Bitcoin has value from being a platform, not money

Like other fiat currencies, Bitcoin is a network-backed currency: It derives all its value from the network effect — also known as Metcalfe's Law. (Monetary economists call this the hot potato effect.)

Many people think that Bitcoin is flawed as a currency because it is not backed by something beyond itself. They are wrong. Bitcoin is flawed as a currency, but it is flawed because of its fixed supply, inherent in the protocol. Contrary to what many Bitcoin proponents argue, fixed supply is not a desirable characteristic of money because it would make monetary policy impossible. And remember, monetary policy is very important because it solves the problem of price stickiness and money illusion. In particular, bad monetary policy causes recessions (and disastrous monetary policy causes depressions).

Thus any currency that does not allow for monetary policy is inferior to the current model and is not likely to be mass adopted in the long-run — unless, of course, it finds some other solution to money illusion. But so far, I have not heard of any solution to money illusion other than monetary policy. To become widespread, Bitcoin needs a central bank that can adjust the money supply to prevent recessions. (Actually, a central bank is not needed if money supply adjustments are built right into the protocol, which would be very interesting, but I digress.)

Now, this does not prevent Bitcoin from being a platform for currencies. I have discussed before that it is likely that central banks will create their own crypto-currencies, and the easiest way for them to do so is to simply fork the existing Bitcoin protocol. Central banks would then be able to change the supply of money by leveraging the network effect (read the post to get a full description of how).

And if Bitcoin is forked to create official central bank money, bitcoins mined today will still have value in the future. But that value will be determined by central banks in the future, and means that today's value comes from Bitcoin being a platform, not Bitcoin being money.

Disrupting from Above by Extending Functionality (The iPhone Case Example)

Summary:

  • It is difficult to analyze the iPhone as a low-end or high-end disruptor because of its diverse functionality. It just does so many things.
  • As functionality extends, the price of each function falls, making the iPhone a high-end disruptor to consumers valuing all of those functions. (Think of a college student using multiple apps.)
  • On the other hand, as the performance of each function improves, the iPhone becomes a low-end disruptor to consumers valuing one specialized function. (Think of a film director using the camera.)
  • This same characteristic applied to PC's decades ago, and is likely to repeat with the Apple Watch.

 

Recently I published a simple framework to explain disruption from above. The framework depends on measuring innovation using affordability instead of performance (the measure classically used in Christensen low-end disruption). In that post, I claimed that the iPhone can be viewed as a high-end disruptor to iPods. However, to be a high-end disruptor, the iPhone must have become cheaper than iPods over time, and many people have pointed out that they have not. Something similar could be said about PC's disrupting typewriters from above.

I stand by my claim, however, because the price of the iPhone has fallen — dramatically, in fact. Let me explain.

Remember, when thinking about disruptions, we have to think in the realm of the job-to-be-done. So the first question we need to ask is: What job-to-be-done did the iPhone disrupt? Well it disrupted many, actually. Many.

In relation to the iPod, the iPhone disrupted the job of personal mobile music. Think back to 2007 when the iPhone was introduced. If you bought an iPhone ($1000) simply as a replacement for an iPod ($400), it would have been a very expensive iPod. However, if you bought an iPhone as a replacement for an iPod and a feature phone, the cost for the iPod function would only be $500 (the other $500 allocated to the phone function). That's still more expensive than the stand-alone iPod cost, but that's just the start. Now add in the iPhone's function as a digital camera and the cost of each function drops even further to $333. Now add in the functions of a GPS, mobile browser, email device, calendar/scheduler, alarm clock and all of the millions of apps in the App Store. As functionality extends, the price of each function falls drastically. In fact, for most current iPhone users, the cost of their iPod is $0, since they would have likely still purchased their iPhone without the music app. And this applies to nearly all of the iPhone's other functions. The iPhone is the ultimate high-end disruptor.

But the iPhone is also a low-end disruptor if looked at from the right point of view. Imagine a user that needs only one specialized function of an iPhone. For example, a documentary film-team might purchase an iPhone simply for its video camera function. From the view of professional film-makers, the iPhone is a very low-performing, inexpensive video recorder. But the video function is much better than it was in 2007, and it is getting better every day. Just last week, the TV series Modern Family aired an episode shot entirely with the iPhone. This is classic low-end disruption. 

