Month: November 2023

My new book “Bitcoin Nation” was published on the 15th anniversary of the Bitcoin Whitepaper, October 31, 2023. You can read it below, one chapter per week. Or buy it here.

The death of a currency usually occurs through a so-called hyperinflation. There are various definitions, but today it generally means a price increase of over 50% per month. At the peak of hyperinflation, as in Germany in 1923, the devaluation of money even led to a doubling of prices every 24 hours.

Depending on the definition, over 50 hyperinflations have been documented in recent history. This raises the question, whether they are inevitable, or if people are simply crazy and keep making the same mistakes.

As is often the case, the answer to this question lies far beyond black versus white.

Hyperinflation could be easily avoided if there were a currency with a strictly limited money supply. However, the technical and social introduction of such a currency is not trivial.

In previous chapters, we discussed why a gold or precious metal standard are so susceptible to manipulation of the money supply. But why does this remain undetected and seemingly without consequences for decades or even centuries? And why do people keep playing this fatal game?

To understand this, we must look at how new monetary units enter the economy.

Once a central authority, usually a state central bank, has forcibly and gradually established itself as the sole ruler over the currency of a monetary area, it can theoretically create money at will. In practice, however, the average citizen initially stands in the way. As limited as the general understanding of money may be, people are hesitant to accept something unfamiliar. Gold works, but paper money is new, and there is a vague collective memory that unbacked money has failed multiple times in history.

A central banker or politician who openly calls for the abandonment of the gold standard will quickly find themselves out of office, and sometimes even in danger of losing their life.

That’s why they must initially act in secret. In a coin-based system, copper is secretly mixed in, or taxes must be paid in new coins, while state expenditures are made in old, worn-out coins. In the case of certificate money, a so-called fractional reserve is employed.

The bank issues certificates that certify more value than is actually available in the vault. This practice has historically worked quite well as long as the reserve is above 50%. Even with 30% precious metal to certificate ratio, a bank is still relatively stable. With each percentage point fewer reserves, the risk of a bank run increases exponentially.

A bank run occurs when many people try to exchange their certificates for deposits at the same time. If the bank has covered less than 10% of its certificates and every fifth depositor wants their gold, the bank becomes insolvent.

A bank run can be triggered by many factors, often simply by competition between banks. One bank senses the weakness of another and demands all its deposits from the weak bank, while simultaneously leaking the liquidity problems to the local press.

Central banks have also historically used this tactic to assert their authority. If citizens don’t accept the central authority over money, attempts are made to target popular private certificates or note-issuing banks with bank runs, forcing them to their knees. This then gives the state a double opportunity to present itself as the rescuer, and create trust in its own currency. At the same time, it promotes acceptance of strict laws against the evil private banks that have deceived their poor depositors.

Subsequently, the central bank plays the same game as the private banks did before.

Central banks will fractional reserve with ever-increasing leverage, just as many commercial banks do. The sole difference is that in case the liquidity runs out, states can simply ban the right to exchange the certificates to gold. Thus, the central bank doesn’t have to admit its bankruptcy during the national equivalent of a bank run. Instead, it can pay off uncovered debts, by printing money, ultimately culminating in hyperinflation.

One could, of course, attribute ill will to both private and central banks and spin wild conspiracy theories about why they manipulate money and impoverish people. The sad truth is probably much simpler and at the same time more concerning.

Everyone sees themselves as the good person. Even mass murderers find an excuse to justify their killings. So, it’s not surprising that self-interest and a lofty goal are usually the cause of the fatal expansion of the money supply. A central bank might, for example, claim that the money printing is necessary to prevent economic collapse. But how is it possible that many politicians and central bankers convince the general population that a fiat currency is a good idea and that inflation is acceptable, even necessary?

: Bitcoin Nation – PATHOLOGY OF HYPERINFLATION (Pt.1-Ch.4)

My new book “Bitcoin Nation” was published on the 15th anniversary of the Bitcoin Whitepaper, October 31, 2023. You can read it below, one chapter per week. Or buy it here.

