Monthly Archive for April, 2011

A Broader Definition of Currency

Published on April 10, 2011 in Future of Money. 19 Comments Tags: , , , .

Money and currency are considered synonymous, but a broader definition of currency gives an interesting perspective on the current financial crisis, as well as the next wave of currency innovation.

The Difference between Money and Currency

In a recent panel discussion called “Monetizing Intangible Capital” at the Future of Money conference (Feb 2011), Art Brock drew an interesting distinction between money and currency which I had not heard before. Brock suggested that a currency could be regarded as any symbolic representation of value, issued according to a set of rules:

I use the word currency distinct from money. Normally in every day speech we collapse the two. But monetary currencies or money is a subset of the overall range of currencies that we have. For me, something like “Certified Organic” is actually a currency. There are rules by which it’s issued. It changes value flows. It changes the way people shop. It changes the way production is done.

Art Brock, Monetizing Intangible Capital

According to this view of currency, money is just one type of currency which is fungible, enabling it to serve as a medium of exchange and a store of value. Symbols like “Certified Organic,” “Fairtrade,” or “AAA-Grade investment” or even “CNN” are all currencies too. Their issue is subject to rules which give them meaning, usually by the organisation which owns and operates the currency.

Brock suggests that one of the functions of a currency, in this broader sense, is to “change the way value flows.” The existence of the “Certified Organic” sticker on an apple makes visible an otherwise intangible part of the apple’s value. Consumers are able to factor in an aspect of the product they wouldn’t have otherwise known about, or perhaps valued – its organic production. Currencies of the broader sort have the power to change the way people perceive and value goods and services, and hence change patterns of consumption and production generally.

Brock’s distinction between money and currency is not entirely new. The ancient Greeks held a similar view. Diogenes the Cynic, a Greek philosopher and vagrant in the 5th century BC, famously called for the “defacement” of all currency. Diogenes was the son of a money changer, but meant more than “money” by the word “currency”. According to Peter Marshal:

The Greek for currency was nomisma, derived from the word Nomos (custom). Since Diogenes felt that the standard of society was wrong, his call to deface the currency represented an attack on all prevailing customs, rules and laws.

Peter Marshall, Demanding the Impossible

The less frequent use of the word “currency” – to describe an idea, belief or opinion which has common acceptance, also casts light on this broader definition of currency. Our currencies are, after all, symbols of value issued according to rules which have common acceptance.

Why do we need currencies?

After pondering Brock’s distinction for a while, I got thinking about the reason why currencies came into existence in the first place. It seems that symbols like “Fairtrade” or even brand names like “BMW” solve an epistemological problem faced by people having to make quick, accurate decisions based on limited knowledge of a complex world.

Our capacity for knowledge is limited in the first instance by sheer scarcity of attention. We don’t have enough time in the day to personally inspect and evaluate the production process underlying each good or service we consume. Additionally, and crucially for a democratic society, the degree of technical expertise in any domain of knowledge, from organic farming to finance, is beyond the grasp of the average citizen. There are very few people who know how to operate nuclear power stations, for instance. Yet, if we are going to rely on nuclear technology, we need to come up with a way of knowing who to trust, even if we don’t share their expertise.

It seems that we have invented currencies as a kind of social heuristic to solve these epistemological problems. By navigating our decisions with the help of currencies, we turn the knowledge problem into a trust problem. Rather than thinking about whether this apple really is produced organically (not to mention defining what “organic” means exactly,) by using the “Certified Organic” sticker we trust the organisation who regulates “Certified Organic” to do the job for us.

The trust problem which currencies give rise to is technically easier for us to solve than the knowledge one. This principle seems to be true of almost any currency you can think of. Take, for example, a car brand name like BMW. The value of the BMW symbol is a largely dependent on the quality of the cars to which it is attached. Consumers benefit from not needing deep knowledge of motoring and car manufacturing – they use “BMW” as a kind of short-hand in this regard – turning the absence of knowledge into an issue of trust towards the BMW brand.

When currencies go wrong

Brock’s distinction between money and currency also provides a powerful lens though which to view the ongoing financial and economic crisis. In many ways, there is a theme of “currency breakdown” where numerous, interdependent commonly accepted currencies failed to accurately reflect the underlying value they were supposed to represent. (The fact that such currencies still enjoy currency in the sense of common acceptance is perhaps an indication that the crisis is not over.)