It is thus difficult to analyze the iPhone as a low-end and high-end disruptor because of its diverse functionality — it just does so many things. As functionality extends, the price of each function falls. At the same time, the performance of each function is constantly improving. The iPhone has so much functionality and is constantly improving that it disrupts everything, from multiple angles. The same thing can be said of PC's decades ago, and explains why PC's were eventually preferred over typewriters for even the most cost-conscious consumers. And it is likely that we will see a similar phenomenon play out with the Apple Watch.

Extending functionality doesn't mean better performing functions, necessarily, it means more functions to solve more jobs. This is why I do not subscribe the theory of new-market disruption, which I think is just another misclassification like Ben Thomson's obsoletion. Instead, you can think of the term new-market disruption as describing a product that disrupts several jobs-to-be-done, from both the low- and high-end, by extending functionality and improving performance. 

The iPhone example reinforces the fact that low-end disruption and high-end disruption are idealized special cases of a general disruption phenomenon which occurs by innovating along both performance and affordability. It also reinforces the need for a synthesized framework.

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High-End Disruption: Using Affordability to Measure Innovation

Summary:

  • The key insight to understanding high-end disruption is that innovation improves products either by increasing performance or by increasing affordability.
  • While low-end disruption occurs through improvements in performance, high-end disruption occurs through improvements in affordability.
  • While incumbents chase profit margins in low-end disruption, incumbents chase market volume in high-end disruption. In both cases, incumbents are acting rationally by improving their profitability through sustaining innovations — at least at first.
  • Christensen's low-end framework can be modified to visualize high-end disruption by changing the vertical axis from performance to affordability.
  • In low-end disruption, consumers are performance-choosers. While in high-end disruption, consumers are price-choosers. Low- and high-end disruption are idealized special cases of a general phenomenon of disruptive innovation. 

So, in short, the master plan is:
  · Build sports car.
  · Use that money to build an affordable car.
  · Use that money to build an even more affordable car.
Don't tell anyone.
— Elon Musk


The purpose of this article is to present a case for disruptive innovation from high-end products. This article is intended for readers who are already familiar with the classic theory of low-end disruption as described by Clay Christensen.

Intuitively, we know that industries can be disrupted with (what are initially) high-end products. For example, iPods were a high-end disruptor to CD players, and iPhones were then a high-end disruptor to iPods (among many other things). And there are countless other examples (see the end of this post). In these cases, incumbents were displaced by disrupting entrants, despite the strength, market power and resources of the incumbent. However, the classical theory of disruptive innovation developed by Clay Christensen only explains disruptive innovation from the view of low-performing products. We need a way to approach disruptive innovation from the view of high-performing products.

To understand high-end disruption, we must first take note of a stylized fact: Innovation improves a product by either improving performance or by improving affordability. There is, of course, a direct relationship between product performance and price, but innovation does not imply better performance, necessarily. Instead, innovation can also manifest in the form of a lower price. This distinction is the key insight to understanding high-end disruption: Whereas low-end disruptors enter the market with a low-performing, low-price product and then work to improve performance, high-end disruptors enter the market with a high-performing, high-price product and then work to improve price. In each case, the entrant eventually takes over the entire market with a high-performing, low-price product.

We can adjust the Christensen low-end disruption framework to visualize high-end disruption simply by changing the measure of innovation from performance to affordability. If you are already familiar with the Christensen low-end disruption framework, everything is straightforward once you make this change.

To start, we can simply think of affordability as the inverse of price. That is:

Affordability = 1/Price

Similar to the performance needs distribution, consumers will fall into the affordability needs distribution.

In the Christensen low-end case, the left-tail of the performance needs distribution comprises consumers that value affordability and are willing to pay for it with low performance. In the high-end case, however, the left-tail of the affordability needs distribution comprises consumers that value high performance and are willing to pay for it with low affordability. In both cases, the entrants are competing against non-consumption — although under-consumption may be a better term for the high-end consumers.

