Practical Blockchains and Cryptocurrencies: Speed Up Your Application Development Process and Develop Distributed Applications with Confidence

© Karan Singh Garewal 2020

K. S. GarewalPractical Blockchains and Cryptocurrencieshttps://doi.org/10.1007/978-1-4842-5893-4_1

1. A Short History of Money

Karan Singh Garewal¹ 

(1)

Toronto, ON, Canada

We are going to embark upon a deep dive into cryptocurrencies and blockchain applications. The canonical blockchain application is bitcoin, the world’s first cryptocurrency. It would thus be fitting to survey the history of money and see how bitcoin has radically changed the paradigm for currency creation and distribution. In this chapter, I will present an opinionated history of money from the Neolithic age to the present time and, in particular, I will highlight landmark events in the evolution of money. This chapter will conclude with a brief overview of bitcoin and how it differs from traditional money.

The Neolithic Age

One of the earliest forms of human interaction was the exchange of goods. For example, a transaction could involve exchanging 100 eggs for a blanket or a stone ax for 35 hens. These types of transactions are called barter, and they involve the exchange of commodities between two transacting parties. An object or a commodity acquires value when it has utility (usefulness) and scarcity. Ornaments acquire value because of their beauty and the considerable effort that a skilled artisan has to expend to create them. The expenditure of considerable skill and effort makes ornaments scarce.

There is a fundamental problem with barter; it is an inefficient way to exchange value. For example, if you have an ax that you want to trade for some hens, then you will have to find a person who has some hens available for trade and who wants an ax. Conceivably, there could be no one who satisfies this criterion, in which case an exchange of value cannot be consummated. Furthermore, even if such a person exists, there is the issue of establishing an exchange rate, that is, how many hens should be traded for the ax. This depends on the size and quality of the ax as well as the quality of the hens. Finally, there is a divisibility problem. For example, there could be a person who wants an ax but only has 12 hens to trade. Finally, there is problem that bartered goods are not typically fungible. A thing is fungible if it is indistinguishable from any other thing of the same type. As these examples demonstrate, barter is a very inefficient technique for trade.

Necessity is the mother of invention, and consequently, the inefficiencies of barter produced the requirement of creating an efficient medium of exchange. Money or currency in the form of coins made its first appearance in China during the Neolithic age about 3000–4000 years ago. Money can be thought of as an object which represents a certain amount of value. For example, a metal coin with an ax inscribed on it could symbolically represent the exchange value of an ax. The efficacy of money in any form depends upon its acceptance as symbolically representing value. Such acceptance requires money to be a store of value. That is, if the coin with an ax inscribed on it is exchangeable for 35 hens today, then it should also be exchangeable for 35 hens 90 days hence. By 700 BC, the use of coin money had spread from China into the Indian subcontinent.

Around 210 BC the first Chinese emperor Qin Shi Huang introduced a standardized coin based on copper as the official currency of the first Chinese Empire and abolished other forms of money that were being used locally. It was a brilliant policy because it unified the empire by increasing trade across the breadth of the Empire. This, in turn, led to accelerated economic growth and prosperity in the empire. It was a golden age in China. Since copper was relatively abundant, these copper coins had low value. The acceptance of these coins was cemented by the fact that the treasury of the empire guaranteed the convertibility of the coins into utilitarian objects of value at a fixed rate. The introduction of this coinage had all of the characteristics that we now typically associate with money; they were accepted as a medium of exchange and a store of value, and finally the coins were fungible.

The Emergence of Banks and Banknotes

By the seventh century AD, bearer promissory notes had appeared in China, and they gained rapid adoption. A bearer promissory note is a document wherein the maker of the note promises to pay the bearer of the note a certain amount of money or commodity, either upon demand or at a certain fixed date in the future. Since the promissory note embodied a promise to pay a bearer, the holders of these notes would frequently sign them over to other recipients. Consequently, these notes started to circulate like a modern paper currency. Clearly, the acceptance and negotiability of bearer promissory notes depended upon the reputation of the maker. There must have been very wealthy merchants with stellar reputations whose promissory notes were accepted by the public as money. The rapid expansion in the use of promissory notes led the Tang dynasty to create a treasury that printed promissory notes which were backed by the wealth and prestige of the Empire. This was the first appearance of paper currency in the ancient world. At about the same time, bearer promissory notes made an appearance in India.