For many people, the existence of fiat money and the central banks that control it is almost a natural law. They are often surprised to learn that less than 150 years ago, there was a time of free banking, where no central authority existed to control money. Even more surprising to many is the fact that the era of free banking was the time of the greatest and fastest increase in prosperity in human history. In the United States, the central bank was not established until 1913 and only since 1971 has it had complete control over the creation of base money.

So, how did we come to use central bank money in almost every country in the world today?

The causes lie in the physical properties of gold. As I mentioned earlier, gold was the best commodity to use as money for the longest time in human history.

Gold allowed for the exchange of great value across continents. Once gold coins were minted, they were – except for deliberate destruction – indefinitely durable.

That is why gold prevailed over barter or other currencies, such as voucher currencies, in most parts of the world early on. The latter were not so dissimilar to our beer vouchers from the previous example and while they worked well regionally, they had massive difficulties in international trade.

A voucher denominated in grain, issued by the largest trader in Mesopotamia, would be accepted within a day’s travel radius, as everyone knows the trader and he is liable for the voucher’s coverage with his reputation, wealth, and even his life if necessary. However, the voucher would hardly convince a trader who delivers goods from distant China. He does not know the issuer and would have to travel for months to redeem the voucher. Direct barter would be much more convenient.

But grain is a bad currency. It spoils easily and is so widely available that it requires whole shiploads to handle even relatively small transactions.

Over time, gold became the currency of choice because it combines the six aforementioned properties better than any other commodity. Of course, gold is not perfect. Its divisibility, for example, is limited. A coin with only a few micrograms is impractical in everyday life, but would be needed for buying bread. Most economies solved this problem by using silver –the second-best material for money – for small transactions.

Large and international transactions, on the other hand, have always been and still are the Achilles heel of gold. Due to its weight, it is very cumbersome to transport gold from one place to another, and the risk of robbery is enormous.

As a solution, history once again turned to the proven technique of vouchers. The Order of the Knights Templar, for example, used gold certificates nearly a millennium ago. They solved the problem of voucher acceptance by using an international association as a backer of the coupon. A Templar who deposited his money with the Order before leaving Europe received a certificate for his deposit. Later, upon arrival in the Holy Land, he could have the local branch of the Order pay him back in gold and silver.

This provided several advantages:
If a Saracen stole the gold certificate, they could do little with it, unlike a treasure chest. No Templar would believe that they were the European noble mentioned in the certificate. If the certificate holder died or the paper was destroyed, a relative of the unfortunate could go to the Order and request a new one.

However, the other disadvantages of vouchers still existed in the certificates. For example, a knight who had the misfortune of depositing money with the Templars when they were disbanded by the Catholic Church lost everything. The counterparty risk persisted.

This counterparty risk, and the methods developed throughout history to minimize it, explain why the last 5,000 years of monetary history have been an endless cycle of the same four stages. A gold standard, accompanied by an increase in prosperity, is followed by a creeping devaluation of money, leading to fiat money without backing, and eventually a collapse, starting a new cycle.

With variations, this cycle has always followed a nearly identical pattern. Usually, gold coins were introduced first, minted by a powerful merchant or state, enabling people to quickly verify the authenticity of a monetary unit. Standardization and centralization of coin minting were necessary compromises, as gold can be tested for authenticity with some effort, but an effort too high for everyday use.

This opened up an attack vector. A mint is a trusted party; all users of coin money must rely on the coins containing the stamped precious metal content.

Throughout history, however, this content has been successfully manipulated. The Roman Empire, for example, used various techniques to reduce the precious metal content of its coins from over 90% to almost 0% over several centuries. This allowed for the financing of wars and palaces that the population would hardly have been willing to finance through more transparent taxation.

Since coins, like certificates, carry counterparty risk, and certificates are also easier to transport and can be provided with a certain degree of theft protection, the latter gradually gained ground over coins.

Usually, it was either private banks or states that standardized and issued these certificates.

Sadly, like the clever innkeeper’s son from earlier, the certificate issuers quickly realized that they did not necessarily have to hold 100% of the certified precious metal amount.

Some certificates get lost, while others are not redeemed for a long time, either because they are used for saving or as a convenient substitute for gold in transactions.

Over time, more and more customer deposits were taken for personal gain, until one day all historical certificate currencies had as much precious metal backing as the late Roman Sesterce before them. Zero.

