The History of Money, Part 2 — From Fiat to Cryptocurrency

In this second of a two-part series on the history of money, we explore humanity’s journey from using gold and paper money as legal tender to cryptocurrency.

Introduction

For decades, gold-pegged and fiat currencies formed the backbone of the global economy. But an alternative financial system, also known as decentralised finance (DeFi), has emerged following the creation of Bitcoin. Here, we explore humanity’s journey from using gold and paper money as legal tender to cryptocurrency.

This article is a follow-up to Part 1 of the History of Money series, which explores the origins of money through bartering, the early coinage system, and the first banknotes. This series intends to help readers understand how the current monetary system came to be so they can make more informed financial decisions.

Key Takeaways:

• Commodity money, representative money, and fiat money are the three types of money used throughout history.
• The gold standard was adopted by many countries in the late 19^th century but was abandoned during World War I.
• After the Bretton Woods System quietly dissolved in the 20^th century, fiat currency became the dominant form of money.
• Quantitative easing was put forth as a solution to the Great Recession of 2007, but it has regressive effects, such as increasing income and wealth inequality.
• Bitcoin rose from the unstable financial environment of the 2010s and offers many unique benefits as a medium of exchange, most notably its decentralised nature.

Overview

What Are Commodity Money, Representative Money, and Fiat Money?

Commodity money derives its value from the commodity of which it is made. It consists of objects having value or uses in themselves (intrinsic value) as well as their value in buying goods.

Representative money is any medium of exchange, often printed on paper, that represents something of value but has little or no value of its own. Unlike some forms of fiat money, which may have no commodity backing, representative money must have something of intrinsic value supporting the face value.

Fiat money is a currency without intrinsic value that has been established as money, often by a governing entity. It has value only because a government maintains it, or because parties engaging in exchange agree on its worth.

Here is an overview of different monies that have been used in history:

The Modern Art of Money

Money has gradually become more abstract. Its earliest forms, like agricultural items, were tangible goods that could be consumed. This later changed to metal coins, where the underlying materials (i.e., metal) were capital goods (i.e., used in the production of equipment).

The introduction of banknotes marked the transition from commodity money to representative money since they only represent a peg to metal coins but have no intrinsic value. After the abandonment of the gold standard, banknotes became fiat money, which is neither pegged nor possesses intrinsic value.

The Gold Standard

As banknotes only represent a peg to their underlying metal coins, their intrinsic value is still determined by the demand and supply of their underlying metal. Some metals are easily mined (e.g., copper), so they gradually lose their status as ideal money over time. This leaves two metals as ideal money since they are mined with difficulty: silver and gold. The gold and silver standards are monetary systems in which the standard economic unit of account is based on a fixed quantity of gold or silver.

A Volatile History: The Gold Standard’s Rise and Fall

From 1870 to 1939, the international monetary arrangements were dominated by one story: the rise and fall of the gold standard regime.

In 1870, about 15% of countries were under the gold standard, rising to about 70% by 1913. This period was the first era of globalisation, with increasing flows of trade, capital, and people between countries. A fixed exchange rate facilitates trade, so more and more countries began switching to the same measurement standard.

One may wonder: why peg to gold? In the 1870s, most countries were still using the silver standard. But a network effect began taking place at the end of the 19^th century, as the global superpower at the time, Great Britain, was using the gold standard; its colonies followed suit. More and more countries began adopting the gold standard, as it allowed them to trade with Great Britain and its colonies at lower costs. Eventually, it became a global standard.

However, not every country that adopted the gold standard found it to be beneficial, especially during deflation and recessions. When World War I began, participating countries needed a way to finance themselves, but the gold standard forbade them to do so because printing more money required proportional ownership to gold. Many countries decided to print more money despite not having enough gold reserves, making their currencies free-floating from 1914 to the 1920s.

The Gold Standard Act of 1925

There was a return to the gold standard in the late 1920s to early 1930s as a result of the British Gold Standard Act of 1925. Many other countries followed Britain. However, the return of the gold standard led to recession, unemployment, and deflation in these economies. This state of affairs lasted until the Great Depression (1929–1939) forced countries off the gold standard.

On 19 September 1931, speculative attacks on the pound forced Britain to abandon the gold standard. Loans from American and French central banks of £50,000,000 were insufficient and exhausted in a matter of weeks because of large gold outflows across the Atlantic. The British benefited from this departure: They could now use monetary policy to stimulate the economy. Australia and New Zealand had already left the standard, and Canada soon did the same.

