Understanding Bitcoin through the US Dollar, Part 1
Navigating the water around us.
‘…that all physical theories, their mathematical expressions apart, ought to lend themselves to so simple a description 'that even a child could understand them.' ' Albert Einstein
We were born into a world defined by economics, and it is difficult to be conscious of an environment in which you have always existed. In this sense, talking about economics can be like trying to explain water to a fish. The fish wouldn’t know the word water, it has always existed in it and as far as it knows, always will — it knows nothing else.
Being conscious of one’s environment does not come naturally, but it can carry significant benefit. Our economic system has great effects on each individual and group, and learning about the water around you can greatly aid your navigation through it. Such is the goal of these articles: to explain the economic world we live in, and ideally as simply as possible.
A different approach to Bitcoin
Every once in a while a sensational trend hits headlines that carries more energy than it does substance. Bitcoin has been subject to this phenomenon more than a few times. No doubt you have heard buzzwords like “mining”, “cryptocurrency”, “decentralization” and “blockchain” enough times from crypto bros that we’re still waiting for your eyes to finish rolling from the back of your head. Well, I’m impressed you’re here subjecting yourself to this subject once again, and I hope allowing a crypto bro one more pitch might just help some things click… (then you can continue rolling your eyes).
I’ll be honest — I’ve never read a book about Bitcoin, and at this point I don’t know if I ever will. One does not study a solution without understanding the problem first, and I feel that many of the educational materials surrounding Bitcoin focus on the solution itself (Bitcoin) before the problem (our current economic situation). This is an attempt at the opposite.
I believe the most efficient way to understanding the principles behind money and our economic situation, and what makes Bitcoin valuable, is by studying the U.S. Dollar’s transition from being backed by gold to becoming a fiat currency (an unbacked currency). This transition and it’s associated economic effects bring valuable insights into the nature of money.
We interface with money today in a manner never done in human history: a digital screen.
Only a few generations ago, precious metals, or paper that represented precious metals, particularly gold, were the main way in which humans interfaced with currency, and throughout history, money has typically been something tangible that could be held in your hand. That association with value is still embedded in the collective psyche today.
In a relatively short time, we went from transacting exclusively in precious metals and paper bills that represented those precious metals, to hardly using them at all. It might never be that someone counts out gold ingots for purchasing a vehicle, or sorts through tiny silver coins to pay for their morning coffee.
Having all of your money on you, or stored in your home always in physical form seems like a very strange way of dealing with money now. Even when it was commonplace, it was still less than ideal. There is significant risk of loss, or theft of your money when it exists in physical space. Banks offered a solution by storing funds in a protected vault, keeping note of how much belonged to each individual on a piece of paper, a ledger.
In addition to safety, this also made financial transactions more efficient. When a payment occurred, the bank wrote down how much was paid to someone by someone, and transferred the money on the ledger from one account to another. All of this was completed without physically moving money. Instead, a line on the ledger was simply changed. The bank would keep track of transactions, and periodically sum up those transactions into their total account balances. Soon, a vast majority of transactions took place on a ledger instead of through physical means.
Connection to gold
For a long time, even though gold wasn’t actively being used in the vault, the money on the ledger was still tied to it. You couldn’t create more money on the ledger without increasing the amount of gold in the vault to represent that change. The two were intrinsically tied: if more money was added to the ledger, then gold had to be obtained to reflect that change. Originally, the US Dollar originally was just a representation of gold.
This connection between USD and gold was known as The Gold Standard. A money being based off of a naturally occurring resource (or not) is the most defining characteristic of money, and carries significant economic implication.
Before we go into how the US Dollar was eventually severed from the gold standard, let’s talk a little bit about why precious metals were used for money in the first place, or in a deeper sense: what makes something valuable.
You find yourself on a small hike stepping through dirt, rocks, grass, weeds, and flowers. Every once in a while you pass by a large clump of vegetation. Approaching one of these clumps, you lean down to pick up an especially notable flower. These are different than others, bright blue, edging on violet—a color you don’t often see, especially not in this environment. You gently pick it up from the roots, beaming with the thought of showing your friends when you return.
There were plenty of other flowers up there, but you find that you care about these more than the others. Why didn’t you toss it down the waterfall into the lake—like you did with an assortment of rocks earlier?
Scarcity is what makes something valuable. If one of those rocks had sparkled, shown in the sun in a way the others hadn’t, and you had looked closer to see a crystalline structure embedded in it, maybe you would have thought twice about throwing it. Not every day do you find something different, precious, a ‘special’ rock to take home and show others. This is also why you don’t toss away your new, precious flowers.
A limited amount of something is what gives it value. (and that’s part of the reason you have so much value—there’s only one of you!) :)
This is also why sand can’t be used as a form of currency. Sand has incredibly low scarcity, and if it was used as money, a majority of people’s time would be spent on the beach with shovels and wheelbarrows gathering more and more of what ought to be worth something, but because of it’s ubiquity and the ease of harvesting, becomes worthless.
Gold and silver are very scarce assets, and in addition to other attributes, were why they worked so well as a form of money. They are universally found among various peoples, but are also rare enough to require significant effort and energy to bring into circulation, striking a good balance between the two attributes. The US Dollar being tied to the supply of gold, is what defined its scarcity, and thus, it’s value.
Severance from gold
Over time, that connection deteriorated. As the ledger became increasingly relied on, it wasn’t long before the US Dollars were created on that ledger without the accompanying gold to back it up. In the case of the US Dollar, this started out implicit, then quickly explicit.
More dollars had been issued, in particular to foreign governments, without the gold in vaults it was supposed to represent. This became an issue as these governments (particularly France) started redeeming their US dollars for the gold it supposedly represented. By the 1960’s there clearly wasn’t enough gold redeemable for US Dollars in existence and in 1968, it became official policy that only 25% of US Dollars were to be backed by gold. Shortly thereafter, in 1971, Nixon announced the US Dollar to be officially and completely severed from Gold.
USD thus fully became a fiat or unbacked currency, a money the scarcity of which was no longer tied to an underlying asset, but based upon the rules of the issuing authority, the Federal Reserve.
With this simple single policy change came significant economic and geopolitical effects that have come to shape the world we live in.