Money and Bitcoins part 1: What is money?

Bitcoin has been in the news a lot lately. I’ve been trying to ignore it, even though lots of people have sent me questions about it.

In the last couple of days, Bitcoin has been in the news even more. Mtgox, one of the major companies associated with bitcoin has gotten into serious trouble. It’s not entirely clear what exactly is going on, but it appears that mtgox lost a massive quantity of bitcoins. As a result, they’re almost certainly going bankrupt, and a whole lot of people are about to lose/have already lost a huge amount of money. This burst of news about mtgox has turned the trickle of questions into a flood.

In order to shut you all up, I’m going to try to answer the questions. I started off working on one post, but it’s gotten out of hand – over 5000 words, and not finished yet! Instead of just posting that monstrosity as one gigantic mega-post, I’m splitting it up into several posts.

To understand bitcoin, first you need to understand what money really is. That’s going to be the focus of this post: what is money? And how is bitcoin both similar to, and different from, other things that we call money?

Money is, ultimately, an elaborate shell game. Currency is a bunch of worthless tokens that we all agree to pretend are worth something, so that we have some way of exchanging valuable things in a reasonable, fair, and easy way.

To understand that, let’s start with a really simple scenario. We’ve got two farmers: Will grows wheat and turns it into flour, and Pam raises pigs and chickens. Will has lots of wheat, so he can grind it into flour and make bread – but he’d also like to be able to have some bacon with his toast for breakfast. Pam, meanwhile, has all the bacon she can eat (lucky lady!), but she’d like to have some bread, so that she can make a BLT for lunch.

There’s an easy solution. Will goes over to Pam’s place, and offers her some bread in exchange for some bacon. Between them, they figure out how much bread is worth how much bacon, and make the trade. And hurrah! both are happy. This is simple barter – no money needed.

Things become more complicated when we add more people to the story. We can add Mary the miller who gets wheat from Will and grinds it into flour, and Bob the Baker who gets flour from Mary and bakes it into bread. Now the process of making bread has gotten more elaborate: the person who grows the wheat is no longer the person who sells the final product to the pig-farmer!

Now if Will wants his bacon, it’s harder. He has wheat, but Pam doesn’t want wheat, she wants bread! As long as Mary and Bob both like bacon, this can be made to work. Bob can go to Pam, and trade bread for her bacon. Then he can take some of the bacon he got from Pam, and give it to Mary in exchange for flour. Mary can take part of the bacon he got from Bob, and give it to Will in exchange for wheat. Then Mary, Bob, and Will all have their bacon, and Pam has her bread, and everyone is happy. We’re still in the land of barter, without any money, but it’s getting difficult, because everything is stuck going through intermediaries.

This works, as long as everyone in the chain is happy with bread and bacon. But as things get more complicated, and you get more people involved, you get situations where you have people who want something that they can’t easily trade for what they have. We could add Phil the plowmaker to our scenario. Phil makes the best plows you’ve ever seen. If Phil wants to get some wheat, he’s in great shape: Will would love to get one of Phil’s plows to plow his fields. But Phil doesn’t want to deal with freshly harvested wheat – he wants bread and Bacon! That means he’s got a problem: Pam has no use for a plow, and neither does Bob. In order to get bread and bacon in exchange for his plows, he somehow needs to get something that Pam and Bob want. He’s not part of the chain from Will to Pam.

If you’re sticking with barter, then poor Phil has a very complicated problem. He needs to go to Pam, and figure out what she wants in exchange for bacon – she could say she needs a new butcher’s knife, and she’ll trade that for bacon. So now Phil needs to find someone who’ll trade a plow for a butcher’s knife. He can go to Kevin the knifemaker, and see if he’ll take a plow. If Kevin doesn’t want a plow, then he needs to find out what Kevin wants, and see if he can find someone who’ll trade a plow for that. He’s stuck running around, trying to find the sequence of exchanges that give him what he wants. If he can’t find a chain, he’s stuck, and he’ll just have to give up and not have any bacon, even though he’s got beautiful plows.

The solution to this mess is to create create a medium of exchange. You need to create something which has a symbolic value, which everyone is willing to trade for his or her stuff. Will his wheat for little green pieces of paper. Pam exchanges her bacon for little green pieces of paper. Phil exchanges his plows for little green pieces of paper. The little green pieces of paper are completely worthless themselves – they’re just green paper! But everyone recognizes that other people want them. Because the other people want them, they know that if they take some, they’ll be able to use them to get stuff from other people.

