in a given money when it is familiar, meaning it has widespread acceptance such that the populace is prepared to conduct economic transactions in it. Unit of account, therefore, is very much the cherry on the top when it comes to money. It is the gold star of money success.

For a currency just entering its teenage years, it is unsurprising that it is not used widely as a unit of account, but there is nothing inherent in Bitcoin i.e. a design flaw that stops it from being so. In fact, Bitcoin and other cryptocurrencies, notably Ether, are already widely used as a unit of account in one area, NFT marketplaces. Almost certainly this is indicative of the high degree of overlap between NFT market participants and crypto enthusiasts who are, by definition, familiar and accepting of cryptocurrencies.

Acceptability is also, as mentioned above, critical for money to serve as a medium of exchange. Without confidence that others will be prepared to provide goods and services in exchange for it, it - whatever it is - cannot function as money[11]. Furthermore, acceptability is intimately connected to the store of value function. Money that consistently loses its value is unlikely be widely accepted.

So fundamental is acceptability, it probably should be viewed as the primary condition for money to satisfy. Simply put, whatever form money takes (digital, paper, metal, stone or shells) it requires a network of participants prepared to accept it for economic transactions: no adoption, no network, no value[12].

Absent acceptability, money cannot exist.

This network theory of money is not as weird as it may first sound. Imagine, back in 2009, if no one bothered with or took an interest in Satoshi’s innocuous sounding “solution to the double-spending problem using a peer-to-peer network[13]”. Bitcoin would have been stillborn[14], cryptocurrencies may have appeared but at a later date, and the Hilary Clintons of this world would be sleeping somewhat easier in their beds.

Obviously, this didn’t happen. Bitcoin is not only in existence, but it continues to attract interest and capital. Presently, it has a market cap[15] of just under $1 trillion and an estimated 106 million owners (this is a murky number for obvious reasons but it equates to roughly 1.3% of the world’s population which is not a million miles away from survey based estimates)[16].

Bitcoin’s acceptability it would appear is on a rising trend, one that may accelerate further if all the chatter about institutionalization of capital flows into cryptocurrencies proves anywhere near accurate.

What this continued rise in acceptability, as evidenced by broadening ownership and a rising market cap, also suggests is that the Bitcoin bears’ argument about high price volatility undermining its ability to function as a store of value is not gaining traction, regardless of how compelling it appears logically.

Then again, when thought about more deeply, perhaps this is not that surprising.

Over the past 13 years, we have witnessed the birth of a new asset class – albeit it one with considerable heterogeneity[17]. This is very much a work-in-progress. No one has perfect clarity as to how this will evolve, what the end-game will look like, whether cryptocurrencies will replace fiat currencies – as Hilary Clinton is concerned about – and there is an absence of a valuation framework. We are all feeling our way in the dark, one transaction on the blockchain at a time.

For Bitcoin, and many other cryptocurrencies, there is a compounding effect on price volatility by design. Because of its decentralized structure, there is no central authority tasked with smoothing out demand and supply imbalances (one of the key roles performed by central banks in fiat currency systems)[18]. There is no way to overcome this aspect without fundamentally altering the nature of Bitcoin.

Given such circumstances – part growing pains, part design – it is only natural for Bitcoin’s price volatility to be higher relative to more established forms of money. If we were living in an ideal world Bitcoin’s proclivity towards higher price volatility would be damaging, potentially fatal, to its ability to serve as money - but we don’t and it’s not. Bitcoin does not have to be perfect, it just has to be sufficiently attractive enough relative to the alternatives for people to want to use it as money. One does not have to look very hard to see what might be the encouraging factor.

The ability to hold (should that be “hodl”[19]) one’s financial wealth in something that cannot be readily debased by governments has perceived value because fiat currencies have a perfect record of ending in failure - a widely circulated fact in the crypto space.

Even though history suggests otherwise, there is no inherent reason why fiat currencies should collapse. It critically depends upon the soundness of macroeconomic policy of the issuing authority[20].

Under a pure fiat system, the value of money is underpinned by the government’s ability to raise future revenues by taxing macroeconomic activity (the alternative is hitting the button on the printing press). As long as the NPV (net present value) of a government’s liabilities is lower than their ability to raise future tax revenue then fiscal solvency and currency/monetary stability is assured.

This budget constraint cannot be evaluated using an excel spreadsheet as there is considerable opacity on future tax receipts. What is visible though is the current level of government debt.

The combined effect of the fiscal hangover from the Great Recession, where private debt was effectively substituted for government debt, and more recently the Covid-19 pandemic, is public sector debt as a percentage of nominal GDP has surged to a post-war high both in advanced and emerging economies.

Due to the aforementioned opacity it is impossible to know ex ante if governments have breached their inter-temporal budget constraints. That said,  the probability of it being breached, particularly as the Covid-19 crisis is ongoing, is rising not declining.

