Crypto and Fiat Currencies Are Essentially Different, Here’s Why
One of the essential narratives of Bitcoin (BTC) since creation is the oft-stated aim of separating money from state. While this has certainly been a strong creed driving the currency’s early adoption by the crypto-anarchist and techno-libertarian communities, what does this actually mean? How crypto system differs from fiat one? It’s quite simply a call for a neutral form of money.
Putting aside political messaging, Bitcoin is basically the introduction of a credibly neutral, global system of value transfer which is open and permissionless yet cryptographically secure and verifiable. This flourishing crypto economy is still relatively early in its development, yet in the ten-plus years since its launch, it has significantly altered the discourse around what money could or ought to become in the future.
Bitcoin’s third halving on May 11, a 50% cut in the BTC block rewards that miners get for validating transactions and securing the network, shows an acute difference between fiat monetary systems controlled by whim and crypto monetary systems executed through software. A global crisis like the one we’re struggling with now is a crucible for any monetary system, often revealing what the priorities of the powers that be are.
The ability to print money endlessly in the fiat world represents a harsh contrast to Bitcoin periodically decreasing the issuance with an unchangeable monetary policy. The Bitcoin halving in the discourse of the pandemic offered an interesting starting point in contemplating the principal difference between the fiat and crypto systems and the distribution of power in both.
Fiat monetary systems
The key global monetary systems are fiat systems supported by the sovereign entity of the state via arbitrary decree. Such currencies have value because the state enforces their use as a medium of exchange, store of value and unit of account: the three qualities of money. The most obvious evidence of this enforcement is that the state requires taxes to be paid in the national currency.
This relationship between state authorities and money dates back hundreds of years to when governments and empires would carve the visage of the current ruler of the territory into the hard metal currency. Today, fiat money exists in the form of pieces of paper printed by a central mint controlled by a state department. This money is supported by the state rather than any commodity.
The United States used to stick to a gold standard, with bank notes backed and redeemable for precious metal reserves, but when people flocked to a secure store of value in gold during the Great Depression the government decided to untether the dollar from the underlying commodity. The systemic challenges of a monetary system based on gold would have inevitably led to the state further abstracting the connection to the underlying resource to the point where the scaffolding would have become the building, in a sense. In short, fiat currency can be viewed as a technical response in simplifying the management of money at great scale.
There is a host of various of fiat currencies circulating throughout the global economy, but only one has obtained hegemonic status: the U.S. dollar. After the end of World War II, an agreement entitled the dollar as the global reserve currency. Even though the agreement suggested that the dollar would be backed by gold and thus ended when the gold standard was abandoned outright during the Nixon administration, organizations like the International Monetary Fund and the World Bank were created to support a neutral, international monetary system — revolving around the dollar.
As the government can print pieces of paper supported by nothing but the power afforded to it by itself, people place a lot of trust and responsibility in the government to adequately control the mint and avoid economic instability. If a government prints too much money, inflation occurs, steeply devaluing the value of the money in the economy. Some governments have severely mismanaged the money supply, leading to hyperinflation where the volatility for the price of a country’s currency against other global currencies starts to decrease rapidly, eventually becoming more valuable as kindling or paper-mache than a reliable medium of exchange.
Does this make the state a boogeyman that chains the people into arbitrary financial systems that they can’t break out of? There are certainly many advocates of Bitcoin that would support that claim, but let’s consider the bigger picture. The reason why state-managed currencies gained traction is because people agreed to the unwritten social contract behind the money, entrusting the state to manage the complexities of such a system. This issue of trust is significant and is essential to understanding what Bitcoin brings to the table.
The Bitcoin paradigm
While fiat monetary systems operate monetary policies determined by what the lawmakers believe is necessary, Bitcoin and other cryptos are decentralized, autonomous monetary systems with rules hardcoded from their launch. Programmable, predictable and trust-minimized from the first day, cryptocurrencies are radical experiments in value creation and distribution enforced through an unrivaled display of digital certainty.
Bitcoin’s monetary policy is unique because it is based on the open-source software rather than a central mint operated by treasurers and politicians. Its core features include a capped supply of 21 million BTC, around 10-minute block times, an incentivized issuance mechanism for minting BTC and an adaptive mining difficulty to maintain this economic schedule.
A crucial part of Bitcoin’s monetary policy, the halving, is a periodic change to the BTC supply schedule which takes place every 210,000 blocks, or approximately every four years. This preprogrammed, automatic deflationary measure is unprecedented in the history of money and constitutes a drastic difference to the dominant fiat systems of the world.
These protocol design features, merged with innovative economic incentives and cryptographic security, allow Bitcoin to possess four principal attributes: resistance to confiscation, resistance to censorship, resistance to counterfeiting and resistance to inflation. Or to put it simply, resistance to the very failings that have plagued monetary systems past and present.
So, where does this place Bitcoin and other cryptos in relation to fiat currency systems? While many narratives have been around for years — electronic cash, “End the Fed,” digital gold, “bank the unbanked,” etc. — the most relevant one at the press time and perhaps moving forward is the concept of money neutrality.
Currency in crisis
The subject of money neutrality is a part of a much larger discourse — the distribution of power in society. The circulation of currency reflects the overall health of the economy and its participants. If resources such as currency are not widespread or accessible in different strata of society, pathologies develop — much like disrupted blood flow in a human body.
