Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks: Here is the short summary. We need: More tokenization Crypto credit-money...
Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks:
Here is the short summary. We need:
In the previous article, we looked at what influences the fiat economy's interest. The focus of this article is the crypto economy. We have three parts here: 1. We look...
In the previous article, we looked at what influences the fiat economy’s interest.
The focus of this article is the crypto economy. We have three parts here:
1. We look at the same factors, which are influencing interest in the fiat monetary system:
The individual’s preferences to consume, invest or borrow
The individuals preference short term versus long term borrowing or investment
Rate of base-money production/destruction in the economy
Rate of credit-money production/destruction in the economy
The proximity of individuals to the “money creation” in society
2. We calculate how much should be the base interest (interest without the credit risk) in the crypto economy.
3. In the end, we compare the fiat monetary system with the crypto monetary system. We see as well, which system benefits which segments of the population.
1. Consumption preferences
Consummation preferences are presumably the same as in the fiat economy.
However, crypto users are rather younger generations / Millenials, which are characterized by relatively low saving rates and higher consummation preferences. i.e. the demand for borrowing is bigger than the demand for lending. This factor translates into higher interest.
2. Time preferences
Time preferences for crypto users are very similar to consummation preferences. This factor translates into higher interest as well.
3. Rate of base money creation /destruction
Rate of base-money production/destruction – Bitcoin, Ether, Dash, Litecoin, etc. have built-in growth mechanisms/inflation mechanisms, where miners are getting paid with the freshly minted crypto-coins for providing the infrastructure for the decentral networks.
These platforms are open source platforms, but the costs for running network infrastructure (hardware, bandwidth, and power) are real and they need to be financed. The built-in inflation mechanisms are the solution for financing the real network infrastructure costs.
This crypto-monetary expansion is at the moment following:
For example – Bitcoin monetary inflation is 4.29% per year and Litecoin monetary inflation is 8.41% per year.
4. Rate of credit money creation /destruction
Rate of credit money production/destruction – today’s fiat credit money – the commercial banking money, which is 90% of the total money – this is missing at the moment in the crypto economy. The crypto economy has only base-money. The crypto sector does not have credit-money yet.
The credit money has been around for the last 5’000 years, the first instances of the credit money are known from Mesopotamia and it was created in the peer to peer transactions. Credit money was created in peer to peer way for the first 4’700 years until the commercial banks started to emerge ca 350 years ago.
Then the “private credit money” of the commercial banks emerged and after the introduction of central banking, we arrived into our current “central credit money” incarnation.
Let’s put this in the perspective – our current fiat monetary system is 100 years old; the credit-money exists in different incarnations for the last 5’000 years. As credit-money has been around so long, we support the thesis, that it will emerge as well in the crypto sector.
5. Store of the value function
The store of value is very strong in Bitcoin. It’s called as well the “digital gold”. Store of the value function is present in other crypto-currencies as well, but less strong than in the Bitcoin.
Crypto-currencies are not manipulatable by the central instances as the base-money or credit-money in the fiat economy. This missing manipulation is the basis for the store of value in the crypto monetary system.
As there is no-manipulation compared with the fiat monetary system, then this results in higher demand for the crypto-currencies, which translates into higher interest.
6. Proximity to the money creation
Proximity to money creation – base-money is created by decentral means and it finances the miner’s operations. Decentral credit-money is still missing in the crypto sector, but it should be the only question of time until it will emerge.
If we decentral credit-money will emerge, then the proximity to money creation will equalize between the wealthy and the un-wealthy. It’s not only corporates and wealthy, who will be privileged, but everyone will be privileged to receive crypto credit or credit-money.
7. Summary of Factors
Here is the summary of the factors for the crypto-interest:
Factor
Comment
Consummation preferences
Results in higher interest than the equilibrium
Time preferences
Results in higher interest than the equilibrium
Rate of base money growth
Bitcoin base-money is growing 4.29% per year; other main crypto-currencies are in the same area. It is less compared to the fiat world.
Rate of credit money growth
Credit money is yet missing in the crypto sphere. The total money growth ratio is therefore equal to the base money growth ratio.