Once a currency is no longer backed by a scarce asset, it becomes fiat money. The issuer of the money is the one who controls the scarcity of the units and can simply create more with their command “Let it be done!”.

The incentive for the creator of the money is obvious. Why work hard to earn money when it can be created much more easily?

But why don’t the other market participants resist?

My new book “Bitcoin Nation” was published on the 15th anniversary of the Bitcoin Whitepaper, October 31, 2023. You can read it below, one chapter per week. Or buy it here.

“I have a very valuable watch.”

What comes to mind when you hear this statement?

Depending on your personal experiences with timepieces, an image will likely appear in your mind that falls into one of the following two categories:

1. An expensive watch.
2. An emotionally significant watch.

The first category creates an image, such as a man wearing a suit with a gold Rolex on his wrist.

The second one evokes a picture of a boy receiving his great-grandfather’s watch, which was bought with his first salary after the war.

How can this one word “value” have such different meanings? How can something be valuable in terms of market price but completely worthless to you, and vice versa?

To understand this, we must recognize the difference between subjective and objective value.

We have already considered subjective valuation at the beginning of this book. It is characterized by its relationality, temporal volatility, and the impossibility of quantification, which is called “ordinality”.

Objective valuation arises from subjective valuation through the price discovery process of the free market. Whenever two individuals voluntarily exchange goods and services, two subjective valuations meet.

If we trade 1000 eggs for a pair of boots, we only do so because at that moment, I value the boots more than 1000 eggs, while you, conversely, want the eggs more urgently than the boots.

The objectively observable action does not reveal how we each value the goods, since I might have also paid you 2000 eggs, or you might have accepted 500 if one side had negotiated more persistently. We cannot verify this objectively. It is evident however that the intersection of our respective priorities is precisely at 1000:1.

If we make this observation across an entire economic space, it turns out that there is an equilibrium price for every good. This is also called the market-clearing price, as at this price, theoretically, all demanders can receive a good and all suppliers can receive money.

In short, when many individual transactions are made, misjudgments converge to zero on average. It should be emphasized that the “error” of judgement here is not necessarily an error from the perspective of the acting individuals, but merely that the person who paid more than the equilibrium price was not maximally economical with their resources. They could have apparently obtained the good from another trading partner at a better price.

There are many valid reasons why people pay “too much” for a good, such as the cheaper dealer being significantly further away.

People act to reduce their dissatisfaction. In doing so, it is natural for them to try to minimize their dissatisfaction using the means available to them.

This implies that although individuals subjectively perceive what reduces their dissatisfaction, it is universally true that people do what they think contributes most efficiently to their satisfaction.

If a pair of shoes costs 1000 eggs here and 500 eggs 100 km away, it is my subjective decision whether the expenses and travel time are worth saving those 500 eggs. However, if two dealers at the same location offer equivalent shoes at such different prices, I will always choose the cheaper option as a logical thinker.

The market price of a good thus contains concentrated information about the value judgments of all market participants. This information cannot be reverse-calculated to quantify individual subjective value judgments. Nevertheless, this information is important.

Just as the hash function in cryptography cannot be reverse-calculated but still carries essential information, such as proof of possession of Bitcoin private keys, the market price indicates how scarce and in demand a good is.

This is of course only true if the money in which this market price is expressed has not been manipulated beforehand.

But how do you know whether money is manipulated or not manipulated?

My new book “Bitcoin Nation” was published on the 15th anniversary of the Bitcoin Whitepaper, October 31, 2023. You can read it below, one chapter per week. Or buy it here.

Throughout the millennia, a lot has been written and talked about money. Unfortunately, the understanding of what money actually is remains regrettably low. Today, money is widely assumed to be bad, shady, or even dangerous.

One could rightly blame the church and the state as the originators of this miserable reputation. Both institutions controlled education for many centuries and had a vested interest in ensuring that the masses did not understand money. This allowed those in power to covertly increase taxes through inflation without finding citizens armed with torches and pitchforks at their doorstep. The Catholic Church, in particular, has often unfairly maligned money while hoarding gold themselves.