Hawala

The appearance of demand promissory notes on the Indian subcontinent led to a significant innovation. Previously, the exchange of value required the participants of a transaction to both be present at the time the transaction was consummated. Hawala (called Hundi in India) eliminated the need for participants to be present to consummate a transaction. In other words, value could be exchanged between parties far removed from each other. Hawala is believed to have been instrumental in the development of the ancient Silk Road from China to Venice.

The manner in which Hawala works is as follows. A transactor gives a person called a hawaladar value (say, some coins or a demand promissory note) and orders him to pay this value to a person in some remote city. The hawaladar contacts a hawaladar in the remote city and orders him to pay the intended recipient. At the end of the month or some other agreed-upon settlement date, the two hawaladars settle accounts among themselves. Notice that the order given to the second hawaladar is not accompanied by the transfer of value to him. Indeed, if the two hawaladars have equal amounts owing to each other on the settlement date, no value will be transferred by them when they settle their accounts interse.

If the recipient lived in a city very far away, several hawaladars could be involved in the transaction and the hawaladars would settle accounts between themselves periodically.

There are several aspects of Hawala which should be noticed. Firstly, it is based on a chain of trust. Secondly, value can be transferred between traders in remote locations without any money being transferred between the participating hawaladars themselves. For example, if traders in Peking used a hawaladar to order goods worth one million Ban Liang from traders in Shanghai during a settlement period and traders in Shanghai used a hawaladar to order goods worth 900,000 Ban Liang from traders in Peking, then the hawaladar in Peking would only need to transfer 100,000 Ban Liang to the hawaladar in Shanghai on the settlement date. The last aspect of Hawala worth noting is that it largely bypasses the modern commercial banking system.

The Roman Empire and the Origins of Inflation

There is one singular lesson to be learned from the history of currency in the Roman Empire. That lesson is how the debasement of coinage causes hyperinflation. There is also a secondary lesson: how an over-extended empire is forced to debase its currency and thus becomes the instrument of its own destruction.

Roman coins were made from a variety of metals, including silver, lead, iron, and copper. The standard coin of the empire was the denarius. The denarius was a 4.5-gram coin composed almost entirely of silver, meaning that it was a coin with at least 95% purity in silver. Silver was a relatively scarce metal in the Roman Empire, and considerable effort was required to mine it. The denarius cemented trade through the breadth of the vast Roman Empire and was widely accepted and circulated primarily due to the purity of the coin and the power and prestige of the Roman Empire. Not only was the denarius a stellar coin for facilitating trade but it was perceived as an excellent store of value.

However, the maintenance of the ever-expanding Roman Empire was a very expensive proposition. There were numerous cost impositions on the Roman treasury. For example, nearly 50,000 miles of roads were constructed to bind the empire, numerous aqueducts and public works were built, the Roman legions had to be well paid, the city of Rome had a population in excess of one million people, and the maintenance of the city was a considerable drain on the Roman treasury. Finally, trade accounts with distant countries such as India had to be settled. The trade between Rome and India was estimated to involve approximately 200 ships a year.

The problem confronting the Roman treasury was that the costs of the Roman Empire could not be sustained by taxation and the plunder of conquered territories alone. Rome did not have financial institutions or mechanisms for financing government deficits and debt. Thus, there were only three ways to finance government expenditures: increase the taxation level, increase the supply of silver, or debase the denarius. The Roman Empire itself contained only a few silver mines, so the production of silver could not be easily increased. Increased taxation was infeasible, so the Roman emperors started to debase the denarius. The drain of silver from Rome to India through trade deficits is believed to have been one of the major causes for the debasement of the denarius. At the time of Julius Caesar, the denarius was only 75% pure silver, and by the advent of the third century, its purity had declined to about 5%. This debasement had disastrous consequences and caused hyperinflation in the Empire. Trade collapsed as traders lost faith in the denarius. Traders and foreign mercenaries in the employ of Rome demanded payment in gold only. The Roman legions became weak and demoralized as the denarius became a worthless currency. The debasement of the denarius is proof that Rome could not bear the costs of maintaining its empire. The end of Rome is well known; Germanic and Hunnish barbarians from Asia repeatedly attacked the empire itself, and the last emperor to sit on the throne of Rome was a barbarian. The debasement of the denarius can be construed to be one of the major causes of the collapse of the empire.