Proximity to money creation
Market participants will have the same proximity to money creation. No-one has an advantage compared to the others
Store of the value function
High store of the value function, especially for the Bitcoin
8. How much should be the interest in the crypto sector?
The following will answer the key question of this article – how much should be the base interest for the crypto sector – we look at this at the example of Bitcoin and Ethereum.
Factor
Bitcoin
Ethereum
Consumption preferences
Younger population results in higher interest
Younger population results in higher interest
Time preferences
Younger population results in higher interest
Younger population results in higher interest
Rate of base-money growth
4.29% per year
4.64% per year
Rate of credit-money growth
0.00% – it’s missing at the moment
0.00% – it’s missing at the moment
Store of the value function
High store of the value function drives the interest higher
Medium store of value function has a positive impact on the interest
Base interest per year
7% – 8%
6% – 7%
These would be the estimated base rates for the crypto base interest rates. I.e.if lending crypto, then the interest rate should start from this area.
9. Comparison fiat interest rate versus crypto interest rate
This table summarizes the above discussion:
Parameter
Fiat money
Crypto money
Consumption preferences
Less impact than in the crypto sphere
Rather younger populous implies higher consummation preferences, resulting in higher interest
Time preferences
Less impact than in the crypto sphere
Rather younger populous implies shorter time preferences, resulting in higher interest
Rate of base money growth
300% to 1’000% depending on the central bank in the last 12 years
4% – 8% per year depending on the crypto
Rate of credit money growth
6% of total money growth per year
0.00%
Proximity to the money creation
The ones with high proximity to the money creation have preferred terms
No preferred segments
Store of the value function
Low store of the value due to continuous monetary inflation
High store of the value
Fiat money is inflationary money, with a low store of the value function. It’s the money, which benefits the ones, with high proximity to the money creation, but not the general population. It benefits the few and not the many.
The benefitted ones have better credit conditions and are paying less interest than the required base-interest in the economy. This results in the continuous wealth transfer to the benefitted ones (at the cost of all other segments). Crypto money is at the first-hand high store of value money. There are no preferred segments, the proximity to the money creation is the same for all. This money benefits the general population. It benefits the many and not the few.
In every monetary system, there is interest - the price to be paid for using someone else money. In this article, we focus on the “base interest” - i.e. how...
In every monetary system, there is interest – the price to be paid for using someone else money. In this article, we focus on the “base interest” – i.e. how much should be the interest, if there is no credit risk.
We focus here on two topics:
Which factors influence the base interest in the fiat sector?
How much should be the base interest in the fiat sector?
The drivers for the interest are:
Consumption preferences
Time preferences
Rate of base-money production/destruction in the economy
Rate of credit-money production/destruction in the economy
The proximity of individuals to the “money creation” in society
Store of the value function
First, we analyze these factors and then we conclude how much should be the base interest in the fiat economy.
1. Consumption preferences
The output of the economy is expressed as GDP – Gross Domestic Product. There are multiple ways to define what the GDP is, but for this article, we use the following definition – GDP the sum of all income paid to persons (not to the companies, but the natural persons). So, the persons are receiving an income and then they decide how much to consume or to invest/save. The interest is the price for the money, it’s the price, which has to be paid to someone else for delaying his consumption. High interest would imply, that rather a small number of persons would like to delay their consumption – this results in the shortage of money in the economy – therefore the price for money – the interest – will be higher than equilibrium. Low interest would imply, that rather a big number of persons are confident to delay their consumption – this results in the over-supply of money in the economy – therefore the price for money – the interest – will be lower than equilibrium.
By adding all these different wants of different individuals together we will get the fixed income markets, which intermediate between the “endpoints” – between the natural persons.
2. Time preferences
The time factor has his influence too:
Some people want to save their retirement or the schooling of their children – these are long periods.
Other people just want to finance a trip to a sunny beach – these are short periods
If the amount of money in the economy would be constant, then the consumption preferences and time preferences would determine the price for the money – the interest – in the economy.
But as we see in the following – the amount of money in today’s fiat economy is not constant, but continuously growing.
3. Rate of base-money creation/destruction
Central banks are creating/destroying base-money. It exists:
In the form of notes and coins – one as an individual can use them
In the form of electronic base-money – for the payment flows between the commercial banks and central banks (others have no access to the electronic base money)
The amount of base-money is not as stable as you might think. Federal Reserve increased the amount of base money after the 2008 financial crisis by 350%. Swiss National Bank did the same, but by 1’100%. This was called Quantitative Easing. We think Quantitative Perpetuity would be a better term to describe this.