One particularly obvious example is financial investment ratings leading up to the financial crash of 2008. The role of ratings agencies like Moody’s, Fitch and Standard and Poor’s is to analyse and rate financial products according to their level of risk. The three major firms effectively monopolise the ratings market: they are ubiquitous in the financial world, and their ratings are considered very strong indications of the safety of an asset. Many pension funds, for example, are forbidden from investing in sub-AAA rated investment products, which gives the ratings agencies a critical role in determining the flow of capital in the economy. This sounds very much like the kind of currency Brock is describing.

However, in 2008 investment ratings were one of the most unambiguous points of failure in the financial system, which led to the misallocation of billions of dollars into the sub-prime housing bubble. Financial instruments such as CDOs, which are complex combinations of sub-prime and prime mortgages, were systematically over-rated by the big three agencies, leading to large losses. It seems like an excellent example of a currency failing on a very large scale. Furthermore, there are some interesting insights to be learned about currencies by asking why this happened:

Centralisation

One of the overriding reasons for the failure of the ratings system were the conflicts of interest which arose within the ratings agencies, due to their centralisation and dependence on the investment banking industry for fees. The agencies’ revenues came from the investment banks who securitised and sold toxic financial products. A combination of short-termist self-interest, wilful delusion (and perhaps worse) led all three agencies to tell the investment banks what they wanted to hear.

Opacity

Another reason was the degree of complexity in the financial products which were being assessed. If the role of a currency is to provide a social heuristic for making accurate judgments about complex issues, there is a problem when the people responsible for regulating that heuristic – the investment ratings – do not themselves understand what they are rating. It doesn’t seem unlikely that investment banks benefited from and promoted complexity in their products for this reason.

Fetishism

What further characterises currency failure is a kind of fetishism where people mistake a symbol of value for value itself. In many cases, individuals made poor investment decisions because they uncritically accepted currency systems like investment ratings, allowing them to monopolise their attention and decision making.

Karl Marx described described something similar when he wrote of commodity fetishism – the fallacy of attributing inherent value to money and commodities, while failing to perceive the underlying social relations they derive it from. This fetishism is described quite well in a World Policy Institute article by Matthew Bishop and Michael Green:

The global economic meltdown may have busted these toxic ideas, but the institutional framework of today’s capitalism—including our economic statistics—still rest upon them. To tell us where the economy is going, business television channels keep on reporting quarterly profits and minute-by-minute stock price movements. Politicians are cheered or tormented by quarterly GDP statistics that are taken to be a measure of whether voters’ lives are getting better or worse.

Matthew Bishop and Michael Green, World Policy Institute, We Are What Me Measure

The example of the investment ratings shows how currencies in the broader sense can become “debased” in the same way that money can. This is why it is also an apt distinction. During the Roman Empire’s Crisis of the Third Century, the Severan emperors reduced the quantity of silver and gold in the aurei in order to finance the expansion of the military to police the Roman empire, bringing Rome to the brink of collapse. Today, fiat money is backed by nothing and debasement thought so-called “quantitative easing” is done at the push of a button. In the same way, the “AAA” currency of the rating agencies have been debased as a result of improper issuance.

The future of currencies

Brock’s main interest in proposing a broader definition of currency is to consider what the future of currency might look like. It seems natural, looking at the failure of antiquated pre-information age currency systems, to ask how we might be able to build more robust and reliable currencies in the future.

Brock suggests that we are in fact at the cusp of a new wave of currency innovation, which he compares to the advent of language. Much like language enabled humans to create and share gradients of meaning, future currencies will do a better job of capturing gradients of value. In this sense, Brock seems to see the future of currency as a kind of major cognitive and social leap forward, which could change the way “value flows” for the better.

Quantifying new flows

The first observation to make about the future of currency is that information technology gives us the possibility of quantifying the previously unquantifiable. The ability to make intangible types of value, like reputation, trust, or authority, visible is the idea behind the metacurrency project. We can see such currency systems at work already on the web. One example is StackOverflow, a masterful implementation of social software which rewards people for asking and answering programming questions. StackOverflow has a single “reputation” currency, which can be earned in a number of ways – by asking good questions, giving good answers, voting answers and questions up and down. StackOverflow also rewards participation with badges, which it hands out liberally for key achievements. The reputation currency drives further participation, increasing the value of the site for its users.

