What I Learned in UC Berkeley‘s Blockchain Class
By: Josh Ephraim
Tags: Economics, Bitcoin, Blockchain, Uc Berkeley

What is money?

The first class started with a lecture from Greg La Blanc on the origin, purpose, and definition of money. He assigned On the Origins of Money by Carl Menger, published in 1892 (which is a little dense!). The main takeaway is that money is (1) a store of value, (2) a unit of account, and (3) a medium of exchange. I think this is the most important thing to take from day one. Also important to note is that money doesn’t need to be “backed” by anything, it’s value is that others value it.

He also assigned Island Money by Michael F. Bryan, which discusses the Yapese stone money called Rai stones. There is a NPR Planet Money podcast about this type of money too. Explorers took limestone deposits they found on an island hundreds of miles away from their village and carved it into huge stone discs. They brought the discs back across the sea on their small bamboo boats. They weren’t transportable at all so the value became something relatively abstract. The stones wouldn’t actually change hands but people would know whose stones were whose (sort of like a distributed ledger).

La Blanc mentioned a funny anecdote that one time the Yapese were bringing a disc back and the stone wound up on the bottom of the ocean, but the tribe said it was still valuable even though it was underwater.

Yapese stone money

The remaining assigned readings are Digital Currencies, Decentralized Ledgers, And The Future Of Central Banking, Some Simple Economics of the Blockchain by Christian Catalini, and Joshua S. Gans, and Is Bitcoin A Real Currency? An Economic Appraisal by David Yermack.

This class really focused on defining what money is and how it works. La Blanc went through a number of colorful examples of different types of money to illustrate that there is more to it than just paper dollars the government prints. There is commodity money, fiduciary money, commercial bank money, and fiat money.

La Blanc started off by defining a bank as an institution with loans (assets) and deposits (liabilities). But before there were banks there was money. Why was there money? Because it’s easier to exchange goods and services for money than it is for buyers and sellers to barter directly. Bartering works really well if there are only two commodities available, but if you get more complicated than that, having a currency is much more efficient.

Edgeworth Box

So when there are more than two commodities to trade, societies usually pick some sort of commodity money. Commodity money is anything that is fungible, durable, portable, uniform, limited in supply, acceptable, and divisible. Gold, silver, copper, grain, cowry shells, wampum, cigarettes, etc. can all be commodity currency.

Properties of commodity money

Then La Blanc shifted to the difficulties of money. It’s sometimes dangerous and difficult to carry, difficult to measure, and costly to produce. Bringing the Yapese stone money back to Yap was really dangerous and people even died in the process.

So why not pay with an “I Owe You”? An IOU, or in another word, credit, is great if you trust the person that gives you the IOU. Credit is great when you want to buy something but you either don’t have the money now or prefer not to carry or spend it. The limit of IOU’s is that the seller must know and trust the buyer. In addition, if the seller knows a third party that knows the buyer, credit can also work. Banks initially played this third party role where if a buyer is a stranger to the seller but the bank knows the buyer, that bank can vouch for the buyer with a “bill of exchange.” A bill of exchange is a letter from the bank saying, “yes this buyer has this money with us and we’ll give it to you, the seller, if you come to us with this bill of exchange.” Therefore, if you are the seller you can go to the bank to get your money from the buyer.

When everyone trusts that third party bank, then that is fiduciary money. The issuer of fiduciary money promises to exchange it back for a commodity or fiat money if requested by the bearer. As long as people are confident that this promise will not be broken, they can use fiduciary money just like regular fiat or commodity money. For example, checks are fiduciary money.

La Blanc also discussed how a bank creates money, sometimes known as commercial bank money. Commercial bank money is created when banks use fractional reserve banking to issue loans worth multiples of the actual currency they hold (current US reserve requirements are around 1/10th). When a bank lends out money which it does not actually have, that money generated only exists on paper.

What is fiat money?

US Consitituion

In the US, congress has the power to coin money and regulate the value thereof. Fiat money is currency that a government declares as legal tender, and is not necessarily backed by a specific commodity. The value comes from the relationship between supply and demand rather than the value of the material it’s made of.

Connecting this to blockchain technology

La Blanc argues that all currencies are tokens on a larger scale. Poker chips are currency within a casino. You trade in your money for chips, and when you’re done, you can cash out into the currency you came in with. Going to another country works pretty much the same way. If you go to France you get Euros to buy things while you’re there, and when you’re done with the Euros, you can turn them back into dollars. I think the implication here is that when you’re talking about crypto tokens, you’re really talking about a type of money.

I wonder how La Blanc would say utility tokens fit in, since they are services or units of services that can be purchased. I think this is different from coins or cryptocurrencies, which are simply digital currencies where encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds. But perhaps this is why he mentioned Ithaca Hours, which are a currency that has been used in Ithaca, New York and is typically used to pay for one hour of a service.

Ithaca Hours

With Ithaca Hours, one problem was who would be willing to work for the first Ithaca Hour? If you did work for the first Ithaca Hour, how would someone pay you if they had not worked for their Ithaca Hour? La Blanc says for Ithaca Hours they ended up doing a “helicopter drop” to get the system started. Crypto faces the same issue. Bitcoin and Ethereum are currently Proof of Work coins, similar to gold and silver that’s mined, or even the Yapese stones. The first units are generated through mining. But initializing a system without Proof of Work is difficult. Some ICO’s have used “Air Drops” where they randomly deposit coins to compatible wallets. Ethereum plans to switch from a Proof of Work system to a Proof of Stake, where a person is selected at random to validate a transaction and paid a mining fee. This could enable them to avoid this initialization problem because there is already a network of users and miners.

La Blanc also discussed the economic inspiration for Satoshi Nakamoto’s Bitcoin white-paper, Friedrich Hayek. Hayek was a Nobel Laureate in Economics, and theorized that we would not have inflation if we had a choice in the currency we use. Bitcoin in theory could be a way to do this. But at the moment, Bitcoin and other cryptocurrencies are not good currencies because they are inferior to others as mediums of exchange, stores of value, and units of account. Maybe at some point cryptocurrencies will do these things better than our other options.

I wish he spent more time on this, but right before we ended we briefly discussed the Quantity Theory of Money. In the long run, the price level moves in proportion to the money supply. We can use the equation MV=PQ to find the “right” price level. M is the monetary base, V is velocity (the number of times a currency changes hands within a particular time frame), P is the average price of a basket of goods, and Q is the quantity of the asset (digital or otherwise) which should be publicly available in cryptocurrencies as well as traditional ones.