Countries that stuck with the gold standard (e.g., France and Switzerland) paid a heavy price. Compared to countries that stayed with gold, countries that floated had 26% higher output in 1935, and countries that adopted capital controls had 21% higher output.

What a Trilemma: The Impossible Trinity

The ‘impossible trinity’, also known as the ‘impossible trilemma’ or ‘Mundell-Fleming trilemma’, is a concept in international economics stating that it is impossible to maintain all three of the following conditions at the same time:

• A fixed foreign exchange rate
• Free capital movement
• An independent monetary policy

It is both a hypothesis based on the uncovered interest rate parity condition and findings from empirical studies, where governments that have tried to simultaneously pursue all three goals have failed. The concept was developed independently by both John Marcus Fleming in 1962 and Robert Alexander Mundell in different articles between 1960 and 1963.

Picking Sides

From 1870 to 1917, countries that adopted the gold standard picked side A (see diagram above), where they had a fixed exchange rate and free capital flow in order to facilitate international trade. After 1931, most countries abandoned the gold standard and were either pegged to the US dollar, British pound, or French franc (side A), following the Bretton Woods system (side C) or free-floating (side B).

It is possible to reside somewhere in the middle, such as ‘dirty floats‘ or pegs with limited flexibility. Overall, monetary policies can be picked either at side A, B, or C, as well as some mixed choices in between.

The Bretton Woods System

The international monetary system of the 1930s and ‘40s was chaotic. Near the end of World War II, allied economic policymakers gathered at Bretton Woods in the United States to try to ensure that the postwar economy fared better. The architects of the postwar order, notably Harry Dexter White and John Maynard Keynes, constructed a system that preserved one key tenet of the gold standard regime: fixed rates. But it discarded the order by imposing capital control, therefore opting for side C.

The ‘trilemma’ was resolved in favour of exchange rate stability to encourage the rebuilding of trade in the postwar period. Countries would peg to the US dollar, making it the centre currency and the United States the centre country. The US dollar was, in turn, pegged to gold at a fixed price, a last vestige of the gold standard.

However, imposing capital control is difficult. By the 1960s, controls were leaky, and investors found ways to circumvent them, moving money offshore from local currency deposits into foreign currency deposits. Some even used accounting tricks to move money from one currency to another.

The End of the Dollar Peg

As capital mobility grew and controls failed to hold, countries pegged to the dollar stood to lose their monetary policy autonomy and began to rethink their dollar peg. As it was increasingly apparent that US policy was geared to US interests only, the commitment to convert dollars into gold no longer existed. Some countries started to frequently devalue their currency or even cancel the peg to the US dollar.

The Bretton Woods system dissolved quietly. Since then, the international monetary system has transited into the era of fiat currency.

What Is Fiat Currency Worth?

Fiat currency is established as money by government regulation and does not have intrinsic value; it has value only because a government maintains it, or because parties engaging in exchange agree on its value.

Fiat money began dominating in the 20^th century. Since the decoupling of the US dollar from gold by Richard Nixon in 1971, a system of national fiat currencies has been used globally.

Fiat money can be defined as:

• Any money declared by a government to be legal tender.
• State-issued money that is neither convertible by law to any other thing, nor fixed in value in terms of any objective standard.
• Intrinsically valueless money used as money because of government decree.
• An intrinsically useless object that serves as a medium of exchange (also known as fiduciary money).

Fiat currency did not appear suddenly but gradually came to be through the evolution of the monetary system. Countries tried to tie themselves to the gold standard but eventually failed because they needed flexibility when regulating the economy. Ultimately, the cost of sovereignty insolvency outweighed the drawbacks of letting the government control the money supply.

However, allowing the government to print new money creates another problem: inflation tax. For example, suppose it costs one dollar to buy an apple. If the government prints one more dollar, the total dollar supply in the market becomes two. Now, one dollar is only enough to buy half an apple. Issuing new currency is considered a tax on holders of existing currency.

Shaking the Fiat: The Subprime Mortgage Crisis and Quantitative Easing

The US subprime mortgage crisis was a nationwide financial crisis that significantly contributed to the global recession that began in 2007. It was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies, foreclosures, and the devaluation of housing-related securities.

The housing bubble preceding the crisis was financed with mortgage-backed securities (MBS) and collateralised debt obligations (CDOs), which initially offered higher interest rates (i.e., better returns) than government securities, along with attractive risk ratings from rating agencies. Elements of the crisis first became evident in 2007, and several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers.

Quantitative Easing as the Silver Bullet?