If the global macroeconomy, particularly government balance sheets, were in better shape, acceptability of fiat money would be assured and cryptocurrencies would likely have remained an (exotic) plaything of the tech community. The networks of participants, or hodlers of cryptocurrencies would be small, their market caps would be low and the government’s grip this key policy lever would be assured.

Unfortunately for them we do not inhabit such a world. Far from it, and we are getting further away every day. Add in the recent surge in CPI inflation, which may not be solely attributable to supply-chain disruption (and hence transitory), and it is hard to imagine people viewing potential fiat money substitutes whose supply is either fixed (like Bitcoin) or relatively inflexible (like gold bullion[21]) as having little or no value.  If anything, the global macro backdrop is conducive an ongoing shift out of fiat currencies whose supply is infinitely expandable at almost zero marginal cost and into non-printable forms of money, such as Bitcoin. This stands to provide cryptocurrencies with a favourable valuation tailwind, further strengthening its store of value function[22].

That said, transition away from centralized fiat money systems to decentralized cryptocurrencies will be neither smooth nor swift.

Near-term, central banks could begin to withdraw monetary stimulus in an attempt the stymie inflation thereby boosting perceptions that macroeconomic policy remains sound. This will generate downward pressure on cryptocurrency prices. (The sell-off in cryptocurrencies in the last week of 2021 after the release of more hawkish Fed minutes is a timely reminder of this risk). However, if the government’s inter-temporal budget constraint really has been breached, monetary policy capitulation[23] is inevitable as the economic cost of not inflating away sovereign debt is too high[24]. Such a shift would provide a powerful impetus to the price of Bitcoin and other limited supply cryptocurrencies.

Despite the solid macroeconomic case for a continued upward trajectory for Bitcoin’s price, extrapolating this to the point where it threatens the USD’s role as a reserve currency is, however, a big ask… huge in fact.

According to a UBS survey conducted last year[25], only 11% of reserve managers would consider cryptocurrencies as an alternative to holding gold in their reserves.

This is hardly surprising. Reserve managers are a very cautious and conservative bunch, with their primary objective being capital preservation. Price volatility alone would be enough to scare off all but the most risk-taking reserve manager (and, more importantly, their bosses).

Furthermore, while the survey showed they shared the same macroeconomic concerns as outlined above - outside of the pandemic, the top two were government debt levels (71%) and inflation (57%) - human nature dictates that continuing to hold US dollars, or any of the other seven primary fiat reserve currencies[26], entails less career risk than switching into a cryptocurrency even if both witnessed the same percentage point loss in the future. There is comfort in being in the herd.

A more plausible scenario for reserve managers seeking to move up the technology curve is for them to begin investing in CBDCs[27] - centralized public digital money as opposed to decentralized private digital money. Not only would they be dealing with their peers – other central banks – they would benefit from the visibility of transactions being on-chain as well being able to maintain control of the monetary policy levers.

For many crypto enthusiasts, CBDCs are a complete anathema. The technologically-facilitated financial utopia where money is freed from bondage to governments and politicians would turn into hell. Governments would have even greater control over money than they presently do[28], the role of commercial banks would be lowered as transactions could be done direct with the central bank and financial privacy thanks to blockchain technology would be a thing of the past.

At the risk of sounding like a conspiracy theorist perhaps that was Hilary Clinton’s “real” message. Raising concerns over the evolution of private cryptocurrencies as a subtle way to nudge nation states to speed up the creation of public alternatives.

After all, the potential loss of seigniorage and reduced control over the macroeconomic policy levers is not something any government gives up lightly. As Mayer Amschel Rothschild was quoted as saying

“Permit me to issue and control the money of a nation, and I care not who makes its laws!”

Monetary hegemony is powerful stuff.

Whether CBDCs and private cryptocurrencies can peacefully co-exist, or will be allowed to co-exist, is an open question[29]. One we intend to explore further in the next article[30].

Until next time.

Ryan Shea, crypto economist at Trakx


Footnotes

[1] At the time of writing (January 20, 2022) -  see: https://coinmarketcap.com/all/views/all/

[2] Hint – market cap is crucial as we will go on to explain.

[3] I chose this word carefully for reasons likely to feature in future articles.

[4] Confession time. In a former life I was a professional economist. Thankfully, I was blessed with an inquisitive mind and a low tolerance for bullshit and group-think so I never bought into much of what I was actually taught. Contrary to what my university degrees might indicate, it was trading in financial markets that provided my real education in economics.

[5] See: https://www.stlouisfed.org/education/economic-lowdown-podcast-series/episode-9-functions-of-money

[6] Intrinsic worth is a red-herring when it comes to money. In an ideal form money should have no other uses to ensure that its supply is not impacted for non-monetary reasons.