For Phil to get his bacon, there’s still got to be some chain: he exchanges his plow for some green paper; he goes to Pam, and gives her green paper in exchange for the bacon. Pam uses that green paper to get stuff she wants. The chain is still there: ultimately, what Phil did by giving Pam the green paper is give her something that she wanted. But instead of needing to find a concrete product or service that she wanted, he was able to give her symbolic tokens of value, which should could then exchange for whatever she wanted.

That’s what money is. It’s a symbolic medium, where we all agree that the symbolic tokens are worth something. The tokens only have value because we believe that other people will also take them in exchange for their stuff/their work. And because we believe that, we’ll take them in exchange for our work. When we do this, we’re simultaneously being perfectly rational and completely delusional. We’re trading the products of our work for something utterly worthless, because we’ve all agreed to pretend that the worthless stuff isn’t worthless.

Of course, when you’ve got valuable stuff moving around, governments get involved. In fact, governments exist largely to help make it safe for valuable stuff to move around! Money ends up getting tied to governments, because the governments exist in large part specifically to provide an enforceable legal system to manage the exchange of money.

In todays world, money is just a set of tokens. If you go back a hundred years, all over the world, people had what they believed what a different idea about money. Money was backed by gold. If you had a dollar, it wasn’t just a green piece of paper. It was a lightweight representation of about 1.67 grams of gold. You could go to the government with your dollars, and exchange them for that quantity of gold. According to many people, derogatorily called goldbugs, this was fundamentally different from todays money, which they call fiat currency, because it was backed by a tangible valuable asset.

The problem with that argument is: why is gold any more valuable than green paper?

Gold is valuable because it is a pretty yellow metal, incredibly malleable and easy to work with, non-corrosive, and useful for a wide variety of artistic and industrial purposes. It’s also relatively rare. In other words: it’s valuable because people want it. It’s not valuable because it’s tangible! No one would say that a currency backed by rocks is intrinsically more valuable than a so-called fiat currency, even though rocks are tangible. People don’t want a lot of rocks, so rocks aren’t worth much.

Now we can finally get around to just what bitcoin is.

Bitcoin is a currency which isn’t backed by any government. In fact, it’s not backed by anyone. It’s a fundamentally decentralized system of currency. There’s no central authority behind it. Instead, it works based on an interesting protocol of computation over communication networks. Everything about it is distributed all over the world. You could pick any individual computer or group of computers involved in bitcoin, blow them to bits, and bitcoin would be unaffected, because there would still be other people in the bitcoin network. It’s all driven by distributed computation. A bitcoin is an utterly intangible asset. There is no coin in a bitcoin.

I’ll go into more detail in my next post. But the basic idea of bitcoin is really, really simple. There are a bunch of computers on the network that are keeping track of bitcoin transactions. Between them, they maintain a ledger, which consists of a list of transactions. Each transaction says, effectively, “X gave N bitcoins to Y”. The only way that you can own a bitcoin is if, somewhere in the ledger, there is a transaction saying that someone gave a bitcoin to you. There is no coin. There is no identifying object that represents a bitcoin. There’s not even anything like the serial number printed on a banknote. There is no bitcoin: there is just a transaction recordin a ledger saying that someone gave you a bitcoin. There is absolutely no notion of traceability associated with a bitcoin: you can’t take a bitcoin that someone gave you, and ask where it came from. Bitcoins have no identity.

The point of it is specifically that intangibility. Bitcoin exists largely as a way to move valuable stuff around without the involvement of governments. Bitcoin is, really, just a way of making a computationally safe exchange of value, without transferring anything tangible, and without any single central authority in control of it. You know that someone gave you money, because there are thousands of computers around the world that have agreed on the fact that someone gave you money.

Obviously, there needs to be some technical muscle behind it to make people trust in those unknown entities managing the ledgers. We’ll talk about that in the next post.

What’s amusing about bitcoin is that in many ways, it’s no different from any other kind of money: it’s absolutely worthless, except when people agree to pretend that it isn’t. And yet, in bitcoin circles, you’ll constantly see people talking disdainfully about “fiat money”. But bitcoin is the ultimate in fiat: there’s nothing there except the ledger, and the only reason that anyone thinks it’s worth anything is because they’ve all agreed to pretend that it’s worth something.

11 thoughts on “Money and Bitcoins part 1: What is money?