The US’s solution to the recession was ‘quantitative easing (QE)’, which is a monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to inject liquidity directly into the economy. By buying specified amounts of financial assets from commercial banks and other financial institutions, central banks are able to raise the prices of those financial assets and lower their yield while simultaneously increasing the money supply.

By March 2009, the Federal Reserve had repurchased US$1 trillion of bank debt, mortgage-backed securities, and treasury notes, and all the cash used to repurchase these assets was flowing out to the market. This amount reached a peak at US$1.35 trillion in June 2010. Five months later, the Fed announced a second round of quantitative easing, buying US$600 billion of Treasury securities by the end of the second quarter of 2011. The market called it the ‘QE2’.

‘QE3’ was announced on 13 September 2012, when the Fed decided to launch a new US$40-billion-per-month, open-ended bond purchasing programme of agency mortgage-backed securities. The balance sheet increased rapidly after QE, from US$900 billion to US$8.4 trillion as of May 2023. The difference is all the liquidity (i.e., money supply) that has been injected into the economy up to today.

QE has led to many problems, however. One notable issue is income and wealth inequality. British Prime Minister Theresa May openly criticised QE in July 2016 for its regressive effects: “Monetary policy — in the form of super-low interest rates and quantitative easing — has helped those on the property ladder at the expense of those who can’t afford to own their own home.“

In 2012, a Bank of England report showed that its quantitative easing policies had mainly benefited the wealthy and 40% of those gains went to the richest 5% of British households.

Finally: The Arrival of Bitcoin

Amid the economic turmoil, Bitcoin was created in 2008 by Satoshi Nakamoto, who voted against the trust towards central bank-owned currencies in the Bitcoin white paper:

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.“

—Satoshi Nakamoto

It should be noted that Bitcoin is not the first attempt at digital currency. Before Bitcoin, there were DigiCash (founded in 1989 by cryptographer David Chaum) and e-gold (founded in 1996 by oncologist Douglas Jackson and lawyer Barry Downey). However, both projects failed because of centralisation.

Is Bitcoin Ideal Money?

Using the criteria applied above, here is an evaluation of the efficacy of Bitcoin as money:

Based on this analysis, Bitcoin is a more ideal candidate to be a medium of trade than fiat currency. While fiat currency is more generally accepted and has a stable value, these are subjective measurements and can change over time.

Bitcoin does have some limitations, though:

• Slow finality (needs at least one hour to confirm transactions)
• Limited throughput
• Requires sophisticated knowledge from its users (e.g., private key management)

These deficits do not exist for physical forms of money. Therefore, solving the blockchain scalability problem is a prerequisite for the mass adoption of Bitcoin and other cryptocurrencies for daily transactions.

For a detailed overview of the technical aspects of Bitcoin, read how Bitcoin transactions work.

How to Position Bitcoin in the Financial System

Bitcoin is neither commodity money (it has no intrinsic value), representative money (it is not pegged to something with intrinsic value), or fiat money (it is not backed by the government). It is of its own kind, which we call decentralised money.

As Saifedean Ammous has pointed out in his book The Bitcoin Standard: “For every other money, as its value rises, those who can produce it will start producing more of it.“ The value of Bitcoin is solely determined by the market equilibrium between those who trade it. This is in line with the subjective theory of value, which states:

“Value of a good is not determined by any inherent property of the good, nor by the amount of labor necessary to produce the good, but instead value is determined by the importance an acting individual places on a good for the achievement of his desired ends.“

The decentralised nature of Bitcoin ensures that no single entity has the power to create more of it out of thin air. Thus, another important characteristic is that Bitcoin’s scarcity is guaranteed by decentralisation.

Bitcoin fulfils most qualities as ideal money and has the foundations to disrupt the centralised fiat monetary system that has dominated up until this point. It will take more time to become a true medium of exchange, but with global cryptocurrency users reaching 425 million at the end of 2022 — a 39% increase since the start of the year — Bitcoin and altcoins are poised to be at the centre of humanity’s ongoing search for better money in the coming decades.

Interested in joining the cryptocurrency community? Check out this University article for step-by-step guides on purchasing Bitcoin and 250-plus other coins and tokens in the Crypto.com App.

Due Diligence and Do Your Own Research

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Past performance is not a guarantee or predictor of future performance. The value of digital assets can increase or decrease, and you could lose all or a substantial amount of your purchase price. When assessing a digital asset, it’s essential for you to do your own research and due diligence to make the best possible judgement, as any purchases shall be your sole responsibility.