If we look at the total base money growth of all central banks over the last 40 years, then we see the following:
We see continuous world-wide base-money production of ca 12% per year since the 1970s. If one asks, where is the inflation coming from, well – that’s one of the reasons here. Increasing the amount of base-money lowers the interest rate – there is more supply of money in the economy, and the price of money – the interest – will go down. Decreasing the amount of base-money decreases the interest rate – there is less supply of money in the economy, and the price of money – the interest – will go up.
Central banks influence interest as well with the interest they pay for the reserves of commercial banks on their central bank deposits. For example, in Switzerland, this rate is negative – 0.75%. Commercial banks have to pay interest to the Swiss National Bank (and not vice versa as one would think).
The hypothesis is that negative interest rates will stimulate bank lending – the idea being that banks would rather put the money into the circulation instead of paying interest to the central banks for their deposits. Well, the reality is, however, that these costs are just passed over to the consumers.
4. Rate of credit-money creation / destruction
The biggest part of the money is not the base-money but the credit-money. The amount of credit-money is changing even more than the amount of base-money.
Commercial banks create credit money when the loans are issued; commercial banks destroy credit money when the loans are paid back. In the relative terms – 90% – 97% of the money is credit money, created by private organizations – by the commercial banks.
The money that you have on your bank accounts is not the base-money from the central banks, it’s the credit-money created by the commercial banks. The only way for the non-bank-entities to use the base-money is to use the coins or the notes (they are issued by the central banks).
The amount of credit-money can grow and can decline in the economy. If more loans are issued than paid back – then the amount of the credit-money is growing in the economy. This means there is more money supply, which leads to lower interest – the price for the money. If more loans are paid back, then issued – then the amount of credit-money is declining in the economy. This means there is a declining money supply, which results in increasing interest – the pice for the money.
The amount of total credit money (so-called M3) is growing by 5% – 6% per year. One could say that every unit of credit-money is then devalued by the same ratio year by year (there is rather a constant amount of the real assets and continuously growing amount of the credit-money).
This continuos devaluation of the money-units means from another side the inflation for the end-users. The interest paid to the lenders should compensate for the continuous devaluation of money.
5. Store of the value function
The store of value function derives from the other parameters. It’s listed here because it’s very different for the fiat monetary system as compared to the crypto monetary systems.
The world economy had mainly deflationary scenario 1870 – 1910. After WWI it’s mainly the inflationary scenario. The deflationary scenario benefitted the savers – their money was worth more and more, the deflationary scenario enabled the middle class to emerge.
The inflationary scenario – our current fiat system scenario – benefits the debtors – they have to pay back less and less real value. This scenario hurts the middle class as well via pension fund mechanisms. The value of the pension funds should grow at least as much as the loss of value through inflation. But as this is not the case, then the pension funds pay-outs will be much smaller as required for keeping the life-standards of the middle-class.
Benefitting the savers is the store of value function of the money. Now, if the amount of credit-money in the economy is growing ca 5% – 6% per year – meaning every unit of credit-money is devaluing by the same ratio – then how is it possible to have a store of the value function in today’s fiat money?
Well, it’s clear, the current fiat monetary system does not possess any store of the value function. It’s an inflationary monetary system, where the wealth creators of the economy – the middle class – will discover latest by their retirement that after working all their life, they have not created any wealth for themselves…
6. Proximity to the money creation
If a debtor has to pay less interest, then the fair interest in the economy, then we have hidden wealth transfer to the debtors. It’s because of the following – if inflationary money is losing more value than the interest, which the debtor has to pay than the debtor is benefitting financially from this transaction.
The wealthy have to pay little interest, which is less than the fair interest in the economy. This results in the hidden wealth transfer to the wealthy.
The non-wealthy have much higher interest, which usually higher than the fair interest in the economy. This results in the hidden wealth transfer away from the non-wealthy.
Why are there different interest rates for the wealthy and for the non-wealthy? Well, it’s the proximity to the money creation, it’s the proximity to the commercial banks’ lending, which counts. The wealthy, which are closer to the commercial banks, will do better and the non-wealthy, which are definitively not close to the commercial banks, will do not so well.
