Month: December 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:

https://geni.us/BitcoinNation

Ever since humans have lived in groups, they have collaborated and shared responsibilities. In the family, daily tasks are distributed among generations according to knowledge and abilities. In a village, one family specializes in food production, another in clothing. Without this division of labor, there would be no society, technology, nor prosperity.

But how can everyone be fairly paid for their work?

In the family, everyone usually contributes without compensation, expecting the family to help them in return to the best of their knowledge and abilities. Even in this small circle, unpaid labor often leads to frustration. The mother accuses the father of not taking out the trash, while the father replies that he works hard all day, while she “just” looks after the children. Besides that, the 15-year- old son could do it. The son in turn thinks that he already helps much more with household chores than his younger siblings. And so on…

The cause of these conflicts lies in individual value judgments. Everyone considers their work to be at least as valuable as that of others.

This uncompensated, nonspecific system of reciprocity obviously cannot be applied to an entire city, let alone a nation. Work must be fairly paid.

But what does “fair” even mean?

As we have seen, everyone values their work differently. One might consider payment based on working hours as a solution. Unfortunately, this leads to the question, of whether it is truly fair that a worker who assembles ten machines a day earns the same hourly wage as one who assembles fifteen. What if the assembly of one machine involves dangerous steps, and another does not? What about a farmer who works hard for a year but loses the entire harvest due to drought? Who pays him for his work?

You will surely admit that the value of work cannot be easily determined “fairly.” The best-known method to determine it is through the free market. What works for the price of goods is also an effective means for the value of services, including individual labor. But for this value to be determined “fairly”, the market must not be manipulated by altering the currency in which wages are measured.

Ancient philosophers concluded thousands of years ago that hard money, i.e., one with a constant amount, is the only means to achieve this goal. This insight has been derived and confirmed in previous chapters.

But how to maintain a constant money supply?

For about 5,000 years, the answer to this question has been gold.

Since gold is relatively scarce and difficult to mine, its quantity can only be slightly expanded each

year. Still, even gold can experience inflation. For example, when vast amounts of gold and silver were looted from the New World and imported to Europe, it had the same devastating effect on ordinary citizens as if the nobility had developed Midas’ touch. With advancing mining technology and the development of new rockets, it is only a matter of time before an even worse wave of gold inflation from outer space or the earth’s crust arrives.

Moreover, gold has the previously mentioned disadvantages that lead to the cycle from full reserve to partial reserve to fiat.

Is there a better solution?

Let’s take a look at the alternatives:
Central banks and political control over money are one option. Albeit, one that can never work in the long term. The incentive to manipulate the money supply for one’s own advantage is too great for mortals to resist indefinitely.

At the beginning of the twentieth century, Henry Ford came up with the idea of tying money to

energy. At first glance, the idea is appealing, as energy is the one thing in the universe that can neither be created nor destroyed.

However, there are many practical problems in implementing such a currency. Only the invention of computers and the internet made it possible. But on the internet, everything can be easily copied. How could a currency be created on the internet that could not simply be duplicated, thus expanding the money supply without cost?

The answer is the so-called distributed ledger. In short, if all transactions are made public and every user of a currency can verify all transactions, the money supply cannot be expanded unnoticed.

But who can write in this ledger?

Most email account owners are familiar with the phenomenon of spam. An open ledger could easily be crippled by a hacker flooding the servers with spam, such as in a DDoS attack.

To solve the spam problem, Adam Back invented the concept of Proof of Work (PoW) in 2002.

Before someone could send an email to a user, the sender had to find a hash of the email that fell within a specified range.

A hash is the value that a certain type of algorithm outputs when it receives a sequence of bits and bytes at the input. The interesting thing about hashes is that they cannot be reverse-calculated (as far as mathematically known). Having a hash, I cannot reconstruct the originally input bits and bytes. But conveniently, the same input always produces the same output, so a hash provides an unfalsifiable proof of the input without revealing the input itself.

If I were to publish a hash of this book on the internet, the timestamp of when I uploaded the hash would be proof that I wrote this book and no one else. Yet, the content of the book could not be stolen by copying the hash.

Modern hash functions, like SHA-256, are designed to be very sensitive to the smallest changes in inputs. If I remove just one whitespace from this book, it is impossible for anyone who does not have both unhashed versions of the book to recognize that both hashes belong to the same book.

