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?