Wealthy individuals and big corporations have easier access to credit creation via commercial banks. They have to pay much lower interest. Consumer segments, however, have reduced access to the credit. They have to pay much higher interest for the same nominal values.
Central banks quantitative easing, which started after the Lehman crisis, set the goals to facilitate the lending. But it didn’t work – the QE landed in the bank accounts of corporations or big banks. Little of this trickled down to the general population, to the non-wealthy.
It’s the proximity to money creation, which counts in the current financial system. If commercial banks don’t want to lend to the Small Medium Enterprises or consumers, then they will not do this. Pushing QE into the economy, will not force private organizations (banks) to do more lending. Pushing QE means only, that the wealthy are becoming more wealthy.
7. How much should be the base interest based on inflation?
Inflation is defined as a loss of purchasing power of money. Mainstream macroeconomy presents the orthodox view that healthy inflation is always required and healthy for the economy. U.S. Fed for example targets 2% inflation per year.
This struggles us because the productivity increases continuously due to the innovation, which should lead to the decline of the prices, i.e. to the deflation (opposite of the inflation). This healthy deflation is beneficial to the savers because they will be able to consume more real assets (opposite to today’s situation, where money buys less and less).
However, as central banks are using monetary instruments to create inflation, then we have inflation in the economy.
Back to the interest – the base interest in the economy should be at least as much as the inflation, i.e. it should compensate for the loss of the purchasing power of the money.
This leads us to the question – how much is the inflation in today’s economy? We have to distinguish between the:
Official inflation and
Real inflation
Official inflation calculation is “kind of optimized” – let’s think here on the transfer costs (health insurance costs are not included) and substitution effects (one should eat chicken if beef prices grow too much). The fact is that the official inflation calculation was changed in the 1990s. It is now circa 2.5% in the U.S. Real inflation, based on the before 1990’s method, should be around 6% per year in the U.S. (please have a look at the www.shadowstats.com for the backgrounds).
This implies that the base interest should be ca 6% in today’s economy.
8. How much should be interest based on the rate of total money growth?
There is a total output of the economy (GDP) and there is a total amount of the money in the economy (so-called M3).
There are two scenarios for the base interest:
Inflationary scenario – The amount of money is growing faster than the output of the economy. Money can buy less and less – the purchasing power of money will decline.
Deflationary scenario – The amount of money is growing at a slower speed than the output of the economy. This would be a natural scenario due to the continuous productivity increase through continuous innovation.
The first scenario helps the party’s with huge liabilities – for example, our governments. Having higher inflation allows to reduce nominal liabilities, it allows to “inflate” the debt away.
The second scenario helps anyone, who is borrowing for investing in the real assets – either for buying a house or for the retirement or for the kid’s education. This scenario is the best for the middle class.
The rate of credit money growth is circa 6% in the U.S, based on the discontinued government M3 statistics, however, recalculated by ShadowStats:
This implies the base interest should be as well ca 6%. Otherwise, the money would lose his value just by staying on the bank account.
9. Why are the central bank interest rates so low?
Central banking is driven by the philosophy that there has to be inflation in the economy. Negative inflation (or deflation), which would be actually beneficial for the savers, is considered something very bad by the central banks…
Central bankers will explain their view in the following way – if the value of money will increase over time, then the consumers start to delay consummation decisions; enterprises will not invest, and all economy will become to the standstill.
Well, central bankers forget that, for example, the U.S. economy before the creation of Fed was a deflationary economy – it was economic boom time and it was the time where the savers become wealthier.
But why then this misconception in today’s central banking? Well, the trigger is the amount of credit money in the economy. Today’s economy is significantly over-leveraged by debt. The pre-Fed economy had much lower debt ratios. There was a clear separation of the base money (gold) and credit money in the pre-Fed area. Credit money was temporary and was always reversed back into the base money (gold). This system didn’t allow to create debt bubbles. It’s not the fear of deflation, it’s the fear of the debt bubble, which keeps the central bankers inflating the system. Our current system doesn’t have a clear separation between the base-money and credit-money. Credit-money was supposed to be temporary and always reversed back to the base-money. But this is missing – we have not temporary but a permanent credit-money, which leads through inflationary policies to ever-growing bubble.