In Christensen's low-end theory, low-end disruptors enter the market with a product that is low-performing but highly affordable. Low-end entrants initially under-serve the performance needs of the majority of the market, but are good enough for the low-end which values affordability. Established incumbents are under-serving the low-end of the market because it is simply not attractive in terms of profit margin. For the entrant, however, the profit margin of the low-end market is attractive. Entering the market with an already highly affordable product, low-end entrants move up the market by increasing performance through sustaining innovations. As low-end entrants improve performance, their product becomes good enough for more and more of the market, eventually over-taking the entire market. As Christensen describes, established incumbents are unable or unwilling to adopt the new disruptive technology because they are incentivized against competing with low-end entrants, and instead move further up the market towards higher performance in order to attain higher profit margins. Incumbents facing low-end disruption are seemingly acting entirely rational by ceding the lower-end of the market, since achieving higher profit margins through sustaining innovation boosts profitability — at least at first, and until it doesn't, when it is too late to pivot to the disruptive innovation.

On the other hand, high-end disruptors enter the market with a product that is low in affordability but high-performing. High-end entrants initially under-serve the affordability needs of the majority of the market, but are cheap enough for the high-end which values performance. Often times, this niche high-end market is comprised of hobbyists and enthusiasts  although not always. Established incumbents are under-serving the high-end of the market because it is simply not attractive in terms of volume. For the entrant, however, the potential volume of the high-end market is attractive. Entering the market with an already high-performing product, high-end entrants move down the market by increasing affordability through sustaining innovations. As high-end entrants improve affordability, their product becomes cheap enough for more and more of the market, eventually over-taking the entire market. Established incumbents are unable or unwilling to adopt the new disruptive technology because they are incentivized against competing with high-end entrants, and instead move down the market towards higher affordability in order to attain higher sales volume. Incumbents facing high-end disruption are seemingly acting entirely rational by ceding the higher-end of the market, since chasing sales volume through sustaining innovation boosts profitability — at least at first, and until it doesn't, when it is too late to pivot to the disruptive innovation.

It is important to note that both low-end and high-end disruptors enter the market by serving consumers that are under-consuming given their preference for performance and affordability. Whether starting from the low- or high-end, the disruptor eventually takes over the market with a product that is both better performing and more affordable. High-end disruption could thus also be described as ‘low-affordability disruption’.

In low-end disruption, consumers are performance-choosers: they choose their desired level of performance and pay the corresponding price. In high-end disruption, consumers are price-choosers: they choose their desired price level and receive the corresponding performance. This distinction between low- and high-end disruption is similar to the distinction between Cournot competition (quantity-choosers) and Bertrand competition (price-choosers) in oligopoly theory. Readers familiar with oligopoly theory will know that both Cournot competition and Bertrand competition are useful for understanding different types of markets in the real world. Bertrand competition is useful for understanding Pepsi and Coca Cola, for example, while Cournot competition is better for understanding cartels such as OPEC. Similarly, low-end disruption and high-end disruption are useful for understanding different types of innovations for different jobs-to-be-done.

The famous key phrase for thinking about low-end disruption is good enough, while the key phrase for thinking about high-end disruption is cheap enough. To reiterate: Established incumbents that are being disrupted from the low-end chase profit margins, while incumbents being disrupted from the high-end chase sales volumes. The same incentives that encourage incumbents to move up the market in search of higher profit margins in low-end disruption also encourage incumbents to move down the market in search of larger sales volumes in high-end disruption. In each case, incumbents are (initially) increasing their profitability, until it is too late. And in each case, the entrant is competing against non- or under-consumption in the consumer needs distribution.

Let me thus emphasize that low-end disruption and high-end disruption are idealized cases of a general phenomenon of disruption, where price and performance both interact within consumer preferences. That is to say, we need to synthesize the theories of low-end and high-end disruption. More to come on that in the future.

Christensen famously dismissed the iPhone as a non-disruptor since it was not starting from the low-end. I have recently noticed that Horace Dediu dismisses Tesla’s strategy in the auto market for similar reasons. Of course, looking through the lens of affordability, we can see that both the iPhone and Tesla are high-end disruptors. (The iPhone case is a little tricky  maybe I will explain in a future post. Update: here it is.) This mistake is actually unfortunate because Christensen’s low-end theory never provided a case against high-end disruption, but only provided a framework that explained low-end disruption. Measuring innovation using affordability instead of performance, however, explains high-end disruption very well. I have graphed several cases of high-end disruption at the end of this post. You will notice that high-end disruption is actually quite common. The best example of high-end disruption is the general-purpose computer — viewed as an entire group, including mainframes, PC's and smartphones — which has disrupted many industries from the high-end on the back of Moore's Law. Indeed, the importance of Moore's Law is due to the phenomenon of high-end disruption. An example of high-end disruption outside the realm of transistors is the light bulb (with electricity), which disrupted candles from the high-end. A modern example is Chipotle, which is disrupting McDonald's from the high-end. (Yes, Chipotle has become more affordable over the years — you must remember to account for inflation and income growth.)