Gold and the Plunder of the New World

The art, literature, and intellectual grandeur of Rome did not survive its collapse. Europe was plunged into a dark age lasting a thousand years as religious fanaticism and Christian superstition gripped the continent. By the early sixteenth century, Spain had colonized portions of the new world and was mining gold and silver using the aboriginal inhabitants as slave labor.

The prevailing economic theory at this time was called mercantilism. The foundational principle of mercantilism was that the wealth of a nation was measured by the amount of gold, silver, and other precious metals that were held in its treasury. In addition to spurring the search for gold and silver, this theory also led to the imposition of customs duties and other barriers that restricted the flow of trade between nations.

The Spanish incursion into the new world led to the mining and transportation of large quantities of gold and silver from the new world into Europe. About 10–20% of this gold and silver is presumed to have been looted by privateers acting under charters granted by the English Crown and buccaneers operating under pirate flags.

Spain used this influx of precious metals to build magnificent cathedrals, execute vanity projects, and most importantly finance wars for the benefit of the Church of Rome. The influx of gold and silver from the new world permitted Spain to maintain the largest army in Europe, build a large navy, and finance wars against England, France, The Netherlands, the German principalities, the Ottoman Empire, as well as non-Catholics who were viewed as heretics.

One of the immediate effects of the influx of gold and silver into Spain was to cause widespread inflation in Europe. In Spain, prices are believed to have increased by 300% over the sixteenth century. Spain had a primitive agrarian economy that did not benefit in large from the plunder of gold and silver from the new world. Spain had a disdain for commerce as a human endeavor and viewed it as having limited religious and ethical merit. Consequently, Spain became increasingly dependent upon the influx of precious metals to finance the extravagant imperial and religious misadventures of the King. The Spanish Exchequer being primarily reliant on the looting of gold and silver from the new world went into bankruptcy four times in the sixteenth century in the years 1557, 1560, 1576, and 1596. These sovereign bankruptcies were a clear indication that there was no taxation base of significance in Spain. Eventually, Spain lost its apex position in Europe, and by 1750, it was a backwater.

The Gold Standard

As Spain receded from the stage of world history, Britain began to emerge as the predominant power in Europe. Britain was a trading nation with a large and sophisticated merchant class and also valued the benefit of trade between nations. In addition, England had been at the forefront of the Protestant reformation and adhered to the Calvinist doctrine that the performance of everyday work had substantial religious value. In 1776, Adam Smith wrote The Wealth of Nations which demonstrated the fallacy of mercantilism and showed that free trade could be a nonzero-sum game in which each participant in trade could benefit due to the theory of comparative advantage. Adam Smith also introduced the concept of the division of labor and its benefits. The Wealth of Nations espouses the benefits of free markets and free trade and marks the starting point of modern economic theory. At this time, England also started to develop a sophisticated law of contract and the stellar innovation of joint-stock companies which allowed large amounts of risk capital to be raised efficiently. The invention of the joint-stock company kick-started the industrial revolution. Starting at the end of the eighteenth century, Britain embarked upon a century of colonial expansion.

In 1844, the British Parliament passed the Bank Charter Act, wherein the Bank of England promised to redeem its banknotes at a fixed rate into gold specie. This established a gold standard across the British Empire as well as in the United States, Canada, Australia, and other countries which had extensive trade relations with Britain. It also established the pound sterling as the world’s reserve currency. Trading nations were content to use the pound sterling in trade and hold reserves thereof since they had the assurance that their currency holdings could be converted into gold. Gold is a precious metal in scarce supply, and the promise of redeem ability of banknotes issued by the Bank of England into gold at a fixed rate effectively constrained the ability of England or any other country adhering to the gold standard to print paper currency at will. A country printing its currency in excess of its gold and sterling reserves faced the possibility of a run on its currency as speculators converted their holdings of the currency into pound sterling or gold.