A hash function can also protect against counterfeiting. A PDF document or even a printed contract can be easily manipulated. In court, thus, your deposition stands solely against that of the counterparty. There is, in the worst case, no reliable way for the court to determine which contract is real and which the forgery. Suppose the parties to the contract have also signed the hash of the original document. In that case, it’s next to impossible to falsify both the contract and the corresponding hash in an undetectable way.

Proof of Work uses these properties to make spam costly. By accepting only a certain range of correct hashes, the sender must add characters to the meta-data of the email to obtain a hash that falls within the specified range. Since the hash cannot be reverse calculated, the sender can only do this by adding random characters and testing various hashes, until they find a hash function with a fitting output. Thus, a certain amount of computational effort is required to contact the recipient. Since computation requires electrical energy, spam becomes expensive and is reduced.

This could create a currency structured in a way that the next entry in a distributed ledger is always made by the person who first constructs a transaction with a hash which falls within a specified range. Then, all users who read the ledger would verify whether this transaction is allowed. That is, if only money was spent that previously existed, and if the owners of the money initiated the transaction.

David Chaum proposed Such a concept in basic terms in 1982 called Blockchain.

But something was still missing for a functioning digital currency.

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:

https://geni.us/BitcoinNation

So far, we have used the terms “un-backed” and “backed” money quite loosely in this book. Most often, we spoke of “backed” when the money was deposited one-to-one in gold. However, this term, although frequently used, is misleading and, in my view, incorrect.

We previously clarified how market prices are formed from many individual value judgments, with the “error” of one individual always equally benefiting another person.

To elaborate briefly:
If I pay you 1000 eggs for shoes that have a market price of 750, you gain 250 eggs. If you ask for only 500, I save 250. In both cases, after the transaction, our combined purchasing power remains the same.

But what happens when the money supply expands?

Since it is nearly impossible to study economics empirically due to the many changing parameters that are difficult to measure and control, we must use a thought experiment to answer this question.

Let’s assume that all other individuals in the economy keep their demand and supply constant.

We conduct the shoe transaction with a money supply of 1 million dollars for 1000 dollars. As we shake hands on the deal, the money supply suddenly increases to 2 million dollars. Under the given assumptions, your purchasing power has suddenly been halved. But not only yours, the sum of our combined purchasing powers has also been halved.

Of course, in real life, inflation of the money supply usually does not manifest so directly, as money does not enter the economy evenly. Only in cases of hyperinflation, such as in Venezuela, where the state regularly decides to add or remove zeros from all accounts, can this effect be observed clearly.

In debt-based currencies – like the dollar since the abolition of the gold standard in 1971 – one must look more closely to understand this effect.

As previously discussed, a bank can use a borrower’s collateralized debt to create demand deposits. In a debt-based currency, the central bank does nothing more than grant a loan to commercial banks and, in return, take collateral on their balance sheet. We have already seen the problem with this. Just because collateral covers the debt today does not mean its market value cannot fall, leaving large parts of the debt uncovered.

This is particularly devastating in modern fiat money, as commercial banks create additional demand deposits based on central bank money. If a central bank mistakenly overvalues bank collateral by a factor of 10 and the bank itself leverages its capital by a factor of 10, the coverage shortfall multiplies to 100.

The risk of a deflationary crash is thus significantly higher than in the traditional gold-based fractional reserve system.

To make matters worse, the definition of backing becomes entirely arbitrary. In the gold standard, a fixed exchange rate between gold and certificates is agreed upon. This means the value of money can only fluctuate slightly around that of gold. The fluctuations themselves are primarily due to the difficulty of transporting gold.

The market value of gold in the gold standard arises from the individual value judgments of market participants.

When we trade the shoes in gold, only our subjective evaluations are relevant. To you, an ounce of gold is worth more than the shoes, while to me, the footwear is worth more than the yellow metal.

In an economy where gold is used as the only form of money, this means that the value of all transactions must be represented by the total circulating supply of gold.

Along with the realization that the market price of each individual good is formed solely by the efficiency of its production – when the supply-demand ratio remains constant – it can be concluded that the velocity of circulation is a self-regulating parameter.