By lowering the central bank short term interests, by Quantitative Easing, by lowering the balance sheet requirements to the commercial banks – all these instruments are there to create an additional amount of credit-money and via this additional inflation and to prolong the status quo.
10. Reflection
Let’s reflect the key points from here:
Base interest in the economy based on the credit-money growth should be around 6% (if lenders receive less than they lose value)
Base interest in the economy based on real inflation today should be around 6% (if lenders receive less than they lose value)
Access to credit is challenged to the majority of the population. The banking system should bring financing to the end-points of the economy, but the “money does not arrive in the real economy”. The ones, who have higher proximity to the money-creation, have access to the credit. The others (the 99%) are in a challenging position.
The wealthy, who have high proximity to the money creation, have to pay lower interest rates than the real base interest in the economy. The un-wealthy, with their low proximity to the money creation, have to pay higher interest rates than the base interest.
The results in continuous wealth transfer from the un-wealthy to the wealthy, from the ones who are not close the financial institutions to the ones who have high proximity to the financial institutions – year by year, generation by generation.
The current fiat money intermediation system is “kind of de-functional” in the current state.
It is not designed to keep and expand the middle-class. It’s current design and implementation leads to a continuous wealth transfer from the non-wealthy to the wealthy. It leads to a society with 1% and the rest.
World today is by a big extent influenced by the wealth pyramid, so that to 1% of people own 46% wealth in the world. It is known, that the rich become richer and we have got somehow used to it. We don’t question it, we see it almost as normal.
But why is it like this? Why is the wealth in the world distributed so unevenly? How did it come that 3.7 billion people have only 2.7% of the world wealth?
One of the main reasons is our current banking system — the fiat money system. It creates the impression that stable money is available in the world, right? But behind the scenes, the amount of money is continuously expanded and the unfortunate side effect is that from the money creation profits rich class and poor class sees only inflation of prices.
Even if the poor class has an impression of stable money, relatively they can buy less and less for their money as profits from the fiat money creation accumulate to the rich class.
Why does it
happen so? Key drivers here are the proximity to the money creation
(commercial banks do this) and having access to the credit on favorable
terms. We can summarize this as follows:
Rich class is closer to the credit creation via commercial banks and they have easier access to the credit.
The poor on the other side have much less access to the credit or they have access on very challenging terms. Credit is, not always, but very often, the basis for wealth creation.
20% of GDP receives 80% of credit money (corporations and rich individuals) and vice versa in modern economies — i.e. the credit is not equally distributed in the society.
Simulation of wealth pyramid with fiat-money-system parameters
Effect of the fiat money creation system on the wealth pyramid is clear. Rich become richer and the poor become poorer.
What can we do? Cryptocurrencies created non-government controlled money. It is a big step forward. But it is not enough. We need more. We need to distribute profits from money creation (seigniorage) evenly in the world.
Therefore, we created SmartCredit.io. To make the world a better place, to have more even wealth distribution in the world, to give chance to the non-included people in our world and to reduce inequality in our world!
In the previous article, we looked at the two dimensions of money — base money and credit money. We also looked at the different kind of monetary systems that existed in the...
In the previous article, we looked at the two dimensions of money — base money and credit money. We also looked at the different kind of monetary systems that existed in the last 5’000 years and possible scenarios for the future.
The key question is — will it be different this time? Will we enter a phase of crypto-based money without having some form of crypto-credit money or will credit money be included in the crypto sector?
Classification
Here is the summary of the monetary systems from the past 5’000 years.
The first conclusion from the previous article is that monetary systems are not static, but are ever evolving:
The monetary system started with commodity-based money and decentralized credit money.
The next phase was sovereign coin-based money and decentralized credit money.
The next phase was national-based money (either from the sovereign or central bank) and private-credit money.
The next phase was the current central banking based money and its central credit money system.
The second conclusion is that the decentralized credit money system has existed for thousands of years without central intermediaries.
How did decentral credit money worked in the past?
As we are in the crypto age, let’s analyze how decentralized credit systems worked in the past.