Nevertheless, the 20th century clearly demonstrated that most citizens have a broad disinterest in how money works and thus share the blame for their ignorance.

As early as 1921, Alfred Lansburgh, writing under the pseudonym “Argentarius”, warned of an impending financial disaster, which Germany would indeed later experience in the form of hyperinflation in 1923. He noted the population’s lack of interest in his warning along the following lines:

As long as money works well enough, people don’t want to think about it.

According to Argentarius, a major monetary crisis hits a country about every 100 years, or whenever those who experienced the last one have died.

Another aspect is that money is such a fundamental building block of our society that a single discipline is not enough to explain it. To fully understand money, one must be a universal genius, well-versed in all sciences. Therefore, I do not presume to provide a comprehensive explanation of all aspects and social implications of money in this book. Luckily, that is not necessary, as a basic understanding of money will suffice for most people. The aim of this and the following chapters is to make the aspects of money that are important to you in your daily life understandable. In doing so, I hope to give you a competitive advantage over all those who lack this understanding.

So, what is money?
Before we can understand that, we must first ask: What does money do?

A core function of money is to be a medium of exchange. This means we do not use money directly but indirectly. Most goods are either consumed directly or indirectly by using them to produce other goods. In contrast, we do not consume money; we exchange it.

Such an exchange is necessary, as a pure barter economy is extremely cumbersome and impractical in a highly developed, specialized economy.

Let’s assume I am a farmer and you are a shoemaker. If I want to buy shoes from you, I could pay you the price in eggs all at once. However, 1000 eggs, with their limited shelf life, would hardly be an acceptable payment for you. So, you would either arrange installment payments with me or use the eggs as a medium of exchange and pay your suppliers with them.

In the latter case, the eggs obviously serve a money function for you, as you exchange them instead of consuming them. But even in the first case, the eggs serve a money function, albeit indirectly. Because if we agree on installment payments,one of us has to grant the other credit. Either I deliver the eggs to you first without receiving the shoes, or you deliver the shoes first without receiving the full number of eggs.

So, if you deliver the shoes first and then receive a daily breakfast egg for years, you have effectively granted me credit denominated in eggs.

We will delve deeper into the topic of credit later. At this point, we want to summarize the two functions of money we have identified so far.

Money is a medium of exchange. A medium of exchange is needed to trade with people who do not have a good that I need or do not want a good that I have to offer.

Money is a unit of account. If an exchange cannot be completed immediately, one side must grant credit, which is quantified in the thing used as money.

These two functions can be summarized by the fact that they enable a direct exchange in person, place, and time to be postponed.

Instead of exchanging eggs and shoes directly, we can agree that payment will not be made immediately (postponement in place and/or time). Alternatively, you can accept the eggs directly even though you don’t need them and exchange them further yourself (postponement in person). A combination of both is also possible. For example, if I pay you first, then you exchange the eggs for raw materials and deliver the shoes later.

Since, as we have seen, any good can function as money, Hayek also argues that money should be an adjective. So one should rather discuss how much “moneyness” a good has instead of money and non-money goods.

How high the moneyness of a good is at any given time depends on numerous factors. First, there are the physical properties of the good used as money. Six properties are usually mentioned:

1. Divisibility
2. Durability
3. Verifiability
4. Transportability 
5. Fungibility
6. Scarcity

Eggs are bad money because they are not divisible without destruction and have a very short shelf life. Moreover, eggs usually have a low market value due to their generally low scarcity.

Thus, larger transactions are difficult on an egg standard.

In contrast, gold has been the preferred money for millennia, as it is almost infinitely durable, reasonably divisible, verifiable, and fairly transportable. Above all, it is quite scarce.

Why, then, is gold no longer the world reserve currency?

Is there better money now?

Until 2009, the answer to this question would have been a clear no.

Since at least 1971, no major world currency has been backed by gold or anything else of value. Today’s state-issued fiat money (from the Latin “fiat”, meaning “let it be done”) is not scarce. States, central banks, and commercial banks can create it in virtually unlimited quantities at will.

Of the six properties mentioned above, scarcity is the essential one for a sustainable money function because only scarcity can allow money to preserve value.

