Understanding Bitcoins: How Barter Became Banking

Considering the number of questions I get asked about Bitcoins, what they are, how they work, are they reliable and many more, I decided to address some of these questions as best as I could. 

This post is the first in a three-post series that will form a primer for anyone seeking more information about banking, Bitcoins and how they work.

Bitcoin: A passing fad or something more genuine?

It’s impossible to be in the payments business today and not talk about Bitcoins. They are all over the place. Friends and family both want to know if it is a passing fad, a fraud or something more genuine.

As a digital money evangelist, it’s my communal fiduciary responsibility to make sure the correct story or Bitcoins is told. On countless occasions I have sat down and patiently explained Bitcoins.

I almost never explain Bitcoins immediately, in fact, my storytelling starts with the age-old concept of barter: how people used to exchange sheep for rice and vice versa. Add to this a mix of problems when direct barter just wasnt possible.

The person who had the sheep, did not want more rice. He wanted wood. So now, you had to find someone who would take your rice for wood, and in turn you would barter that for sheep. The general concept is pretty easy to grasp. We trade with each other for goods or services the other one needs.

Then came the concept of coins. Coins, universal in trade (and acceptance), were generally made of gold or silver. Market demand and supply set the rate for commodities and how much you could buy per coin. Depending on where you were, and the weight of the coin (in gold or silver), you could buy 20 bags of rice, or 10 sheep or 7 barks of wood. Market dynamics eventually stabilised the prices for each commodity.

 Carrying coins attracted the bad guys (and gals). Being robbed of your pouch containing coins became a common occurrence, hence the need to safe guard them and instead issue promissory notes or deposit notes.

You went to a bank (or goldsmith) and deposited your coins (gold) and got a receipt for it. These Receipts (or Promissory Notes) were easier to trade and convenient to hide and carry.

Eventually these depository goldsmiths (or banks) noticed a strange phenomenon. Only 1 out of every 10 coins was ever claimed, 9 of the gold coins just sat there. Their receipts were being traded happily while the inherent need to collect the coins was diminishing. Knowing that their deposit was secure and on demand, people realized the coins (gold) could be collected at any time upon presenting the receipt.

All across Europe (at the time) these deposit goldsmiths / banks noticed that the number remained more or less constant. One coin was claimed while the remaining nine just sat there throughout the year.

Then someone thought of a brilliant idea, presumably the Money Lenders.

With nine coins that could potentially be lent out to the market, they did just so. What resulted, to put it simply, was that money was lent out when there was no money to be loaned out.

Let’s say the interest on the loaned nine coins was two gold coins. This created a problem. The total coins in circulation were ten. Yet, the number of receipts (assume each receipt equals 1 gold coin) was 19 receipts (10 issued to the original depositors and 9 issued to the people to whom coins were loaned out). Add to this, the interest payment of two additional coins, the total circulation should be 21.

  • 10 original coins
  • 9 loaned out coins
  • 2 coins (interest)

The ecosystem (or money supply) was thus a mirage. How could the system have 21 gold coins, when only 10 coins existed?

Hence the term fractional reserve banking or loaning. Only a fraction of the money was kept, the rest was literally “created on receipts and loaned out. The one person who, if ever, came to collect his gold coin (of the original 10 depositors) would be sure to get his money. However, if a larger percentage or all the depositors came back to reclaim their deposits, there would be a problem. The coins are simply not available in the vault. Youd have a run on the bank!

This is the money system (in a crude sense) that we have today. Every US Dollar that is created is essentially loaned out to the US Government by the Federal Reserve Bank. This is a very important point: every Dollar that is created (out of thin air) is essentially a debt instrument. Human slavery to money from get go.

When more money is created (or more receipts / notes are printed) and injected into the banking system you tend to lose the buying power of your coin.

So back to our hypothetical village, where previously with only 10 coins and 10 coin receipts in circulation, you could get 10 sheep or 20 bags of rice or 7 barks of wood. With more and more money in the village, let’s say, 50 gold coins and 50 equivalent receipts for it, the buying power of your coin decreases. Why?

Because everyone seemingly has a gold coin receipt and something that was once precious and held by a select minority, now seems to be in the hands of everyone.

