Thinking about money like a programmer Part 2

In my previous article, I explained money in terms programmers could understand. This is part 2 of that and explores the implications of this analysis.

Brief recap

interface IMoney
{
int MediumOfExchange {get;set;}
int StoreOfValue {get;set;}
int UnitOfAccount {get;set;}
}

Fiat currency understood as a type of Cryptocurrency

The Miners

You might be tempted to think that with fiat currency, no analogue exists. After all, new money is just printed by the central bank. You’d be wrong. In modern economies, most of the new money is actually lent into existing by banks using an accounting legal loophole called fractional reserve banking. How fractional reserve banking increases the money supply is way beyond the scope of this article. For now, assume the banks have a magic mechanism for increasing the money supply by taking whatever the central bank prints and multiplying it manifold over. (For what I consider to be the best explanation of fractional reserve banking, see The Mystery of Banking by Murray Rothbard. It’s free to download.) In this setup the banks are the miners. Since the rise of banking, a mutually beneficial relationship between the banks and nation states has emerged. In return for distributing and issuing a currency of the government’s choice, the bankers are given a list of advantages:

  1. Cartel. Entrance into the fractional reserve mining gig is limited by licences. When the central bank creates money it issues this newly created money to a small list of privileged financial institutions who are then able to multiply it using fractional reserve banking.
  2. Perpetual inflation. As mentioned before, saving money is difficult in an economy with perpetual inflation. Conversely, owing money becomes cheaper because the money you owe loses value over time. For this reason, citizens are encouraged to rather borrow money than save. This creates more bank customers since banks are the primary issuers of credit. Similarly, perpetual inflation drives ordinary people to seek out such sophisticated financial instruments as pension funds, exchange traded funds and mutual funds. Perpetual inflation creates perpetual business for Wall Street.
  3. Stable currency. In part 1 we saw that sophisticated finance and accounting relies on using a currency that has a high value for the UnitOfAccount property. Since financial institutions don’t only expand the money supply as miners of fiat, but also operate in financial markets, governments have an incentive to establish a currency with a strong UnitOfAccount property. Volatility is the enemy of this property which is why government obsess over international exchange rates and keeping inflation moderate rather than letting it go into double digits. The desire to establish perpetual inflation needs to be carefully balanced against the need to establish a stable unit of account. This is why the monetary policy of central banks can get so complex. Balancing these needs to achieve the perfect sweet spot of a stable currency both in international markets and domestically while guaranteeing some degree of price inflation is no easy task for central banks.

In return for establishing the bankers’ dream currency, the central government gets a few favours from the banking system along the way. The 2 most important are:

  1. Hegemony. The financial system so pervasively establishes the norm of the national currency that every aspect of economic life becomes dominated by it. This gives the central government enormous power over the population because it can essentially print up revenue rather than just rely on tax receipts. Monetary history is quite fascinating in this regard. During the era of gold backed money, the rule for governments was that in times of war, the gold convertibility was suspended. This basically gave governments the ability to expand without limit.
  2. Debt financing. The trouble with running government deficits is that the money has to be paid back. With interest. What if the government could borrow almost without limit and at low rates of interest? A little accounting trick combined with fractional reserve banking allows just this. To borrow money, the government issues an IOU to the fiat miners, that cartel of banks mentioned above. Treating the IOU as a perfect money substitute, the bankers use it to expand the money supply with fractional reserve banking. In this way, the banks get free new money and the government gets eager financiers willing to back any budget deficit.

It’s a big Club and you ain’t in it. — George Carlin

Free Ponies for everyone

Bitcoin can’t exist if it only benefits miners and nodes. In order to have value it has to be desirable by ordinary people who wish to use it in trade, as a store of value or more sophisticated blockchain stuff such as multisig escrow and smart contracts. Similarly, fiat currency would be worthless if it only circulated between bankers and governments. How do governments get us to use fiat and what do we get out of it? In order to get us to use a currency that perpetually loses value, the bankers rely on the State to enforce legal tender laws. This establishes a local monopoly on the national currency. If you live in England, you can’t use Yen to buy coffee. You have to trade the Yen for Pounds. Attempting to use a non-legal tender can result in imprisonment. Secondly, governments denominate their tax rates in their currency. So even if you earn all your money in bitcoin, you have to trade in a certain portion of that for fiat currency to meet your tax obligations. We can think of these 2 threat-backed demand stimulants as fiat’s proof of violence algorithm as contrasted with bitcoin’s proof of work. Remember that governments get cheap debt and banks get more customers from fiat than either would otherwise have received. This benefit has to be paid for. This growth in banking and government can’t come out of nowhere. These sectors aren’t expanding because they’re producing anything more of value. Therefore, their growth has to be at the expense of some other part of the economy. So who are the losers in fiat?

Cantillon Effect

Richard Cantillon

In fractional reserve banking, new money is created in the banking system before finding it’s way into the broader economy, causing price inflation. At first when the money is initially created, the inflation hasn’t occurred yet. The bankers and their friends can buy up assets and other goods at pre-inflation prices. After successive spending, prices rise and eventually that new money finds it way to us ordinary peasants having lost its value to inflation. Another way of thinking of this is that bankers buy everything at discount and we ordinary folk pay for the discount with lost purchasing power. This process of money entering the economy at a high value and gradually losing its value as it changes hands from the politically connected to the fringes is called the Cantillon Effect, named after the man in the picture with the fabulous wig.

Summary

  • Because bankers are large players in the financial sector, their block reward has to be in a currency that is highly suited to finance. It must implement MediumOfExchange and UnitOfAccount very well.
  • In order to maximize mining rewards, national governments need to create a currency that draws people toward the financial sector. Perpetual inflation does just this. Therefore, fiat currency does a poor job of implementing the StoreOfValue property. However, high price inflation undermines MediumOfExchange and UnitOfAccount. This requires central banks carefully balance inflation against stability, leading to the norm of single digit inflation national currencies throughout the world and the tendency of monetary unions to form.
  • In return for meeting bankers’ needs, national governments get almost unlimited spending power through debt financing.
  • The swelling of the public and banking sectors are paid for with stolen purchasing power. This creates a society of 2 classes, the banking-political class and the productive class. Wealth is gradually redistributed through complex finance from the latter to the former without explicit and obvious mechanisms like tax but through the nebulous forces of inflation.

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