The enormous costs of World War I on the English Exchequer led Britain to impose exchange controls; this effectively suspended the convertibility of its currency into gold. Many European countries followed in lockstep and abandoned the convertibility of their currencies into gold. The effect of this was to cause massive inflation as the costs of World War I were financed by simply printing large quantities of paper currency to pay off the debt. In other words, the cost of World War I was passed on to the population by increasing the money supply. This meant that the costs of World War I were borne by the population of Europe through inflation. It is well known that inflation causes fixed income assets, such as bonds, to decrease in value. In 1925, Britain returned to the gold standard in order to preserve the status of the pound sterling as the reserve currency of the world. It would prove to be a short-lived effort.

The Great Depression and Keynesian Economics

On September 4, 1929, the stock market on Wall Street faltered and dropped significantly. Over the next month and a half, the stock market oscillated wildly indicating significant uncertainty among investors and speculators. Then on October 29, 1929 (Black Tuesday), the Dow Jones Industrial Average on the New York Stock Exchange plummeted by 20%. It was the beginning of the great depression, and it plunged the world into an unprecedented economic depression that lasted a decade. Industrial output in the United States declined by nearly 40%, trade collapsed by some 70%, and unemployment climbed to 25% of the population.

The impact on Britain and Europe was similar. Britain abandoned the gold standard fearing a run on the pound sterling. The foremost economic problem of the day was how to climb out of the great depression and get the world economy moving. There were two diametrically opposed points of view, the American Hooverites advocated fiscal conservatism and the need for governments to scale back their expenditures in order to prevent any further increases in the public debt. Opposing them was the great English economist, John Maynard Keynes, who argued in his book The General Theory of Employment, Interest and Money that increased public expenditures on public works should be undertaken to provide employment and increase production in the economy. The basic premise of Keynesian economics was that the increase in public debt would be paid for by the increase in tax revenue once the economy climbed out of the depression. This is the basic principle of Keynesian economics; public expenditures should be increased during recessions and depressions, and the public debt so incurred will be paid off when the economy recovers due to the increase in tax revenue. President Roosevelt’s economic plan to bootstrap the American economy out of the depression was an exercise in Keynesian economics.

Implicit in Keynesian economics is the idea that the supply of money should not be tied to a standard guaranteeing the convertibility of the currency into gold or any other precious specie, that is, the government should be free to print money or incur public debt as required to maintain full employment. It’s a neat theory, but as history has repeatedly demonstrated, the power to print money at will is like a dangerous and highly addictive drug that ultimately destroys the patient.

The Petrodollar System

The conclusion of World War II saw Europe shattered and the United States emerged as the sole economic powerhouse in the world. In 1944, the United States and European signatories assented to the Bretton Woods Agreement wherein the signatory countries agreed to peg their currencies to the US dollar at a fixed rate and the United States agreed to redeem the US currency holdings of any foreign central bank at the rate of 35 dollars for an ounce of gold. At this juncture in history, the United States held most of the world’s gold. This agreement replaced the pound sterling with the US dollar as the reserve currency of the world. Bretton Woods also effectively established a gold standard across the world with the United States as the guarantor of the standard. The promise of convertibility at the rate of 35 dollars for an ounce of gold as well as the rapidly expanding American military and industrial power established the US dollar as the primary instrument to facilitate international trade.

Problems started to appear 18 years later as the United States got embroiled in the Vietnam War. The United States started to have persistent balance of payment deficits with its trading partners. In addition, the treasury had to grapple with the extensive war expenditures incurred by the Vietnam War and inflation. In 1971, Britain losing faith in the stability of the US dollar redeemed most of its US dollar holdings into gold. Fearing a run of the dollar triggered by Britain’s actions and in order to protect US gold reserves from depletion, President Nixon suspended the convertibility of the US dollar into gold. This action converted the US dollar into a fiat currency. A fiat currency is a currency that is not convertible into gold or any other precious asset, and the value derives solely from the willingness of users to utilize it as a medium of exchange and a store of value.

The Treasury of the United States realized that with the US dollar off the gold standard, there was in principle no compelling reason for nations to use it in trade or as an international reserve currency. It was thus important to compel the use of the dollar as an international reserve currency rather than relying on the good faith of nations to continue using a fiat US dollar. This is the problem that the Petrodollar system solved.