Connecting flows

Another of Brock’s insights is that in the future, currencies will become more interconnected, much like web pages are hyperlinked to each other. He gives the example of borrowing a power drill from someone, based on trust points earned from receiving CouchSurfer guests. Similarly, we can already see eBay reputation points playing an important role in determining prices – sellers with less reputation history are likely to earn less on their sales, as the increased risk is priced in. StackOverflow are also putting their reputation metric to use in the area of recruitment – their careers site allows members to apply for programming jobs. Rather than claiming to know a programming language on a CV, today’s talented coders can simply point to their StackOverflow reputation score. More recently, a story has surfaced about a professor achieving tenure based on his 16,000 Wikipedia edits.

Decentralisation and transparency

This vision of currencies seems to reintroduce some of the lost values of the pre-industrial era, where the consumer’s contact with a producer was far greater than today, and values like reputation factored into decisions far more. The exciting prospect of meta-currency is that it will allow us to extend reputation, trust and other metrics beyond our immediate social circle, making them count among people we have never previously come into contact with.

The currencies of the future will need to learn from some of the mistakes of industrial-era currencies which are continuing to fail the global economy, leading to large resource misallocation and market failures. These currencies failed due to a combination of centralisation, fetishism and opacity, which made them impervious to scrutiny and prone to debasement. A network of meta-currencies will need to leverage the power of decentralisation and transparency to prevent these mistakes from being repeated.

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Bitcoin and Fractional Reserve Banking

Published on April 2, 2011 in Future of Money, Money and Technology. 10 Comments Tags: , , , .

What would happen if Bitcoin became the base money of a fractional reserve banking system? Would it spell disaster for the anonymous crypto-currency? To answer this question, we have to look at the history of banking and the role government has played in both exacerbating and concentrating its risks.

In a previous post on the future of money, I looked at Bitcoin, a cryptographic peer-to-peer currency. Bitcoin’s core innovation, which sets it apart from any other digital currency, is the lack of a central authority to issue new money or to keep track of transactions. Instead, these tasks are handled by a distributed network over which nobody has total control.

There are currently 5.8 million BTC in existence, and one Bitcoin trades at $0.78 on the exchange market. Close to BTC 100,000 are sent in transactions every hour, and there are between 5,000 and 10,000 nodes connected to the network at any time. The total processing power of the Bitcoin network now rivals some of the most powerful distributed computing networks, such as SETI@home (8057 TFLOP/s according to BitcoinWatch.)

The Rise of the Bitcoin Banks

We are seeing the rise of one of the first viable internet currencies where nobody is control. The growth in size, payments and goods and services offered are evidence of this. However, the future of Bitcoin may look quite different to its origins as a cypher-punk geek project. One possible future was alluded to by Gavin Andresen, Bitcoin’s technical lead, in a recent interview for CIO Magazine:

In the future the Bitcoin payment network might be used only by major banks and financial institutions, with large-value payments made to “settle accounts” periodically through the day. Small transactions might be bundled up by the banks over proprietary payment networks, as is done now with Visa and MasterCard or bank debit-card payments.
In other words, there is a distinct possiblity that Bitcoin could ultimately become a reserve currency, used by financial institutions to settle payments between each other. Such institutions would hold accounts denominated in Bitcoins, just like modern banks hold accounts denominated in fiat currency. However, the actual Bitcoin wallet would be owned by the institution, rather than the individual.
There are a number of factors which could drive this trend:
Firstly, there could concerns over security, as less technical users opt for the safety of storing their wallet “in the cloud,” as opposed to on their computer. A physical device can be lost, stolen or hacked into by malicious software, while a bank account places the onus for security on the institution.
Secondly, institutions which process payments outside of the Bitcoin network will be able to offer faster transactions, as payments do not need to wait for the Bitcoin network to confirm them. This makes it more convenient to transact in Bitcon for day to day purchases, using a bank’s own payment network, alongside a debit card or near-field communications device. It would also take some of the network load off of Bitcoin, as banks would only settle the differences between their accounts in the network, rather than process every transaction.
Thirdly, banks may pay interest to those who hold Bitcoin with them, as well as issue credit. Their loans would also be issued in Bitcoin denominated accounts, and spendable within the banking system. Perhaps it could also be redeemable in Bitcoin, like today’s bank credit is redeemable in cash. However, this leads us to an interesting paradox:
… the arrival of Fractional Reserve Banking to Bitcoin.
There is nothing about Bitcoin which could prevent institutions using Bitcoin as the high-powered base money of a fractional reserve banking network.  The ability of banks to extend credit over and above their actual reserves depends solely on people’s willingness to accept such bank credit as payment for goods and services. In effect, a Bitcoin bank would be creating and issuing its own currency, backed by a promise of convertibility into Bitcoin on demand. Groups of banks could collude to accept each other’s bank credit, increasing the viability of their own Bitcoin credit and therefore their ability to make loans.

