What is Money?

Money is any object like stones, shells, metals or tool that can be used as a unit of account, medium of exchange, and store of value. There are objective and identifiable characteristics that make something a good form of money. A specific type of money is known as a currency, and the world has seen many currencies. Most of these are no longer in use, largely because they did not meet the necessary characteristics as well as their disruptors. History has shown that every currency has either ended entirely or been significantly devalued over time.

Currently, the world has many successful currencies existing simultaneously because there are many markets that have a need for money. The most common issuer is a country or a union of countries, and the most common currencies are fiat currencies controlled by politicians. Most countries have their own currency, limited by the geographic and political boundaries of the region.

Within a region, there is a market incentive to use the same currency so that transactions and informational exchange can proceed efficiently. This powerful network effect is only in equilibrium when everyone agrees on a currency, at least within a given market. Accordingly, a better, borderless currency that serves the entire world would inevitably become universal.

There are objective characteristics that make an asset a good candidate for a currency. These characteristics are: fungibility, durability, portability, verifiability, divisibility, scarcity. Depending on the use case and the way a society operates, these qualities will vary in importance.

The U.S. dollar works well as a medium of exchange because it is sufficiently portable, divisible, fungible, and verifiable. It is not perfect in any of these categories, but it is good enough that the system can work.

The dollar is not scarce because the government is constantly printing more dollars to pay bills, make room for tax breaks, or provide its citizens’ stimulus checks. This makes the U.S. dollar a poor store of value. In an efficient modern economy, nobody interested in preserving their wealth would store their assets in dollars sitting in a bank account or under their mattress.

Gold, on the other hand, is sufficiently scarce and durable, giving it a strong use case as a store of value. Gold bars sitting in a bank vault could make sense for investors depending on their goals and the state of the economy. However, gold is rarely adopted as a medium of exchange because it does not have the necessary characteristics. The logistics of carrying around a chunk of gold everywhere you go and chipping off the right amount to pay for a coffee make this currency completely infeasible as a medium of exchange. These two use cases are not inherently exclusive, but there are not many currencies that are good at both.

The purpose of money is to simplify transactions by providing an easy-to-use and uniform system, regardless of the specific use case. This system works best when everyone participates.

If you had $10,000 and wanted to buy a sandwich at a shop that only accepted silver, you would have a problem. You might be able to work out an exchange rate with the shopkeeper, but this extra step would be inefficient and would detract from the utility that the currency provides.

The network value of being on a single system gives all currencies a powerful network effect. The utility you get from a currency depends on adoption. Accordingly, market is a winner-take-all market that can only be in equilibrium when everyone in a market uses it or nobody does.

An incumbent currency that has been adopted by a market will enjoy stickiness due to its established network value. Therefore, wide adoption of a disruptive currency is most difficult in the earliest stages. Every additional adopter creates a positive feedback loop that encourages their peers.

If the currency is adopted by critical mass, where the network value gives the new currency more utility than the incumbent currency, then wide scale adoption will occur rapidly. The adopters prior to this critical mass would have to be motivated by other factors such as investment potential or transaction functionality.

The properties of this network effect would lead us to believe that the entire world would use a single currency. However, the main currencies used today are fiat currencies and are controlled by groups with specific goals: centralized governments. Each government desires the ability to control monetary policy within their country. This lets them enact policy that can prevent recessions, influence inflation, fund government projects, and affect consumer habits. Through these actions, each government ensures that their citizens subscribe to the local currency.

The Japanese yen and the U.S. dollar are both established currencies, but an American citizen deals exclusively in dollars and a Japanese citizen deals exclusively in yen. These political boundaries create segmented markets that can each have their own dominant currency. As a result, trade across these boundaries is difficult for everyone involved, but the governments have decided that autonomy over their monetary policy is worth the hassle imposed on their citizens.

Additionally, when transacting across borders, subscribing to a centralized government’s currency means following the government’s decisions and trusting their goals for the currency align with yours. Using the currency means using the government’s system. Your store of value and ability to purchase goods and services depends on the government’s survival. It is subject to every law, agency, and regulation the country engages.

The idea of replacing a currency may seem far-fetched, but it has happened before. The first currency used in ancient Mesopotamia was barley. It was used to pay for goods and services, and people hoarded stashes of barley much larger than they could ever consume.

Once standardized silver coins were introduced, barley was entirely replaced as a currency. The portability and consistency of the coins made it a better currency, and the network effect barley enjoyed was destroyed. In the American colonies, colonists traded in commodity money such as tobacco and beaver skins when gold or silver was unavailable.

These items lacked durability, among other issues, so they were quickly retired once the U.S. dollar was introduced. The dollar was once backed by gold or land, with a promise from the government that it could be exchanged at any time. During the Great Depression, the United States government nullified the gold standard and confiscated all privately held gold to enable the quantity of money printing that was needed to combat the crisis.

At this point, the dollar had an established history from a trusted government, so it was able to retain its worth without backing from anything that held inherent value. Today, the most inherently valuable thing about the currency is the fabric on which it is printed, but people continue using it to buy food, houses, and cars. The value exists solely because everyone agrees that it has value and demands convenience.

Any currency could hypothetically be replaced. A valid currency does not need inherent value in order to be widely accepted. A disruptive currency would be a competitor for a dominant currency if it were better than the incumbent based on aforementioned metrics of quality. Additionally, being immune to censorship and the constantly evolving policies of a government would add utility for some people.

A currency that has the characteristics necessary for both storing value and for exchanging goods could serve both use cases simultaneously. This would further simplify the system, adding to the utility that the currency provides. A currency with an advantage on all these fronts would then need to overcome the network value enjoyed by an incumbent currency. It is impossible to say how much better a rising currency must be to overcome this hurdle. What we do know is that every time the challenging currency gains a user, the difference in network values declines. Each additional adopter faces an easier adoption decision than the previous. If the currency gains sufficient adoption, it would pass a tipping point and rapidly establish itself as the incumbent within its market.

For a digital currency in the age of the internet this market would not be restricted by physical distance. If the currency were decentralized and independent of any government, then it would not be restricted by political boundaries. If both scenarios were true the market of this currency would be any person who was connected to the internet network on which the currency existed. Soon, that network could include the entire world. How much would a store of value and medium of exchange for the entire world be worth?

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