On Money – Part 1: It’s a Hack

Why does money exist?

We could point to the things we carry in our wallets and purses: cash, coins, and credit cards; but, throughout history and around the world, different things have been considered valuable.

It also doesn’t explain why money can be printed in abundance, and yet always be in limited supply; why some amass immense wealth, while others live paycheck to paycheck; or, why some economies barter, while others establish banks. Money is a bit of a mystery: it is inherently understood, but hard to explain.

In this four-part series, I will explore why money exists, why bitcoin is not the future, how cryptocurrency in developing countries is inevitable, and what one would have to do in order to build a global, world currency (and yes, I think it’s possible in our lifetime).

Let’s begin with why money exists. There are a number of answers to this question, but I favor one in particular. For me, money is not simply a medium of exchange allowing us to trade goods and services. Money is memory. It is an attempt to solve what our brains struggle to do in modern society: keep track of whom we can trust. Hence, as a heuristic, money is a hack.

The concept of memory in economic theory was first introduced in 1996 by Narayana Kocherlakota, the former President of the Federal Reserve Bank of Minneapolis and now Economics professor at the University of Rochester and an avid contributor to the Bloomberg View. In his seminal paper in 1996, Kocherlakota defended the theory that money effectively functions as a rudimentary form of memory.

In order to understand this point, let’s enter the small village of our ancestors. In this small village, every person can observe the conduct of their neighbors, record those actions, and retrieve those records before conducting trade with members of the village. This is memory. In the village, memory is subjective because everyone is aware of everyone else’s affairs, dealings, misdeeds, and accomplishments. It reminds me of Nathaniel Hawthorne’s novel, The Scarlet Letter.

In this 17th-Century Puritan Massachusetts Bay Colony, the heroine, Hester Prynne is forced to wear the letter “A” as a mark of her adultery. Hester is found wanting of purity by her community and thus, spends the rest of her life exiled in a cottage at the edge of town earning a meager living as a seamstress. The good thing about living in a small village is that a good reputation can buy you more than the material goods you can offer. Credit is as cheap as saying, “I owe you next time” because trust has been purchased through a history of good deeds. However, one’s reputation can also be severely tarnished with dire consequences, as in the case with Hester Prynne.

As we move from rural villages to agricultural settlements and then to urban cities, it becomes difficult to monitor the conduct of our neighbors, individuals whom we neither know nor trust. Our memories require an intermediary, something or someone who can help us determine if a person is running a current deficit or surplus with society. We begin to settle our transactions by offering symbolic objects – this is money (namely, cash) – to conduct business because “I owe you” is no longer an adequate medium of exchange, since devoid of any known history of commitment, they are meaningless words. As Francisco d'Anconia says in Ayn Rand’s Atlas Shrugged: “money is men’s protection” against the stranger.

Nowadays, our entire global economy is reliant on a few designated intermediaries to maintain the ledger of our increasingly complex balance sheet of trust. It’s like we’re all playing a game of Jenga where the blocks are wads of money. The most important players are our designated intermediaries, which include nation-states, banks, hedge funds, and venture capitalists. Each player is trying to feel their way around just enough to claim their block, sometimes at the expense of others; but rarely so, in fear that the entire apparatus will come crashing down.

Nations standardize and commoditize trust as a medium of exchange and call it currency. Banks allow people to make promises to pay debt outstanding upon demand or over time and call it credit. Hedge fund managers pool together debt from diverse payers (auto loans, house mortgages, credit card receivables, etc.) and call it asset-backed securities. Investors bet millions of dollars on entrepreneurs pattern matching against a thesis and a few qualifications, like whether one of the co-founders holds an engineering degree from a top-tier university, and call it venture capital.

All things considered, money does a pretty good job of ensuring trust –– until it doesn’t. For example, I recently went to an upscale restaurant in San Francisco to celebrate an anniversary with my girlfriend and I decided to use a new credit card for the bill. Minutes after the waiter took my card, he returned, and informed me that my card was denied. What happened here? The bank determined that based on its records – my financial history – it was unlikely that I would spend so much money at a restaurant, so it determined that I was the someone was impersonating me.

What my bank didn’t know was that I was out on a date so I was paying for two, that I preferred using my credit card for expensive tabs to maximize point accumulation, and that I had received my paycheck earlier that day so would immediately pay off the charge. In other words, the bank didn’t have enough recorded information on its ledger to trust my ability to pay; so it declined the charge. What was a lovely dinner ended with me having to swap out my preferred credit card with a less advantageous card, though this second card went through. It had more memory of my trustworthiness.

So what have we learned about the why money exists?

  1. In small villages, memory is subjective. Reputation goes a long way in ensuring trust with other people in the village because all of your actions are publically on record. The downside is that your name can be easily tarnished by gossip, rumor, and unjust accusations.

  2. As societies evolve, memory becomes mediated. An increasing dependency on intermediaries is necessary to safeguard our reputations. Money becomes a hack for a world where we move too fast and too far for our reputations to keep up.

  3. Yet, in both economies, information recorded about our identities can be misremembered or patently mistaken. It’s trite when our brains forget another person’s name or my credit card is denied; it’s tragic when an eyewitness misidentifies the perpetrator of a terrible crime or your identity is stolen.

Now that we’ve defined the purpose of money, let’s consider what the future holds. As a thought experiment, imagine if you were a store clerk and you had this uncanny gift of remembering every purchase made in the store, the price associated with the item, and the name of the person who purchased it. After every purchase, you logged this information into a public database using a coded numerical tag for each customer.

Let’s go a step further. What if everyone had this ability and similarly recorded everything they had ever bought or sold into a public ledger with sensitivity towards anonymity? This system wouldn’t be subjective because all transactions are flawlessly recorded by at least two primary witnesses. In addition, this system wouldn’t require mediation because all transactions are recorded on a public transcript. In summary, the future of money would be a system with objective memory and without monetary intermediaries.

As it turns out, until 2008, this was purely a theoretical exercise; then, bitcoin arrived. So what does this mean for the future of money? Well, many people think the future is here.

In part 2 of this series, we will explore if the buzz around bitcoin is warranted. As a sneak peak, I’ll say that it’s without question that bitcoin is an elegant hack for objective memory without monetary intermediaries but cool technologies don’t necessary scale and first movers rarely win the market. We will explore if bitcoin is the “killer app” for blockchain à la email for the internet; or, if there is something else to look forward to in the future. We’ll get to it — and a lot more — in part 2.