It was all based on the bill of exchange — these are legal documents enforced by the court system. Anyone can issue a bill of exchange, it has only 8 attributes, including the wet signature of the borrower. The borrower has to pay, not to the issuer, but to the owner of the bill of exchange. This gives value to every bill of exchange as they are backed by the borrower’s obligation to pay. This allows the use of bills of exchange as a mean of payment:
Bills of exchange are enforced by the court system — there is no court hearing, there is only validation of the evidence, analysis of who has to pay whom, and a court decision. It is as simple as that.
The bill of exchange system is a P2P system backed by the court system. Every lender can create new credit money — the bills become the credit money, till they are paid back to the holder. One doesn’t need banks to create the credit money, every person can do this via a bill of exchange.
This system works as well today, even without the blockchain. This system has been the basis of all decentralized credit money systems in the last 5’000 years.
But there are limitations to this system:
Wet signature has to be used — digital signatures are not accepted by the court system.
Nominations of the bills were arbitrary — tokenization was not possible.
Time periods on the bills of exchange were different.
Insurance mechanisms were missing, except the strong support from the court system.
Bill of exchange networks could become arbitrarily complex, with multiple borrowers, lenders, and holders. But without central middlemen:
How could it work in the future
Here is a more detailed view of how it could work:
Elastic crypto credit money is created in P2P borrowing/lending transactions.
Elastic crypto credit money is destroyed when the loan time period is finished.
Bitcoin, Ether, and stablecoins serve as base money.
A pulsating supply of elastic crypto credit money is placed on top of the base money.
It would work very similar to the bill of exchange system, but it has to address the weaknesses of the previous systems:
Bills of exchange cannot be used because of wet signatures — We have to use standard contract law.
Different nomination issues — Tokenization of loan obligations via standard ERC20 contracts.
Different time periods of the bills of exchange — Tokenization via standard ERC20 contracts help here.
Insurance mechanism is missing — Decentralized insurance mechanism will be introduced.
Forecast
Our forecast for the future is the following:
There will be a national crypto-base money like Venezuela’s Petro.
There will be a decentrally created crypto credit money on top of the national base money.
In parallel, there will be a global base money (BTC, ETH, …).
In parallel, there will be a global decentralized credit money.
This future does not depend on central bank based money creation or commercial bank credit money creation. Instead, it will be an alternative financial system. However, it’ll not really be a new system as it has existed for the last 5’000 years. Only this time it will be empowered by the blockchain.
Roadmap
Our forecast roadmap:
It all started 10 years ago with the creation of decentralized crypto-based money — Bitcoin.
5 years ago, decentralized programmable smart contracts were added.
Now we are in a phase where stablecoins are emerging.
In 5 years, there will be decentralized elastic crypto credit money
Summary
This time
will not be different, there will be crypto credit money as well. It’s
not yet there, but it might be there faster than anyone is anticipating.
During presentations about money, we usually hear that money has to be durable, portable, divisible and fungible. We fully agree with this distinction. However, there is a bigger picture. Money...
During presentations about money, we usually hear that money has to be durable, portable, divisible and fungible. We fully agree with this distinction.
However, there is a bigger picture. Money doesn’t have just one dimension, it actually has two — the base money and the credit money. The notes and coins in your wallet are the base money. The money what you have in your bank account is actually the credit money.
This article:
Analyses how base money and credit money work today.
Analyses how base money and credit money worked in the last 5’000 years.
Discusses credit money in the crypto sphere.
Below is a picture of the first known credit money, from Mesopotamia, from ca 2’500 B.C., now in the possession of the British Museum in London:
The intuitive answer to the key question of this article will be — yes. Since credit money has been around for so long, it will be around in the future as well.
But how?
The crypto sphere today does not have any form of credit money. Bitcoin, Bitcoin Cash, Ether, etc. can only be used as base money because credit money has to be dynamic. Credit money is elastic; it is created and destroyed every time we perform economic transactions.
Base money versus the credit money
Let’s start with how they work today. Base money is created by central banks and credit money is created by commercial banks. Base money constitutes about 3% — 7% of today’s money, the rest is credit money.
Credit money is elastic, it’s amount grows and declines together with economic transactions. More economic transactions result in more lending which results in more credit money and vice versa.
This elasticity parameter is the key reason why we say that Bitcoin, Ether, etc. are not a form of credit money, but base money.
The supply of credit money also rises and falls — additional economic activities lead to additional demand for credit and reduced economic activity to reduced demand.