In this artificial scenario, it responds to economic growth by increasing and to recession by decreasing. The value of gold is thus a reflection of the individual market values of all other goods. If the price of a good measured in gold decreases, it means that the good is now being produced more efficiently; if the price increases, the good must be more difficult to produce, for example, due to natural disasters.

Although in the real economy, demand for each good is not constant, this statement can be made about all market prices in total. After all, people can only act. Inaction is logically impossible. All market participants continuously express their value judgments, which through gold are transformed into a function of demand, supply, and production efficiency, which is expressed in the price of all goods.

If an economy solely uses gold as money, then the sum value of all ounces of gold must be precisely the sum of all individual goods times their market price.

In this case, gold is not backed by the number of gold atoms in each coin but by the individual decisions of all market participants. The purchase contract gives gold its backing. The physical gold atoms are merely a means to an end, to keep the money supply constant.

This would change abruptly, if someone had Midas’ ability to turn objects into gold by touch.

If all existing gold is in circulation, each market participant can only obtain gold by offering another participant a good or service worth at least as much as the gold. The voluntary purchase contract determines and backs the value of gold.

However, Midas can easily and effortlessly obtain gold. He can outbid any market participant without hesitation. The value of the gold that Midas brings into circulation is determined entirely differently than that of all the gold already in circulation. Its value is formed solely by King Midas’s judgment.

Since Midas can easily obtain abundant gold, he will drive up the price of all the goods he desires by outbidding competing offers. This leads to suppliers of these goods receiving disproportionately large amounts of gold, allowing them to pay more to satisfy their needs in turn.

Thus, the price increase caused by inflation gradually spreads from the source of money into the economy. Those who receive the new gold first gain unearned purchasing power, while those further away from the source of inflation lose purchasing power. The apparent winners are Midas and his court suppliers; the losers are those to whom the money trickles down to last. This is called the Cantillon effect.

Ultimately, however, everyone loses due to this inflation. The distortion of money prevents it from serving as a unit of account. The market price increasingly loses its meaningfulness, making it difficult for companies to calculate their economic performance and thus to allocate their resources efficiently. The economy becomes less and less performant over time.

Thus, while Midas and his courtiers get a larger piece of the pie, the capital stock erodes, and the pie becomes smaller and moldier with every new ounce of gold put into circulation.

A constant money supply is therefore in the interest of all market participants. But how can this be ensured?

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:

https://geni.us/BitcoinNation

Black Friday, October 25, 1929. The news of the great stock market crash in the USA shocked the world, and a long, deep recession begins. Historians today refer to it as the Great Depression. An economic shock from which the US economy would not recover until the outbreak of World War II. An event of such magnitude that economists still regularly warn against it almost 100 years later. Some even argue that risking a second Weimar hyperinflation is better than another 1929.

The seemingly logical conclusion that central banks and politicians draw from this is that some inflation is necessary. After all, every child knows that 1929 was a “deflationary crash” caused by the inflexible money supply of the gold dollar.

Well, every child also knows that Santa Claus exists. In fact, Santa can probably be better historically substantiated than the connection between hard money and the crash.

A deflationary crash cannot occur in hard money, i.e., one with an almost constant money supply. As we discussed in the previous chapter, price competition between different producers of all goods would have to arise, forcing them to lower their prices to the point of bankruptcy.

Producers would only engage in such price competition in a free market if they could afford it. That is, if one market participant produces more efficiently or believes they can produce more efficiently and make up for losses if they only force enough competitors out of the market.

The likelihood of such competition suddenly developing across all product categories is extremely low. And if it should develop, a large part of the suppliers would go bankrupt after a short time, leaving only the innovative ones to survive. A gain for the consumer.

A deflationary crash requires a fractional reserve system. It is the Wall Street equivalent of a bank run. If stock prices are manipulated upwards with bets on margin and other methods, a hype can arise that even the average person eventually jumps on. Prices soar, more and more people gamble on the stock market instead of working. Companies are incentivized to shift their focus from production and innovation to their stock price. Instead of building reserves and investing, they buy back their own shares.

This leads to stock prices increasingly decoupling from reality until the frenzy eventually fades. The trigger for this sobering realization can be a crisis or just an uncomfortable newspaper report at the wrong time. Suddenly, major investors realize that their portfolio’s nominal value is backed by a tiny real value. They sell, and the price falls. This triggers panic among those investors who only joined to participate in the hype. Like in the game of musical chairs, when the music stops, all investors try to sell their shares quickly, but there are far fewer willing buyers than sellers.

