Chapter 2: A World Without Money
Credit in Ruritania
"A stable price level and a high level of employment do not permit the total quantity of money to be kept constant."
– F.A. Hayek (1976)
Let us start our journey from a world without money.
Why? The purpose of money is to facilitate indirect exchanges, and such exchanges have two sides, one with money and one with goods or services. By starting with money, we risk a one-sided perspective. Most current holders of Bitcoin hope to profit from price appreciation which influences their preferences for its future development and even their perception of its nature. Fiat money advocates are inclined to focus overly on Bitcoin’s current shortcomings: minimal adoption in the real economy, its primary use for speculation, and its high volatility.
So we begin from a clean slate: before money.
“Barter! Not again!” my readers may cry. “We have heard it all before. We know that barter existed only in primitive societies, that it hampers division of labour. We know that famous movie scene from Vienna in the year after World War II. We know about the time consuming problem of finding the right trading partner.”
I know that you know. That is why I will not plague you with the double coincidence of wants by starting with barter. I will start with credit which is what comes after barter but before money.
“How can credit come before money?” you will ask. “If I go to a bank to get credit, they give me money. So money is first, or at least money and credit go together.”
Not so. What we get at the bank is a loan. Credit – in the original sense – is something we have: a personal quality. Having credit used to mean that you are a reliable person, that you are honest and good to your word. People believe that you will keep your promises and honour your debts.
Imagine a little hamlet isolated deep in the remote forests of Ruritania. There lives Farmer Albert who plants wheat and harvests 1 ton of it every year in fall. His wife Alice bakes their bread which is all they eat, year round. Sometimes they get a whiff of fried bacon from their neighbour’s farm. There lives Farmer Bob who raises pigs and slaughters 20 in each spring. Hs wife Bonnie cures and smokes the meat. They eat ham and bacon year-round but sometimes the breeze carries the wonderful smell of freshly baked bread from Albert’s farm.
One fine day, our two farmers agree – unsurprisingly – to exchange half their produce. Bob will send 10 slaughtered pigs in spring, and Albert will send half a ton of wheat in fall. Both families can now enjoy a more varied diet, such as roast pork with bread dumplings, an old Ruritanian favourite. Both are better off due to the economic Law of Marginal Utility.
Note that this is not straight barter. It is credit because time and counterparty risk come into play. Albert is indebted to Bob for half a year. His debt is settled upon delivering the promised wheat, this delivery concludes a real exchange of real goods. The temporary credit cancels out and disappears. Poof!
Also, note that this credit is not denominated in any monetary unit, it is simply expressed in wheat, the future good. Albert and Bob can do their business perfectly fine without a need for money.
“Gotcha! Wheat was used as a form of money in Ancient Egypt,” my clever readers will now object.
Indeed, the boundaries between a commodity and a money blur when that commodity is used as a medium of exchange. Before metal money and coinage, Ancient Egyptians bartered grain for other goods like livestock, tools, or pottery. They also paid their taxes to the pharaoh in grain, which the state stored in huge granaries and redistributed as payment to officials, soldiers, and workers, even speculation.1 However, grain is not a good money, it is foremost a food needed for consumption, and it spoils over time by mould, fungus, weevils, mice, rats, and birds. Once eaten or spoiled, or upon a crop failure, there is nothing left to trade with and the economy breaks down.
Looking further into our hamlet, we see Farmer Charlie, who raises cattle and slaughters 4 animals in spring, and Farmer Dave, who harvests 2 tons of potatoes in fall. If they agree on a similar trade as their neighbours, their credit would be denominated in potatoes. A greater variety of goods is highly desirable, but the more products, the larger the number of denominations. This leads to a confusing cacophony of credit denominations – a proverbial Babel of units of account.
Can the four farmers simplify their exchanges by agreeing on a common standard denomination? For example, they could use wheat for the purpose, just like the Ancient Egyptians.
“But why Albert’s wheat and not my potatoes?” Farmer Dave may then protest.
The farmers could bypass conflicting individual preferences by choosing an outside good to denominate their respective credit. They could agree on, say, 10 goats’ worth of wheat. Or 1 ounce of gold’s worth, 0.1 bitcoin’s worth of it – less tasty but more durable. Whatever commodity they choose, it will assume the role of base money.
Note that there need not be a single goat in our hamlet, not to speak of gold or Bitcoin, as all farmers can settle their debt perfectly fine with what they ultimately want: the real goods.