Ben Thomson distinguishes between disruption and obsoletion, and also makes the case that disruption does not apply to personal consumer markets because people have infinite wants — but that’s not right either. Infinite wants simply means that there are infinite jobs-to-be-done, whereas disruption theory only exists in the realm of one job-to-be-done at a time. I think that what Thomson classifies as obsoletion is simply the phenomenon of high-end disruption.

To finish, below I have graphed case examples of high-end disruption for several jobs-to-be-done. If you liked this article, please share, follow me on twitter or subscribe to RSS.

Will Bitcoins Ever Become Money? A Path to Decentralized Central Banking

So, will bitcoins ever become money? It’s tricky… I would like to discuss a scenario where bitcoins (or something like it) would be money, why central banks would want to create their own crypto-currency protocols, and how monetary policy would be conducted in such a world.

Imagine that a private entity with significant resources and credibility implements a crypto-currency (like Bitcoin) that it backs with real, hard, good old-fashioned central bank currency. So imagine Google creates a protocol similar to Bitcoin called gCoin, and publishes the protocol publicly so that anyone can use it. In particular, anyone is able to mine gCoins by contributing computational power to the network. At the same time, Google says that it will buy unlimited gCoins in exchange for dollars, say at a price of 1 for 1, and that it will also sell gCoins that it has already mined for the same price. Thus gCoin would initially derive its value from Google's promise to exchange gCoins for real dollars at any time.

First off: Why would Google do this? Who knows! Google is very well known for building useful services that it isn’t yet sure how to monetize. And gCoin is useful: Like Bitcoin, using gCoin to buy and sell goods on the internet is faster and much cheaper than using a credit card. A simple way to monetize gCoin would be for Google to provide a ‘wallet’ service that helps facilitate the use of gCoin, which you could just think of as a chequing account for gCoins. You would “deposit” your gCoins with Google, use their online service to keep track of them and transact them, and Google would charge you a monthly fee just like a regular bank. Google would also have a reserve amount of gCoins that it initially mined before publicly releasing the protocol, which would be very valuable if the use of gCoin became widespread. I’m sure there are other and better ways to monetize crypto-currencies that we can’t even imagine yet — we don’t need to discuss this.

Now, who would use gCoins? Only someone who had faith in their value. If people believed Google would always convert their gCoins into dollars, they would gladly accept gCoin as payment. But as you see, we are in the same situation as we were with the gold-backed bank notes in the 19th century: What if there is a bank run on Google? And if other organizations like Amazon, Facebook, Apple (and PayPal?) have their own digital currencies, a bank run on just one of them could cause bank runs on the others — the same financial contagion effect that paper currencies experienced. Privately issued crypto-currencies are susceptible to the same problems as privately issued bank notes.

You can thus imagine that, just like what happened with paper currencies, central banks will eventually step in to create their own crypto-currency protocols and forbid the use of any others. For simplicity, let’s call the central bank crypto-currency protocol BitDollar. Of course, these BitDollars would always be redeemable in regular dollars by the central bank, at least at first.

The exchange rate between BitDollars and regular dollars does not necessarily have to be 1 for 1. In fact, the central bank could adjust this exchange rate in order to conduct monetary policy, although there is a better, more natural way to do monetary policy — more on that in a minute. Assuming the exchange rate is fixed, say 1 for 1, the distinction between dollars and BitDollars no longer exists. Just think of dollars as an abstraction which can be manifested in traditional paper form and now digital form. And like original gold-backed currency, we eventually won't even need regular dollars to back BitDollars, as long as the network effects of BitDollars exist to justify their value  though this transition will happen gradually.