Here we have discovered the third function of money: money serves as a store of value. As mentioned above, we need a method to shift transactions over time in our daily interactions. Let’s assume we have agreed that I will deliver one egg to you daily for 1000 days. Only after that will you deliver the shoes to me.

As a good merchant, you make the shoes one day before I make the final payment, avoiding storage costs. However, it turns out that the cost of raw materials, measured in eggs, has risen significantly. Your suppliers now demand 2000 eggs, which means you effectively make a loss on the sale of the shoes. In this example, the eggs have failed in their monetary function. The value was not transported over time, so it would have been economically better for you to demand 1000 eggs immediately.

As absurd as this example with eggs may sound, it has happened in reality many times. Argentarius describes in his works how entrepreneurs in the Weimar Republic fell into this trap shortly before hyperinflation. They agreed on a price in Reichsmarks for a future delivery. However, by the delivery date, the Mark had lost so much value that either production could no longer take place, leading to bankruptcy, or the inventory could not be restocked with the paper profit made after the transaction. Some companies went under, even though their balance sheet showed a significant profit.

But how does such a loss of value occur?

So far, I have simply stated that this has to do with the scarcity of a good.

This can be proven in two ways. I will briefly explain both, as understanding them is essential for understanding other monetary phenomena.

The first approach comes from praxeology, the science concerned with the logic of human action, developed by Ludwig von Mises and other representatives of the Austrian School.

Let’s first ask ourselves why people act. No matter what we consciously do, even if we decide to do nothing, it is always an action. “Man acts” is a universally valid axiom. We always choose the action that is best suited to satisfy our most urgent needs.

When we see a burning house with cries coming from inside, we can decide to either run in or simply watch the house burn down. Which of the two actions we pick depends on our preferences.

What is more important to us? The life of the person in the house or our own life, which we would risk?

You are probably more willing to run into the house for your child than for a stranger. In short, your child’s life is more important to you than your own, while a stranger’s life is less important.

However, you likely wouldn’t just give your life for your child for fun, but only because the situation requires it. How you prioritize your actions depends on both your preferences and the circumstances.

If you have a ladder at hand, you will likely save the unknown person you can see through the window, even if you are not willing to risk your life. This is because, in this case, while there is still a risk for you, you consider it so small that the indirect guilt of the person’s death seems more pressing than the slight risk of dying.

The interesting thing is that this assessment occurs without a unit of measurement. You won’t create a formula to weigh how many strangers your life is worth, and then compare it to the amount of guilt you would feel if the person dies.

Your preference hierarchy is purely subjective, temporally variable, and relational, so it is not absolutely quantifiable. That’s why it also eludes mathematics.

Your life is probably one of the things high up in your preference hierarchy. Therefore, one could assume that everything that sustains your life also ranks high and is valuable to you.

Since you would die within a few minutes without oxygen, one might expect that you would be willing to pay many units of money for oxygen. Surprisingly, oxygen is available for free almost everywhere on this planet. You would probably even be outraged if you suddenly found a bill for breathed air in your mailbox.

However, things are different in the example where you want to save your child from a burning house. Breathable air is hard to come by within the inferno. A bottle of compressed air would be very useful there and would significantly improve both your and your offspring’s chances of survival.

How many units of money would you pay to be able to enter the building with a compressed air bottle? Ten units? One hundred? Even a million? You would probably give away everything you carry with you, and in doubt, you might even promise a multiple of your wealth if you could only take this precious air inside.

As you can see, the price you are willing to pay for a good or service depends not only on how much you want or need it, but also on how scarce the good is at the particular location where you want to acquire it.

Mises explains this with the diminishing marginal utility of a good as its availability increases.

You urgently need air, but it is usually abundant. Therefore, you can satisfy your need to breathe air without taking it from someone else. Having more air than you need has no value for you, as you can’t store it and have no use for it.

If air is scarce in a situation, it will quickly rise to the top of your priorities, and you will take any action to get air.

If you are deeply interested in this topic, I recommend the book “Human Action” by Ludwig von Mises.

Another way to reach the same conclusion is the so-called quantity theory. It is often criticized or even ridiculed by modern economists, but in my view, it has its value.

