Is Crypto a Scam?

No More Than Paper Money Is

Cryptocurrencies

The rise of cryptocurrencies appears baffling at first sight. Unlike normal electronic money, the kind that you transfer from your bank account to a vendor, there is not even the illusion of something “real” behind cryptocurrencies.

And yet, Bitcoin is at an all time high of around USD 75,000, and the market is now chock full of Bitcoin imitators, with oddball names like Brett, Solana, and so on, all being bought and sold with real money, like company stocks, but seemingly without any tangible backing.

At least, when you buy Apple stock, you are buying shares in a company, with tangible assets that you can touch. But what exactly are you buying when you buy Solana?

It seems like a mania, and it may very well end up like one, with most cryptocurrencies crashing to zero. However, it is not all fluff. And to understand why, you have to go back to the dawn of human history.

Hunter-Gatherers

Modern humans arrived on the scene around 200,000 years ago, with most of our ancestry going back to Africa. A relatively small group, less than 500 people, managed to migrate out of Africa around 70,000 years ago, and leave descendants (there may have been earlier migrations, but they left no descendants).

The members of this small group were phenomenally successful, as everyone who is not of sub-Saharan African origin is descended from them, except that somewhere along the way, they also managed to interbreed with Neanderthals, and to a lesser extent, with Denisovans, related human species which separated from the human lineage around 800,000 years ago.

Until the rise of agriculture, around 10 to 12,000 years ago, human beings lived as hunter-gatherers, which meant that there was hardly any economic surplus, and they lived in small groups, so the group basically produced what it consumed.

In other words, there was not much trade, and what little exchange there was could be carried out quite effectively through a barter system.

The Rise of Agriculture

All this changed with the rise of agriculture, which not only created settled communities, but also generated an agricultural surplus, which then was expropriated by a ruling class, creating both an economic hierarchy as well as inequality.

Inequality is generally considered to be a bad thing, but by concentrating a little bit from each of many into the hands of a few, it allowed for the concentration of wealth, which in turn led to human advancement (though it was painfully slow) — an egalitarian society would not have been able to build pyramids.

It also allowed for specialization of labor, as the agricultural surplus could support people who could do non-agriculture (so to speak) — whether it was making pots, forging metal weapons, or becoming scribes.

This in turn created a significant increase in the number of different items that could be traded…which created a problem. It is relatively easy to have a barter system when you have a few items that need to be traded, but when you have many, the number of prices increase exponentially.

For example, if you only have cows, pots, wheat, and fur clothing to trade, you will have six possible combinations (so much wheat for one pot, and so on). But when you have a thousand items, you have almost half a million possible combinations. Trade becomes unwieldy.

Money as a Reference Point

But what if you could express the price of everything relative to one item only? It could be cowrie shells, salt, silver, gold, or even widgets — it doesn’t really matter. Then each item would be priced against this standard item, so 1,000 tradable items would only have 1,000 prices.

As a significant additional advantage, you can now even cater for fractional prices. For example, it would be very difficult to engage in barter trade if I only have cows to trade, but I just need one small pot.

Ultimately, at least in Eurasia, silver and gold became almost ubiquitous choices as reference points for exchange.

It was a quantum leap in conceptual terms, because unlike in a barter economy, where you were exchanging goods that had intrinsic value, because they could be utilized in some way, gold has no intrinsic utility — you can’t eat it or wear it.

It was merely a store of value, convenient to hold, and moreover quite “dense” — not only in the physical sense, but also in terms of how much of everything you can get for relatively little of it.

Trusted Money

Then there was a second quantum jump, which was far more significant. This was the leap from the tangible to the intangible.

Imagine that there is a kingdom that mints gold and silver coins. For example, in the Islamic world, silver and gold coinage was standardized in the form of the dirham (typically around 3 grams of silver) and the dinar, a coin containing around 4.25 grams of gold.

Now imagine that you come to buy some cows from me, and offer me a choice: A gold nugget weighing 4.25 grams, or a dinar. If I trust the king in whose name the dinar was issued, I will be willing to give you more cows for the dinar than the gold nugget of the same weight, because who knows how pure the nugget is?

Even if I have a means of assaying the nugget, and am convinced of its purity, it is not just what I believe, but what is generally accepted by people “out there” that matters.

This is a critical point, for we have now reached a stage where the gold coin has some additional value, an intangible portion, over and above the 4.25 grams of tangible gold it holds, simply because society as a whole finds that coin to be more “trustworthy.”