As a result, prices usually crash significantly below the market value justified by productivity, and companies that have borrowed heavily on their shares or depend on liquidity from credit are eliminated.

Such deflationary disasters are typically short-lived. Like the hangover after a night of heavy drinking, there is a brief painful period, and then the economy continues as before. Often even much better than before, as primarily the strongest and most efficient companies have survived the crisis.

A deep, persistent crisis like the Great Depression requires another layer of madness that goes far beyond the price hype frenzy.
At its core, it is a combination of a bank run and a stock market crash.

Leveraged loans, or fractional reserves, allow banks to lend more money than they can cover with their deposits. To not appear over-indebted on the balance sheet, a bank requires collateral from its borrowers.

For example, if you buy a house that costs one million dollars, the bank will lend you a maximum of one million dollars. At the same time, it will demand that the same one million dollars plus interest be registered as the bank’s claim in the land registry. If you can no longer service the loan, your house will be foreclosed, and the bank will receive the portion of your debt plus interest and compound interest from the proceeds. As long as the house can be sold at a sufficiently high price, there is no problem. However, if this is not possible, the bank incurs a loss. The bank cannot reclaim the money you once paid for the house from the previous owner. It circulates in the economy and will perform its function as money many more times. Only the collateral behind it has disappeared.

Let’s now look at the case of leveraged shares: Suppose the fictional company X has a share value of 100 dollars and one million shares in circulation. It borrows 100 million dollars from the bank. The bank adds the 100 million dollars as collateral to the balance sheet and credits X’s account with a balance of 100 million dollars.

This so-called creation of demand deposits is seemingly 100% covered, so it appears to be a full reserve.

What happens when a stock market crash reduces X’s market value to 1 dollar?
Suddenly, the bank has a fractional reserve of a factor of 100. The bank’s balance sheet liabilities of 100 million dollars are now only covered by 1 million dollars in assets.

If this crash occurs in a gold certificate-based currency, it will easily trigger a bank run, as informed investors recognize the bottleneck and quickly exchange their certificates for gold.

If this happens en masse while banks are highly leveraged, the financial system collapses. Banks can no longer redeem the certificates, people lose confidence and hoard gold. This erodes confidence in the demand deposits recorded in the banks’ books even further. A vicious cycle begins.

By hoarding gold, the velocity of money is reduced while the money supply simultaneously shrinks. Considering the Fisher equation, either the number of transactions – i.e., the economy – must shrink, or prices must fall. Usually, both happen.

A crisis becomes particularly severe and prolonged when a central bank or government tries to intervene through regulatory measures, such as distributing subsidies. These interventions prevent creative destruction. Strong companies have to draw on their financial reserves for longer than without intervention, while unprofitable ones are kept alive. Sometimes, innovative and efficient companies are even killed to keep zombie companies going.

This further undermines confidence in the money, driving smart investors even more into gold and tangible assets, leaving the economy with even less covered money. At this point in the cycle, states typically react by banning private ownership of gold, which only exacerbates the problem.

In the case of the United States, the gold ban was enacted in 1933 – four years after the collapse – and lasted until 1974 – three years longer than the gold standard itself.

Strictly speaking, the United States has not overcome the crisis of 1929 to this day, despite the massive war profits from World War II. The gold ban did not help and could only be “lifted” after the petrodollar was established, effectively making the use of any money apart from the uncovered dollar in international trade a capital offense.

Before we go into more detail about the petrodollar, we need to delve deeper into the topic of gold backing, we thus reserve this topic for another book.

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:

https://geni.us/BitcoinNation

Without a central bank, chaos would reign. The economy would collapse, the value of money would fluctuate wildly, and the population would become impoverished. Only a state central bank can guarantee price stability.

Arguments against free banking frequently sound something like the above. Hardly any economist dares to contradict these statements. But just because something is generally accepted knowledge does not mean it is true. On the contrary, it is a well-known psychological phenomenon that we believe false information if we simply hear it often enough. Sometimes, even when we consciously recognize the information as false, it gradually becomes ingrained subconsciously.