Throughout this book, I shall use the term ‘real credit’ for credit created in exchange for real goods and ‘credit money’ for real credit denominated in a single, generally agreed commodity – the ‘base money’. In a way, real credit is the raw material for the production of credit money. Financial credit, such as loans, government bonds, company shares, and dry bills of exchange2 yield highly problematic money substitutes, which we shall call ‘fiduciary media’ issued against thin air.
It is the prerogative of any seller of real goods to grant real credit to his buyers, in an instant and at any time. This freedom enables the immediate flow of goods and forestalls undue delays in trade, where goods may deteriorate or spoil altogether. The creation, circulation, and redemption of credit money – which serves as the predominant medium of exchange – is quite independent from the production, trading, and hoarding of the base money commodity – which mostly serves as the unit of account.
Our rustic example above shows that the supply of credit money must be elastic because demand for money appears and disappears depending on the timing of goods ready for sale. In the real economy, money demand changes all the time: there are weekly and bi-weekly cycles for workers’ wages, monthly ones for employees’ salaries or for house rents, there is seasonality during harvest time, Christmas, and holiday periods. And finally, there are long-term fluctuations like the four-year pork cycle.
Both types, fixed base money and elastic credit money, are needed to form a complete monetary system, the former serves for value measurement, the latter for value exchanges. Basic mathematics proves that the total systemic money supply, the fixed plus the elastic component, must also be elastic.
“Elastic? No way! An ideal money’s supply is fixed so that nobody can produce more of it,” some bitcoiners may disagree. “That’s what Austrian Economics teaches us.”
Not so. This is certainly not what the major economists of the Austrian School wrote about the money supply in the context of a free banking system, where banks compete with independent banking policy.
“A stable price level and a high level of employment do not permit the total quantity of money to be kept constant,” writes nobel laureate F.A. Hayek.3 In a similar vein, Ludwig Mises explains that “the theory of elasticity is correct” as follows: “banks increase and decrease their circulation pari passu with the variations in the demand for money. In doing so, they help to stabilise the objective exchange value of money.”4 And Carl Menger wrote: “Production, or more extensive fabrication at least, is very often only possible through credit; hence the pernicious stoppage and curtailment of the productive activity of a people when credit suddenly ceases to flow.”5
As mentioned earlier, not a single gold coin or bitcoin is needed just because our farmers agree on it as a unit of account. Does this mean that in 2015, the Greek people could have changed from the Euro to Bitcoin in an instant? Could they have bootstrapped a Bitcoin system, bypassing the ECB’s blockade?6
Almost. In principle, the Greek producers could have created the raw material for credit money by selling domestic goods, such as olive oil or Greek wine, for bitcoin-denominated credit. However, several hurdles remain for the production of credit money.
First, the necessary economic method and system for Bitcoin credit money creation and burning has not yet been developed, nor is there a consensus on what constitutes acceptable proof-of-value.
Second, many bitcoiners are sceptical about the necessity for bitcoin-denominated credit money, the quasi-religious 'fixed money supply’ narrative causes them to conflate credit money with fiat money.
Third – and most importantly – the volatility of bitcoin is much higher than that of the major fiat currencies, therefore businesses are highly reluctant to assume the risk of bitcoin-denominated credit.
Volatility presents a catch-22: without a credit superstructure backed by real goods, Bitcoin’s objective exchange value will always remain volatile; and while Bitcoin remains volatile, businesses cannot assume bitcoin-denominated credit and the necessary credit superstructure cannot emerge and grow.
Bitcoin has a classical chicken-and-egg problem.
The good thing is that this type of problem is demonstrably solvable; after all, chickens and eggs do exist. In a later chapter, I will present a plan to solve the volatility problem for Bitcoin. Spoiler: we must write code.
Genesis 41:56.
"Dry exchange" (cambio secco) is bill of exchange drawn without trade in goods. See De Roover, Raymond. "What is dry exchange?" In Business, Banking and Economic Thought, pp. 183–99.
Friedrich August Hayek. “Denationalisation of Money” (Chapter XIV).
Ludwig Mises. “Theory of Money and Credit” (Part 3: Chapter III § 4).
Carl Menger. “Principles of Economics” (III 3. C.).
See Chapter 1.
Do not the same arguments hold true if you replace the word, "Bitcoin" in your essay with the word, "gold" or "silver" or "market basket of selected commodities?" What makes Bitcoin special? Is it the fixed supply, and why does that matter?