[7] The frequency rises sharply after either a price surge or slump.

[8] See: https://www.fundera.com/resources/how-many-businesses-accept-bitcoin

[9] Low transaction throughput is also problematic. A lightning network, which allows off-chain transactions, boosts scalability by speeding up processing times and reducing transaction costs – see: https://lightning.network/

[10] See: https://link.springer.com/content/pdf/10.1007/s00181-020-01990-5.pdf

[11] Divisibility is a further factor because economic transactions come in a variety of different sizes. Cows – the often used example in introductory economics - may not be divisible but both fiat and cryptocurrencies are so this will not be addressed outside of this footnote. As a small aside, many know Bitcoin is divisible to eight decimal places (so-called Satoshis). As far as I am aware there is no inherent technical reason why this limit was chosen by Bitcoin’s creator(s) - happy to be corrected on this. This prompted me to ponder as to whether it provides some indirect insight into Satoshi Nakamoto’s thinking about the eventual valuation of Bitcoin. Even if Bitcoin was conceived as a facilitator of micro payments, it seems unrealistic to expect payments to be made for less than a penny – the smallest unit for US fiat money. Equating one Satoshi to a US penny implies a valuation for one Bitcoin of $1 million. Food for thought.

[12] Satoshi Nakamoto was more than aware of this risk when he wrote on a thread “I’m sure that in 20 years there will either be very large transaction volume or no volume.” - see: https://bitcointalk.org/index.php?topic=48.msg329#msg329

[13] It is clear from the very title of Satoshi’s white paper “Bitcoin: A peer-to-peer Electronic Cash System” that Bitcoin was conceived to be a form of money. It may have differed from fiat money in that it stood outside the traditional financial system and its integrity is backed by computer code rather than a trusted centralized official entity, but that was its obvious purpose.

[14] For Bitcoin this risk was considerably higher by virtue of it being the first cryptocurrency and, as such, very much a proof-of-process.

[15] Market cap is really important when it comes to money.

[16] See: https://www.buybitcoinworldwide.com/how-many-bitcoin-users/

[17] As Hilary Clinton failed to realize or acknowledge.

[18] Stable coins, such as USDC, do have such mechanisms by design.

[19] A light hearted reference to the infamous Bitcoin typo - see: https://bitcointalk.org/index.php?topic=375643.0

[20] Most central banks follow a discretionary approach to monetary policy as it provides considerable flexibility. Bitcoin, in contrast, follows a hard rule embedded in code. In theory this part of the code could be altered but given how fundamental fixed supply is to Bitcoin’s design we see no chance of this change being enacted and accepted by the community. Such a change would just lead to a hardfork.

[21] Gold has a long history of being a form of money. In fact, until August 15, 1971 when US President Nixon closed the gold window it was the anchor for the global monetary system – see: https://www.federalreservehistory.org/essays/gold-convertibility-ends. Bitcoin has, in our view correctly, been called the hi-tech equivalent of gold but we will delve more into what Bitcoin is in a later article.

[22] Its inherent price volatility due to its decentralized design will always impinge upon its medium of exchange function. But, as mentioned above, Bitcoin does not have to be perfect for people to want to use it as money.

[23] Central bank independence is a myth. Just ask the Bank of England. The UK’s central bank was nationalized in 1946 and did not regain its policy independence until 1998. No central bank whose independence is in the gift of the government can be considered truly independent.

[24] Debt can either be defaulted on or restructured to the financial detriment of bond holders or it can be inflated away to the financial detriment of everyone. As the experience of 2009 illustrated this is a very tumultuous process.

[25]  See: https://www.ubs.com/global/en/asset-management/global-sovereign-markets/reserve-management-seminar-highlights-2021/27th-annual-reserve-management-seminar-survey.html?campID=PR-RMSSURVEY-GLOBAL-ENG-ANY-ANY-ANY

[26]  The top eight reserve currencies in order of holdings are USD, EUR, CNY, JPY, GBP, AUD, CAD and CHF and account for all but $0.3 trillion of a total of just under $12 trillion. It is no accident that those eight (out of an investible universe of 180 fiat currencies around the world) belong to the largest economies with the deepest i.e. largest market cap financial markets. Further evidence of how powerful the network effect is when it comes to money - see: https://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4

[27]  Probably around around three years away according to the UBS survey.

[28]  The ace card held by governments in relation to money is the public has to hold it, by law. It is the only accepted way to extinguish tax liabilities. Conferring the same status on CBDCs would legally enforce acceptability.

[29] What is certain is, regardless of their form, only a relatively small number of digital currencies (either public or private) will dominate due to the powerful network effects of money.

[30]  Government regulation – something we haven’t touch on in this article but will feature in the next one – is another tool that can be deployed to protect the fiat money system.