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