I used to play Diablo II, an action role-playing game that could be played online with other players. In the game, the players’ characters would slay monsters which occasionally dropped weapons, armor, and other items that could be used to make characters more powerful. The items they’d get from slaying monsters would be generated randomly by the game, and every now and then they’d get lucky and find exceptionally rare and powerful equipment. However, the valuable items found were not always useful to the character that found them, and an in-game barter system quickly arose.
Let’s say I found a rare crossbow, but my character had no need for a crossbow and instead could use a better helmet. I would look for another player who wanted a crossbow and was offering a helmet so we could make a mutually beneficial trade. However, this was not always a simple task. What if the player offering the helmet didn’t want a crossbow? What if the player who wants a crossbow doesn’t have a helmet to offer? What if someone does want a crossbow and offers a helmet, but my crossbow is much rarer and more powerful than his helmet, or vice versa? These issues complicate trading.
Currency and its characteristics
Currency can facilitate these types of trades. However, the Diablo II universe did not trade in dollars, euros, pounds, or pesos. There was an in-game currency called gold, but it was exceedingly common and there were restrictions on how much of it a character could carry or store which made it useless for trading rare items.
A useful form of currency should have the following characteristics:
- Fungibility: One unit of the currency must be equivalent to any other units.
- Portability: It must be easy to move and carry around significant amounts.
- Divisibility: It must be able to be split into smaller quantities for precision when performing transactions.
- Scarcity: It must be difficult to find or produce in large quantities.
- Durability: It must not spoil or decay over time.
- Acceptability: It must be recognizable, desirable, and demanded by a large portion of the population.
Over time, one item started being used as a de facto currency in the Diablo II world. The Stone of Jordan (SOJ) was a rare type of ring that was useful across all the different character classes and most character levels. It was small and therefore possible to carry and store large amounts of them at once. All SOJs were more or less equivalent to each other, and they never decayed. As such, it had all of the above characteristics except divisibility, and soon all rare items and valuable transactions were denominated in SOJs. A player could sell his rare crossbow for SOJs, and then use them to buy a rare helmet. Trade flourished and the players benefited.
Suppose that one day a player in Diablo II announced that he had made his own rings. These rings were small and durable like SOJs, but they conferred no bonuses to the character that wore them and were therefore worthless on their own. Furthermore, the player that made these rings would have the ability to make more of them whenever he wanted at his own discretion. Imagine you were a Diablo II player and this player offered to trade you his rings in exchange for your rare equipment or SOJs. You would laugh him off and tell him to take his useless trinkets elsewhere, right?
SOJs in the Real World
Now, let’s go back to the real world. Currency has been a boon to trade and the prosperity of humanity. Gold and silver are the SOJs on planet Earth; they are fungible, portable, divisible, scarce, durable, and widely recognizable and desirable. They’ve been valuable across generations and across eras. However, they are not as convenient to use for currency as paper money. It’s much easier to give someone exactly $3.50 than it is to give someone the equivalent amount in gold or silver (which would involve a lot of dividing and weighing I imagine).
There is a workaround for this, however. Banks can accept deposits of gold and silver and issue bank notes that are redeemable for the gold and silver on deposit. These notes can come in varying denominations – grams, milligrams, etc… – which makes the underlying commodity even more portable and divisible. Notes from banks that are sufficiently reputable and reliable can be considered as good as the gold or silver they represent. There are shortcomings of such a system, namely the risk of fraud and bank failure, but that is a different topic altogether.
Gold, silver, and notes that represent them have been used as currencies in human history because they were the best forms of currency known to man at the time. Suppose that you lived in a society where these were the most widely used and accepted forms of currencies. And suppose that, as in my Diablo II example, a person started making his own currency and this time called it “monopoly bucks.” These offered the same convenience that bank notes did but had no intrinsic value of their own and were not redeemable for anything that did. This person could also make more monopoly bucks whenever he felt like it. If he came up to you and offered you his monopoly bucks in exchange for your gold, silver, or other objects of value, wouldn’t you laugh him off just as you would the Diablo II player peddling his trinkets?
Fiat money – “This is valuable because I said so”
If, however, a national government were the entity making the monopoly bucks instead of some arbitrary person or private party, what you wind up with is basically the fiat money system that is used all over the world today. What are fiat bills if not arbitrary, inherently useless artifacts that can be created in unlimited quantities by an issuing authority? They are not truly scarce – producing them is a matter of turning on the printing press. Perhaps more importantly, they don’t provide any functional advantages over other forms of paper currency.
What makes US Dollars any different from the monopoly bucks in my previous hypothetical? Americans are, to a certain degree, compelled to use dollars by the government. Legal tender laws make it so that only debts in dollars are enforceable by the courts. Taxes are imposed in dollars, and Americans must pay capital gains tax on their nominal gains when they convert other currencies to dollars, even if those gains do nothing more than keep up with inflation.
Dollars can satisfy the demands of the US Government and, to that extent, they have a use that other fiat currencies don’t. Even in places outside of the US government’s jurisdiction, dollars are recognized as valuable because it’s understood that they are useful for people in the USA. However, the value of the dollar isn’t due to it being any more desirable or better suited for use as a currency than other types of paper money. Its value is artificial and propped up by the policies of the US government.
Bitcoin – The Cadillac of monopoly money
Bitcoin is a decentralized, virtual currency with a predictable and limited supply. Bitcoins are inherently worthless and they are not backed by anything of value, like fiat money. However, they have essentially all of the desirable characteristics of currency.
Bitcoins are extremely portable; carrying large amounts is no more difficult than carrying small amounts and bitcoins can be sent across the globe in seconds with virtually no transaction fee. They can easily be divided down to eight decimal places. They are scarce, with a fixed long term supply of roughly 21 million bitcoins and no possibility for any party to increase the bitcoin supply or to create counterfeits. Bitcoins never decay, and large amounts can be stored securely without needing to trust a bank.
When I tell people about bitcoin (which is often), I usually am faced with skepticism. Some of the first questions I generally get are:
“What are bitcoins backed by?”
“Who decides what they’re worth?”
“Who invented bitcoin and who makes new ones?”
The answers are simple: Nothing. Nobody decides but the free market. An anonymous software developer designed and released it, all the code is open-source and the process for making new bitcoins is entirely predictable and open to anyone with a computer.
Bitcoins combine the scarcity of gold and silver with divisibility and portability even greater than that of paper money; and that’s without needing to trust banks to honor their notes. Although bitcoins are inherently worthless, their scarcity and superlative usefulness as a currency makes them valuable to society and to whomever holds them. That is something that can’t really be said about fiat money.
Many still dismiss bitcoin as online funny money, yet those same people are generally blissfully unaware and accepting of the inherent worthlessness of the government fiat money that pervades their lives.
I don’t expect the US Government to start printing $500,000,000,000 bills any time soon, although that is an inevitability if we continue with our current monetary system. Nor do I expect it to revise its legal tender laws or accept alternate currencies to satisfy tax payments. But, if that were to happen, I wonder how long it would be before people realize their dollars are only truly good at hotels on Boardwalk and Park Place…