Indeed, a similar type of network effect is what most Bitcoin startups today are betting will give bitcoins their value in the future, and they are building services that allow customers to easily transact regular bitcoins instead of building their own protocols. You can think of these startups as Bitcoin banks: They provide banking services for bitcoins. Currently these banks operate with 100% reserve ratios because they record your ownership of bitcoins on the official Bitcoin blockchain. We will have to wait to see how the value of bitcoins plays out and what banking business model emerges, but it is clear to me that Bitcoin banks and the Bitcoin network will be just as prone to bank runs as Google's gCoins would be, or traditional banks were before the days of central banking. More simply: Bitcoin needs a central bank. And BitDollar would be the answer to that.

But what type of protocol would BitDollar be? Well certainly, the central bank needs the ability to conduct monetary policy, so it would need a protocol where it could easily adjust the money supply at will. It would also need the ability to be the lender of last resort, which means access to an unlimited supply of BitDollars.

The simplest way for a central bank to create its own crypto-currency is for it to fork the Bitcoin protocol into a new protocol that is unchanged in every way except that, going forward, the central bank would set and adjust the block mining reward at its discretion. (Remember, the block reward is arbitrary in Bitcoin and other crypto-currency protocols, and can change to anything that the network agrees upon going forward.) In this world, the central bank can conduct monetary policy by changing the block reward, which in turn changes the future supply of base money. In particular, increasing the block reward corresponds to loosening monetary policy, and decreasing the block reward corresponds to tightening monetary policy. A more intuitive way to think about this is that increasing the block reward decreases transaction costs, while decreasing the block reward increases transaction costs — for every single transaction. For central banking, this is the key to understanding crypto-currencies. And like paper currency, the central bank's crypto-currency would be both decentralized (in transaction) and cenralized (in supply).

Why would people start using the BitDollar protocol and not the original Bitcoin protocol? Again, it’s simply a matter of network effects, and the fact that BitDollar would be legal tender under the law, including the requirement to pay taxes with them. The answer to this question is the same answer to: Why do people US dollar bills instead of notes printed by private banks? It's tautological: People use US dollar bills because people use US dollar bills.

We still need to resolve how the central bank can access an unlimited supply of BitDollars so that it can continue to act as a lender of last resort. The central bank can create unlimited BitDollars for itself by leveraging the the network effect — let me explain. Remember, BitDollars can only be created by solving a block in the blockchain (i.e. processing transactions) and, as we have discussed, the reward for solving a block is now set by the central bank. But also remember, the transaction history in the blockchain is impossible to change, so the central bank can only change the reward for future blocks. So to create BitDollars for itself, the central bank would announce two things to the network, both at its discretion: (1) It announces a future transaction block, and (2) It announces a one-time reward amount for that block. Once that transaction block comes to pass, the central bank will solve the block and announce the updated official blockchain to the network, walking away with the reward. Anyone else that tries to solve that block will not be recorded as such on anyone else's copy of the blockchain because everyone else will be using the official blockchain released by the central bank. Again, why would people using the protocol simply agree to this? Because…networks. The central bank said so. In fact, the central bank doesn't even need to solve the block itself for this process work, simply by also providing an additional transaction reward for whoever processes the block.

Of course, with the ammunition of unlimited BitDollars, there is no need for the central bank to change how it conducts monetary policy by using the block reward method I described previously. But I think that adjusting the block reward is a much more natural way to change future money supply and conduct monetary policy because it affects every transaction in the economy — it is very broad based.

A smooth transition from paper-currencies to crypto-currencies will require central banks to understand the importance of crypto-currencies early on, as they develop. If central banks wait too long, there will be risks of bank runs and financial instability from privately issued crypto-currencies. It is important that central banks recognize this and respond accordingly.

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This is Part 4 of a discussion on the economic consequences of Bitcoin. You can access the remaining parts here:

1.  A Friendly Introduction for Economists to the Bitcoin Protocol
2.  A Monetarist View of Money and Bitcoin
3.  A Brief History of Paper Currency and Central Banking
4.  Will Bitcoins Ever Become Money? A Path to Decentralized Central Banking

A Brief History of Paper Currency and Central Banking

In order to better understand how Bitcoin or some other crypto-currency may evolve to be used as money, I would like to discuss how early paper currencies first developed and came to be used as money, and why central banks were created to regulate them. That is the purpose of this post.