However, this future scenario seems quite at odds with the stated goal of Bitcoin. According to Bitcoin.org, a reason to use Bitcoin is to:

[b]e safe from instability caused by fractional reserve banking and central banks. The limited inflation of the Bitcoin system’s money supply is distributed evenly (by CPU power) throughout the network, not monopolized by banks.

This might seem paradoxical: one the one hand, Bitcoin presents itself as an alternative to the global fiat-money banking regime, and on the other, it could be used to enable a version of fractional reserve banking by itself. My view of this is that the paradox is superficial: the kind of fractional reserve banking which might arise around Bitcoin is fundamentally quite different from the kind we have in the banking system today.

However, before I explain why, it’s worth taking a detour to examine the nature of the fractional reserve system today, and precisely why it is unstable, exploitative and unsafe for society.

The Fiat Fractional Reserve Banking System and its Discontents*

The heart of any fractional reserve banking system is the ability of depositors to withdraw their cash at any time, while banking institutions have simultaneously lent out this money as long-term loans. This fundamental tension within the banking system is possible only insofar as the majority of bank depositors don’t try to withdraw their money at the same time. The system can, under those circumstances, maintain the illusion that its customers’ deposits are “in the bank,” whereas what they really have is a promise by a bank to pay the depositor a certain sum of money, on demand.

With the rise of digital banking, electronic payments became more common, reducing the need for cash. This meant that it became even easier to transact in bank credit – the bank’s promise to pay money – rather than money. In fact, the two are so interchangeable nowadays that the distinction is hardly noticed. What’s more, banks can simply settle the differences between their accounts at the central bank, further reducing their need for actual cash at any given moment.

The folly of this system has been noted by no less than Mervyn King, the governor of the Bank of England, who called it a “poor advertisement for human rationality”:

“Eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not co-exist with risky assets.” (BBC)

The fractional reserve system’s alchemy enables it to extend credit to businesses, rather than use up a scarce supply of funds. The banks’ ability to lend is constrained only by its reserve requirements, and the market’s perception of its financial strength. This has certain advantages to businesses, who enjoy an abundant supply of credit in the good times, limited only by their ability to productively invest it. However, the system has some less fortunate consequences, as evidenced by the most recent banking crisis:

  • The debt imperative. Since the majority of money in circulation is in fact bank credit, the overall level of indebtedness in the economy is close to the entire money supply. It is impossible for everyone to pay off their debts, as the money required to do so has to be introduced into the system as more debt. If people stop borrowing, the money supply begins to shrink, and there is less money available to service debt.
  • Misallocation of credit. Problems arise when banks misallocate credit. Bank credit can be created to fuel harmful speculation, to manipulate markets, as well as to create asset bubbles. The positive feedback loop whereby banks continued to expand credit on the basis of rising house prices, which they were also causing, can have drastic consequences for the real economy. (The 2008 sub prime debacle is an obvious example).
  • Exacerbation of the business cycle. The business cycle, whereby production expands and contracts, is exacerbated by banks extending too much credit (increasing the money supply) when times are good, and restricting credit too harshly (decreasing the money supply) when times are bad. Economic performance is affected by the money supply, which is in turn a function of banks’ often foolish lending.
  • Usurpation of wealth. Because banks increase the money supply when they issue bank credit, and often do so in excess of the economy’s capacity to productively invest it, they create inflation. Such inflation erodes the value of savings, and is the reason why most fiat currencies have strongly depreciated since their inception. Furthermore, banks charge interest on practically the entire world’s money supply – a huge and seemingly arbitrary transfer of wealth from the productive economy to the banking system.

Returning to Bitcoin, we can see that a future scenario in which the above system is replicated would repeat its disastrous results. However, as I have already said, there are some reasons to believe that a fractional reserve system based around Bitcoin would be much less dangerous to the economy and society. To see why, we have to go back in history to the Free Banking Era in the United States.