Credit money is, by principle, rather temporary. However, in our current monetary system, we create more credit money than we destroyed, resulting in the continuous growth of the total credit money available circa 5% — 7% per year.
How is credit money created today?
Credit money is created by commercial banks in the lending process (no, commercial banks are not lending your grandma’s deposits, they create credit money by the so-called “balance sheet extension” procedure).
Credit money is created every time you receive a loan from a bank and destroyed every time you pay back a loan. The money, which you have in your bank account, is not as durable as you might have thought — there are continuous cycles of destruction and creation happening in the background.
Banks create credit money and protect it with their reserves (for example, the Deutsche Bank which has a balance sheet to equity ratio of 100:1) and there are national deposit insurances as well (for example, the Swiss deposit insurance, which has reserve funds to cover 4% of all Swiss deposits).
In practical terms, banks do the following:
Banks protect the value of the credit-money which they have created with this mechanism.
Well, what happens if this mechanism fails? No problem, it’s fixed by creating more of the same (creating more credit money):
The central banks will create additional base money and push it into the circulation via commercial banks. (Quantitative Easing) or
Lending criteria are simplified (for example, Federal Reserve interest rate is reduced or the balance sheet to “mark to model equity” requirements are relaxed) so that more and more credit money will be created via lending. Or
Governments will take on more debt and try to pump it into the real economy to stimulate the multiplication effect (this only works in cases of real investments, doesn’t work in cases of just spending).
Obviously, this mechanism will result in inflation (sooner or later) or in deflation (if no-one wants to borrow anymore), but as this happens later, then this is someone else’s problem.
Some people say that this system reminds them a little of the “musical chairs game”. We think that’s wrong — it IS the musical chairs game.
Monetary systems now and in the past
Monetary systems have always been made up of base money and credit money. The differences lie in:
Who is creating base money?
Who is creating credit money?
Our current fiat monetary system is actually not very old, it started in the time period between the Federal Reserve creation (1913) and the gradual gold standard abolishment (1933 — nationalizing gold in U.S., 1944 -Bretton Wood agreement, 1971 — removing gold backing from USD base money, 1992 — removing gold backing from CHF base money).
Our fiat system looks as follows:
How did it work before our fiat system? Through the following:
Practically, commercial banks created their own private credit money, which was exchangeable for physical gold.
Central banks created the national base money, which was backed by and exchangeable for gold.
This system started to emerge around the time period of the creation of the first central banks (in Sweden and England in 1660’s) and lasted until the Federal Reserve was created in 1913.
There were several sub-phases during this time — free banking areas, gold-based systems, some countries introduced central banks earlier, some later. In some cases, the central banks were “independent”, in other cases there were state treasuries, etc.
The key to this phase was however
Base money was backed by a commodity — gold.
Commercial banks created their own private credit money, which they protected with their reserves.
The earlier phase started around 500 B.C. and lasted until 1660. The first coins were created around 500 B.C. — this was the time when the standing armies in Europe, India, and China had to be financed — they were financed with sovereign minted coins.
In the beginning, the coins were usually 100% gold or 100% silver. Then later the kings started to reduce the ratio of precious metals in the coins — this caused hidden inflation in base money. However, the coins were legal tender and one had to accept them.
In the time period when the Phoenicia, Islamic Trading Network, Mediterranean and Hanseatic Trading Networks existed. Decentralized credit money was created, in peer to peer transactions. Obligations to pay were used as bearer notes which could be used to pay third parties, who could pay fourth parties and so on. In the end, the borrower had to pay to the owner of the bearer note.
So, the key to this phase was:
Base money was created by sovereigns and was inflated slowly.
Credit money was created decentrally by people in peer to peer transactions.
But how did it all work before 500 B.C? There were many blossoming civilizations during that time and the following are common to all of them:
Commodities — gold, silver, grain, shells — were used as base money.
Credit money was created decentrally.
However, governments and sovereigns were not involved in the definition of what the base money had to be — the people decided it. Neither did they define how credit money had to work — the people also decided it. There was no government involvement. But there was a court system for enforcing contracts. And there was a government system for enforcing the court’s decisions.