  1. John Armstrong

    The best introduction to the idea of money — and some of its problems — I’ve seen is, of all things, Raising Hope season 4, episode 2: “Burt Bucks”. Unfortunately it’s old enough you can’t get it on hulu without hulu plus.

  2. Ryan Williams

    Hey Mark, thanks for this, I’m looking forward to reading subsequent posts!

    I’m not sure what you mean by “bitcoin is the ultimate in fiat”; in my experience the bitcoin-boosters who speak disdainfully about fiat are referring primarily to fiat currencies’ ability and tendency to be inflated for political ends, which bitcoin is in fact immune to.

    I’m not sure how there being “nothing there except the ledger” makes it fiat-like. My understanding is that being controlled by a government is a necessary condition of being a fiat currency:

    1. markcc Post author

      Hey Ryan! Good to see you here!

      Terminology around this stuff inevitably gets caught up in the political squabbling, so it’s tricky.

      The definition that I’m using is that fiat currency is fiat because there is no tangible asset behind it. We accept that it is currency because some authority declared that it’s currency, and transactions performed in an appropriate way will be legally acceptable.

      Bitcoin claims to be different from that. But it’s hard to really see how. Some group of people got together, worked out the bitcoin protocol, and said “this is money”. They declared a set of rules: “A transaction is valid if and only if it follows the rules that we made”.

      If that’s not fiat, I don’t know what to call it. The only difference is that instead of having a government making the rules governing transactions, there’s a loose collection of agents doing it. But they control the bitcoin supply, by controlling the way that bitcoins get created, and by controlling the protocol governing bitcoin transactions.

      1. Shane Stringer

        The state has the power to declare a medium of exchange legal tender, to control its issue, and to mandate that it be accepted as payment for debts. This is what makes that medium fiat currency, not the fact that there are rules for well-formed transactions; any medium of exchange must have those.

        1. Dale

          It’s the lack of intrinsic value (and hence, convertibility) that makes a currency fiat, not government backing. Not all legal tender is fiat, and not all fiat is legal tender.

          1. markcc Post author

            Thanks – that’s my understanding as well.

            The control factors are part of being “legal tender” – that is, of being part of a legal regime. The “fiat” is just “this has value because we say that this has value”.

  3. Brian Slesinsky

    Regarding your point about “governments exist largely to help make it safe for valuable stuff to move around,” I think this Hacker News post said it best:

    “There are two sides to a transaction: the transfer of money in one direction and the transfer of goods or services in the other. Making one side very secure (or free from government intervention etc.) while neglecting the other is like building a bridge with one pillar made of tungsten and the other of adobe bricks. It’d only be as usable as its weaker side.
    The existing financial system is perhaps suboptimal in terms of transferring money, but it has pretty good tools of ensuring the expected goods and services flow back to the buyer […]”


  4. curmudgeon

    Another big difference between fiat currency and bitcoin: Fiat currencies are truly scale-free. A government that’s too leveraged could, in principle, inflate away it’s debt by creating a ton of new money. Double the money supply and the value of existing debt, measured in big macs or barrels of oil, will be halved. This can’t happen with bitcoin because there is, by construction, a finite amount of bitcoin that can ever exist.

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  6. Joker_vD

    Eh, you’ve forgotten to mention one more difference between gold and green paper: producing more gold is way harder than producing more green paper. If you have 1000 tons of gold, and you need 2000 tons of it, well, your only option is to go and pillage some neighbours.

    Also, the idea of currency being backed by gold only is… hm. Soviet ruble, for example, was backed by the whole USSR’s property: that’s literally what was being printed on it.

    Anyway, that was a nice retelling of the chapter I of Marx’s “Kapital”.

  7. Corey

    I’m not a bitcoin booster (I’m all for central banking, in fact), but it’s worth repeating Ryan Williams’s point: when bitcoin enthusiasts speak disdainfully of fiat money, it’s because they don’t trust the agents who get to pronounce “fiat pecunium!” over pieces of paper. If you get distracted by the label “fiat money”, or even by the issue of commodity backing, you’ll be talking past bitcoin advocates and displaying your ignorance of their actual arguments (however foolish those might be).

    Whether you want to call bitcoin fiat money or something else (I’ve run across the term “factum money”), the whole point of bitcoin is that the supply of bitcoins is not under control of an agent with incentive to mess with it — the supply of bitcoins will top out at 21 million, period. This makes it somewhat similar to gold-backed money, in that there is a fixed amount of gold in the world, and (barring nuclear reactions) there’s no way for anyone to make more of it.


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