The Free Banking Era (1827 – 1862)

The firm paid my wages in wildcat money at its face value. – Mark Twain

The Free Banking Era was perhaps the most interesting stage of American financial history. Between 1827 and 1862, responsibility for regulating banks was dissolved to the states, many of which pursued laissez-faire strategies, allowing unchartered banks to exist as long as they adhered to basic reserve requirements, capital ratios and interest rates. In all other respects, the states treated individual banks much like any other private corporation: they did not enjoy any special guarantees such as deposit insurance (though there were some voluntary schemes.) Banks were certainly never bailed out or prevented from collapsing. Most significantly: banks were not permitted to issue Federal reserve note money. Bank credit had to be extended in the bank’s own credit notes – often derogatorily referred to as “wildcat money” because of its precarious nature. Underlying bank credit was a promise that bank notes could be redeemed in specie – namely, gold or silver.

During this period, there was a large increase in the number of banks, as well as increase in the rate of bank failures. Bank money was recognised to be inherently risky, since no Government support existed to guarantee its value if the issuing bank failed to make good on its redemption promise, or went bust. Furthermore, because bank money wasn’t legal tender, nobody was forced to use it. This imposed a further discipline on banks: their money was only as good as the market’s belief in their financial strength. It was commonplace for bank notes to trade at a discount the further they travelled from their issuing banks. An industry of middlemen arose who bought up notes out of state and brought them back to redeem them – another source of constraint on the banks’ ability to issue credit.

While the conventional view of this period is one of instability and endless banking collapses, judged as a whole it was actually more stable than the system we have today. The reason is that risk was transparent: individuals entered into voluntary agreements with banks, which they knew carried risks. They were therefore more careful about where they placed their money. Banks in turn had to be more careful about how much credit they could extend, because they lived and died by the market’s perception of their financial position. While the system saw banks collapse around the edges, the structural integrity of the system was greater – its resilience lay in its diversity. Today, the inherent risk of fractional reserve banking is assumed by the entire system, and ultimately by society, should the entire edifice need rescuing from collapse.

Incredibly, this view of the Free Banking Era is supported by another famous central banker, Alan Greenspan:

Throughout the free banking era the effectiveness of market prices for notes, and their associated impact on the cost of funds, imparted an increased market discipline, perhaps because technological change–the telegraph and the railroad–made monitoring of banks more effective and reduced the time required to send a note home for redemption. (…)

Part of this reduction in riskiness was a reflection of improvement in state regulation and supervision. Part was also private market regulation in an environment in which depositor and note holders were not protected by a safety net. That is, the moral hazard we all spend so much time worrying about today had not yet been introduced into the system.

Bitcoin’s Free Banking Era
The important lesson for Bitcoin’s future is that fractional reserve banking is not inherently problematic. It is the combination of fractional reserve banking with Government which creates problems. The often overlooked cornerstone of this support is the Government’s willingness to treat bank issued credit as if it were legal tender: enforcing its acceptance as payment for debts. This guarantees the value of bank credit, while displacing the risk of bank failure onto society.
If a fractional reserve banking system is ever built around Bitcoin, it will be a lot more like the system under the Free Banking Era than what we have now.  The main reason will be that bank credit will be sharply distinguished in the marketplace from actual Bitcoin. The pretence that bank credit for Bitcoin is the same thing as Bitcoin will not be possible to maintain, as there will be no central authority able to enforce its acceptance as legal tender. Bitcoin’s decentralisation will prevent such a system from coming about.
Online Bitcoin banks technically exist already, insofar as there are services willing to hold Bitcoin on behalf of their depositors. It is not too hard to imagine a time when such banks will also want to issue their own credit, by simply crediting accounts in their ledger system beyond their ability to redeem it for Bitcoin. If this does happen, it will be up to the marketplace to evaluate the desirability of such service against the risks they entail. It may be that a fractional reserve Bitcoin system never gets off the ground for that reason. In either case, the distinguishing mark of Bitcoin – its decentralisation – will ensure that this will be a conscious choice rather than an inevitability.
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* My sketch of modern fractional reserve banking is admittedly simplistic. Today’s banks don’t keep “reserves” in anything other than a hypothetical sense. They create new money as credit on the strength of their ability to borrow reserves, including from other banks. For a better explanation see this on the ‘fraction-less banking system’ by Max Keiser.