Starting in 1974, the United States and oil-producing countries came to agreements to sell oil on international markets in US dollars only. The immediate effect of this was to require countries that wanted to purchase oil to maintain an adequate amount of dollar reserves. Such a country could obtain these reserves in two ways, either by selling goods to the United States and receiving dollars on its foreign exchange account, or by doing the same with a third country. There was an implicit supposition in the Petrodollar system that most US dollars circulating abroad would never return home – a supposition which was largely true if the world economy kept on expanding. Since these dollars would not return home, this effectively meant that the United States could purchase goods and services from countries for free (i.e., by simply printing dollars or dollar-denominated debt). Furthermore, since the dollar was not on a gold standard, the US Federal Reserve System was not constrained in its ability to print dollars at will. At present, the federal debt of the United States is in the range of 26 trillion dollars. This is a consequence of imperial overreach, unconstrained government spending, primarily on the military; a weak tax base that cannot sustain the recurring government expenses, the non-convertibility of the dollar, and the Petrodollar system.

Prior to the Petrodollar system, a currency acquired status as an international reserve currency through the guarantee of the maker to convert it into gold specie at some fixed rate. A country not wishing to hold the reserve currency could simply convert its currency holdings into gold. The Petrodollar system has replaced this with a compulsion. A country wanting to buy oil has to have fiat US dollars on hand to make such a purchase.

Making Money in a Fractional Banking System

Throughout the course of history, the power to create money has been viewed as a sovereign prerogative. For example, only the Roman emperor had the right to create denarius coins. So it might come as a surprise to you that in the modern world most of a nation’s money is not created by the treasury but by banks. This is a consequence of the fractional reserve banking system.

In fractional reserve banking, a bank is required by law to hold a certain percentage of its deposits on hand to cover withdrawal requests. This is called the reserve requirement. Let’s look at how a hypothetical bank can create money ex nihilo (out of nothing). Suppose we have a bank called Bank of Ontario which has initially no deposits or liabilities and has a statutory reserve requirement of 10%. A customer comes in and deposits one million dollars. The position of the Bank of Ontario is now as shown in Table 1-1.

Table 1-1

Bank Position

The Bank of Ontario lends $900,000 to a borrower, and this borrower deposits the loan amount with the Bank of Ontario. The financial position of the Bank of Ontario is now as shown in Table 1-2.

Table 1-2

Bank Position

Notice that the amount of funds that the bank can lend is

Amount Available for Loans = Total Deposits – Reserve Requirement – Loans Made

The Bank of Ontario now lends $810,000 to a customer who again deposits it with the bank. The financial position of the bank is now as shown in Table 1-3.

Table 1-3

Bank Position

Notice that at this stage the bank has created an extra $1,710,000 of money (deposits with the bank) from the initial $1,000,000 deposit.

And if we continue in this manner, the Bank of Ontario can keep on making loans (money) up to a theoretical maximum amount dictated by the money multiplier:

Initial Deposit/Reserve Requirement

What this means is that if the bank receives a deposit of one million dollars, it can create up to ten million dollars in deposits (money) and derive the interest income from these loans.

If the bank charges an interest rate of 6% per annum on its loans to customers, it will derive a maximum interest income of $600,000 per annum. As you can appreciate, the ownership of a bank in a fractional reserve banking system is a very profitable proposition.

The adherents of the Austrian School of Economics (Friedrich Hayek, Ludwig von Mises, Ron Paul, etc.) posit that fractional reserve banking is inherently unstable and gives rise to boom-bust cycles, and furthermore, it is a form of legalized theft since it gives a preferential class the power to create purchasing power (money) out of nothing.

In monetary theory, M1 is defined as coins, paper currency, as well as other financial instruments that are as liquid as money; these include demand deposits at banks, travelers’ checks, and so forth. M2 includes instruments that cannot be readily converted into money, such as bank savings deposits, 30-day treasury bills, money market funds, and so forth. M2 is comprised of instruments that take a short, fixed amount of time to convert into M1 specie.

It should thus not surprise you that most of M1 is composed of bank demand deposits.

Essential Monetary Economics

Let’s take a brief look at the Equation of Exchange , which is a basic equation in monetary economics. This equation is represented as follows:

MV = PT

The Equation of Exchange is computed by reference to a fixed period of time, say, a year. M is the supply of money or M1. V is the velocity of money or