Irving Fisher formulated the quantity theory using the following equation:

M·V = P·Q

M stands for “money supply,” which refers to the circulating amount of money in the economic area under consideration.

V is the “velocity,” the speed at which money circulates.

P represents the “price,” describing the general price level.

Q for “quantity,” expresses the number of transactions.

Since this equation is difficult to understand at first glance and is frequently misrepresented or misinterpreted, we need to resort to examples again.

As a native Bavarian, I have been familiar with the interior of a beer tent since I was a child. The economically interesting thing about a beer fest

is that a separate currency is usually used there. Beer and chicken are typically unavailable for the legal tender, but for tokens.

You can obtain these tokens either by purchasing them, exchanging the country’s fiat currency for them, or by earning them. Sometimes, of course, friends also gift them to you.

If you help the innkeeper set up tables, you will quickly be given a handful of beer tokens as compensation.

Let’s take a closer look at this small festival economy.

Say the innkeeper orders 1,000 liters of beer, and one token corresponds to one liter. Thus, the innkeeper can distribute 1,000 tokens. Since the tokens are invalidated after use, each can only be used once, resulting in a maximum possible circulation speed of one.

Ideally, 1,000 tokens (M) circulate once (V) and allow exactly 1,000 liters of transaction volume (Q) at a price of one token per liter (P).

As you can see, the equation works perfectly in this case.

Unfortunately, the world is not perfect. Suppose the conductor of the brass band had one too many drinks, and a roll of 100 tokens falls out of his pocket and is lost forever.

In this case, the innkeeper has several options. He can give away the remaining 100 liters of beer, consume it himself, or generously reprint a roll of tokens and hand it to the conductor.

What happens if the innkeeper chooses the latter option, and the lost roll suddenly reappears? In this case, some festival-goers will inevitably miss out despite having legitimately acquired tokens.

Now the resourceful innkeeper comes up with the idea to balance this discrepancy elegantly. He simply promises his supplier that they and their employees will receive an extra 200 tokens next year for the quick delivery of an additional 100-liter barrel this year.

He has successfully postponed the problem until next year, and since he wanted to retire anyway, his son will take care of the matter.

The son, equipped with his father’s cunning, continues the game the following year. Since tokens are bound to be lost one day, he simply promises everyone who missed out this time two tokens in the following year.

This works well for several years. Unfortunately, the young innkeeper eventually succumbs to gambling. All the tokens are quickly gone, and he has nothing left to pay the suppliers. Therefore, he prints more and more tokens every day until, one day, a high multiple of the available beer’s nominal value is circulating in tokens. Knowing that his guests will hardly be satisfied with the promise of future beers this time, he escapes abroad. A scandal that shakes the honest village population to the core.

To resolve the drama as fairly as possible, the mayor determines how many tokens are in circulation. It turns out that 100 tokens correspond to a liter of beer. Therefore, the mayor decides that instead of laboriously collecting tokens and issuing new ones, a liter of beer will simply cost 100 tokens this year.

As you can see, also in this example, the quantity equation could not be violated. If the money supply increased, either the circulation speed had to fall proportionally (not all tokens could be redeemed), the quantity of goods had to be increased, or the price had to be raised.

When we switch from the festival to the national economy, the quantity equation becomes difficult to apply.

This is partly due to the question: What is the general price level P?

To stay with our example:
If one token buys one liter of beer, but five tokens buy a roasted chicken, today. And next year it’s still one token for a liter of beer but now ten tokens per chicken. Has the price level stayed the same or risen?

This question can only be answered individually. For the vegetarian, purchasing power has not changed. For the non-drinking alcoholic who enjoys eating grilled poultry, it has been halved.

So, when a central bank claims its goal is “price stability,” you should ask:

For whom?

Of course, this does not mean that the quantity equation is useless. Just because it is difficult to measure the price level of all products and derive individual purchasing power from the general price level, the mathematical consideration still has an essential application.

It allows us to estimate the possible effects of monetary changes and what cannot be affected. In addition, we can understand through Fisher’s equation under which conditions money can successfully fulfill its function as a store of value, that is, the postponement of a transaction into the future.

But what is this “value” that a saver seeks to store in money?