Money and hardness
In this excerpt from "Money, Bitcoin and Time", Robert Breedlove explains the role of money and what hard money is.
This is an excerpt from a larger resource named Money, Bitcoin, and Time by Robert Breedlove.
Story of Money [1]
Let’s begin with first principles and follow logic from there. The simplest form of human exchange is the direct trading of actual goods, say guns for boats, in a process known as direct exchange or barter. Direct exchange is only practical when few people are trading few goods. In larger groups of people, there are more opportunities for individuals to specialize in production and trade with more people, which increases the aggregate wealth for everyone. This simple fact, that exchange enables us to produce more goods per hour of human effort is the foundation of economics itself:
Economics is the social science of increasing production per unit of contribution.
Larger groups of people exchanging goods mean larger markets, but also creates a problem of non-coincidence of wants — what you are seeking to acquire by trade is produced by someone who doesn’t want what you have to offer. This problem has three distinct dimensions:
Non-coincidence in Scales — imagine trying to trade pencils for a house, you cannot acquire fractions of a house and the owner of the house may not need such a large amount of pencils
Non-coincidence of Locations — imagine trying to trade a coal mine in one place for a factory in another location, unless by coincidence you are seeking a factory in that exact location and the counterparty you are dealing with is seeking a coal mine in that precise place, the deal will not be completed since factories and coal mines are not movable
Non-coincidence in Time Frames — imagine trying to accumulate enough oranges to trade for a truck, since the oranges are perishable they would likely rot before the deal could be completed
The only way to resolve this three-dimensional problem is with indirect exchange, where you seek to find another person with a good desired by the counterparty and exchange your good for theirs only to, in turn, exchange it for the counterparty’s good to complete the deal. The intermediary good used to complete the deal with the counterparty is called a medium of exchange – the first function of money. Over time, people tend to gradually converge on a single medium of exchange (or, at most, a few media of exchange) as it simplifies trade. A good that becomes widely accepted as a medium of exchange is commonly called money.
Money offers its users pure optionality, as it can be readily exchanged for any good available in the marketplace. In other words, money is the most liquid asset within a trade network. In this sense, money is said to have the highest salability, meaning the ease with which it can be sold on the market at any time with the least loss in price. Salability of a good is relatively determinable by how well it addresses the three dimensions of the non-coincidence of wants problem:
Salability across Scales — a good that is easily subdivided into smaller units or grouped together in larger units, which allows the user to trade it in whatever quantity desired
Salability across Space — a good that is easily transported or transmitted over distances
Salability across Time — a good that can reliably hold its value into the future by being resistant to rot, corrosion, counterfeit, unpredictable increases in supply and other debasements of value
It is the third element, salability across time, that determines a good’s utility as a store of value — the second function of money. Since the production of each new unit of a monetary good makes every other unit relatively less scarce, it dilutes the value of the existing units in a process known as inflation. Protecting value from confiscation via inflation is a critical feature of money, and money is critical to the existence of flourishing trade networks.
Hard Money
Hard money is more trustworthy as a store of value precisely because it resists intentional debasements of its value by others and therefore maintains salability across time. The hardness of a monetary good, also known as its soundness, is determined by the stock of its existing supply and the flow of its new supply. The ratio which quantifies the hardness of money is called the stock-to-flow ratio:
‘Stock’ is the existing supply of monetary units
‘Flow’ is the newly created supply over a specified time period, usually one year
Dividing the stock of a monetary good by its flow equals its stock-to-flow ratio
The higher the stock-to-flow ratio, the greater the hardness (or soundness) of money
The higher the stock-to-flow ratio, the more resistant the money is to having its value compromised by inflation. There are no correct choices as to forms of money, however there are consequences to what form a market naturally selects. If people choose to store their wealth in a monetary good which exhibits less hardness, then the producers of this monetary good are incentivized to produce more monetary units, which expropriates the wealth of existing unit holders and destroys the monetary good’s salability across time. This is the fatal flaw of soft money: anything used as a store of value that can have its supply increased will have its supply increased, as producers seek to steal the value stored within the soft monetary units and store it in a harder form of money. As many historical examples in this essay will demonstrate, any monetary good which can have its supply cheaply and easily increased will rapidly destroy the wealth of those using it as a store of value.
For a good to assume a dominant monetary role within an economy, it must exhibit superior hardness with a higher stock-to-flow ratio than competing monetary goods. Otherwise, excessive unit production will destroy the wealth of savers and the incentives to use it as a store of value. Particular goods achieve monetary roles based on the interplay of people’s decisions. It is from the chaos of complex human interactions that monetary orders emerge.
Takeaway Distributing goods and services efficiently across a society requires an abstraction of value that functions as a medium of exchange. There are some criteria that such a money needs to meet to become widely used. Its hardness - how difficult it is to create more of it - is fundamental to it being able to survive as money over time.
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