“Give me control of a nation's money and I care not who makes its laws." – Mayer Rothschild
This week we continue our series of posts inspired by our recent talk entitled Decrypting Cryptocurrencies. These first four weeks we’ve spent all our time looking at money since we must first understand it before we can even try to begin to understand cryptocurrencies. First we came up with a definition for money. Then we looked at the history of money before discussing the characteristics of good money using something we called the moneyness test. We determined that one of the most important aspects of good money is that it is widely accepted. In this week’s post we’ll look at why certain forms of money, such as the US Dollar, are much more widely accepted than others.
In our first post we talked about how money has implied value due to a society wide networking effect. In other words, I want to acquire money because I know that other people I interact with assign value to it, which in turn makes it valuable to me. But what we didn’t explore in the opening post was why certain types of money benefit from the networking effect while others don’t. To answer that question, we must first understand the hierarchy of money.
The hierarchy of money is used as an illustration to show how money can exist at multiple levels in society, but the money which is accepted on all levels is the best. At the bottom level we have households, which can create money in the forms of IOUs or handshake commitments. My neighbor might “owe me one” because I cut his grass one afternoon after I noticed it was getting a little long. That might be all well and good and maybe next week he trims my trees to repay the favor, but the fact of the matter is I can’t take the “one” that he owes me and use it to settle any debts or pay for anything else of value. As such, the money I’ve created with my neighbor has limited use and acceptability.
The next level up is money created by private businesses. We’ve already referenced how this was common place when paper money was first introduced in Europe and was actually the norm here in the US up until the Civil War when the US government decided to centralize its currency by placing an excise tax on any other forms of tender. But we don’t have to go back hundreds of years to see examples of businesses creating their own money. A perfect modern day example is airline miles. Airline miles were created as a way to reward customers for their loyalty. They can be used to acquire a number of different things including flights, car rentals and hotel stays but everything has to be run through and is dictated by the issuing airline company. I may even be able to use my miles to settle household level debts or purchases if the person on the other end of the transaction assigns value to my miles, but I can’t use my miles with any other non-partner businesses or to settle any obligations I may have to the US government. As such, airline miles are definitely a form of money and do hold value, but they too are limited by their acceptability.
And that takes us to the pinnacle of the hierarchy which is the government and its chosen medium of legal tender. Typically when a government creates and regulates its own legal tender, it becomes the defacto currency. In the case of the Iraqi Dinar, which we also referenced in that first post, the old dinars continued to enjoy the benefits of the networking effect because the Iraqi citizens placed little trust in Saddam Hussein being a good steward of the newly issued Saddam Dinars, but this is much more the exception than the rule. The reason legal tender becomes the defacto currency and the largest benefactor of the networking effect is because it is the only form of currency which is accepted across all three levels of the hierarchy.
Here in the US, the government is able to create and perpetuate the network effect for the US Dollar by making it the only acceptable form of legal tender to settle all debts and tax obligations. Since taxes are recurring liabilities, households and businesses will continuously need US Dollars. If a business owner or individual knows they have a tax obligation to the US government that must be paid in US Dollars, they are highly incentivized to accept and transact in US Dollars versus any other type of money. This is the true genesis of the networking effect and why the US Dollar is the most widely accepted form of money here in the US. The government’s power to levy and collect taxes makes it virtually impossible to unseat the legal tender as the defacto currency without some sort of anarchic shift or radical change in the current form of government. This is why Mayer Rothschild, the founder of the Rothschild banking dynasty, emphasized the power of controlling money in the opening quote.
And with that stage set, we now turn our attention to cryptocurrencies. What are they, how do they work, where did they come from and are they money? We’ll address these questions and more over the next several weeks.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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