Paper Money

The next stage in the evolution of money more or less coincided with the rise of capitalism, as banks or finance houses came into being, and started issuing paper receipts for the gold or silver that had been deposited with them.

It became more convenient for people to simply exchange these paper receipts when making transactions, instead of going through the laborious process of going to the bank, getting their metal, and then using the metal as the means of exchange.

These paper receipts were ultimately formalized as bank notes issued by a reputable authority, which did not even have to be a central bank, so long as it had people’s trust.

For instance, in England, in the late seventeenth century, the one-pound note was pegged at just over 112 grams of sterling silver, and then pegged further to gold in 1717, with the price of one ounce of gold fixed at 3.89375 pounds, effectively making gold 15.38 times more expensive than silver (the corresponding differential at the time of writing is over 80 times).

Thus, through most of the seventeenth to nineteenth centuries, anyone could have gone to the Bank of England, and exchanged pound notes for actual gold.

Metal-Backed Currencies

Of course, every bank note was not fully backed by gold, so the amount of paper currency in circulation was (say) ten or twenty times the actual amount of gold that was available in the bank’s vault.

This is analogous to the way that a bank does not keep enough cash to pay off every depositor in full, but carries just enough to meet its withdrawers’ normal transactions, while investing the balance.

There was however a problem with linking a finite resource that was difficult to mine, such as gold, to the amount of currency circulating in the market, and this was due to the rise of capitalism, which created a significant increase in human productivity.

Put simply, the total amount of goods and services that an economy was producing soon started rising faster than the amount of currency in circulation, so that the nineteenth century had periodic problems with deflation, i.e. too little money “chasing” too many goods — the exact opposite of the inflationary crises that we are used to.

Bretton Woods and the Rise of Fiat Money

The era of metal-backed major currencies continued in one form or another until 1944, when in a conference at Bretton Woods, the major economic powers agreed to peg their currencies to the US dollar, and the Americans agreed to back the US dollar with gold, at the rate of USD 35 per ounce.

Unfortunately, over the next few decades, the Americans were profligate with the printing of money, until they reached a point where they had no hope of ever redeeming all the dollars that they had printed for actual gold.

On 15 August 1971, President Richard Nixon, facing the inevitable, made a fateful decision: To delink gold and the US dollar, finally putting an end to the convenient fiction that paper money was backed by anything.

Gold or silver may not have had much utility, but at least they were tangible and seemed to have intrinsic value. In contrast, while paper money seems tangible, in the sense that you can hold it in your hand, that “tangibility” is rather nominal.

In practical terms, therefore, the USD (or GBP or SGD or whatever) note you hold in your hand has no intrinsic value at all.

Then why do we accept this paper as a store of value? Because with many, many millions of types of goods and services that we can buy or sell, it is simply practical for us to pretend that the paper in our hand is a (temporary) store of value, at least until we can exchange it for something else.

But — and this is the key point — the paper has value only if the majority of people accept it as such.

If a majority of us decide that we no longer trust the government that issued the paper, or that government has printed too much of it, then the paper becomes worthless, which is another way of saying hyperinflation — just ask the Germans of the Weimar Republic.

Which brings us to cryptocurrencies.

Crypto and the Future

In essence, a cryptocurrency is no different from a bank note or paper currency, except that it has not been issued by a government bank.

Some pieces of paper, like the SGD, are more trustworthy than others, while others, like the USD, are accepted simply because there is no other choice. Then there are the ones that are scraping the bottom of the barrel, for which I will not give a paper currency example.

In a similar way, some cryptocurrencies, like Bitcoin, are more trusted, which is why it is selling for tens of thousands of dollars. Others are not, which is why they are selling for minute fractions of a US dollar.

Ultimately, like paper money, all cryptocurrencies are just stores of value, like gold or silver. But again, this capacity to act as a store is dependent on us — if tomorrow, for whatever reason, a majority of people decide that Bitcoin does not serve this function, its value will drop to zero.

So what does this mean for the future? This is anybody’s guess, but the internet has democratized things, and taken power away from centralized authorities. One can view the rise of cryptocurrencies as continuing this trend.

Taken to its logical end, we can imagine a future where virtually all government-issued notes wither away, as people stop trusting governments. At the other extreme, we can also imagine a situation where central bankers manage to wrest control back, and cryptocurrencies die a natural death.

Either way, a prudent investor would be wise to move away from abstract stores of value, whether crypto or paper, and shift to tangible stores of value that also happen to have utility, like real estate.