The first known credit money is from Mesopotamia, from about 5’000 years ago. It was created decentrally, in peer to peer transactions. Mesopotamia used grain as their base money — the unit of account was a barrel of grain. On top of this was the decentralized peer to peer credit money, in this case, clay plates with the stamps of the borrowers.
Obviously, the barrels of grain were not easy to use in daily transactions. This facilitated the usage of clay plates based credit money even more.
Classification of the monetary systems
By using base money and credit money dimensions we can classify the monetary systems of the last 5’000 years as follows:
The current crypto sphere doesn’t have the credit money approach, but none of the civilizations in the past has survived without credit money. Which leads us to the next question:
How will it work in the future?
The first conclusion is that credit money has been always there. It has been created either as:
Decentralized peer to peer transactions.
Private credit money of commercial banks.
Central credit money of commercial banks.
The second conclusion is that we are presented with two different possibilities to create base money:
Controlled creation of base money — in this case, it’s created by central banks or sovereigns.
Uncontrolled creation of base money — in this case, commodities like gold, silver or grain are used as base money.
Uncontrolled creation of base money means that a commodity, which cannot be manipulated, will be used as the base currency. The Swiss National Bank has increased its amount of base money by 10x in the last 10 years since the Lehman crisis. One cannot do this with commodity-based base money.
U.S. Courts have defined Bitcoin as a commodity. Some people are unhappy about this. However, we are very satisfied with this — it allows us to move back to the commodity-based monetary systems (which are then by definition, non-manipulatable).
But what’s about the crypto credit-money? If we use the Bitcoin as our base money, who will create crypto credit money? In the end, there are 3 possibilities — decentralized credit money, privatized credit money or centralized credit money.
Summary
Credit-money has been around for the last 5’000 years. No key civilization from the last 5’000 years has survived without using elastic credit money of one form or another.
But credit money is currently missing in the crypto sector. Bitcoin, Bitcoin Cash, Ether, etc. have the characteristics of base money. They are missing various characteristics, the elasticity, the continuous creation, and destruction, and more of credit money.
So, who will create elastic credit money for the crypto sector?
Will it be created by the existing commercial banking infrastructure? Probably not since the crypto sector will not accept the “old world credit money”.
Will it be created decentrally without commercial banking? Probably yes!
Our thesis is that the pendulum will move back to where we started:
We will have commodity based base-money (Bitcoin, Ether, …).
We will have decentrally created elastic credit money.
The court system will be there for enforcing the agreements.
The government will be there for fulfilling the court’s decisions.
It will be the same as it was in Mesopotamia 5’000 years ago. But this time empowered by the blockchain.
We were presenting at the Blockercon Conference in Bristol (https://blockercon.com) in June 2019 about our favorite topic - Crypto Credit-Money - Why do we need it? Here are the Slideshare...
We were presenting at the Blockercon Conference in Bristol (https://blockercon.com) in June 2019 about our favorite topic – Crypto Credit-Money – Why do we need it?
Here are the Slideshare slides of this presentation
[slideshare id=161340702&doc=programmableelasticcreditmoney004-190805192742]
SmartCredit.io is close to launching our platform. This platform shows in real life how to create decentral crypto credit money. Decentral credit money is created in the same way, as it has been created in the last 5’000 years – via the lending process. And it’s destroyed in the same way, as it has been done in the last 5’000 years – via payments of principal and interest. Everything is the same, as it was for thousands of years – but this time it’s empowered by blockchain.
In this scenario there are no banks involved – it’s peer to peer platform. Today’s banks earn high profits from credit money creation, it’s called seigniorage. It is estimated to be 3% of the principal. Now, let’s imagine this seigniorage will not belong to the selected view (commercial banks), but it will be distributed via decentral lending into the society. Just imagine what would be the effect of this for the wealth distribution in society.
We would be very happy if you look at our conference presentation and our pilot demo as well.
Thank you!
I was presenting on 28th of November 2018 at the moontec.io conference in Tallinn, Estonia about the monetary systems and about why one will need credit money in the crypto...
I was presenting on 28th of November 2018 at the moontec.io conference in Tallinn, Estonia about the monetary systems and about why one will need credit money in the crypto sector.
I was happy with the participants of the conference, not only could they understand what the others were telling them, but they could as well synthesize new ideas!
SmartCredit.io