Imagine a world where gold (or maybe silver) is money. That is, pounds of gold or silver are used as the unit in which prices were quoted. (This is actually is how it was. It is why the name of UK money is pound sterling.)

Now, instead of keeping all their gold on hand, people would leave their gold with goldsmiths or deposit their gold at private banks. Private banks would then issue 'bank notes' to their depositors. To get their gold deposits back, people would would simply show up at the bank, hand over their note, and retrieve their deposit. Naturally, instead of going to the trouble of retrieving their gold deposits, people would simply exchange their bank notes when buying/selling goods. Modern banks still use this technology, in fact — we call them "cheques". (Americans call them “checks”.)

Now, of course, people would only accept bank notes as payment if they had faith in the bank that issued them — they had to be sure that the notes really could be redeemed for gold at the bank, no questions asked. This issue of trust is an important concept to remember as we will reference it from time to time. As trust in bank notes grew, more and more they were used as a medium for transaction. (The bank notes are not yet money because prices are still being quoted in gold. See the previous post.)

Except there were problems. Because bank notes were being used for transactions, depositors weren’t likely to redeem their gold too often, so banks found that they needed to keep less gold on hand in their vaults. Instead, the Banks found that they could lend out this extra gold and charge interest. This all works fine until you get an unexpected influx of people requesting to withdraw their gold and you don't have enough to fulfill their requests.

As a result, private banks become susceptible to bank runs: What happens when many people all at once lose faith in a bank and try to redeem their notes? Even if the initial concerns are unfounded, the act of many people withdrawing their deposits really will make a bank that has loaned out its deposits insolvent. You may have heard this referred to as a self-fulfilling prophecy or a self-fulfilling panic. An extension of this is when the loss of credibility in one bank causes people to question the credibility of other banks, even if only one of the banks has been behaving badly. All of a sudden, the loss of faith in just one bank causes many other banks to face huge deposit withdrawals as well. And since the huge withdrawals in fact do cause those once "good" banks to fail, you can see how a cycle would develop. This type of cycle is called financial contagion. Such a contagion happened in 2008 when US regulators allowed the investment bank Lehman Brothers to fail. Right away you can see the important role governments play in maintaining a healthy financial system, which we will return to.

With the widespread adoption of bank notes, very large banks soon realized that they had the ability to put any smaller bank out of business, overnight. How? Well due to their size, large banks accumulated large volumes of bank notes from smaller banks, and they could easily cause any small bank to fail simply by redeeming these notes all at once. Large banks didn't do this, of course, because they were also very well aware of the risk of financial contagion described above. The large banks thus developed a live and let live attitude: A large bank would allow a small bank to remain stable as long as it kept a deposit at the large bank. In the UK, there was just one large bank that played this role and it was the Bank of England. (Eventually the Bank of England became the central bank for the UK  we'll get to that.) In the US, there were several large banks playing this stability role, each dominating a different region. (This is why the US has 12 regional Federal Reserve banks  we'll get to that too.) It is hard to understate the important role these large banks played in maintaining a stable financial system.

Now there was still a problem with these bank issued notes: Not all bank notes had equal value. Notes issued by banks that were seen as less risky traded at a premium, so that even if two notes had the same par value (in terms of gold), they would not be treated as equal value. Merchants would have books full of exchange rates between the notes of issuing banks. These discrepancies made exchanges with bank notes harder than they were originally intended.

Soon, governments decided to take over the role of issuing notes and stabilizing the financial system, not leaving it in the hands of private banks. In the UK, the Bank of England was nationalized and was given sole authority to issue notes. In the US, the process was more evolutionary. At first, all banks were required to keep a deposit with the US treasury to back any notes that they issued. Moreover, the US treasury took over the responsibility of printing all notes, but outsourced the printing to the largest banks in each region  12 in total. Every bank note that the US Treasury issued looked exactly the same, except for the name of the printing bank which would be printed on the note. The US treasury would redeem any of its notes at the same level, no matter which bank printed it. As a result, all banks honoured each other's notes at par, thus fixing the bank note problem. Eventually, the US treasury created its own regional banks that would oversee the administration of both notes and deposits in each region  12 official regional banks were created with a headquarters in Washington DC, and this became known as the Federal Reserve system.