One such piece of information is the myth of price stability. In most economic fairy tales, it consists of two components:

1. A growing economy needs more monetary units.

2. Falling prices lead to an economic collapse.

The first part should appear obviously false to you with the knowledge you’ve already gained, but since it is such a popular fallacy, I still want to test your patience and briefly address it here.

The thinking behind it is based on the voucher concept. In our beer tent example, tokens were destroyed after being redeemed, so a maximum circulation speed of one could be achieved. In such an economy, a new voucher would indeed have to be issued for each new good or service. Luckily, hardly any monetary system works this way. Instead of destroying money when paying for an existing good and creating it again when a new good is produced, we simply pass money on. I can pay you 1000 units of money for my shoes, and you can use the same 1000 units to satisfy your suppliers, who in turn use it to buy something for themselves, and so on.

The circulation speed in money systems can thus be significantly higher than one. In the example just mentioned, 1000 units of money would already have been used for a transaction volume of 3000 money units once your suppliers spent it. These 1000 units can represent any number of transactions. The only limiting factor is that individual transactions can have a maximum amount of 1000 money units. However, if these 1000 units are infinitely divisible, for example into micro-money, nano-money, etc., they could easily represent today’s world economy.

At the time of this writing, the dollar money supply, including derivatives, is estimated at over 1 quadrillion, a number with 15 zeros. With a world population of 8 billion – 9 zeros – depending on the chosen estimate of the money supply, there is a 6- to 7-digit amount of dollars per person. Far more than necessary, especially since the dollar is already divided into 100 cents and can be digitally divided further. Thus, even the largest transactions and transaction volumes can be conveniently represented in dollars.

So, why does the money supply continue to grow steadily?
The pretext for this is reason number two. A constant money supply would inevitably lead to an economic collapse like the Great Depression of 1929 in the USA and the subsequent economic crisis.

But is that true?

The argument put forth for this is based on a similar fallacy as the first point. While the first point neglected the fact that the circulation speed is not constant and not limited upwards, the other side of the Fisher equation is neglected here.

It is assumed that the price level must logically fall with an increasing supply of goods and a constant money supply. However, here too, the circulation speed can react in a regulatory manner. It doesn’t matter whether one shoemaker offers a pair of shoes for 1000 units of money or 1000 shoemakers offer 1000 pairs of shoes for 1000 units of money each. If the economy grows to the extent that one person who can afford and wants shoes becomes 1000 persons who can afford and want shoes, the price of shoes remains the same since the production costs have not changed. If shoemakers find enough buyers to avoid stronger price competition, why should they lower their prices?

The real reason for the price decline, which goes hand in hand with economic growth, is technical deflation. Due to innovation and automation, the costs of producing most products decrease over time. This also lowers prices, as innovative companies secure more market share by lowering their prices below the competition’s costs, pushing them out of the market. So if prices fall due to technical deflation, it is not deflation in the monetary sense. Market participants are simply adjusting to the new equilibrium price that has shifted downward due to increased efficiency. When discussing price stability, falling prices due to technical deflation are stable prices from an economic perspective.

It is this process of technical deflation that has fueled the enormous increase in prosperity during the Industrial Revolution. The more efficient the economy, the more goods a worker can buy for their wages, and the more goods a worker can produce in their working hours, which in turn allows for higher wages.

Demanding price stability here – defined as constant prices without excluding technical deflation – is in truth a forced redistribution. The increased efficiency should not benefit workers and consumers, but shareholders and financiers of companies. A truly cynical demand, as it usually comes from those who claim to fight for the workers and the masses.

But that’s not enough. Since not all goods and services are subject to technical deflation to the same extent, price stability, as defined by central banks today, is a contradiction in itself.

We already discussed how, based on personal preferences, a person may not perceive a price increase while it can be a massive price increase

for another. If a central entity defines a basket of goods to measure price stability, it pretends that these are the products that all citizens must consume and accepts that all citizens who consume products not included in the basket must pay higher prices to keep the prices in the basket constant.

This is not only a terrible paternalism but also a targeted redistribution from the bottom to the top.

One could argue that this is the necessary price to pay for a functioning economy, as without the 2% inflation target of central banks, the world economy would certainly collapse.

So we need to ask once again: 
Is that true?