The true crucible for complex systems such as money or the economy is how they adapt to crises. The sudden arrival of crises — unprecedented or severely ignored — tends to disclose the inherent weaknesses within our infrastructure and where the priorities of the powers that be truly lie.
Quantitative easing and the hierarchy of money
Within a few months, the ongoing coronavirus pandemic has crashed entire economies, supply chains and various systems that support people’s health and well-being. Much of the core infrastructure of society has been and will be disrupted by the first- and second-order effects of the virus.
In times of crisis, like a current recession or potential risk of inflation, governments will start a monetary policy known as quantitative easing, or QE, in which the central bank prints a huge amount of money and injects it into the economy by purchasing financial instruments such as stocks, bonds and others. While the goal is to keep the economy up and running by sticking to target inflation levels, ensuring the stability of the monetary system and securing citizens’ trust in the currency, it can result in increased inflation and distrust in the currency, even making cryptocurrencies appear a viable alternative to investors and the populace alike.
A large part of the U.S. government’s multitrillion-dollar stimulus package is relying on QE to stop the precipitous drop in the market. In doing so, the government is preferring large corporations over small to medium-sized businesses — which have limited loan programs — and the millions of individuals and families adversely affected by the pandemic set to receive a single $1,200 check (at the press time). Why does it appear that the government is prioritizing bailing out banks and corporations, printing trillions of dollars to do so, rather than ensuring the well-being of its citizens first and foremost?
To no small degree, the loopholes of the legacy financial system are a system design problem. A specifically useful framework for comprehending how the situation came to this point is the Cantillon effect, an 18th-century theory developed by French banker and philosopher Richard Cantillon that states the printing and distribution of money and wealth in society often follows a top-down hierarchy of institutions before reaching the common people.
The financial systems and intermediaries at the top of the pyramid in closer proximity to the rulers run better than the disjointed and inefficient systems further down the chain. Thus the rich have initial access to new money by design, with the value eventually distributed down to everyone else over time — something that many do not have. This is an easily observable phenomenon of a legacy financial system that favors Wall Street over Main Street.
Consistency in chaos
While fiat systems are controlled entirely by their overseers, cryptocurrencies such as Bitcoin are governed solely by the execution of software that stems from high mathematical certainty. While fiat systems as implemented by the U.S. government are showing significant strain and favoritism amid a global crisis, the economic clock of Bitcoin and other cryptos is ticking without interruption in a series of predetermined protocol upgrades of its supply schedule based not on a whim but by programmable design since launch.
Bitcoin halving is the antithesis of the quantitative easing monetary policy of the fiat world. Rather than quickly inflating the supply of money, Bitcoin’s monetary policy cuts down the issuance of the BTC currency in specified intervals of time in a process some have called “quantitative hardening” or “quantitative tightening.” The entire ecosystem of stakeholders in the Bitcoin space — the miners, traders and holders — have to adapt to the rules of this software, never the other way around.
However, there are some points to consider in analyzing the distribution of power in the Bitcoin network and its neutrality. Firstly, if we take a look at Bitcoin through the lens of the Cantillon Effect, we can indeed see a hierarchical distribution of value in motion. While the network is distributed and decentralized, as opposed to the fiat system with a literal central bank, the issuance of Bitcoin goes through certain intermediaries before it can circulate freely: the miners.
The block subsidy is not only the economic incentive for miners to allocate considerable resources in securing the network but also the minting process for the currency itself. The first new Bitcoin in existence is held by miners as they compete to solve the proof-of-work algorithm. While the sell rate differs according to business models, operating expenses, capital expenditure costs and so on, Bitcoin does not circulate until miners sell it into the open market, which is in turn rife with speculation.
Miners are theoretically the only entities capable of compromising the network through collusion with over 50% of the hash power. While there are strong economic incentives in place to prevent this from occurring, it is necessary to admit that the distribution of power — in a literal sense as well — strongly favors these particular actors in the network.
Also, it can be argued that having an absolutely immutable monetary policy can produce complications down the line. Certainty and determinacy are unique and powerful features of Bitcoin and other cryptocurrencies, but this does not defend the system from unpredictable volatilities and distortions in the future.
For instance, in the realm of chaos theory, there is the notion that seemingly deterministic systems can shift to disorder or chaos because they are highly sensitive to their state of initial conditions. In the context of Bitcoin, the proof-of-work model could perhaps lead to further consolidation and monopolization of the network such that its decentralization and distribution is minimized to a cartel of industry players. Moreover, the pyramidal distribution of wealth in the crypto ecosystem may also repeat the sins of fiat.
A benefit of an open-source financial system is that such discourse around Bitcoin’s resilience can enrich and influence its ongoing development. While it may not adapt fast, it will ultimately do so through a global consensus.
Is Bitcoin a completely neutral monetary system? Not yet. It is, however, the crest of a powerful techno-social movement that aims to build credibly neutral systems that support lives and well-being. In an era of uncertainty, a crypto monetary system owned and maintained in common by a global network of peers and bound by a shared set of rules could become increasingly attractive as the cracks begin to show within the fiat legacy structures to which humanity has become accustomed.