Now this didn't end the bank runs, unfortunately, because the same mechanics that allowed banks to lend out extra gold deposits also allowed them to lend out extra treasury note deposits. That's why governments had to take the extra step of creating deposit insurance and other regulations. Another important detail is that the Federal Reserve and the Bank of England took on the added responsibility of being the lender of last resort  but we won't get into all that except to say that being the lender of last resort requires access to an unlimited supply of money.

Banks which are granted the monopoly of issuing notes, like the Bank of England in the UK or the Federal Reserve in the US, are called central banks. In different countries, the framework of how these central banks originated are slightly different, but the underlying economics is the same: Governments would guarantee the value of all bank notes and in return private banks could no longer issue their own notes, only the central bank could do that. At first, these notes would be backed by gold, just like the original private bank notes, but that would eventually be removed for reasons soon explained. In America, notes issued by the Federal Reserve are called dollars

So are these dollars money? Not yet. Right now they are only a medium of transaction. Remember, dollars only become money once they are the medium of account  that is, once the price of goods are quoted in dollars (and not gold)  which is of course what happened.

Why were prices suddenly quoted in dollars? Well the reason is very natural: Since there was only one bank now  the central bank  issuing dollars that were convertible into gold, why not just quote prices in dollars instead of gold to make the transaction smoother? And that's indeed what happened. More importantly, though, the government actually made it against the law to quote prices in anything but dollars (i.e. legal tender), and required that all taxes be paid in dollars as well. (You weren’t allowed to pay your taxes in gold.) This created enough network effects to make dollars the medium of account: All prices were quoted in dollars, meaning that dollars were money.

But now notice something: We don't even need the dollars to be redeemable into gold for this system to work. The network effect of people using dollars is enough to give these "fiat" dollars real value. And you are probably already aware that dollars are no longer redeemable in gold. Instead, the dollar gets all of its value from the fact that it is the medium of account  the definition of money  and this is due to the network effects originally imposed by government. In short, dollars are money because dollars are money. And similarly, bitcoins are not money because bitcoins are not money. Yet.

Having the power to create money, central banks soon realized something very important: They realized that by changing the supply of money, they had the power to change interest rates, exchange rates, prices, and even employment, among other things. Having access to unlimited money is also important to the central banks' role of being the lender of last resort, ensuring that they are able to do so. Central banks thus take their responsibility very seriously and they play a crucial role in maintaining stability in modern economies. In fact, many economic crises have been caused by errors made by central banks  the Great Depression, the Great Inflation, Japan's lost decade, the recent Eurozone crisis and the Great Recession quickly come to mind.

The decisions central banks make over the supply of money thus received its own name and is called monetary policy. Through history, central banks have tried to use monetary policy at various times to set interest rates, exchange rates, prices and employment. Today, most modern central banks use monetary policy to keep inflation stable within a pre-defined range. We don't need to get into these details. The point is this: The job of a central bank is very important. We cannot live without effective monetary policy.

So that is the story of how paper currency came to be and how central banks use their monopoly over paper currency to conduct monetary policy. If you really grasp this story, the concepts described, I think you will understand the concept of money better than most economists you meet on a daily basis. The interested reader should also read the story of the Capitol Hill baby-sitting co-op.

Contrary to what Bitcoin proponents say, transacting paper currency is, like Bitcoin, very decentralized. If you and I want to transact using paper currency, we don't need anyone's permission, we simply physically transact. (Transacting through the internet, however, is still very difficult, and this is something Bitcoin is helping to improve.) However, only the central bank has power over the supply of the paper currency. So paper currencies are both decentralized (in transaction) and centralized (in supply). It is likely that crypto-currencies of the future will have this property as well. We will discuss this more in the next post.

What we need to think about is: Under what scenario would central banks adopt crypto-currencies in the same way they adopted paper currencies? And what innovations would this allow to monetary policy? I keep asking myself this question and in the next post I will try to explore this.

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This is Part 3 of a discussion on the economic consequences of Bitcoin. You can access the remaining parts here:

1.  A Friendly Introduction for Economists to the Bitcoin Protocol
2.  A Monetarist View of Money and Bitcoin
3.  A Brief History of Paper Currency and Central Banking
4.  Will Bitcoins Ever Become Money? A Path to Decentralized Central Banking