The lesser there is, the more it is wanted (provided demand exceeds supply). If we produced less rice than what was needed, the value of rice would shoot up. But it there is a surplus, the value would decline.

The same example can be used with wood, or sheep or pots and pans, horses, etc. The less of these resources, the more valuable they are. The more of such resources, the less valuable they are.

Abundance of anything and we give it less importance (or value) in life. Scarcity of anything and we give it more importance (or value) in life.

Federal Reserve Bank Building (Washington DC)
Federal Reserve Bank Building (Washington DC)

So the question asked is, why not mine more gold to make coins? Short answer: Because it is hard. Because of fractional banking, it is much easier to just print currency out of nothing than to mine gold and keep reserves in gold.

Consider this moot point (something that will be of prime important when we discuss Bitcoins):

Let’s assume Gold has never been mined on Earth before. Also, lets assume the total amount of gold on Earth is 100 kilos.

Now the 1st kilogram of gold to mine would have been pretty easy, it might just be lying around in the ravine (anywhere on Earth) or in the shallow riverbed or even protruding out of some cave.

The 2nd kilogram of gold is also easier to mine, but ever so slightly more difficult than the 1st kilogram. So on and so forth, gold is mined. Soon enough 50 kilograms of gold has been mined. This was the easy part. There still remains 50 kilograms of gold scattered across the Earth’s crust, either deep inside the ocean bed or some cave or mine that has yet to be explored. So, mining for the 51st kilogram takes more effort, and so on and so forth. The last few kilograms are conclusively extremely difficult to mine. So, in some weird way, Mother Nature has a way of making it harder to extract more gold, every time 1kilogram of gold was mined.

Considering mining, which is hard work, the Bankers already decided that since people are not really looking at gold as such (assume 100 years have progressed – no one in these years has actually seen the gold coins, they just use the deposit notes), they decided to rid themselves of this requirement to hold reserves in gold all together.

So, from now onwards, Bankers unanimously decided, all currency would be a flat currency and not a commodity based currency. In plain words, currency will be created by a government decree which specifically gives right to a specific organization (like the Federal Reserve) to print money and they, and they alone, can do it. All other forms of money printing would be banned (made illegal).

Workers inspecting sheets of money for printing flaws and smudges, circa 1917.
Workers inspecting sheets of money for printing flaws and smudges, circa 1917.

This is like wining a lottery and then wining it again and again for bankers. Take a few pieces of cotton, make them into notes, using some fancy ink, print some symbols, some portraits of politicians (or royalty or even monuments) and affix some numbers on it – Voila! You have money! Literally created out of nothing, and suddenly you have money for which everyone slaves day and night, through which trade is done, though which we are paid.

Between mining or printing money, guess what the Bankers choose? The latter of course!

So, to sum up…

  • Currencies are being created by Central Banks without being backed by any form of commodity or naturally mined valuable reserve. [Anything that is naturally mined is limited in quantity on Earth]. Such currencies are called Fiat Money.
  • The interest accumulated on this money is essentially the national debt. There is no possible way it can be paid back. That money just does not exist.
  • With no gold standards being maintained, governments print money when they need it (and borrow this from the central banks).
  • This additional supply of money into the money supply increases inflation, id est, the buying power of your money gradually declines. In fact it is always declining.
  • There is no easy fix for this problem. We cannot just abandon the monetary system we have in play today. Doing so will create a worldwide panic to a degree not fathomed by us.
  • Where is all the Gold? is a good question to be asked. Majority of the worlds gold today lies in private hands and is not owned by governments.
  • Every time a new Dollar, Euro or Rupee is printed, it is essentially a Debt instrument.
  • Unless you have somehow managed to live a life which in no way touches money, everyone who owns money is a debtor.

Comments

comments

2 thoughts on “Understanding Bitcoins: How Barter Became Banking”

  • Bitcoin remains a mystery to most individuals and investors too. The basic idea of a currency is something everyone understands up until now. Up until now it is issued by a sovereign state whether stable or dubious and its value is tied to a variety conditions within that state and formerly its stockpile of gold.

    Bitcoin’s point of reference for value is nothing but itself, and there is no single "authority" that has responsibility for its integrity such as a national bank or Federal Reserve. A good easy means to understand the definition of "currency" that easily encompasses Bitcoin would go a long way to providing it widespread credibility if such a definition is possible.

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